Monetary Policy in the United States: An Intellectual and Institutional History
Government Intervention in Banking Has Caused Crises and Failures
MAY 01, 1994 by STEVEN HORWITZ
Both the public and most economists have generally agreed that of all the sectors of the economy, the production of money and financial services requires a significant amount of government intervention in order to work “properly.” The common view is that, more than any other industry, supposed laissez-faire has failed consistently in banking and has been responsible for various crises, panics, and difficulties throughout American history. This trend has begun to reverse itself in the last twenty years, however, as more economists and bankers are beginning to understand how regulations can destabilize the banking system and how various free-market alternatives might provide monetary order.
Richard Timberlake’s study is sure to push this debate to the next level. In a comprehensive and readable book, he carefully scours the history of American banking from Colonial times to the early 1990s to document the increase in government intervention and its deleterious effects on both the banking industry and the economy more broadly. His book is a perfect complement to the more technical and statistical work of Milton Friedman and Anna Schwartz and will likely, like their work, be considered a classic of monetary history.
Two themes form the backbone of Timberlake’s historical story. The first is the way in which increased government intervention has occurred not because laissez-faire has failed, but because various interventions served the revenue-raising interests of the political sector. Timberlake carefully documents how each of those interventions led to further crises and failures, resulting in calls for even more government regulation and more problems down the road. Although he does not mention it explicitly, the story he tells is a perfect historical example of what Ludwig von Mises called the “logic of interventionism.”
Timberlake’s second theme is that this increasing encroachment by government has moved us away from the rule of law in the monetary realm, to the rule of all-too-fallible humans. Each successive intervention undermined the Constitution’s attempts to prevent government from doing any more than stipulating the gold or silver content of the medium of exchange, leaving the production of money to the private sector. As earlier systems and now the Federal Reserve System have led to increased government power, the quantity of money and the range of financial services available have become the products of intentional human-designed policy, rather than the more automatic and unintended consequences of the market.
The danger in this shift is that when human policymakers are unable to provide rational solutions, they will turn to those policies that work to their own self-interest, or the interests of the political actors to whom they answer. As Timberlake’s historical story reveals, one of the primary purposes of various bank regulations and other government powers has been to facilitate growing government deficits and the vote-seeking of elected officials.
For example, one of the regulations of the National Banking System (1863-1914) forced banks to purchase federal government bonds to serve as collateral for the currency they created. This law provided the federal government with a captive market for its bonds, both to finance the Civil War and other government expenditures. The result was a lack of flexibility in the currency supply leading in turn to the periodic panics during the late 1800s and early 1900s. Many would ascribe these crises to the failure of the market, but as Timberlake and others have demonstrated, the problems of the system were the result of mistaken, and politically self-interested, regulations.
A second example Timberlake notes is the Fed’s acquisition of open market powers in the mid-1930s. The Fed increases the supply of bank reserves by buying government debt in the open market. Having this power enables the Fed to purchase, if it so chooses, any level of debt Congress creates. Without such powers, debt creation is limited to the amount the public willingly purchases. With open market operations, the Fed can always buy any amount of debt the public does not voluntarily wish to hold. Congress was more than happy to give the Fed open market powers so that it could finance the debt of both the New Deal and World War II.
These are only two examples of the kind of historical evidence that Timberlake has documented. Some of his best work is on the 1960-1990 period, particularly the inflation of the late ‘70s. He also effectively demolishes the myth that monetarism was tried and failed in the 1979-82 period as well as unmasking the confusion that underlay most Fed policy since World War II.
Of particular importance is his discussion of the final nail in the coffin of the gold standard the closing of the international gold window in 1971. Franklin Roosevelt had ended the American public’s ability to exchange Federal Reserve Notes for gold in 1934, but foreign holders of U.S. currency could redeem them for gold at a stipulated price. This process put some limits on the Fed’s ability to increase the money supply. However, as Timberlake argues, President Johnson’s decision to finance the Vietnam War and the Great Society through inflation forced the end of even international redemption.
As the money supply grew in the mid and late 1960s, more foreign recipients of U.S. dollars began to return them to the Fed, leading to a significant outflow of gold. Rather than lose the gold or reduce inflation, President Nixon ended international redemption in 1971. Since then the U.S. dollar has been a complete fiat currency. Once again, the spending proclivities of the federal government drove monetary policy in directions that benefited the political process at the expense of the general public.
Timberlake’s book is sure to quickly become a genuine economic classic. Unlike many such books, however, it is readable by the nonspecialist and of important relevance for current events. As Washington is debating the consolidation of bank regulatory agencies, and the possibility of a new regulatory push, a careful examination of the history of bank regulations, and their role in causing monetary disorder and economic disaster, could not be more important. Richard Timberlake has given us just such an analysis, and a masterful one at that.