Who Will Guard the Monetary Guardians?

“Do we really need the FR?” — Ronald Reagan, 1981[1]

Gerald O’Driscoll raises several questions that the American public and their elected representatives ought to be pondering as the U.S. central bank celebrates (?) its centennial.  Regrettably, the first question many people may have is “What is the Fed and what does it do?”  An excellent recent John Stossel hour-long program is a great contribution to the task of educating ordinary people about our central bank.

Of course, even people who know something about central banking may be asking themselves “Can an advanced country in the 21st century have a stable, reliable banking system without a central bank?”  O’Driscoll points them to literature about places and times where countries, including the United States, did not have a central bank.  Specifically, there is considerable scholarly research into the varieties of what is generically called “free banking,” which is not the same as “unregulated, unsupervised wildcat banking” that is probably still taught in high school American History classes.

O’Driscoll addresses the question, “Why do we even have central banks?” by briefly summarizing the episodes in history in which governments got themselves in a fiscal bind and needed more cash to spend than the tax system would raise, so having a central bank with a printing press came in handy.  For the past few centuries central banks certainly have been more efficient in ballooning the money supply and creating inflation than in Roman times when melting down gold and silver coins and adding in some lead was the preferred method.

However, O’Driscoll does note that the fiscal needs of government were not the original reason for creation of the Federal Reserve System a century ago.  Basically, the United States had an archaic banking regulatory structure that had left the country with thousands of small, often unit, banks that were subject to bouts of illiquidity, bank runs, insolvency, and failures.  Because of the political impossibility of reforming and modernizing the private banking system, Congress created a system of twelve regional “bankers’ banks” that were intended to bring stability to the volatile private banking system.  At the time, the chief architect of the Federal Reserve, Congressman Carter Glass of Virginia, claimed that the Federal Reserve was not a central bank because we were on the gold standard and did not have the authority to create money.

Probably the most challenging question raised in O’Driscoll’s essay is the following: “What are the risks of doing nothing?”  Currently, the U.S. inflation rate is reported to be quite low, so it is hard to get people to think much about the dangers of central banking.  For the many people who think, “If it ain’t broke, don’t fix it,” O’Driscoll draws the connection between budgetary deficits and the national debt.  At its root, monetary policy is a fiscal instrument in a fiat currency world.  The power to create money is the power to tax, because inflation is merely a form of taxation.  It is a regressive tax—it hurts lower income people more than the rich—it is a dishonest tax, and it strains the social fabric of nations.  Nevertheless, throughout history it has been politicians’ preferred form of taxation.

In economics, the true burden of taxation is whatever the government spends.  All current expenditures of government as well as promises to spend in the future must be paid: (1) out of current tax receipts; (2) out of future tax receipts—budgetary surpluses; or (3) via the implicit tax of debasing the currency through inflation.

Politicians find it difficult to restrain government spending, they know the voters do not like broad-based tax increases, and perpetual deficits are both unpopular and create economic distortions that make us poorer.  As a consequence, the very existence of central banks with the power to buy the government’s bonds with newly created money causes moral hazard in other institutions of government.  Even when it is widely understood that sluggish economic growth reflects perverse taxation and regulatory policies of government, politicians find it irresistible to attempt to correct the mistakes of the rest of government by printing money.        

As O’Driscoll points out, when monetary systems are on a gold standard central banks cannot do great harm because monetary discipline is assured by the necessity to exchange surplus paper currency for gold.  That limits the amount of money in circulation, so inflation is contained.  However, once the link between the nation’s currency and gold or silver is severed, a crucial restraint on government spending is missing.

This point was well understood by James Madison.  In drafting the Constitution, in considering what kind of monetary system the new country should have, Madison wrote,

It cannot be doubted that a paper currency, rigidly limited in its quantity to purposes absolutely necessary, may be equal and even superior in value to specie.  But experience does not favor reliance on such experiments.  Whenever the paper has not been convertible into specie, and its quantity has depended on the policy of the Government, a depreciation has been produced by an undue increase, or an apprehension of it.[2]

Later, Madison addressed the question of maintaining fiscal discipline if the country created a central bank with the power to create money, “But what is to ensure the inflexible adherence of the Legislative Ensurer to their own principles and purposes?”[3]

This is the essential question that must be answered.  In the past century, all forms of institutionalized restraints on the size and scope of governments—limitations on their current expenditures and on their promises of future payments—have been tested and failed.  Constitutions, treaties, statutes, and specie-standards for currencies have all been pushed aside, repealed, revoked, or simply ignored.

Proposals for answering Madison’s question range from simply trying again to put teeth into previous approaches, to bolder ideas that are new and even global.  The challenge of institutionalizing discipline is not avoided by a simple “balanced budget amendment” to the Constitution.  Politicians are at their most imaginative and creative when it comes to avoiding having to say “No” to constitutional limits on spending more money:  Witness the fiscal messes facing state governments even though they are required to balance their budgets every year. Some ambitious ideas call for grand human design requiring major international consultation, cooperation, and even treaties. Less ambitious ideas would rely on the competition of human actions that would result from the end of central bank monopolies of currency.    


[1] Ronald Reagan, handwritten note on correspondence he received from Gordon Luce while President of the United States, 1981.  Reagan Library archives, FG 143033198.

[2] Padover 1953: 292; see Dorn 1988: 90–91] Dorn, J. A. (1988) “Public Choice and the Constitution: A Madisonian Perspective.”  In J. D. Gwartney and R. E. Wagner (eds.) Public Choice and Constitutional Economics, 57–102.  Greenwich, Conn.: JAI Press.

[3] Madison, James. Letter to Mr. Teachle, March 15, 1831.

Also from this issue

Lead Essay

  • Gerald P. O’Driscoll reviews the history of central banking. He argues decentralized banking is possible, but getting there will be difficult. Under a commodity money regime, central banks are neither necessary nor particularly dangerous, while under a fiat money regime, central banks are capable of exerting substantial influence on monetary policy. The Fed’s use of that influence has been, in O’Driscoll’s words, “unenviable.” Governments have come to depend on central banks to run deficits and spend more than they otherwise could. To do without central banking, however, we will first have to shrink the federal budget itself, and this will be no easy task.

Response Essays

  • Lawrence H. White explains that the Federal Reserve has “dramatically increased secular inflation.” Additionally, it has increased price level uncertainty, while failing either to tame the business cycle or to reduce unemployment. Instead, throughout its history, it has bowed to political pressures and expanded the money supply again and again.

  • Scott Sumner argues that monetary policy needs to respond to crises, and that commodity standards don’t meet that test. He argues that a politically independent central bank tasked with keeping a low rate of inflation will generally be able to fulfill that obligation, and that rigid monetary regimes do much greater harm when they ultimately collapse. In particular, the failures of such regimes have usually been attributed to free-market capitalism, and the result is ever-greater financial regulation.

  • Jerry L. Jordan argues that legislative restraints on monetary policy tend to fail; in this area, we just can’t trust government to watch itself. Standards intended to preserve the value of the currency have all fallen, as legislatures simply find it too convenient to siphon away value through inflation. Jordan is skeptical even of a balanced budget amendment, noting that state governments with such amendments have still come to fiscal grief. One of his most important concerns is that the public right now is dangerously apathetic about this underappreciated issue.