Anti-Fed Hysteria

Austrian-School libertarians such as Ron Paul claim that the Fed is responsible for runaway inflation and its monetary policies are always bad for the economy.

Historical facts say they are wrong.

The basic point is this: the existence of a central bank (such as the Fed) is merely a tool. Doing away with them will no more do away with inflation than banishing headaches by outlawing aspirin.

There are multiple evidences that reject the claim that the Fed (or the existence of a central bank) causes high inflation. For one thing, cross-country evidence shows there is a negative correlation between the independence of a central bank and inflation. And eliminating that central bank trivially reduces seigniorage independence to zero.

How does that pan out in the American experience? The is the inflation rate during the American Civil War (1861-1865) when the US did not have a central bank:

1861 5.96%
1862 14.17%
1863 24.82%
1864 25.14%
1865 3.68%

This is the inflation rate (see link above) in the US during WWII, when the US did have a central bank:

1941 4.99%
1942 10.66%
1943 6.13%
1944 1.73%
1945 2.27%

Guess which war was more driven by inflation?

How did the US finance the Civil War? By effectively running the printing press; in contrast, WWII was financed through war bonds. While this might seems like a trivial difference, greenbacks were effectively currencies, and war bonds, which are far less liquid, has the incidental effect of causing lower inflation. The proof is in the pudding.

The claim that doing away with the Fed will in and of itself lower inflation rate is only true when compared some pie-in-the sky libertarian financial utopia that has never existed on planet earth. The point is not that the Fed cannot cause inflation, but that unless you plan to never fight a war, having an independent central banks tempers the impulse to finance the war through the printing press.

Now it is also true that on the aggregate that inflation rate is lower pre-Fed than post-Fed. But this fact alone undermines the claim that the Fed monetary policy makes the economy worse off. During the pre-Fed era, this low inflation is achieved via extreme deflation. For example:

1861 5.96%
1862 14.17%
1863 24.82%
1864 25.14%
1865 3.68%
1866 -2.53%
1867 -6.82%
1868 -3.91%
1869 -4.14%
1870 -4.24%

Let's say you're an industrialist in 1860 and you want to built a factory. You know that the venture will give you a 7.5% return, and you take out a 10 year, 5% loan from the bank. This would have been your real interest rate.

1861 -0.96%
1862 -9.17%
1863 -19.82%
1864 -20.14%
1865 -2.68%
1866 7.53%
1867 11.82%
1868 8.91%
1869 9.14%
1870 9.24%

Look at how the extreme swing would have made this venture basically impossible, even though it would have made the economy better off. Banks who made this loan would basically become insolvent due to inflation incurred in 1861-1865, and industrialist would become bankrupt in 1866-1870 due to the high real interest rate resulting from deflation. You can't exactly have capitalism without, you know, flow of capital.

The typical libertarian rejoinder is that the Fed is distorting the economy and the most efficient thing is to let the economy behave as it does- extreme swings in inflation rates. I have a simple response to that. War also distorts the economy, why not pretend you can outlaw that too?

The other Austrian libertarian rejoinder is this: everything will be fine as long as we adopt the gold standard. Again, history shows why this is wrong. The world was on a gold standard... until the gold standard itself became toxic. We tried it. It failed. This is a non-solution.

This is not to say that central banks are infallible or that the Federal Reserve did not make any mistakes, but there is a long way between saying A is bad in some vague sense and ~A is better than A. The former does not automatically imply the latter.