For many libertarians, the single most important policy reform today would be abolishing the Federal Reserve and replacing it with competing currencies issued by unregulated, private banks. Ron Paul has repeatedly introduced bills to abolish the Fed and has made the issue a key theme of his presidential campaigns. Many libertarians get involved in efforts to use silver as a medium of exchange, such as the Liberty Dollar and Shire Silver.
Why do so many libertarians think that abolishing the Fed should take such a high priority? Some economists have explored the history and theory of “free banking,” such as Larry White and George Selgin. But I suspect many libertarians derive their monetary ideas not from reading White or Selgin, but from Ron Paul or lurid, conspiratorial books like The Creature from Jekyll Island. One commonly encounters views such as, “The Fed is creating hyperinflation that will destroy the value of the dollar,” and, “The Fed prints money to fund the government’s war machine.”
It’s important to note that these views are not correct. The main way that the Fed creates money is by reducing the interest rate it charges to member banks, not by buying government bonds. The main beneficiaries of this new money are member banks and debtors. Recently, the Fed has undertaken large purchases of government bonds, activities that have come to be called “quantitative easing.” But the reason for quantitative easing has not been a desire to fund the “war machine,” but the sincere belief of central bankers that monetary stimulus is effective at bringing an economy out of a severe recession. A further round of quantitative easing now appears unlikely, and so does massive inflation. The Fed doesn’t like inflation beyond a low, consistent level, because the Fed is largely comprised of career bankers and academic economists who realize that high or variable inflation erodes savings and leads to malinvestment.
Isn’t the Federal Reserve a “central planner”? Central planning is bound to fail, so market economists believe. Therefore, shouldn’t the Fed be headed for a fall?
I don’t think the Fed actually is a central planner. The Fed doesn’t determine the actual money supply directly. It can’t force people either to hold or to spend money. It can’t even force its own member banks to loan money. The Fed does tinker with monetary instruments to try to harness the business cycle, often unsuccessfully. The Fed deserves its share of criticism, but there are several reasons why in 21st-century America, its power is limited.
First, the U.S. lacks capital and exchange controls. If you want to convert dollars to gold, silver, platinum, oil, land, or euros, you’re free to do so. Therefore, there is an important competitive constraint on the Fed that central planners don’t face. If the Fed inflated too much, people would get rid of their dollars, the value of the dollar would fall, and the Fed’s monetary policy would become increasingly irrelevant. (If the Fed were orchestrating massive inflation, we would expect to see capital and exchange controls imposed.)
Second, the U.S. doesn’t ban exchange in currencies other than dollars, or force anyone except creditors and government bodies to accept dollars in payment. Most Americans use the dollar because it’s proved to be a convenient medium of exchange and unit of account. It’s passed the market test. Even an advocate of a fully private, deregulated banking and currency market like myself has to concede that such a system would face more costs in this area. In a more competitive system, merchants would have to assess the validity and reliability of each note or coin passed to them. In practice, they are likely to accept only notes from the most reputable issuers, such as the Federal Reserve!
Third, the U.S. government doesn’t actually ban banking outside the Federal Reserve system. Almost all banks choose to join the system because in doing so they enjoy the substantial benefit of taxpayer-subsidized deposit insurance. Now, deposit insurance truly is a bane on the financial system, infecting it with great moral hazard. Because of deposit insurance, most bank customers consider only the interest rate when they choose a bank, a sure incentive for banks to take on risky assets.
So instead of abolishing the Fed, why not argue for abolishing deposit insurance, allowing financial institutions to suspend payments in order to forestall runs, and enacting a credible ban on all future bailouts? Once that happens, the Fed will be more or less just one more note issuer in a competitive market. But don’t expect a business-cycle-free utopia to take hold. The Fed has made plenty of mistakes, but they have also learned how to avoid creating another great depression or another great stagflation. Obsession with free banking makes much less sense than obsession with, say, ending the war on drugs or reforming entitlements.