In the wake of the longest recession since the Great Depression, policymakers have contemplated many monetary policy reforms. While some of these ideas, such as the Fed Oversight Reform and Modernization Act of 2015 (the FORM Act), introduced by Representative Bill Huizenga (R–MI), have received support in the U.S. House of Representatives, the Senate has yet to undertake substantial reforms. Going forward, Congress should implement policies that allow monetary competition in the U.S. It is often assumed that money is best supplied by a central authority, but monetary economists have long-acknowledged that the improved efficiency and reliability of free enterprise can also apply to the provision of money.
Government Monopoly on Money Is Not Necessary
Nobel-winning economist Milton Friedman is perhaps best known for advocating that central bank discretion be replaced by a rule that would automatically grow the money supply at some fixed percentage. It is often forgotten, however, that in 1986, Friedman (along with co-author Anna Schwartz) argued that “leaving monetary and banking arrangements to the market would have produced a more satisfactory outcome than was actually achieved through government involvement.” Friedman even proposed putting such a system, based on the work of F. A. Hayek, into place by freezing the monetary base of U.S. dollars and allowing banks to competitively issue notes redeemable in dollars.
The Federal Reserve Has Not Fulfilled Its Promise
Economic instability is often blamed on the fact that there was no U.S. government monopoly of currency until after the creation of the Federal Reserve. Research has shown, however, that government regulations—not competitive note issuance—were major causes of monetary difficulties in the U.S. prior to the 20th century. Regardless, the overall track record of the Federal Reserve shows that the U.S. experiment with central banking has not fulfilled its promise. Aside from the fact that two of the worst economic downturns in the nation’s history occurred on the Fed’s watch, well-documented data deficiencies have caused key pre-Fed-era data to appear more volatile than was previously believed.
Even when the disastrous interwar period is excluded, updated data suggest that the average length of recessions, as well as the average time to recover from recessions, has been slightly longer in the post-WWII era than in the pre-Fed era. Furthermore, while the variability in inflation declined after 1977, when the Fed received a formal price stability mandate, the average rate of inflation increased. In the post-WWII era, the long-term purchasing power of the dollar has declined, the U.S. price level has become more difficult to forecast, and the benign deflation that arises from improved productivity has all but disappeared.
A Free Market in Money Does Not Fix All Economic Problems
Policymakers should not expect that leaving money and banking to the market will completely eradicate consequences (or sources) of macroeconomic instability such as unemployment and inflation. Neither, however, should they expect legal restrictions and government monopoly to produce such a benefit. Policymakers should apply this perspective to the theoretical case for privately produced money as well as to the history of successful competitively issued money regimes. More than 60 episodes of competitive private note issue have been identified, with well-studied episodes in Scotland, the U.S., Canada, Sweden, Switzerland, and Chile.
Despite the successful history and the theoretical case for privately produced money, it is difficult to imagine any private currency replacing an established national currency such as the U.S. dollar. Such an outcome is particularly unlikely if the Federal Reserve acts as even a moderately good steward of the national currency, but that is precisely why a government monopoly is unnecessary. Monetary policy is likely to be worse when shielded from competition and better when competing against alternative monies. As with any privately produced good or service, no inferior form of money would be expected to replace an economy’s preferred medium of exchange.
Congress should implement reforms that allow the U.S. to move toward a competitive monetary system. Reforms should ensure that the Federal Reserve embraces its role as a facilitator of money creation by competitive banks, and that it does not usurp the role of the private banking sector. Each of the following ideas—many of which are complementary—would help achieve these goals.
- Allow Private Innovations to Flourish. Mutually beneficial exchange is the central element of economic freedom, and this centrality extends to the right to choose a preferred medium of exchange. Furthermore, monetary policy is likely to be worse when shielded from competition, and better when competing against alternative monies. Congress can allow alternative currencies to flourish by removing several key barriers to entry in the market for money. In particular, Congress should modify capital gains tax laws, modify certain statutes concerning private money, address bank secrecy and anti-money-laundering laws, and modify legal tender laws to respect freedom of private contracting.
- Require the Fed to Select a Short-Term, Rules-Based Policy. Congress can greatly improve transparency and predictability by requiring the Fed to adopt a rules-based monetary policy. For example, the approach offered in the FORM Act would require the Fed to choose its own monetary policy rule. It would also give the Fed the flexibility to stop following its policy rule, provided that it explains its decision to Congress.
- End the Federal Reserve’s Emergency Lending. Section 13(3) of the Federal Reserve Act allows the Federal Reserve Board of Governors to authorize Fed District Bank lending to “any participant in any program or facility with broad-based eligibility” in “unusual and exigent circumstances.” Dodd–Frank amended this so-called emergency lending authority after the 2008 crisis, but even if these restrictions had been in place, the Fed still would have been able to conduct many of the lending programs that allowed it to prop up failing institutions. The Fed can conduct monetary policy without emergency lending authority.
- Replace the Fed’s Primary Dealers with a System-Wide Auction. The Fed conducts its open-market operations with approximately 20 financial firms known as primary dealers. This system broke down during the 2008 crisis, and allowing all banks to participate in open-market operations would likely provide a more liquid interbank lending market. The Fed successfully used the Term Auction Facility to inject liquidity into the market during the 2008 crisis, and this program could be modified to replace the current primary dealer system. Replacing the current system in this manner would make the system-wide liquidity provision less cumbersome and also mitigate the notion of systemically important firms.
- End the Fed’s Role as a Financial Regulator. A central bank does not need to be a financial regulator to conduct monetary policy. Allowing the Fed to serve as a financial regulator increases the likelihood that monetary policy decisions will be compromised as the Fed’s employees become embedded in the firms they oversee. The fact that Dodd–Frank imposed a nebulous financial stability mandate on the Fed only increases this possibility. Aside from these recent changes, it is completely unnecessary for the U.S. central bank to serve in a regulatory capacity. Removing the Fed from its regulatory role would leave at least six other federal regulators overseeing U.S. financial markets.
- End the Fed’s Reverse Repo Program. The Fed’s Overnight Reverse Repurchase Facility (ON RRP), whereby the Fed borrows cash from market participants and uses its own securities as collateral, represents yet another expansion of the Federal Reserve’s reach into financial markets. The program increases systemic risk and marks a drastic departure from previous open-market operations because it turns the Fed into a borrower of last resort. The fact that the Fed is testing new ways to influence additional short-term credit markets only underscores that its aggressive quantitative easing policies have damaged markets and should be reversed sooner rather than later.