The Fed Needs Reform: Six Changes for Monetary Policy


The Fed Needs Reform: Six Changes for Monetary Policy

April 1, 2016 6 min read Download Report
Norbert Michel
Norbert Michel
Former Director, Center for Data Analysis
Norbert Michel studied and wrote about financial markets and monetary policy, including the reform of Fannie Mae and Freddie Mac.

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.[1] 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.”[2] 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.[3]

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.[4] 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.[5] 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.[6]

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.[7] Furthermore, while the variability in inflation declined after 1977, when the Fed received a formal price stability mandate, the average rate of inflation increased.[8] 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.[9]

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.[10] 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.[11]

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.[12]

Recommended Reforms

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.[13]

  • 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.[14]
  • 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.[15]
  • 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.[16]
  • 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.[17] 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.[18]
  • 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.[19]
  • 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.[20]
—Norbert J. Michel, PhD, is a Research Fellow in Financial Regulations in the Thomas A. Roe Institute for Economic Policy Studies, of the Institute for Economic Freedom and Opportunity, at The Heritage Foundation.

[1] See Milton Friedman, A Program for Monetary Stability (New York: Fordham University Press, 1960), and Milton Friedman, “The Role of Monetary Policy,” American Economic Review, Vol. 58 (1968), pp. 1–17, (accessed March 4, 2016).

[2] Milton Friedman and Anna Schwartz, “Has Government Any Role in Money?” Journal of Monetary Economics, Vol. 17 (1986), p. 59.

[3] See Milton Friedman, “Monetary Policy for the 1980s,” in John H. Moore, ed., To Promote Prosperity: U.S. Domestic Policy in the Mid-1980s (Stanford: The Hoover Institution, 1984), pp. 21–22, (accessed March 1, 2016), and F. A. Hayek, Denationalization of Currency: The Argument Refined, An Analysis of the Theory and Practice of Concurrent Currencies (London: The Institute of Economic Affairs, 1976), (accessed March 5, 2016). Monetary scholar George Selgin has since extended Friedman’s proposal. See George Selgin, Less Than Zero: The Case for a Falling Price Level in a Growing Economy (London: Institute of Economic Affairs, 1997), pp. 67–69, and George Selgin and Lawrence H. White, “How Would the Invisible Hand Handle Money?” Journal of Economic Literature, Vol. 32, No. 4 (1994), pp. 1718–1749.

[4] Section 18 of the Federal Reserve Act gave national banks 22 years (until 1935) to retire the bank notes they had issued. Federal Reserve Act, Public Law 63-43, 63rd Cong., December 23, 1913, Section 18, (accessed March 5, 2016).

[5] See Ignacio Briones and Hugh Rockoff, “Do Economists Reach a Conclusion on Free-Banking Episodes?” Econ Journal Watch, Vol. 2, No. 2 (1995), (accessed March 5, 2016).

[6] Christina D. Romer, “Remeasuring Business Cycles,” The Journal of Economic History, Vol. 54, No. 3 (September 1994), pp. 573–609. Also see Norbert J. Michel, “Federal Reserve Performance: Have Business Cycles Really Been Tamed?” Heritage Foundation Backgrounder No. 2965, October 24, 2014, (accessed March 4, 2016).

[7] When the entire Federal Reserve period is compared to the pre-Fed period, the frequency of recessions has not decreased. See Michel, “Federal Reserve Performance: Have Business Cycles Really Been Tamed?”

[8] From 1948 to 1978, the average inflation rate was 3.56 percent, and its standard deviation was 3.03 percent; from 1979 to 2013, average inflation rose to 3.74 percent, with variation of 2.78 percent. See Norbert J. Michel, “Federal Reserve Performance: What Is the Fed’s Track Record on Inflation?” Heritage Foundation Backgrounder No. 2968, October 27, 2014, (accessed March 4, 2016).

[9] See Michel, “Federal Reserve Performance: What Is the Fed’s Track Record on Inflation?”

[10] See Selgin and White, “How Would the Invisible Hand Handle Money?” Also see Gerald Dwyer and Norbert J. Michel, “Bits and Pieces: The Digital World of Bitcoin Currency,” Heritage Foundation Backgrounder No. 3047, September 16, 2015, (accessed March 1, 2016).

[11] Kurt Schuler, “The World History of Free Banking,” in Kevin Dowd, ed., The Experience of Free Banking (London: Routledge, 1992), pp. 7–47; Kevin Dowd, “Introduction,” in The Experience of Free Banking, pp. 1–6; and Briones and Rockoff, “Do Economists Reach a Conclusion on Free-Banking Episodes?”

[12] The concept known as Gresham’s law—that bad money drives good money out of circulation—is sometimes erroneously invoked as an argument against currency competition. Gresham’s law applies when government regulation requires different monies to be traded at the same price irrespective of the value to consumers and firms. A more general implication is that people conduct exchanges with the type of money that involves the least sacrifice. Thus, ultimately, the best money wins out. See Robert Mundell, “Uses and Abuses of Gresham’s Law in the History of Money,” Zagreb Journal of Economics, Vol. 2, No. 2 (1998), pp. 3–38, (accessed June 23, 2015).

[13] Details on each of these reform ideas have been discussed in several Heritage Foundation policy papers, each of which is referenced below. Also see Norbert J. Michel, “A Roadmap to Monetary Policy Reforms,” Cato Journal, Vol. 35, No. 2 (Spring/Summer, 2015), (accessed March 1, 2016).

[14] See Dwyer and Michel, “Bits and Pieces: The Digital World of Bitcoin Currency.”

[15] See Norbert J. Michel, “Why Congress Should Institute Rules-Based Monetary Policy,” Heritage Foundation Backgrounder No. 2991, February 11, 2015, (accessed March 1, 2016).

[16] See Norbert J. Michel, “Dodd–Frank’s Title XI Does Not End Federal Reserve Bailouts,” Heritage Foundation Backgrounder No. 3060, September 29, 2015, (accessed March 1, 2016).

[17] See Primary Dealers List, Federal Reserve Bank of New York, (accessed March 30, 2016).

[18] See Michel, “Dodd–Frank’s Title XI Does Not End Federal Reserve Bailouts,” and George Selgin, “L Street: Bagehotian Prescriptions for a 21st Century Money Market,” Cato Journal, Vol. 32, No. 2 (Spring/Summer 2012), (accessed March 1, 2016).

[19] See Michel, “Dodd–Frank’s Title XI Does Not End Federal Reserve Bailouts”; Michel, “A Roadmap to Monetary Policy Reforms”; and Marvin Goodfriend and R. G. King, “Financial Deregulation, Monetary Policy, and Central Banking,” Federal Reserve Bank of Richmond Economic Review (May/June, 1988), pp. 3–22.

[20] See Norbert J. Michel, “Federal Reserve’s Expansion of Repurchase Market Is a Bad Idea,” Heritage Foundation Issue Brief No. 4261, August 14, 2014, (accessed March 1, 2016); and Norbert J. Michel and Stephen Moore, “Quantitative Easing, The Fed’s Balance Sheet, and Central Bank Insolvency,” Heritage Foundation Backgrounder No. 2938, August 14, 2014,


Norbert Michel
Norbert Michel

Former Director, Center for Data Analysis