The Fed: Money Wizard Or Wizard Of Oz

April 20, 2012

Economy, Finance, History, Wealth

In November, 2010, George Selgin, an economist at the University of Georgia, gave a presentation on the Federal Reserve System, in which he concludes that in virtually every conceivable respect, the economy performed as least as well pre-1913 (the year the Fed was created) than post-World War II, and usually better. He also finds that there is good reason for believing that, on balance, the Fed has done more harm than good. The rest of this newsletter paraphrases his argument.

The mission of the Federal Reserve as stated in its own publications is:

– To promote the goals of maximum employment, stable prices and moderate long term interest rates.

– To contain financial disruptions and prevent their spread outside the financial sector.

This suggests a simple criteria to evaluate the Federal Reserve’s success. The factors responsible for unemployment are too numerous for an easy separation of the monetary influences. All we can say is that after 1913 we have had some of the worst periods of unemployment in our history. However, it is much more obvious that the Federal Reserve does influence prices. The following is a quote from Federal Reserve Chairman Ben Bernanke on the importance of stable prices:

“Stable prices allow people to rely on the dollar as a measure of value when making long term contracts, engaging in long term planning or borrowing or lending for long periods.”

On this issue of preserving the purchasing power of the dollar the Federal Reserve’s record has been appalling. Between 1790 and 1913 the difference in prices is about 8%, a trivial difference in a 123 year time span. However, from 1913 the dollar has inexorably declined losing over 90% of its value.


Has the creation of the Federal Reserve reduced the level of uncertainty in the economy? This is important because in making long term investments corporations need to make certain assumptions and have at least some idea how realistic they are likely to be. In the last part of the 19th century corporations regularly issued 100 year bonds because they felt confident they knew what the price level was going to be in 100 years. However, the market for 100 year bonds completely dried up after the creation of the Fed. Nowadays nobody issues 100 year bonds because nobody can claim to know with any confidence what the price level will be that far in the future.

If the Fed has been responsible for inflation and increasing uncertainty what about deflation? Maybe the Fed has prevented the occurrence of deflation, which most economists are more afraid of than inflation. Selgin differentiates between two types of deflation – the good and the bad kind. Bad deflation is what happened in 2008 but good deflation is the decrease in prices as a result of technological innovation and increased productivity. The deflation in the pre-Fed period was mainly benign deflation, driven by improvements in supply which meant that more goods could be made for less. After the Fed’s creation the good deflation virtually disappeared. Selgin finds that post-1913 there is hardly any time when the Fed allowed prices to fall even though output improved for most of this period. Furthermore, the bad deflation became worse. The worst deflations occurred in the 1930’s, 1920/21 and in 2008. Selgin concludes that the Fed has wiped out good deflation, given us worse episodes of bad deflation and in other periods worse periods of inflation. If you don’t have time or inclination to listen to the entire presentation read this article from Barrons.


The money powers prey upon the nation in times of peace and conspire against it in times of adversity. It is more despotic than a monarch, more insolvent than autocracy, and more selfish than bureaucracy. It denounces as public enemies all who question or throw light upon its crimes. I have two great enemies, the Southern Army in front of me and the bankers in the rear. Of the two, the one at my rear is my greatest foe.” Abraham Lincoln



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About Malcolm Greenhill


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