Central banks’ inflation destroys currencies and worsens the boom-bust cycle. Milton Friedman reckoned that computers would do far better.
In What Causes – and How to Prevent – Bank Crises (27 March), I showed that there’s a straightforward way – which entails no change of legislation or regulation – virtually to eliminate the probability that a bank fails. Unfortunately, no bank will adopt these means to render itself impregnable. Why should it? Contemporary banking enriches an anointed few, and it’s of no consequence to them that it impoverishes many others.
The same is true of central banking – and thus the Federal Reserve System and Reserve Bank of Australia. Like Milton Friedman, a giant of 20th century non-Keynesian economics, I acknowledge that the Fed and RBA won’t be abolished anytime soon – but as a matter of logic, evidence and morality, which this wire outlines, I also believe that they should be.
Now is the perfect time to consider whether the RBA earns its keep. In July of last year, the Treasurer, Jim Chalmers, announced a Review of the Reserve Bank of Australia. “The Review,” says its web site, “is designed to ensure that Australia’s monetary policy arrangements and the operations of the Reserve Bank continue to support strong macroeconomic outcomes for Australia in a complex and continuously evolving landscape.”
The Review’s terms of reference rest upon this false premise; consequently, its conclusions will, too. The reviewers submitted their report to the Treasurer on 31 March. He’s said that he’ll release it, as well as the government’s initial response, before the federal budget on 9 May.
It’s a pity: the review’s terms preclude the most sensible recommendation. Indeed, it’s a tragedy: above all, central banks create inflation; and most of all their inflation harms the poor – the very people whom the government claims to champion. If it really seeks to “ensure that Australia’s monetary policy arrangements … support strong macroeconomic outcomes,” then it should abolish the RBA, sack its employees and replace them with a computer that generates mild, steady and wholesome deflation.
Why Abolish the Central Bank?
Today’s central banks do much harm and little good. Specifically, following the commencement of activist central banking operations,
- The purchasing power of the currency weakens and eventually disintegrates. Central banks generate permanent (and damaging) consumer price inflation, and thereby extinguish healthy deflation.
- Partly as a result of their permanent inflation, “real” (net of CPI) economic growth certainly doesn’t increase – and possibly slows.
- Central banks foment inflation and stagnation; consequently, the frequency of economic and financial manias, panics, crises and crashes accelerates.
Reason #1: Activist Central Banks’ Inflation Destroys Their National Currencies
Most of the time in Britain between 1800 and the Great War, but with notable gaps in the U.S., gold backed paper money. During most of those years, if you didn’t trust the government or want its paper, you could simply swap it for a fixed quantity of gold.
That constraint obliged governments to act prudently. That’s why Britain and other belligerents abandoned the classical gold standard in 1914: sound money and finance are incompatible with the welfare-warfare state.
It’s also why, after the Great War, a bastardised form of the obligation – which Britain and the U.S. disavowed in the early-1930s – replaced the previous one. As this tangible commitment weakened, money increasingly (and, since 1971, when the U.S. repudiated the dollar’s last tenuous link to gold, has totally) reflected the intangible reputation of central banks and the “full faith and credit” (to use the phrase in Article IV of the U.S. Constitution) of the government that issued it.
As the definition of money became corrupted and requirement to exchange gold for paper disappeared, central banks’ and governments’ prudence disintegrated. Yet trust in these institutions, although battered, apparently remains unbroken. (More than 20 years ago, this misplaced faith amazed me; today, it amuses me.)
Given this confidence, new expectations have appeared. Central banks are no longer (as the Bank of England was in the 19th century) conservative lenders of last resort: since the Crash of 1987, they’ve become reckless dispensers of liquidity of first instance – and since the GFC they’ve possessed the grossly distended balance sheets to prove it.
What have been the consequences? Paul Volcker was the Fed’s chairman from 1979 to 1987. He’s been widely lauded as the terminator of the high levels of consumer price inflation that prevailed in the U.S. throughout the 1970s and early-1980s.
“If the overriding objective is price stability,” he reflected in 1995, “we did a better job with the 19th century gold standard and passive central banks (than with today’s fiat money and hyper-interventionist central banks).”
Volcker’s successor, Alan Greenspan, agreed. In 2002 he confessed:
In the two decades following the abandonment of the gold standard in 1933, the CPI in the U.S. nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of convertibility into gold, allowed a persistent over-issue of money.
Volcker and Greenspan were wiser (or at least more candid) than today’s mainstream economists and central bankers, who are as perceptive as Mister Magoo to the consequences of interventionist monetary policy. If CPI rises 3% during a given year, then the currency’s purchasing power (“PP”) falls 3%; and if in the next year CPI again rises 3%, then the cumulative reduction of PP is 0.97 × 0.97 = 0.9409. $1 of PP at the beginning of Year 1 has shrunk to $0.941 by the end of Year 2.
During central banks’ activist era since 1913, year by year, inflation has shrunk – and over the years it has crushed – currencies’ purchasing power.
Figure 1: Purchasing Power of the $US, Annualised, 1800-2022
Using data collated by the Bureau of Labor Statistics, Figure 1 plots the PP of the $US since 1800. In order to highlight the central bank’s destructive effect, it sets PP at $1.00 in 1913 – the year of the Federal Reserve’s formation. The era from 1800 to 1913 certainly didn’t lack inflationary intervals, bank failures, financial crises, recessions and wars. In 1807-1815, for example, which encompassed the War of 1812, PP plunged 30%; in 1833-37, during which occurred the conflict leading to the abolition of the Bank of the United States (a rough predecessor of the Federal Reserve) and the Panic of 1837, it fell 25%; and most notably, in 1858-1865 (in effect, the Civil War) it plummeted 44%. The return to peace – and of the classical gold standard – on the other hand, restored PP to its pre-war level. As a result, during the 113 years to 1913 it averaged $0.93.
Congress passed the Federal Reserve Act in December 1913 – and thereby, as its proponents knew and intended, made consumer price inflation the law of the land. Only during the years 1920-1933 did PP rise; otherwise it’s fallen continuously.
As a result, by 2022 it collapsed to just $0.033 – a destruction of 96.7% since 1913. As Figure 2 demonstrates, the Bank of England’s record is even more abysmal, and the RBA’s (before its formation in 1959, the Commonwealth Bank, created in 1911, performed most central banking operations) worst of all: they’ve destroyed 99% of their respective currencies’ purchasing power!
Activist central banks, in short, don’t combat consumer price inflation and promote price stability: they deliberately create inflation and thereby undermine price stability.
Figure 2: Purchasing Power of the $A, £ and $US, Annualised, 1913-2022
Reason #2: Central Banks Don’t Nurture Economic Growth
Why abolish the Fed and RBA? Following the advent of activist central bank operations, inflation rises – but “real” (that is, adjusted for CPI) economic growth doesn’t increase commensurately; if anything, it falls. Using data from Historical Statistics of the United States (1889-1913) and the Federal Reserve Bank of St Louis (since 1914), Figure 3 plots annual percentage changes of GNP net of the corresponding year’s increase of CPI.
Figure 3: CPI-Adjusted U.S. Gross National Product, Annual Percentage Changes, 1889-2022
From 1889 to 1913, real GNP’s rate of increase averaged 4.5% per year; since 1914, it’s averaged 3.1%. Since the Fed’s advent, in other words, the long-term rate of economic growth has fallen by almost one-third (i.e., 3.1 ÷ 4.5 = 0.69).
Although Figure 2’s trend line slopes downwards, it doesn’t do so in a statistically significant manner. As a result, we can’t conclude that the Fed has crimped growth.
Equally, however, we can’t plausibly assert, as its defenders nonetheless do, that the Fed has maintained and even boosted America’s economic growth.
Reason #3: Central Banks Don’t Prevent – They Foment – Financial Instability
Reflecting upon “the number and severity of banking crises since the mid-1960s,” Charles Kindleberger concluded in Manias Panics Crashes: A History of Financial Crises (John Wiley & Sons, 5th rev. ed., 2005) that “… these decades have been the most tumultuous in international monetary history in terms of the number, scope, and severity of financial crises.” The book’s most recent edition was published before the GFC; in its wake, Kindleberger’s conclusion is even more apposite.
Why abolish central banks? They foment volatility rather than promote stability. “Far from being a failure of free-market capitalism,” the great monetarist economist, Milton Friedman, rightly said of the 1930s,
“the (Great) Depression was a failure of government. Unfortunately, that failure did not end with the Great Depression … In practice, just as during the Depression, far from promoting stability, the government has itself been the major single source of instability.”
Disciples of today’s mainstream typically ignore Friedman. But can they dismiss Ben Bernanke? At the conference to honour Friedman’s 90th birthday, held on 8 November 2002, Bernanke, at the time the Fed’s Governor, stated: “Among economic scholars, Friedman has no peer … One of his greatest contributions to economics, made in close collaboration with his distinguished co-author, Anna J. Schwartz, (is) is nothing less than what has become the leading and most persuasive explanation of the worst economic disaster in American history, the onset of the Great Depression …” Bernanke concluded:
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we (the Federal Reserve) did it. We’re very sorry. But thanks to you, we won’t do it again.
Zealots of interventionist central banking ignore Friedman, and they will say of Bernanke’s confession “the Depression was almost a century ago; since then, the Fed has been a major stabilising force.” Recent research conducted by the Fed (“Loose Monetary Policy and Financial Instability,” Federal Reserve Bank of San Francisco Working Paper 2023-06, February 2023), undermines their claim. “Are periods of persistently loose monetary policy more crisis-prone? (Our) answer to this question is in the affirmative.” In particular,
“We see significant estimates in the medium term, that is, around horizons of five to ten years … We do not find evidence for a positive link between loose monetary policy and financial vulnerabilities in the short term. If anything, point estimates indicate a negative relation between financial fragility and a loose stance at horizons below 4 years … (Yet) … potential short-term gains come at the considerable cost in the form of heightened risk of disasters in real economic activity.”
Michael Shedlock (“Fed Study Shows Loose Monetary Policy Leads to Disaster and Financial Crisis,” 6 March) adds that the San Fran Fed’s conclusion “is welcome but was obvious. The Fed kept interest rates too low, too long three times in the past twenty-some years. The result was a dotcom boom and bust, a housing bubble followed by the (Global Financial Crisis and) Great Recession, and what many call an ‘everything bubble’ right now.”
The bank failures that occurred in March, The Wall Street Journal concludes (“And Now for a Little Bank Panic,” 10 March), are “another painful lesson in the costs of a credit mania fed by bad monetary policy. The reckoning always arrives when the Fed has to correct its easy-money mistakes.”
Noting that the Treasury and Federal Reserve have guaranteed uninsured deposits and offered loans to banks so they can avoid losses on their fixed-income assets, WSJ editorialised (“The Silicon Valley Bank Bailout,”12 March): “This is a de facto bailout of the banking system, even as regulators and Biden officials have been telling us that the economy is great and there (is) nothing to worry about. The unpleasant truth – which Washington will never admit – is that SVB’s failure is the bill coming due for years of monetary and regulatory mistakes.” It concluded that central banks and regulators
have encouraged a credit mania and then failed to foresee the financial panic when the easy money stopped … You can’t run the most reckless monetary and fiscal experiment in history without the bill eventually coming due. The first invoice arrived as inflation. The second has come as a financial panic, with economic damage that may not end with SVB.”
This latest panic and cluster of failures and bailouts is the sixth in a quarter-century:
- In 1998, the Fed engineered a $3.6 billion rescue of the giant (and reckless) hedge fund Long-Term Capital Management;
- In 2001, it slashed interest rates after the Dot Com Bubble burst;
- In the GFC, it backed money-market funds with up to $50 billion, poured almost $500 billion into troubled banks and industrial companies, and purchased more than $1.7 trillion of government securities;
- During the ensuing years, it undertook $9 trillion of “Quantitative Easing” and thereby suppressed rates of interest at unprecedented historical lows;
- In 2020, it monetised more than $1.5 trillion of government deficits.
Central banks have adopted a more or less permanent emergency policy: the answer to virtually every economic and financial challenge is to create tsunamis of additional money and credit. Yet as the bailouts have multiplied and so-called “stimulus” has intensified, stock markets have repeatedly crashed.
“Instead of re-energising the economy,” concludes Ruchir Sharma (“The Unstoppable Rise of Government Rescues,” The Financial Times, 28 March), “the maximalist rescue culture is bloating and thereby destabilising the global financial system. As fragility grows, each new rescue hardens the case for the next one.”
Paul Singer, the founder of Elliott Management whom The Wall Street Journal (“The Man Who Saw the Economic Crises Coming,” 7 April) describes as “one of the world’s most successful hedge-fund proprietors,” agrees. “We think it is very unlikely that central bankers will move to normalise monetary policy after the current emergency is over,” he wrote in April 2020 letter to his investors.
“They did not normalise last time (2008) and the world has moved demonstrably closer to a tipping point after which money printing, prices and the growth of debt are in an upward spiral that the monetary authorities realise cannot be broken except at the cost of a deep recession and credit collapse.”
What Is To Be Done? Milton Friedman’s Proposal
Sweden’s central bank sponsors and finances The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (routinely but erroneously called “the Nobel Prize in Economics”). Not surprisingly, critics of central banking seldom receive the gong. But Friedrich Hayek did in 1974 (to his great irritation, he was a co-winner with Gunnar Myrdal, a left-wing economist and sociologist) and Milton Friedman did in 1976. Years afterward, Friedman repeatedly declared that he would like to “abolish the Federal Reserve and replace it with a computer.”
Most notably, in “Do We Need Central Banks?” (Proceedings of the Seminar on Monetary Management organised by the Hong Kong Monetary Authority, 18-19 October 1993) Friedman stated the obvious: “The central banks of major countries like the United States have far from a spotless record.” In particular,
“I have no brief for the American Federal Reserve System which, I think, performed very badly … by laying the ground-work for a massive inflation during the 1970s. In the 1980s it did move in the other direction and taken as a whole accomplished the objective of bringing down the inflation rate, but … in a rather irregular and uncertain way … Do we need central banks? My answer is no, we do not.”
What, then, to do? “There are (two) ways,” said Friedman, “in which we can avoid having a central bank. One thing … I have recommended at times for the U.S., is that we simply fix the total amount of high powered money: the amount of currency plus reserves at Federal Reserve Banks. Fix it at a stable number, then simply abolish the Federal Reserve Banks and let free banking rule subject to the anchor of a fixed nominal quantity of high powered money. I think that would be a pretty good system.”
Alternatively, “we could replace the Federal Reserve System by a computer, and have a computer calculate month by month how much currency has to be printed in order to achieve a steady rate of growth in the quantity of high powered money over time. Those are the kinds of drastic alternatives that we really need to do without a central bank. Personally, I believe they would be far superior to a central bank but I have no great hopes that central banks will willingly be replaced by computers.”
Friedman advocated monetary arrangements that change the supply of money at a pre-agreed, slow, fixed and unalterable rate. He and his colleague, Anna Schwartz, concluded that otherwise “leaving monetary and banking arrangements to the market would have produced a more satisfactory outcome than (has been) achieved through government involvement” (see “Has Government Any Role in Money?” Journal of Monetary Economics, 1986, vol. 17, issue 1, pp. 37-62).
Isn’t a “Lender of Last Resort” Essential?
A “major function that is attributed to central banks,” Friedman noted in 1993, “is as lender of last resort, and there has been a great deal of argument in the technical literature whether we need a lender of last resort. Personally I do not believe (we) do. Hypothetically it is a useful function: in practice, it occasionally has been useful. But in the main, judged by the record of history, it has done more harm than good.” In particular,
“The assurance banks have that they will be bailed out in case of necessity leads them to behave in an irresponsible fashion. Moreover, when you start bailing out one … then you have to go to another and another, and we now have the formula for the U.S., too big to fail. The doctrine which has been adopted is that you can let small banks fail but you cannot let a big bank fail. That in part has led to a debacle in the banking area in recent decades.”
In 1993, Friedman’s conclusion was prescient; today, it’s even wiser:
“So my own judgment is that there is no need for a lender of last resort, that the market is perfectly capable of providing that function, that if banks go bad, it is best that they fail earlier and not later. They will do less harm if they fail early. So taken as a whole, my conclusion is: we do not need central banks (including their “lender of last resort” function), but we shall certainly continue to have them.”
If the Fed and RBA were abolished, computers replaced them and the supply of money changed at a slow, fixed and unalterable rate, what should that rate be? One thing is certain: it mustn’t be positive; that is, the inflation that underpins the financial orthodoxy of most of the past century mustn’t continue. The rate of change might be 0% and probably should be something in the order of -0.5% to -1.0% per year, i.e., -0.04% to -0.08% per month.
Given this slight and steady monetary deflation, over time consumer prices would fall (certainly they would rise less than otherwise) and rates of interest find their own level in the market – which, given that the currency’s purchasing power would increase, would be lower than otherwise but not stimulatory.
But mustn’t deflation be avoided at all costs? Politicians’ and central banks’ obsession about bailouts in times of crisis, and about stimulus at all times, reflects their – and today’s mainstream economists’ – flawed views about consumer price deflation. These views, in turn, are rooted in the view that it’s always horrendously costly. The truth is very much otherwise. A comprehensive study by the Bank of International Settlements demonstrates that deflation is actually beneficial.
“We test the historical link between output growth and deflation in a sample covering 140 years for up to 38 economies,” said the most comprehensive and rigorous analysis. It found that deflation “may actually boost output, lower prices, increase real incomes and wealth. And (it) may also make export goods more competitive” (see Claudio Borio, et al., “The Costs of Deflations: a Historical Perspective,” BIS Quarterly Review, March 2015).
So here’s my humble proposal, based upon Friedman’s, to Jim Chalmers: use the review of the RBA as the ideal opportunity to abolish it and replace it with a computer which slowly decreases the supply of money at slow but invariable – and thus perfectly predictable – rate.
The central bank’s abolition would provide greater certainty, increase financial and macroeconomic stability, lower consumer prices, boost real incomes and wealth, save heaps of money – and, ironically, give to Australian monetary policy something it’s always lacked: independence. What’s not to like?
Moreover, and unlike its inflation, which is a tax-by-stealth, the abolition of the RBA is moral and ethical. Millions of people throughout the developed world have lost their jobs over the past few decades as a result of the relentless – and, arguably, accelerating – advance of technology. In the future, surely millions more will join them. Indeed, in a report released on 29 March, Goldman Sachs prophesied that “one-fourth of current work tasks could be automated by (Artificial Intelligence) in the U.S. and Europe.”
Why should the RBA’s employees be immune from the effects of advancing technology? These civil servants, like most public sector bureaucrats, do far more harm than good, and in any case computers have rendered them superfluous. Why on earth shouldn’t they be dismissed en masse, join the queue at Centrelink and retrain to do something that helps rather than harms society?
In What Causes – and How to Prevent – Bank Crises (27 March), I showed that there’s a straightforward way – which entails no change of legislation or regulation – virtually to eliminate the probability that a bank fails. Unfortunately, the likelihood is effectively zero that any bank will adopt these means to render itself impregnable.
Similarly, and likely for the same reasons, passive central banks and the classical gold standard aren’t returning: today’s decadent and imprudent culture cannot abide honest money and fiscal discipline. Still less can it tolerate a stable standard of value and rates of interest that tell the truth about time.
As a result, short-term debasement and long-term destruction are fundamental features of the financial and monetary regime that today’s mainstream champions. Its only variables are how much debasement central banks produce from year to year, and how much destruction they wreak over time.
The RBA won’t be abolished, or even reformed significantly, anytime soon. As a result, it’ll continue to resemble today’s universities – which, like leaking nuclear reactors, spew dangerous, long-term contaminants far and wide. Years ago, Charlie Munger, Berkshire Hathaway’s vice-chairman and Warren Buffett closest confidante since the 1960s, saw the truth about universities. The same applies to central banks: “There’s a lot wrong with them,” Munger observed. “It’s amazing how wrongheaded [they are] … I’d remove three-quarters of the [staff] … But nobody’s going to do that, so we’ll have to live with the defects.”