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The Federal Reserve and the Dollar Lewis E The Federal Reserve and the Dollar Lewis E. Lehrman To evaluate the history of the Federal Reserve System, we cannot help but wonder, whither the Fed? and to consider wherefore its reform—even what and how to do it. But first let us remember whence we came one century ago. The End of the Classical Gold Standard No one knew better than Jacques Rueff, a soldier of France and a famous central banker, that World War I had brought to an end the preeminence of the classical European states system and its mone- tary regime—the classical gold standard. World War I had decimated the flower of European youth; it had destroyed the European conti- nent’s industrial primacy. No less ominously, the historic monetary standard of commercial civilization had collapsed into the ruins occa- sioned by the Great War. The international gold standard—the gyro- scope of the Industrial Revolution, the common currency of the world trading system, the guarantor of more than 100 years of a sta- ble monetary system, the balance wheel of unprecedented economic growth—was brushed aside by the belligerents. Into the breach marched unrestrained central bank credit expansion, the express government purpose of which was to finance the colossal budget deficits occasioned by war and its aftermath. Cato Journal, Vol. 34, No. 2 (Spring/Summer 2014). Copyright © Cato Institute. All rights reserved. Lewis E. Lehrman is Chairman of the Lehrman Institute. This article is adapted from his closing address at the Cato Institute’s 31st Annual Monetary Conference. He thanks John Mueller for helpful comments. 417 Cato Journal The Rise of Discretionary Central Banking With the benefit of hindsight we can see that quantitative easing (QE) was actually inaugurated with World War I. We can see also that discretionary central banking in the United States coincided with the founding of the Federal Reserve System. After the banking panic of 1907, the Federal Reserve Act of 1913 was designed to pro- vide “an elastic currency” but also to reinforce the international gold standard. Thus, Federal Reserve sponsorship of floating exchange rates in 1971 would become one of the great ironies of American monetary history. To interpret the financial events associated with the Great War and their effect on the ensuing 100 years, my colleague John Mueller and I have highlighted two crucial events of 1913. First, of course, was the establishment of the Federal Reserve System, and second, the publication by the young John Maynard Keynes of his book, Indian Currency and Finance. The inauguration of the Federal Reserve and the intellectual foundation provided by the monetary ideas of Keynes, taken together, soon gave rise to a perfect intellec- tual and financial storm—a storm which would last a century. The Influence of Keynes Keynes had argued in his book Indian Currency and Finance that whether a central bank holds its reserves in gold or in foreign exchange “is a matter of comparative indifference,” and that “in her Gold-Exchange Standard, . India, so far from being anomalous, is in the forefront of monetary progress” heading toward “the ideal cur- rency of the future” (Keynes 1913: 30, 259, 36). In this prewar book, Keynes foresaw the interwar reserve currency roles of sterling and the dollar—an official reserve currency system that Keynes and other British monetary experts succeeded in pressing the European Great Powers to adopt at the Genoa Conference of 1922. By displacing the classical gold standard, and by avoiding deficit settlements in gold, it is no secret that Keynes hoped to forestall repayment of huge sterling debts held by other countries in the form of sterling foreign exchange reserves. Moreover, in the absence of the reserve currency roles of the dollar and sterling, the wars, budget deficits, and balance of pay- ments deficits of the Great Powers could not be so easily financed, except by onerous taxation. Would a postwar democratic people vote in the majority to tax themselves for these purposes? If not, would 418 Federal Reserve and the Dollar the inevitable outcome of government policy be inconvertibility, floating exchange rates, and discretionary central banking? We shall see. Rueff’s Dissent In 1932, ten years after Genoa, and after Britain had abandoned sterling convertibility to gold in 1931, Rueff analyzed the real-world problems of Keynes’s reserve currency theory, and he described the role of the gold exchange standard, a reserve currency system based on sterling and the dollar, in causing the 1930 financial crisis and the Great Depression. Briefly, Rueff ([1932] 1964: 52–53) pointed out that when a monetary authority accepts dollar or sterling claims for its official reserves, instead of settling its balance of payments deficits in gold, purchasing power “has simply been duplicated, and thus the American market is in a position to buy in Europe, and in the United States, at the same time”—tending to cause asset or price inflation. The same was true of the British market. Conversely, the sudden, rapid liquidation of official sterling and dollar reserves could cause equally rapid shrinkage of the banking and credit system, leading to deflation and depression as in the 1930–33 episode. In disagreement with Keynes and Irving Fisher (whose monetary theories would later be adopted by Milton Friedman), Rueff argued that in a reserve currency system “high-powered” money must include both domestic and foreign official monetary liabilities. After World War II, the same gold exchange standard, based this time on the unique reserve currency role of the dollar, was reestablished at the heart of the Bretton Woods international monetary system. Though it was an improvement on the interwar monetary system, Rueff correctly predicted (and tried to prevent) the dissolution of Bretton Woods, which, after perennial foreign exchange crises, col- lapsed in 1971. I cite Rueff’s experience during the interwar period because, among other major events, he was involved in the successful stabiliza- tions of the French franc after the two World Wars. As secretary of the French Treasury, and as deputy governor of the French central bank, his hands-on experience reinforced his path-breaking views on monetary economics. I recommend his theoretical and policy studies not least for the practical reason that his genius inspired two vital restorations of franc convertibility to gold and renewed French eco- nomic growth in 1926 and 1959, even as Great Britain failed in 1925, 419 Cato Journal and the United States in 1971. Rueff’s success, I believe, was in part due to the fact that he was not only a gifted monetary economist but a successful practitioner, whereby he had shorn himself of the illu- sions of his academic counterparts. Considering his more than 20 publications, a few of which have been translated to English, I can focus only on several Rueffian axioms—especially those linked to central banking. I shall try to put them in the context of one century of Federal Reserve operating techniques and their results. Axiom 1: Central Banks Cannot Determine the Quantity of Money in Circulation If a country decides to establish a central bank, Rueff’s fundamen- tal rule by which to guide the central bank is to understand that no central bank, not even the mighty Federal Reserve System, can determine the quantity of money in circulation—except perhaps in a totalitarian social order. In taking this position, Rueff departed from then-ascendant Keynesian orthodoxy. Rueff and Keynes debated one another on monetary economics as did Rueff and Irving Fisher, whose monetary theories Milton Friedman later modified, and they used the terms money and cash balances interchangeably. As Rueff pointed out in his trenchant summary of their differences, “The Fallacies of Lord Keynes’ General Theory” (Rueff 1947), “for Keynes, the quantity of money which the banking system has created is a datum. The total amount of individual cash holding has to be adapted to it. I am convinced, on the contrary, that it is the total of cash holdings desired by individuals which, thanks to the mechanism of [monetary] regulation, determines the quantity of money in circu- lation” (Rueff 1947: 357). Keynes declared in chapter 13 of The General Theory that “the quantity of money is not determined by the public.” Moreover, he presumed that the authorities can “control the activity of the economic system by changing the quantity of money” (Keynes [1936] 1965). In the end, neo-Keynesians and monetarists who believed that the central bank can determine the quantity of money in circulation— and thereby successfully “govern” the economy—could not deny the evidence of reality. Taking only one example, between 2008 and 2013, the Federal Reserve more than quadrupled the monetary base, but the quantity of money in circulation (say M1) increased only a 420 Federal Reserve and the Dollar small fraction in proportion to the central bank’s monetary base. Subsequently, the CPI increased on average only 2 percent annually. There has, of course, been a great asset price inflation, but economic recovery has been the slowest of the postwar years. Does it matter that the Federal Reserve cannot determine the quantity of money in circulation? Consider what happens when the Fed suppresses interest rates to near-zero and issues massive amounts of new money and credit to pay for purchases of Treasury and mortgage-backed securities during periods of sustained quanti- tative easing (2008–13). But market participants may not desire to hold all of the new money and credit issued. The market outcome must be interest rate arbitrage by speculators and investors who get the new credit first. But interest rate suppression and sustained, excess, undesired money are the necessary conditions of asset or price inflation, since interest rate arbitrage causes total demand for higher yielding assets to exceed total supply, the interest rate arbi- trage thus causing mainly asset price inflation.
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