Are Conservatives Right About the Fed? Is It a Malign Force in America?

December 4th, 2013
in Op Ed

by Fabius Maximus,

Summary: Central banks have never been more powerful, more significant to the economy, more controversial (although they've often been unpopular), or more misunderstood. Today we debunk two of the myths about their evil they do; at the end are links to posts about their limitations.

Follow up:


  1. About conservatives' faux history and economics
  2. About investment bubbles
  3. About the joys of unregulated banks
  4. Instead of the Fed, look at the new banks
  5. For More Information

(1) About conservatives' faux history and economics

Conservatives have devised a body of faux history and economics to justify their 1%-friendly public policies. Central to this is Fed-hating. The 1% uses hatred of the Fed to motivate its troops, while cherishing the Fed as one of its most useful agents. The Fed by design supports the banks' solvency and profits (hence drawing its governors from bankers and known bank supporters). This contradiction shows how our inability to see the world around us prevents our effective political action.

Let's examine two charges of the Fed haters:

  1. The Fed creates investment bubbles that distort and disturb the economy - unlike the good old days under the gold standard.
  2. The Fed, and the other bank regulatory agencies, restrain the natural entrepreneurial vigor of the banks.

(2) About investment bubbles

Economic bubbles occur naturally in free-market systems, occurring often even under a gold standard. Such as the 17th century Tulip Mania (see Wikipedia), the earliest documented bubble (although details are uncertain). There are different kinds of bubbles. Here we discuss investment bubbles, excessive enthusiasm for a specific kind of investment which attracts too much capital, followed by a bust.

The giant UK investment bubbles of the 19th century were more similar to those of our time (e.g., in technology and housing). To learn more about them I recommend reading "Charles Mackay's own extraordinary popular delusions and the Railway Mania" (26 February 2012) by the brilliant Andrew Odlyzko (Prof Mathematics, U MN; his bio here). Excerpt:

Those {bubbles} of the 19th century lasted for several years, and involved huge real capital investments.

... The British mania of the mid-1820s ... involved real capital investments of about £ 18 million in joint-stock companies, most prominently for mines in Latin America, and £ 25 million for loans to foreign governments, again largely in Latin America. The total, £ 43 million, was slightly over 10% of British GDP of that period, comparable to $1.5 trillion for the U.S. today, and was regarded by the British public at the time of the Railway Mania in the 1840s as an almost complete loss.


Meet your banker

Meet your banker

The mania of the mid-1830s ... involved real capital investment, almost exclusively in railways, of about £ 70 million, comparable to $2 trillion for the U.S. today. ... it appears to be the unique example of a gigantic investment mania that succeeded. The ... returns to those who invested in the mid-1830s that were higher than the risk-free government bond yields.

What little has been written about this mania by such famous economists as Bagehot, Juglar, Rostow, and Schumpeter is incorrect or at least seriously incomplete. They typically considered only the early collapse of share prices after the most ebullient phase of this episode, and were unaware of the extended period of heavy capital investment and the eventual high profits.

However, the investors of the Railway Mania were very conscious of what had happened during the preceding period. The nice profits resulting from that earlier period of extreme exuberance were the foundations for their belief they could make money from the new wave of railway construction ... The Railway Mania ... was the third and greatest of the four large investment bursts in Britain in the 19th century. It involved real capital investments, from year-end 1843 to year-end 1853, of about £ 180 million, comparable to $5 trillion for the U.S. today.

The fourth, and final, gigantic investment mania of 19th century Britain was the railway mania of the mid-1860s. Investment in this industry between year-end 1860 and year-end 1870 reached £ 180 million, about 20% of the GDP of the UK of that time, so comparable to $3 trillion for the U.S. today.

For a summary of the Railroad Mania see Wikipedia. For more detail see these two articles by the Odlyzko:

  • "The collapse of the Railway Mania, the development of capital markets, and the forgotten role of Robert Lucas Nash (a forgotten pioneer of accounting and financial analysis)", Accounting History Review, November 2011 - See an extended preprint PDF
  • "The Railway Mania: Fraud, disappointed expectations, and the modern economy", Journal of the Railway & Canal Historical Society, November 2012 - See a preprint PDF

Sidenote: another of the Right's bugaboos, fractional reserve banking, predates bubbles and central banks by centuries (see Wikipedia for details).

(3) About the joys of unregulated banks

The Fed-haters show a remarkable lack of interest in our history before the Fed. The United States had two short-lived central banks, 1791-1811 and 1817-1836. The massive damage - and widespread suffering - during Long Depression (1873-1879), the Panic of 1893, and the Panic of 1907 persuaded the nation's leaders to establish a strong central bank.

Each of these downturns included massive bank failures. The loss of depositors' savings plus widespread foreclosures played a big role in the Gilded Age's liquidation of America's small farmer and merchant classes, which Jefferson saw as the foundation of the Republic. These in turn drove the economy into the ground.

The elites suffered less than the people, but this experience with laissez faire banking exceeded the maximum pain our elites could take. Hence the creation of the Fed in 1913, and the subsequent waves of bank regulation. Unfortunately for us, our inattention has allowed bankers to game the new system.

(4) Instead of the Fed, look at the new banks

"The best way to rob a bank is to own one."
- William Crawford, Commissioner of the California Department of Savings and Loans, 1988 testimony before the House Committee on Government Relations

"In Washington, the view is that the banks are to be regulated, and my view is that Washington and the regulators are there to serve the banks."
- Spencer Bachus (R-AL), Chairman of the House Banking Committee, The Birmingham News, 9 December 2010

While conservatives' attention has been focused on hating the Fed, they have ignored a more important evolution in the banking industry. (The enlistment of the Tea Party Movement - born in opposition to the bank bailouts - to elect hard-core Republican supporters of banks provides a wonderful example of the political processes at work building the New America).

The bankers are long gone who invested in sound businesses, and so grew the real economy. Modern large commercial banks (i.e., the money center banks) have little resemblance to traditional banks. The new bankers are as greedy as their predecessors, but specialize in speculation and depend on government bailouts from the resulting losses (every decade in the US). Secularization, proprietary trading, trading in derivatives and currencies, and higher leverage - the profit centers of a radically new form of bank.

Higher leverage is the key, and changes everything. From "The Doom Loop: equity and the banking system", Andrew Haldane, London Review of Books, 23 February 2012:

As unlimited {shareholders'} liability was phased out, leverage among banks rose from about three or four in the middle of the 19th century to about five or six at its close. Leverage continued its upward march when extended liability was removed, and by the end of the 20th century it was higher than twenty. In 2007, at its high-water mark, bank leverage hit thirty or more.

This strategy translated, by the arithmetical magic of leverage, into higher shareholder returns. Having begun the 20th century in modest single figures, equity returns to banks were, on average, close to 20% by its end. At the height of the boom, bank equity returns touched 30%. Higher leverage accounted for almost all of this.

Bank managers no longer had to sweat their assets: they simply had to borrow against them.

The new banking system works well for bankers and the 1%, but not so well for the rest of us who fund the bailouts for the inevitable busts. We have not learned from the experiences of the past 40 years, and have been warned about the future.

Perhaps we need a reminder of how banks worked when their greed built nations, before they became destabilizing parasites. From Mary Poppins:

(5) For More Information

(a) "Modern Money Mechanics; a workbook on deposits, currency and bank reserves", Federal Reserve Bank of Chicago (1992)

(b) About faux economics and history:

  1. A look at Faux Economics, increasingly popular but bizarrely wrong, 15 June 2010
  2. Programs to reshape the American mind, run by the left and right, 2 August 2010
  3. American faux history: could we have avoided the Civil War?, 23 January 2012
  4. American faux history: why did the South leave the Union?, 24 January 2012

(c) About banks:

  1. A free lesson from Russia: how to manage a banking crisis, 6 February 2009
  2. The best way to rob us is to own a bank, 10 April 2010
  3. Former Central Bank Head Karl Otto Pöhl says bailout plan is all about 'rescuing banks and rich Greeks', 20 May 2010
  4. FDR explains one dimension of our problem: bankers own the government, 23 November 2011
  5. The bailout of Spain's banks shows the heart of our problem, 12 June 2012

(d) About central banks:

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