Searching for the Federal Reserve

Amid an intensifying debate over the independence and role of America’s central bank, a former Fed board member is warning that the institution has lost sight of its founding objectives. “The High Cost of the Fed’s Mission Creep,” is how the Journal headlines Kevin Warsh’s caution. Yet Mr. Warsh, in his appraisal of the central bank’s travails, fails to mark the central element of the Fed’s assigned responsibility when it was founded in 1913 — gold.At that time, America was on a gold standard, in which a dollar was convertible into the monetary metal at the legally fixed rate of a 20.67th of an ounce. The gold standard had produced more than a century of high growth and low inflation. Yet Progressive-Era advocates of a central bank lamented what Senator Glass of Virginia called an “unscientific currency system” and sought to create the Fed to manage the dollar and ensure long-term monetary stability.At the time, The New York Sun was an opponent of the central bank. It excoriated the proposal as a “preposterous offspring of ignorance and unreason” that would raise the risk of inflation. The new bank’s power to issue paper money, the Sun’s editors warned, “cannot fail to menace the gold standard.” Not so, Glass averred. The Federal Reserve Act, he insisted in Congress, “upholds the gold standard in every particular.”Yet Glass was forced by critics to include language in the Federal Reserve Act guaranteeing that it did not contradict the Gold Standard Act of 1900. “Nothing in this Act contained shall be construed to repeal the parity provision or provisions contained in an Act approved March fourteenth, nineteen hundred,” the law stated. “Parity” was the term used in the law to insure that paper money was convertible for gold at the rate of a 20.67th of an ounce.So fundamental was gold to the Fed’s operations that its enabling legislation “mandated that each dollar of Federal Reserve notes be backed by at least 40 cents in gold,” the New York Fed has noted. It also mandated that the central bank’s “deposit liabilities be backed by at least 35 cents in gold or lawful money,” which was convertible for gold. Those cautions were meant to prevent inflation by limiting the country’s monetary base. Yet the promises in the Federal Reserve Act would be exposed as hollow 20 years later, when FDR and Congress suspended the gold standard and devalued the dollar by some 60 percent to a 35th of an ounce of gold. Glass, still in Congress, was dismayed to see the bank stripped of its commitment to gold in order to advance FDR’s inflationary agenda. The Fed had been, he griped, “degraded into a servile agency of the Treasury Department and used as a doormat.” FDR’s devaluation proposal “aroused Senator Glass to an eloquent pitch,” Time reported. “With 40% of the entire gold supply of the world, why are we going off the gold standard?” he gasped. “The suggestion that we may devalue the gold dollar,” he added, “means national repudiation. It means dishonor! It is im-moral!” One can only imagine what Glass would say now that the dollar’s value has plummeted to less than a 3,300th of an ounce of gold. Glass, despite his fantods over FDR’s monetary machinations, was astute to point out that the Fed, without its legal obligations to convert dollars for gold — and hold gold reserves against its liabilities — would lose its raison d’être. Which brings us back to Mr. Warsh & Co. The abandonment of gold convertibility enabled the Fed to engage in experiments like Quantitative Easing that have brought the bank far from its original purpose — a stable currency.Mr. Warsh, who served on the Fed during the 2008 crisis, recalls how a former chairman, Paul Volcker, warned that the Fed’s interventions then overlooked “long-embedded central-banking principles and practices,” Mr. Warsh says. Yet the Fed ignored Volcker and has “assumed a more expansive role,” Mr. Warsh says, “on all matters of economic policy.” So it looks like getting the Fed back on track will mean reviving a role for gold in monetary policy.

Searching for the Federal Reserve

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