I got interested in money and banking at a very young age. My mother often took me along on shopping trips, explaining what money was, why we needed it in stores, and how my father got it for us. Trips to the bank were a special treat. The Cleveland Trust branch near us was an imposing affair, with a limestone façade, high ceilings, and tellers ensconced behind ornate barred windows. The architecture was intended to instill confidence, but to me it was just a magic place.

Later, my sixth-grade class operated a student branch of another bank, the Society for Savings. Twice a month our classroom was rearranged like a bank branch. Tellers (all boys, as I recall) would accept student deposits of a dime, a quarter, or sometimes a whole dollar. Assistant tellers (girls) would write the amount of the deposit in the student’s passbook, while the boys handled the cash. After closing we tallied the deposits and packed the loot—perhaps $50—into a canvas bag, and a privileged student would trundle it off to the principal’s office under the watchful eyes of two “guards.” What great lessons we learned: thrift, honesty, attention to detail!

By the time I was 14 I was earning good money shoveling snow, raking leaves, and mowing lawns. I had become something of a saving fanatic. I soon found out that the local savings and loan (S&L) offered higher interest than commercial banks, so I opened an account there. Savings passbooks seem quaint in hindsight, but mine was a treasured possession, a tangible reminder of my growing nest egg.

Not just the passbooks, but the entire banking experience of the 1950s looks quaint from today’s perspective. The banks were open from 10 to 3 five days a week, and there were no automatic teller machines, no debit cards, and only a crude form of credit card (mom’s charge-a-plate was accepted only by the downtown department stores). Those were the days of the 3-6-3 rule of banking: pay 3 percent on deposits, lend it out at 6 percent, and head for the golf course at 3 p.m.

No need to worry about competition. For one thing, potential competing banks from other counties or other states were not allowed to open branches inside Cuyahoga County. And the interest paid on savings accounts was set by government regulators. Banks and especially their S&L brethren did try to compete by offering bonuses like toasters to new account holders.

The stagflation of the 1970s blew the cozy world of banking wide open. When price inflation approached and then exceeded 10 percent, savers began to realize their passbook accounts were guaranteed losers of purchasing power. Some turned to Treasury bills, but at one point the public servants at Treasury, beset by small savers wanting to buy $1,000 T-bills, shooed them away like so many flies by simply raising the minimum purchase to $10,000. Money market mutual funds were devised and helped fill the gap. These funds were a clever innovation that let small savers participate in a pool of short-term, high-quality, market-rate instruments. Prudent management made it possible to maintain a dollar-per-share price, and check-writing privileges were soon added. Eventually this form of asset was included in the broader monetary aggregates. Savings poured out of banks into the new funds.

Regulation Q

The banks badly needed relief from the infamous Regulation Q, which capped the interest rates they could pay. Relief appeared in the form of the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA). Interest-rate ceilings were phased out, and for the first time in many years interest could be paid on demand deposits (checking accounts). Repeal of Regulation Q was framed as a consumer protection measure, and rightly so. Interest limits—and price controls in general—are now thoroughly discredited.

The repeal of usury laws decriminalized high-interest personal loans, which was beneficial to marginal borrowers generally. It did, however, contribute in a minor way to the expansion of unsustainable subprime mortgages.

DIDMCA included minor increases in regulation. All banks—not just those that were members of the Fed—became subject to regulation by the Federal Reserve System. The Fed could now set reserve requirements for all banks, offer them discount loans, and provide check-clearing services. Also, deposit insurance, which is a subsidy to the banks, was raised from $40,000 to $100,000 per depositor. It is a subsidy because although banks pay premiums for deposit insurance, those premiums are almost certainly lower than what private insurance companies would charge.

The Garn-St. Germain Act of 1982 soon followed. Banks were allowed to offer money market deposit accounts in competition with the money market mutual funds that had lured so many savers away. There were numerous other minor changes, but the act’s most important provision was deregulation of S&Ls. Savings and loans were bank-like institutions that had been allowed to pay slightly more on deposits but were allowed to offer only one kind of loan: home mortgages. It was this tradeoff, prompted by politicians who saw it as their job to promote homeownership, that primarily distinguished S&Ls from commercial banks. Garn-St. Germain eliminated the S&L interest-rate advantage and raised the limits on the amount of consumer lending and nonresidential real estate lending they were allowed to undertake.

S&Ls held mortgages that yielded modest returns and had many years to run, but by 1980 they were having to pay ever-higher rates to retain deposits, mostly passbook savings accounts payable almost on demand. They were caught in a classic borrow-short/lend-long squeeze. To make matters worse, most S&L managers lacked the specialized knowledge and personal connections necessary for successful commercial real estate lending. These and other factors led to the S&L crisis of the late 1980s. Had they anticipated these developments, Senators Garn and St. Germain might have phased in the changes more gradually. Overall, though, Garn-St. Germain and DIDMCA ultimately strengthened competition and fostered innovation, thereby serving consumers well.

The Financial Institutions Reform, Recovery and Enforcement Act of 1989 was passed as a cleanup measure. Little remains of this act other than the establishment of the Office of Thrift Supervision, currently targeted for abolition.

The Riegle-Neal Interstate Banking and Branching Efficiency Act took effect in 1994. By opening up interstate branch banking, this act finally caught us up with Canada, which has had large nationwide banks almost since the founding of the Dominion. There were no Canadian bank failures at all during the 1930s, when some 9,000 U.S. banks failed. With branch banking outlawed, small towns in the United States could only be served by small and often fragile local banks. This restriction was a major contributor to the two waves of U.S. bank failures during the Depression.

Nowadays we can travel across the country and see familiar bank names like Chase, Citibank, Wells Fargo, or Bank of America. Young people in particular find this no more surprising or disturbing than the ubiquity of McDonald’s or Chevron. Riegle-Neal has been an unqualified success in this regard.

Gramm-Leach-Bliley

The Gramm-Leach-Bliley Financial Services Modernization Act of 1999 takes the stage next. It repealed (for the most part) the separation of investment banking from commercial banking and insurance, as discussed in my and Jeffrey Rogers Hummel’s October Freeman article on the Glass-Steagall Act. Two minor restrictions remain: Investment banks and commercial banks must be held in separate subsidiaries, and commercial banks still cannot hold shares of corporate stock on their books.

Gramm-Leach-Bliley is widely blamed for the banking crisis of 2008–2009. But before the crisis, several of the largest investment banks had remained stand-alone institutions, and it was only after the crisis that they all acquired commercial banks, as allowed by the law. It is not clear that those which had taken advantage of Gramm-Leach-Bliley were any more to blame than those that hadn’t.

The Commodity Futures Modernization Act of 2000 was a classic example of regulatory catch-up. Sophisticated derivative securities called credit default swaps (CDS) had arisen in the markets. A CDS insures the holder of a debt security against default. Risk is thereby transferred from a risk-averse party to a risk-tolerant party at a price agreeable to both. CDS purchasers need not actually hold the reference instrument, in which case they are speculating. Though not entirely new, these derivative securities had exploded in volume as part of a trend toward more sophisticated instruments.

Regulators were at odds as to whether a CDS is a security subject to regulation by the Securities and Exchange Commission or a futures contract subject to regulation by the Commodity Futures Trading Commission. A turf war broke out. Neither side won, and credit default swaps went largely unregulated. But the presumption that regulation would have prevented problems with CDSs is dubious if one thinks, for example, of the failure of the SEC to catch Bernie Madoff even though a whistle-blower tried for years to get it to pay attention.

Reserve Obligations

The Financial Services Regulatory Relief Act of 2006 was concerned with bank reserves. These are the funds banks keep to back up their deposit obligations; they consist of so-called “vault cash” plus their reserve account at the Fed. At present banks must hold reserves amounting to approximately 10 percent of their demand deposit obligations. Although analogous to the stash you and I might keep for personal emergencies, banks cannot draw their reserves down below 10 percent, come hell or high water.

However, elimination of the 10 percent requirement would be a nonevent in today’s environment, given that most banks now choose to hold reserves substantially in excess of 10 percent. At any rate, the requirement can’t be dropped before 2012, and (in case anyone was wondering) there is no way that anticipation of its elimination had anything to do with the financial crisis. Under the act, payment of interest on reserves was originally scheduled to begin in 2011 but was moved up to 2008, as part of the TARP bailout. The original intent of this provision was to provide Fed money managers with an additional tool to shepherd short-term interest rates, but something quite different has happened instead: Payment of interest gave banks a new incentive to hold excess reserves. This incentive is at least partly responsible for an explosion of excess reserves, from about $2 billion to over $1,000 billion in the last two years.

This brief summary of recent regulatory changes has given only a hint of the bewildering array of laws, regulations, and agencies that deal with banking. Commercial banks are regulated by the Federal Reserve System, the Federal Deposit Insurance Corporation, the Comptroller of the Currency, and the Office of Thrift Supervision (OTS). The National Credit Union Administration is a parallel agency for credit unions, and there are also state banking regulators. Competition and rivalry among these agencies may be a good thing if you like the prospect that their squabbling makes them less effective. But the competition got a little crazy, culminating in the great chainsaw incident of 2003.

OTS had gotten oversight of S&Ls. Director James Gilleran marketed his agency as a champion of innovations such as option adjustable-rate mortgages, later to be the downfall of so many unqualified borrowers. “Our goal is to allow thrifts to operate with a wide breadth of freedom from regulatory intrusion,” he said in a 2004 speech.

The Chainsaw Incident

In the summer of 2003 leaders of the four federal agencies that oversaw the banking industry gathered to highlight the Bush administration’s commitment to reducing regulation. They posed for photographers behind a stack of papers wrapped in red tape. One held garden shears and another a bolt cutter, but Gilleran topped them all with a chainsaw! One of Gilleran’s biggest catches was the infamous Countrywide Mortgage, which chose to place itself under OTS regulation in 2007 and proceeded to generate huge volumes of unsustainable mortgages.

Is this an indictment of deregulation? It might better be called “regulatory deregulation,” which is different from genuine deregulation. When banks or any other businesses are highly regulated, their customers stop worrying about their business practices, assuming the regulators have things in hand. If regulators then begin to promote risky behavior while the public continues to believe they are enforcing prudence, problems invariably arise. Such problems would be much less likely if market discipline displaced regulation entirely—that is, scrutiny by stockholders, bondholders, customers, auditors, independent rating agencies, and of course laws punishing fraud and theft.

Overwhelmingly Beneficial

The record outlined above shows that the deregulatory actions of the last 39 years have been overwhelmingly successful. We must look elsewhere for the causes of the 2008–2009 crisis: government encouragement of risky mortgage lending, low interest rates engineered by the Fed, and to some degree one of the bank regulations that was never lifted. This was the Community Reinvestment Act (CRA) of 1977. This law forced banks to stop “discriminating” against borrowers who lived in low-income areas. In practice this meant diverting some funds away from creditworthy borrowers toward high-risk borrowers. The CRA clearly contributed to the deterioration of credit quality in mortgage lending, but no constituency was strong enough to buck the egalitarian tide and get CRA repealed.

The Dodd-Frank financial “reform” bill is now law. It requires bureaucracies to generate about 67 studies and 243 new regulations, so it’s difficult to say at this point how the new act will play out. Dodd-Frank restricts banks’ “proprietary trading” activities—a concept to be delineated by regulators and, no doubt, artfully skirted by clever bankers. The most important deregulatory reform—allowing nationwide branching—is left intact. Perhaps the act’s full effects will become apparent only when the next financial crisis hits.

Just one day later, September 20, the Bush administration announced a price tag: It would ask Congress for what the Times described as “unfettered authority for the Treasury Department to buy up to $700 billion in distressed mortgage-related assets from the private firms.” News reports noted that $700 billion amounts to more than $2,000 for every man, woman, and child in the United States. Secretary Paulson released a three-page draft of the legislation he wanted. It did not specify how the money would be spent, but did say that no court could review the Treasury’s decisions about spending the money. Paulson warned of dire consequences should Congress not approve the legislation quickly and as proposed.

In asking for huge sums and unrestrained power for government to intervene in financial markets, Bernanke and Paulson discarded any pretense of adhering to free-market principles. The Times reported that an attendee at a strategy meeting quoted Bernanke as justifying the abandonment of principles by declaring that, “There are no atheists in foxholes and no ideologues in financial crises.” The aim of avoiding a deeper crisis, in other words, rationalizes whatever seems expedient. We should flee from the threat of a “financial meltdown” even into the arms of a constitutional meltdown. Surprisingly, many “free-market” commentators and economists echoed this sentiment. Some of them pledged to reaffirm free-market principles in the future even while calling for their abandonment for the duration of the financial turmoil. Their questionable judgment seems to have been that more government intervention was needed to offset—and would offset rather than compound—the previous interventions that had created financial chaos.

Few in Congress questioned the figure of $700 billion. Some House Republicans proposed a nominally less-interventionist plan that would have had the federal government not purchase—“only” guarantee—home-mortgage assets. Instead of putting an explicit price tag on the taxpayers’ burden for the bailout, government guarantees of mortgages and mortgage-backed securities would have obliged taxpayers to pay lenders and bond holders whenever and wherever borrowers or security issuers defaulted, implying off-balance-sheet taxpayer exposure on an unspecified scale. A blank check rather than a $700 billion check—some improvement.

After congressional wrangling for nine days over what to add to the three-page Treasury proposal, a bill of 110 pages emerged. A deal had been struck. The Treasury’s authority to purchase had grown beyond mortgage-related assets to include “any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability.” In other words, whatever the two wanted.

Shock in the House

On Monday, September 29, the House of Representatives shocked political pundits by voting down the bailout bill 228–205. With constituent email and phone messages to Congress running heavily against the bailout (some estimates said 30–1), the majority that day disregarded dire warnings that Congress had “no time” to put any more careful thought into what it was doing.

Two days later, however, the U.S. Senate approved a further-revised bailout bill 74–25. Although they had not taken time to put a lot of additional thought into it, senators had nonetheless added a lot of text: The bill had now grown to 422 pages. The Emergency Economic Stabilization Act of 2008 now not only provided $700 billion for a Troubled Assets Relief Program, but also included sections and subsections on Renewable Energy Incentives, Carbon Mitigation and Coal Provisions, Transportation and Domestic Fuel Security Provisions, a grab-bag of tax-credit extensions, a subtitle for Mental Health Parity and Addiction Equity, another for Heartland and Hurricane Ike Disaster Relief, an increase in federal deposit insurance, and authority for securities regulators to relax accounting rules that financial firms facing mortgage-related losses were finding inconvenient. The height of special-interest absurdity was reached in Section 503 of the Act which, according to the official Library of Congress summary, “Exempts from the excise tax on bows and arrows certain shafts consisting of all natural wood that, after assembly, measure 5/16 of an inch or less in diameter and that are not suitable for use with bows that would otherwise be subject to such tax (having a peak draw weight of 30 pounds or more).”

Two days after the Senate vote, on Friday, October 3, the once-reluctant House approved the bailout bill 263–171. In the second House vote 33 Democrats and 25 Republicans switched from no to yes. One congresswoman unashamedly explained to National Public Radio that she had switched because the new bill included solar-energy tax credits. President Bush immediately signed the bill. Prices on the New York Stock Exchange, which had closed way down the day the first bill had failed to pass, closed down again on the day the revised bill passed and was signed into law.

“Plan” A

The “plan” for how to spend the $700 billion bailout has always been extremely vague, from its inception in the Bernanke-Paulson phone call, through the case Paulson made before Congress, to the passage of the enabling legislation. Improvisation continued up to the date this account was written in late November. The Treasury originally announced an intention to buy troubled mortgage-related assets, and hence the bill refers to a Troubled Asset Relief Program, or TARP. But on what terms would they buy these assets? More than a month after passage, that had yet to be made clear. American Public Media’s Marketplace program reported on November 7 that, “A securities industry trade group just came out with a survey, and it found that financial players are so unclear about how TARP would work, they aren’t sure they want to participate.” The Treasury had to schedule a meeting with banking industry representatives on November 10 to fill them in on the evolving specifics of TARP.

The “troubled” assets to be purchased are mortgage loans, bundles of such loans (“mortgage-backed securities”), and apparently any other financial assets the Treasury wants to include. What makes them “troubled” is basically that financial institutions can’t sell them for what they paid for them. The basic reason is that an unexpectedly huge share of mortgages has gone bad: Mortgage-default rates have skyrocketed. Further, the secondary market for mortgage-backed securities has dried up. A firm trying to sell some of its holdings would fetch only fire-sale prices.

There is a basic problem with having the Treasury buy assets that the market won’t buy except at fire-sale prices. Either the Treasury outbids the market and overpays for the assets—which benefits financial institutions at taxpayer expense—or the government pays the current market price, which would compel banks to mark other assets down accordingly and book the losses they’ve been trying to avoid booking.

In arguing for the bailout, Bernanke proposed that an “auction” of troubled assets for taxpayer-provided dollars would enable accurate “price discovery,” even though the Treasury would be the only bidder, and thereby would restore an active market. How such an auction would work, how it could be designed to arrive at hoped-for prices—above current market prices but not above what the assets would supposedly be worth in a normal market—was never spelled out. In mid-November “Plan A” appeared to have been more or less officially shelved. Never mind that Paulson had told Congress that hundreds of billions for troubled-asset purchases were urgently and immediately needed to avoid financial Armageddon.

On November 25 the idea of troubled-asset purchases made a dramatic comeback under the auspices of the Federal Reserve, which is discussed below.

“Plan” B

On October 13 the Treasury announced a new way to spend $250 billion of the $700 billion: It would inject equity capital into banks, buying newly issued preferred shares. It soon thereafter injected $125 billion into nine major banks: Citigroup, Bank of America, Wells Fargo, JPMorgan Chase, Bank of New York Mellon, State Street, Merrill Lynch, Morgan Stanley, and Goldman Sachs. The last-named is the former investment bank, recently converted into a commercial bank, previously headed by Paulson. From the group of nine banks the Treasury took “preferred shares” with fixed 5 percent dividends (increasing to 9 percent if the shares have not been repurchased in five years).

On November 23 the Treasury announced it would inject an additional $20 billion of equity into Citigroup. For this second injection it took preferred shares with an 8 percent dividend. The Treasury together with the FDIC also provided an off-balance-sheet guarantee against losses on about $300 billion of Citibank’s troubled real estate assets, in exchange for which the Treasury and FDIC took additional preferred shares.

The federal government is now part-owner of the nine banks. The banking system has been partially nationalized. The preferred shares are ownership claims of a type falling between debt obligations (bonds) and common stock shares. They are riskier than bonds because preferred shareholders must stand behind bondholders in the line to get paid in the event that the bank can’t pay everyone.

To compensate for its risk the Treasury also took stock warrants—contracts that give it the right to buy shares in the future at a specified price so that it can make a profit should the banks’ stock prices someday rise higher than that price. “Recapitalizing” a firm normally leads to lower share prices, however, because it means more shares dividing ownership of the same asset portfolio. The infusion dilutes existing shares. For this reason two of the nine banks reportedly objected to participating in the Treasury’s capital infusion with attached strings. The Treasury explained that it did not make participation voluntary because it did not want to stigmatize as weak the banks that chose to participate. A financial analyst’s report in late November named Bank of America, Citigroup, Goldman Sachs, JPMorgan, Morgan Stanley, and Wells Fargo as the weakest institutions.

The other half of the Treasury’s $250 billion has been designated for assignment to smaller banks to be named later. Among other things, the Treasury reportedly hopes these capital injections will enable recipient banks to buy up other, weaker banks. An anonymous Treasury official told reporters: “One purpose of this plan is to drive consolidation.” Thus taxpayer money is being allocated to influence the shape of the banking market.

“Plan” C?

What will “Plan” C be? As the Treasury continues to improvise, everything and anything is possible. So says Neel Kashkari, the former Goldman Sachs employee under Paulson who is now the Treasury’s chief bailout administrator under Paulson. Asked whether funds might go to insurance companies, other financial firms, and even nonfinancial firms like automakers, one news story reported, “Kashkari indicated that everything was on the table. ‘We are looking at everything,’ he said. ‘We are trying to figure out what will provide the most benefit to the financial system.’”

House Speaker Nancy Pelosi, Senate majority leader Harry Reid, and other congressmen have urged the Treasury to use some of the $700 billion to inject capital into the leading U.S. automakers. These same lawmakers specified no such authority in the bailout bill. Some $1.5 billion of the $700 billion will go to local governments for reasons unrelated to the financial system.

Insurance executives have reportedly lobbied for the bailout to include troubled insurance company assets. There is now a precedent: The Treasury has given $67.5 billion of the bailout to AIG, the failed insurance giant brought down by its imprudently massive guarantees on mortgage-backed securities, in exchange for troubled assets and preferred shares. AIG was already on an $85 billion life-support loan from the Federal Reserve.

Second Bailout

The Treasury’s $700 billion bailout is actually the second federal bailout program underway. The press has widely reported on the Treasury bailout bill and the post-bill spending improvisations. Columnists and the public have openly debated the dubious wisdom of that program. Congress has held hearings and has voted on the bailout bill, even if it has left it to the Treasury to decide how the $700 billion will be spent. But flying under the radar, attracting much less public attention and almost zero congressional scrutiny, have been the Federal Reserve’s ongoing efforts that in mid-November added up to a $1.7 trillion shadow bailout program for favored financial institutions, more than double the size of the Treasury’s bailout. On November 25 the Fed announced two new lending lines that will add another $800 billion, bringing the total to $2.5 trillion—more than triple the size of the Treasury’s bailout. (This section draws heavily on my paper for the November 2008 Cato Institute monetary conference, “Federal Reserve Policy and the Housing Bubble.”)

The Fed’s bailout efforts began back in March 2008 with the Fed putting up $29 billion to sweeten a deal in which the commercial bank JPMorgan Chase would take over the teetering investment bank Bear Stearns. A new Fed-owned subsidiary (“Maiden Lane LLC”) was set up to cleanse the Bear Stearns balance sheet by acquiring troubled mortgage-backed securities for the $29 billion. The transformation of the Federal Reserve’s balance sheet, which used to hold virtually nothing but safe Treasury securities, had begun. Between March and November, as the Fed improvised new interventions into financial markets, the dollar amounts of the Fed’s commitments grew and grew.

The interventions are visible among the assets on the Fed’s balance sheet for November 5, where many new entries appear that were absent one year ago. The list begins with “Term Auction Credit” at $301 billion, representing 28-day and 84-day loans to banks. Previously loans to commercial banks were limited to overnight loans for meeting reserve requirements. Banks were expected to attract longer-term funds from depositors or private institutional investors in the money market. Next on the list is “Primary Dealer and other Broker-Dealer Credit” of $72 billion—that is, loans to securities dealers. A year ago the Fed did not lend to securities dealers. Third is the “Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility”—loans to banks or bank holding companies to allow them to purchase assets from money-market mutual funds. Previously money-market funds that needed to liquidate commercial paper holdings were expected to sell them in the money market. “Other credit extensions,” a catchall fourth new entry, amount to $81 billion.

The fifth new entry is “Net portfolio holdings of Commercial Paper Funding Facility LLC,” $243 billion. A memo to the Fed’s balance-sheet release explains: “On October 27, 2008, the Federal Reserve Bank of New York began extending loans . . . to Commercial Paper Funding Facility LLC. This LLC is a limited liability company that was formed to purchase three-month U.S. dollar-denominated commercial paper from eligible issuers and thereby foster liquidity in short-term funding markets and increase the availability of credit for businesses and households.” That is, the Fed has formed a new subsidiary for directly allocating funds to a particular segment of the financial system, the commercial paper market. Previously the Fed purchased only Treasury securities, and let private banking and financial markets allocate the funds it thus injected to their best uses.

Sixth is “Net portfolio holdings of Maiden Lane LLC,” $27 billion, representing the troubled assets acquired from Bear Stearns. Note that the assets have been marked down from their acquisition price of $29 billion: the Fed has suffered a loss of $2 billion. By holding the assets the Fed is speculating that the market for selling them will be better later on. Previously the Fed did not get involved in financial takeovers by absorbing troubled assets to sweeten the deal. The FDIC sometimes did, but only in mergers between two insured commercial banks. Bear Stearns was an investment bank, not an insured commercial bank.

Last September the Federal Reserve began buying federal agency notes—short-term IOUs of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks—from securities dealers. As of November 5 the Fed was holding $13 billion of such notes, where it held zero one year ago, though it has held small amounts of agency debt in the past. The Fed’s “primary” (overnight) loans to commercial banks are currently at $110 billion, up from only $1.4 billion a year ago. In total the Fed’s assets have more than doubled, from $889 billion a year ago to an astounding $2.08 trillion in mid-November. Further increases are on the way.

Two items make the Fed’s bailout loan program even larger than the $1.2 trillion increase in its total assets. First, the Fed has funded $303 billion of its new loans by selling off Treasury securities from its portfolio. Second, off its balance sheet (but recorded as a “memorandum item”), the Fed also runs a “Term Securities Lending Facility” that has lent $197 billion of its Treasury securities to broker-dealers, giving them something liquid to sell in exchange for IOUs collateralized by less liquid securities like mortgage-backed securities. As of November 5 the Fed’s new loans and purchases had extended $1.7 trillion in new credits to financial institutions over the past year.

On November 25 the Federal Reserve announced that in the following week it would begin purchasing up to $600 billion in securities issued or guaranteed by Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. It would buy them from its primary securities dealers through “a series of competitive auctions.” It also announced the creation of a $200 billion Term Asset-Backed Securities Lending Facility to make new term loans to financial institutions, loans to be collateralized by nonmortgage pools of consumer and small-business loans. In both cases the Fed is engaged in price-setting, trying to drive interest spreads (the differential yields over Treasury bills required to attract purchasers) on riskier securities back into their historical ranges. Thus the Fed is second-guessing the risk premiums set in competitive financial markets. As of Thanksgiving, the new facilities had not yet appeared on the Fed’s balance shee

Unprecedented Credit Expansion

From $1.2 trillion of added bank reserves, the late-November lending programs (if not somehow offset) will push added bank reserves to $2 trillion. The Fed has no clear exit strategy from its unprecedented credit expansion. It has too few Treasury securities left to sell in order to pull the credits back in, the traditional method for contracting bank reserves. No doubt the Fed hopes that the new loans will be repaid (and not re-extended) as financial market conditions improve. But borrowing firms whose ability to repay depends on the prices of their mortgage-backed securities recovering may be unable to repay any time soon because the effects of overbuilding during the housing bubble will depress the price of real estate and thus of mortgage-backed securities for a long while. Moreover, they may be unwilling to repay. Nonbank financial firms that are now enjoying the Fed’s below-market lending rates will have no incentive to wean themselves and every reason to lobby for keeping the new bargain lending windows open indefinitely. “Temporary emergency” government subsidies have a way of living on and on. Just ask the recipients of federally subsidized farm loans.

The Fed’s new activities deserve to be called a bailout program because they seek to channel credit selectively at below-market interest rates, or purchase assets at above-market prices, in hopes of rescuing, or enhancing profits for, favored sets of financial institutions. The Fed’s new lending facilities are not parts of a central bank’s traditional “lender of last resort” role. A lender of last resort injects reserves into the commercial banking system to prevent the quantity of money from contracting—and thereby to protect the economy’s payment system—when there is an “internal drain” of reserves (bank runs and the hoarding of cash). There has been only one bank run (on IndyMac) and no contraction in the money stock. Investment banks do not issue checking deposits, are therefore not subject to depositor runs, and are not part of the payment system. Neither are securities dealers. Money-market mutual funds play a limited payment role, but because they do not issue demandable debt, they are not subject to runs. The Fed’s expansions of its own activities therefore had nothing to do with protecting the payment system or stabilizing the money supply.

The “lender” in “lender of last resort” has long been an anachronism. Central banks in sophisticated financial systems discovered decades ago that they can inject bank reserves without lending by purchasing government securities in the open market. By doing so, the central bank supports the money stock while avoiding the danger of favoritism associated with making loans to specific banks (or nonbanks) on noncompetitive terms. It also avoids the potential favoritism in purchasing other securities. The Fed’s new activities, by contrast, extend an array of loans to various financial institutions and purchase securities from nonbank issuers and holders. These activities pose the risk of favoritism—of substituting the Fed’s judgment for the market’s about what kinds of institutions and what particular firms should survive. They have nothing to do with replenishing the reserves of the banking system or preventing contraction in the stock of money. The Fed’s activities seem rather to aim at protecting financial institutions from the consequences of imprudent portfolio decisions.

The Federal Reserve’s new interventions into financial markets over the past year have proceeded at its own initiative and without precedent. They seem to be enjoying the complete freedom from oversight that Secretary Paulson unsuccessfully sought for the Treasury’s bailout program. The Fed’s program has attracted little attention mostly because it has not required a congressional appropriation. The Fed is “self-financing”: It can “print up” any funds it needs to make loans or purchase assets by simply expanding the quantity of unbacked claims on itself. This does not mean that Fed credit expansion provides a free lunch. When the Fed increases the stock of dollars, it levies an implicit tax on holders of existing dollar balances by creating an inflationary depreciation of the dollar.

An Evaluation of the Bailouts

The financial turmoil of 2008 was the result of what may be briefly described as a government-policy-induced cluster of entrepreneurial errors by financial-market participants. Paulson’s and Bernanke’s bailout programs are disabling the key market mechanisms for correcting entrepreneurial errors: price adjustments and bankruptcies. Delays in the correction of mortgage asset prices, and delays in the necessary resolution of insolvent financial institutions, do not promote but rather hinder a sound economic recovery. As ABC News commentator John Stossel has written: “We do need protection from reckless businessmen. But there is only one way to provide that: market discipline. That means no privileges and no bailouts.”

When government does not intervene with taxpayer-financed bailouts, private market participants will recapitalize banks (as Mitsubishi Bank recently did for Morgan Stanley) and buy distressed assets in genuinely price-discovering market transactions, to the extent that those risking their own money think warranted. The resolution (sale or liquidation) of firms that are not worth recapitalizing makes room in the market for better-run institutions to take their place. As the United States discovered in the savings-and-loan fiasco of the 1980s, and as Japan discovered in the 1990s, a government policy of keeping insolvent financial firms open beyond their expiration date makes survival more difficult for healthy firms.

Along these lines, the eminent monetary historian Anna J. Schwartz candidly criticized the bailout programs in an interview with the Wall Street Journal on October 18. To promote recovery the Fed and Treasury “should not be recapitalizing firms that should be shut down,” Schwartz said. Rather, “firms that made wrong decisions should fail. You shouldn’t rescue them. And once that’s established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich.”

Schwartz observed that “Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them.” Removing the uncertainty by enforcing the usual rules requiring insolvent firms to exit the market promptly would provide greater clarity to financial markets. The economist Pedro H. Albuquerque has drawn out the implications of this insight: bailout plans make “the information problem worse by keeping unhealthy banks afloat,” which “endangers the entire economy through planned obfuscation.” A hypothetical used-automobile market in which buyers are reluctant to buy because they fear that sellers are trying to palm off unreliable vehicles is known to economists as a “lemons” market. Albuquerque observes that “The government is artificially creating a lemon market when it does not allow discrimination between healthy and unhealthy banks to occur via bank failures.”

Some editorial and op-ed writers have claimed that many financial institutions have been “unregulated” too long and must now become regulated. But financial institutions have never been unregulated. They have been regulated by profit and loss. The failure of Lehman Brothers and the near-failure of Merrill Lynch raised the interest rate at which profit-seeking lenders were willing to lend to highly leveraged investment banks. The market thereby forced Goldman Sachs and Morgan Stanley to change their business models drastically and to convert to commercial banks. If that isn’t effective regulation, what is? Protecting firms from failure (Bear Stearns, AIG, Fannie Mae, Freddie Mac, Goldman Sachs, Citibank) and mitigating their losses with bailouts renders this most appropriate form of regulation much less effective.

The eagerness of Ben Bernanke and Hank Paulson to substitute their own judgment for the dispersed judgments of a freely competitive financial market may reflect simple intellectual error. Or, less innocently in the case of former Goldman Sachs CEO Paulson, it may be error compounded with partiality. In an open letter to Congress on the eve of the bailout bill’s passage, John A. Allison, CEO of the large and successful regional bank BB&T, pointed out that “There is no panic on Main Street and in sound financial institutions. The problems are in high-risk financial institutions and on Wall Street.” The bailout seemed designed, in his view, to benefit a select group of Wall Street firms: “The primary beneficiaries of the proposed rescue are Goldman Sachs and Morgan Stanley.. . . [T]his is primarily a bailout of poorly run financial institutions.” This design, Allison continued, was not an accident but the result of partiality in the designers’ interests and perspective: “Treasury is totally dominated by Wall Street investment bankers. They do not have knowledge of the commercial banking industry. Therefore they cannot be relied on to objectively assess all the implications of government policy on all financial intermediaries.”

In consecutive issues of The Freeman, Richard Timberlake has contributed an interesting trilogy of articles advancing a monetarist critique of the conduct of U.S. monetary policy during the 1920s and 1930s.^[1] In the first of these articles, Timberlake disputes the late Murray Rothbard’s “Austrian” account of the boom-bust cycle of the 1920s and 1930s. Timberlake contends that Rothbard proceeds on the basis of a “new and unacceptable meaning” for the term “inflation” and a contrived definition of the money supply to “invent” a Fed-orchestrated inflation of the 1920s that, in fact, never occurred. Moreover, Timberlake alleges, Rothbard’s account was marred by a “mismeasurement of the central bank’s monetary data” as well as by a misunderstanding of the nature and operation of the Fed-controlled pseudo-gold standard by which U.S. dollars were created during this period.

In the two subsequent articles, Timberlake also takes issue, respectively, with the U.S. Treasury’s policy of neutralizing gold inflows and the Fed’s policy of sharply raising reserve requirements in the mid-1930s, arguing that these complementary policies aborted an incipient economic recovery and brought on the recession of 1937–38. In what follows I will address the weighty charges brought against Rothbard and, in the process, offer an evaluation of the Federal Reserve System’s culpability for the economic events of these tragic years that diverges radically from Timberlake’s.

The Meaning of “Inflation”

Let me begin with Timberlake’s contention that Rothbard imputes a meaning to the word “inflation” that is both new and unacceptable. In fact Rothbard’s definition of inflation as “the increase in money supply not consisting in, i.e., not covered by, an increase in gold,” is an old and venerable one. It was the definition that was forged in the theoretical debate between the hard-money British Currency School and the inflationist British Banking School in the mid-nineteenth century. According to the proto-Austrian Currency School, which triumphed in the debate, the gold standard was not sufficient to prevent the booms and busts of the business cycle, which had continued to plague Great Britain despite its restoration of the gold standard in 1821.^[2]

Briefly, according to the Currency School, if commercial banks were permitted to issue bank notes via lending or investment operations in excess of the gold deposited with them this would increase the money supply and precipitate an inflationary boom. The resulting increase in domestic money prices and incomes would eventually cause a balance-of-payments deficit financed by an outflow of gold. This external drain of their gold reserves and the impending threat of internal drains due to domestic bank runs would then induce the banks to sharply restrict their loans and investments, resulting in a severe contraction of their uncovered notes or “fiduciary media” and a decline in the domestic money supply accompanied by economy-wide depression.

To avoid the recurrence of this cycle, the Currency School recommended that all further issues of fiduciary media be rigorously suppressed and that, henceforth, the money supply change strictly in accordance with the inflows and outflows of gold through the nation’s balance of payments. The latter provided a natural, noncycle-generating mechanism for distributing the world’s money supply strictly in accordance with the international pattern of monetary demands.

Following the triumph of the Currency School doctrine and the implementation of its policy prescription by the Bank of England, its definition of inflation became accepted in the English-speaking world, especially in the United States, where there existed a much more radical and analytically insightful American branch of the School. The term “inflation” was now used strictly to denote an increase in the supply of money that consisted in the creation of currency and bank deposits unbacked by gold. Thus for example, the American financial writer Charles Holt Carroll wrote in 1868 that “The source of inflation, and of the commercial crisis, is in the nature of the system which pretends to lend money, but creates currency by discounting such bills when there is no such money in existence.”^[3] Even earlier, in 1858, Carroll had written, “Instead of using gold and silver for currency they are merely used as the basis of the greatest possible inflation by the banks,” and that “we should prevent any artificial increase of currency to prevent a future . . . catastrophe.”^[4] So it was the “artificial increase of currency” only—through the creation of unbacked bank notes and deposits—that constituted inflation.

The leading monetary theorist in the United States in the last quarter of the nineteenth century was Francis A. Walker. According to Walker, writing in 1888, “A permanent excess of the circulating money of a country, over that country’s distributive share of the money of the commercial world is called inflation.”^[5] While this version of the definition is applicable to inconvertible paper fiat currency, Walker also believed that inflation was an inherent feature of the issuance of convertible bank notes and deposits that lacked gold backing. In Walker’s words, “there resides in bank money, even under the most stringent provisions for convertibility, the capability of local and temporary inflation.”^[6]

Unfortunately, however, because the writers of the British Currency School, unlike their American cousins, neglected to consider bank deposits as part of the money supply, their policies as adopted in Great Britain failed to prevent inflation and the business cycle. Consequently, and tragically, the School’s doctrines and policies fell into profound disrepute by the late nineteenth century, and its definition of inflation was replaced by that of the opposing Banking School, which saw inflation as a state in which the money supply exceeds the needs of trade.

Early American quantity theorists following the proto-monetarist Irving Fisher, in particular, seized upon and adapted this definition to their peculiar analytical perspective. Thus, Edwin Kemmerer wrote in 1920 that, “Although the term inflation in current discussion is used in a variety of meanings, there is one idea common to most uses of the word, namely, the idea of a supply of circulating media in excess of trade needs.”^[7] Kemmerer went on to define inflation as a state in which, “at a given price level, a country’s circulating media—money and deposit currency—increase relatively to trade needs.” From here it was a short step to the currently prevailing definition of inflation as an increase in the price level.^[8]

So Rothbard’s theory is surely not new and to say that it is “unacceptable” is simply to express one’s agreement with the long-entrenched preference among orthodox quantity theorists, including contemporary monetarists, for the Banking School over the Currency School.

Defining Money

Timberlake also challenges Rothbard’s statistical definition of the money supply for including savings and loan share capital and life insurance net policy reserves, alleging that Rothbard contrived this definition in order to make the rate of monetary growth appear larger than it actually was during the 1920s. Timberlake argues that the two items in question are not money because “they cannot be spent on ordinary goods and services. To spend them, one needs to cash them in for other money—currency or bank drafts.”^[9] Let us take these items one at time.

In the case of savings and loan share capital, there are two responses to Timberlake. First, the “share accounts” offered by savings and loan associations are and always have been economically indistinguishable from the savings deposits offered by commercial banks, included in the older (pre-1980) definition of M2 that Timberlake apparently upholds as the appropriate definition of the money supply.^[10] In practice depositors could withdraw their savings deposits from commercial banks on demand, because the law that permitted the banks to insist on a waiting period was rarely if ever invoked. Similarly, while savings and loan associations were contractually obligated to “repurchase” their “shares” at par on request of the shareholder, they could legally delay such repurchase for shorter or longer periods depending on their individual bylaws. Nonetheless such delays rarely occurred and “for many years savings and loan associations have made the proud boast ‘every withdrawal paid upon demand’ or some similar statement.”^[11]

Moreover, while Timberlake is right that “shareholders” had to trade their share accounts in for currency or bank drafts (at par and on demand) before they could spend them on goods and services, this was equally true of savings depositors at commercial banks. Thus the public has always considered dollars held in savings and loan share accounts or savings accounts as readily spendable as dollars held in commercial bank savings deposits.

Second, Timberlake curiously does not object to Rothbard’s inclusion of the savings deposits of mutual savings banks in the money supply, although they also are not included in the M2 definition he favors.^[12] What makes Timberlake’s position even more puzzling is that mutual savings banks were practically identical in economic function to savings and loan associations and were also technically “mutually” owned by their depositors.^[13] So why, then, does Timberlake insist so vehemently on treating the liabilities of these two institutions differently?

A resolution of this mystery can perhaps be found in the work of Milton Friedman and Anna Schwartz, who excluded the share accounts of savings and loans (and of credit unions) from their definition of the money supply on the grounds that these institutions are technically not banks as defined “in accordance with the definition of banks agreed upon by federal bank supervisory agencies” since “holders of funds in these institutions are for the most part technically shareholders, not depositors.” Despite this legal technicality, however, even Friedman and Schwartz were forced to admit that those who place funds with these institutions “clearly . . . may regard such funds as close substitutes for bank deposits, as we define them.”^[14]

Life Insurance Reserves

This brings us to the issue of the net policy reserves of life insurance companies. Rothbard claimed that the cash surrender values of life insurance companies, that is, the immediately cashable claims possessed by policyholders against life insurance companies, statistically approximated by the companies’ net policy reserves, represent a source of currently spendable dollars and should be included in the money supply. Once again the question is not whether insurance companies superficially resemble banks or can be technically classified as such according to some arbitrary regulatory definition. It is whether they essentially function like depository institutions, receiving funds from the public with which to make loans and investments, while contractually promising that such funds are available for withdrawal on demand by the policyholder. In Rothbard’s view, the policyholder is economically in precisely the same position as a bank depositor (and thrift institution shareholder) in holding an immediately cashable par-value claim to dollars.

Now admittedly, Rothbard’s inclusion of this item in the money supply is controversial, much more so than his inclusion of savings and loan share accounts. However, he was hardly alone in maintaining this position. A number of mainstream writers of money and banking textbooks in the 1960s and 1970s recognized that cashable life insurance reserves possessed some of the characteristics of money. For example, Walter W. Haines characterized insurance companies as “savings institutions” and noted that these savings “can be withdrawn at any time” simply by allowing the policy to lapse, a feature that marks them as a “near-money” on a par with savings accounts.^[15] M.L. Burstein maintained that the cash value of a life insurance policy offered “ready convertibility” into cash, was “almost as liquid as a mattressful of currency,” and satisfied the “precautionary motive” for holding liquid assets no less than savings and loan accounts and savings bonds.^[16] Albert Hart and Peter Kenen included the “net cash values of life insurance” in the broadest class of financial assets possessing the attribute of “moneyness,” while Thomas F. Cargill ranked them on a liquidity spectrum immediately below large certificates of deposit, which are included in the current M3 definition of the money supply.^[17]

More important, however, even if we grant for the sake of argument that net life insurance reserves should be excluded from the money supply, we find that it makes very little difference to Rothbard’s characterization of the 1920s as an inflationary decade. With this item included, the increase in Rothbard’s M between mid-1921 and the end of 1928 totaled about 61 percent, yielding an annual rate of monetary inflation of 8.1 percent a year; with this item left out (but savings and loan share accounts included), the money supply increased by about 55 percent over the period or at an annual rate of 7.3 percent.^[18] Mirabile dictu, by using a definition of the money stock that arbitrarily excludes savings and loan share accounts while including mutual savings bank deposits on the basis of an inexplicable adherence to a legalistic regulatory definition of banks, it turns out that it is Timberlake (and Friedman and Schwartz) who have mismeasured money supply growth during the 1920s.

Flawed Institutions

Timberlake also criticizes Rothbard for “ignorance of the flawed institutional framework within which the gold standard and the central bank generated money” and also of “mismeasurement of the central bank’s monetary data.”^[19] But this is surely a curious charge to level against Rothbard, steeped as he was in Currency School doctrine. In fact, Rothbard was quite cognizant that the U.S. monetary regime of the 1920s and 1930s was not a genuine gold standard in which the supply of money was determined exclusively by market forces, that is, by the balance of payments and the mining of gold, but a hybrid system in which the Fed possessed substantial power to manipulate the money supply by pyramiding paper bank reserves atop its stock of gold reserves. Indeed, Rothbard went much further than Timberlake in rigorously and completely separating those factors affecting the money supply that were subject to Fed control from those that the Fed had no control over.^[20]

In analyzing the central bank monetary data, Timberlake starts with the monetary base or “Total Fed,” which is equal to currency in circulation plus member bank reserves. From this aggregate he properly subtracts the Fed’s legal-tender reserves, mainly the gold stock, whose size depends on balance-of-payments flows and is not under the immediate control of the Fed. What remains is the “net monetary obligations” of the Fed or “Net Fed,” which, according to Timberlake, “faithfully indicates the intent of Fed policy.”^[21] From 1921 to 1929, this aggregate declined by 8 percent per year, leading Timberlake to conclude that the intent of Fed policy was decidedly deflationary during this period. The motive for this deflationary policy bias was, Timberlake suggests, to aid Great Britain in re-establishing and maintaining gold convertibility for the pound sterling.

However, as important as it is, the gold stock is not the only factor that lay beyond the Fed’s control. For as Rothbard points out, currency in circulation, which improperly remains in Timberlake’s Net Fed aggregate, is not controlled by the Fed at all but by the banking public. Any time a depositor withdraws cash from a bank, currency in circulation increases and bank reserves decline, dollar for dollar. Under a fractional-reserve banking system, this loss of reserves causes a multiple contraction of bank deposits that far exceeds the original increase in currency in circulation that induced it and therefore results in a net deflation of the money supply. Conversely, a decline in the amount of currency held by the public causes an overall increase in bank reserves and an overall inflation of the money supply.

This is not all, however—Timberlake also ignores the fact that under the prevailing policy regime the banks themselves could autonomously reduce the amount of bank reserves and thus the quantity of money in existence by deliberately reducing their indebtedness to the Fed. During this period, it was the chosen policy of the Fed to lend liberally and continuously to all banks at an interest, or “discount,” rate below the market rate. While the Fed was legally authorized to make such loans to its member banks, it was not mandated to do so. Furthermore, it also retained complete power to set the “discount rate” it charged on these loans. Hence, if it had chosen to, the Fed could have restricted its lending to emergency situations and charged a penalty rate substantially above the market rate, so as to discourage all but the most seriously troubled banks from applying for loans. In short, it could have almost completely neutralized the inflationary impact of its discounting operations. This “emergency lending” policy had been urged by some prominent officials within the Fed establishment itself.^[22]

The fact that the Fed chose instead to pursue a “continuous lending” policy meant that the increase in bank reserves that resulted from the origination of new Fed loans to member banks via the rediscounting of business bills or advances on collateralized bank promissory notes was under the exclusive control of the Fed. But it also meant that the reduction in bank reserves entailed by the net repayment of discounted bills was uncontrolled by the Fed, because it depended solely on the decisions of the banks. Given the Fed’s indiscriminate, below-market rate discount policy, the banks were always in a position to maintain or augment their debts to the Fed if they so desired simply by discounting additional bills with the Fed. Thus, as Rothbard concluded, when “Bills Repaid” exceeded “New Bills Discounted,” banks were deliberately and autonomously diminishing their level of indebtedness to the Fed and this must be counted as an uncontrolled deflationary influence on bank reserves.

Real Fed Intent

If we follow Rothbard, then, in identifying currency in circulation and the reduction of bank indebtedness to the Fed along with the gold stock as the main “uncontrolled” factors affecting bank reserves, we get a picture of the Fed’s intent during the 1920s and early 1930s that is poles apart from the one suggested by Timberlake. Indeed, we find that from the inception of the monetary inflation in mid-1921 to its termination at the end of 1928, “uncontrolled reserves” decreased by $1.430 billion while controlled reserves increased by $2.217 billion. Since member bank reserves totaled $1.604 billion at the beginning of this period, this means that controlled reserves shot up by 138 percent or 18.4 percent per year during this seven-and-one-half year period, while uncontrolled reserves fell by 89 percent or 11.9 percent per year. Thus Rothbard correctly concluded that the 1920s were an inflationary decade and that it was indeed the intention of the Federal Reserve System that it be so.^[23]

The Fed’s inflationary intent is perfectly consistent, moreover, with its motive of helping Great Britain re-establish and maintain the pre-war parity between gold and the British pound. While Timberlake properly recognizes this motive underlying Fed policy, he is incorrect in suggesting that it necessitates a deflationary policy on the part of the Fed. In fact, the precise opposite is required. The British pound in the mid-1920s was overvalued vis-à-vis gold and the U.S. dollar, causing British products to appear relatively overpriced in world markets. As a result, Great Britain experienced imports chronically in excess of exports accompanied by persistent balance-of-payments deficits and outflows of gold reserves. Had the Fed deflated the U.S. money supply, thus lowering U.S. prices even more relative to British prices as Timberlake claims was its intention, it would have exacerbated, and not resolved, Great Britain’s gold drain. Clearly, then, the Fed’s desire to aid Britain in reversing its balance-of-payments deficits and rebuilding its gold stocks called for an inflationary policy intended to pump up U.S. prices, thereby rendering British products relatively cheap and enhancing the demand for them on world markets.^[24]

This point about the motive for the Fed’s easy-money policy in the 1920s was not only advanced by Rothbard, but by other economists, including monetarists such as Kenneth Weiher. According to Weiher:

Great Britain was calling for help [in 1924] and Benjamin Strong [president of the New York Fed] heard the call. Expansionary monetary policy in the U. S. would drive prices up and interest rates down in this country, which would tend to send gold flowing toward Great Britain, where prices were lower and interest rates higher. These changes would help America’s ally build up its stock of gold. . . . [T]here can be no question that the Fed would not have moved when it did were it not for concern over the gold standard and the plight of Great Britain. . . . By 1927, the stagnant British economy needed help from the United States and the rest of Europe. . . . Just as had been the case in 1924, monetary policy was shifted to an expansionary program in an effort to aid Great Britain’s struggles to return to the gold standard.^[25]

Rothbard’s reinterpretation of the monetary data also cuts against Timberlake’s claim that the Fed “monetarily starved the country into the worst economic crisis it has ever experienced.”^[26] On the contrary, the factors controlled by the Fed continued to exercise a highly inflationary impact on bank reserves and the money supply from late 1929 through 1932, as the Fed attempted desperately to ward off the depression precipitated by the termination of the bank credit inflation that it had orchestrated in the 1920s.

The deflation of the money supply, therefore, was caused wholly by factors beyond the control of the Fed. First, there was a loss of confidence in the Fed-dominated phony gold standard among the domestic public and foreign investors. As a result there occurred an increase in currency in circulation and a decline in the Fed’s gold stock, both of which caused bank reserves to decline. Second, U.S. banks prudently attempted to save themselves and their depositors by restricting their loans to overcapitalized and failing businesses and instead using these funds to pay down their indebtedness to the Fed, which gave further impetus to the “uncontrolled” reduction of bank reserves. Third, in the second quarter of 1932, the banks also began to increase their liquid reserves beyond the legal minimum. The accumulation of “excess reserves,” as they were called, constituted a separate uncontrolled factor that reinforced the deflationary influence of the uncontrolled decline in bank reserves on the money supply.

From the end of December 1929 to the end of December 1931, bank reserves fell from $2.36 billion to $1.96 billion causing RM (for Rothbard’s money supply) to drop from $73.52 billion to $68.25 billion or at an annual rate of 3.6 percent. But this monetary deflation was not caused by the Fed, which pumped up controlled reserves by $672 million or at an annual rate of 17 percent during the period, while uncontrolled reserves declined by $1,063 million or by 27 percent per year. During 1932, RM continued to decline, falling to $64.72 billion or by 5.2 percent. But bank reserves increased sharply during the year from $1.96 billion to $2.51 billion, as the Fed furiously inflated controlled reserves. In the last ten months of the year, controlled reserves rose by a staggering $1,165 million, or at an annual rate of 76 percent. Fortunately, this attempted massive inflation of the money supply was undone by the domestic public, foreign investors, and the banks as uncontrolled reserves dwindled by $495 million and banks began to accumulate substantial excess reserves.

The story was much the same in 1933 as a determined inflationary campaign conducted by the Fed in the early part of the year—controlled reserves rose by $785 million in February alone—was defeated by the public and the banks, and RM declined by over $3 billion, or by almost 5 percent.^[27]

So once the data have been properly arranged and interpreted, it becomes clear that the Fed does not deserve praise for the bank credit deflation of 1930–1933. This honor goes to private dollar-holders, domes-tic and foreign, who attempted to reclaim their rightful property from a central bank-manipulated and inflationary financial system masquerading as a gold standard that had repeatedly betrayed their trust.

“Sterilizing” Gold

In two follow-up articles, Timberlake extends his attack on what he considers to be the “deflationary” monetary policies pursued by the Treasury and Fed in the mid-1930s. In particular, he criticizes the Treasury’s policy of “neutralizing,” or “sterilizing,” the effect of the inflow of gold on bank reserves from late 1936 to early 1938 and the Fed’s policy of increasing reserve requirements in 1936 and 1937. But neither of these policies caused a contraction of the money supply. They merely temporarily interrupted a massive monetary inflation caused by the abolition of the gold standard and subsequent devaluation of the dollar engineered by the Roosevelt administration.

It is important to recognize that this influx of gold was not a result of the “uncontrolled” operation of the gold standard, which had been abolished in 1933. Rather, it was the result of the deliberate and steady increase in the price at which gold was purchased by the U.S. Treasury and the Reconstruction Finance Corporation. By January 1934, the price of gold had risen from $20.67 to $35.00 per ounce, or by almost 70 percent, where it was officially pegged by the Gold Reserve Act of 1934. The Treasury was now legally mandated to maintain this devalued exchange rate between gold and the dollar by freely purchasing all the gold offered to it at this price. In effect, then, Treasury gold purchases were now economically identical to inflationary Fed open market purchases, substituting demonetized gold for government securities. Consequently, in response to this unilateral increase in the price of gold above its world price, there occurred a prodigious influx of gold into the United States—a “golden avalanche” it was called at the time—which vastly increased bank reserves. The result was an unprecedented inflation of the money supply (M2) during 1934, 1935, and 1936 at annual rates of 14 percent, 14.8 percent, and 11.4 percent, respectively.^[28]

With respect to its influence on the supplies of bank reserves and money, the demonetized gold stock thus had been transformed into a factor “controlled” by monetary—in this case Treasury—policy. Given that the use and ownership of gold money by the public had been legally suppressed, gold was effectively demonetized and its continued purchase by the Treasury was purely a matter of discretionary monetary policy. Accordingly—and contrary to Timberlake’s assertion—when during 1937 the Treasury began to finance its purchases of gold in a manner that neutralized their effect on bank reserves, it was not engaging in deflation. The simultaneous sales of government securities to finance these purchases were simply and properly eliminating any extraneous effects of a demonetized asset on the money supply.

Even if gold were permitted to continue in its monetary function, however, Timberlake would still be wrong in criticizing the policy of neutralizing its effect on bank reserves. For under a genuine, Currency School-type gold standard, a country’s money supply would increase by exactly the amount of the gold inflow from abroad. This is not inflationary and represents precisely the proper amount by which the money supply should expand, because it is the outcome of the deliberate actions of the country’s residents who are decreasing their purchases of foreign imports and increasing their sales of exports in order to satisfy their desires for greater money holdings. This balance-of-payments mechanism is a natural part of the market economy and works continually on all levels—including the region, state, town, and even household—to efficiently adapt money supply to relative changes in money demand.

A problem arises, however, when these benign, money demand-driven gold inflows are used, as they were in the 1920s and early 1930s, as bank reserves to create unbacked notes and deposits. In this case, as F. A. Hayek has so aptly described, international gold flows will regularly cause a serious distortion of the free-market interest rate and investment pattern in the affected countries, leading to a business cycle.^[29] The reason is that the needed adjustment in national money supplies upward or downward now entails creating or destroying fiduciary media by expanding or contracting bank loans in defiance of the preferences of the economy’s consumers and savers. Thus, a policy of neutralizing the effect of gold flows on bank reserves in the context of a fractional-reserve banking system dominated by a central bank does not constitute a gross violation of the rules of the gold standard; to the contrary, it tends to facilitate the operation of the natural money-supply mechanism that prevails under a genuine gold standard.

Not surprisingly, in the third article of the trilogy, Timberlake also objects to the Fed’s policy of raising reserve requirements in 1936 and 1937, which was undertaken to mop up the massive amounts of excess reserves held by the banking system. Timberlake advances two criticisms against this policy. First, the policy was unnecessary because, even if all the excess reserves that existed on the eve of its implementation were subsequently fully loaned out by the banks, the inflationary potential was relatively minor. Appealing to the Banking School definition of inflation, Timberlake pronounces the 52 percent increase in the money supply that would have resulted as only mildly inflationary because the larger money supply would have exceeded the needs of trade of a fully employed economy by 5.6 percent at 1929 prices, which were about 25 percent higher than prices prevailing in June 1936.^[30] In plain language, Timberlake is literally defining away a potential money and price inflation of gargantuan proportions because of its perceived expedience in expanding employment and output and extricating the economy from a depression. But as Timberlake himself admits in a footnote—and as Rothbard and other Austrians have never ceased to argue—what impeded the economy’s natural and noninflationary recovery from the depression was the existence of “government programs [that] had actively worked against money price declines for ten years.”^[31]

Growing Money Supply

In his second criticism, Timberlake contends that the increase in reserve requirements went beyond closing off a potential avenue of recovery for the economy and “turned what had been an ongoing recovery into another cyclical disaster.” But if we once again turn to Timberlake’s data we find that the money supply (M2) continued to grow, from $43.3 to $45.2 billion or by 4.4 percent, between June 30, 1936, and June 30, 1937, the year in which this policy was implemented. Even if we focus on the last six months of the period, there was hardly a wrenching deflation, as the money supply increased at an annual rate of 0.8 percent.^[32] Even from Timberlake’s monetarist standpoint, then, it is difficult to blame the “recession within a depression” of 1937–1938 on deflationary Fed policy.

Unfortunately Timberlake’s strained and narrow emphasis on Fed deflationism as the cause of all the woes of the 1930s causes him to ignore a plausible “Austrian” explanation of the relapse of 1937. As a result of a spurt of union activity due to the Supreme Court’s upholding of the National Labor Relations Act of 1935, money wages jumped 13.7 percent in the first three quarters of 1937. This sudden jump in the price of labor far outstripped the rise in output prices and, with labor productivity substantially unchanged, brought about a sharp decline in employment beginning in late 1937.^[33] The large upward spurt in excess reserves and the accompanying decrease in the money supply that we observe in Timberlake’s data between June 30, 1937, and June 30, 1938, therefore, can be explained as the result, and not the cause, of the recession.^[34] As business profits were squeezed by the run-up of labor costs and the economy slipped into recession, banks prudently began to contract their loans and pile up liquid reserves to protect themselves against prospective loan defaults and bank runs. To offset this uncontrolled decline of the money supply, beginning in mid-1938 the Fed (and the Treasury) once again resorted to an inflationary policy, reversing the reserve requirement increase and allowing gold inflows to once again pump up bank reserves. As a result, M2 increased by 5.9 percent, 10.1 percent, and 12.5 percent in 1938, 1939, and 1940, respectively.^[35]

Our conclusion, then, is that the Fed’s monetary policy, except for very brief periods in 1929 and 1936–1937 when it turned mildly disinflationist, was consistently and unremittingly inflationist in the 1920s and 1930s. This inflationism was the cause of the Great Depression and one of the reasons why it was so protracted. []

Notes

1. Richard H. Timberlake, “Money in the 1920s and 1930s,” The Freeman, April 1999, pp. 37–42; “Gold Policy in the 1930s,” The Freeman, May 1999, pp. 36–41; and “The Reserve Requirement Debacle of 1935–1938,” The Freeman, June 1999, pp. 23–29.
2. For a review of this debate, see Murray N. Rothbard, Classical Economics: An Austrian Perspective on the History of Economic Thought, Volume II (Brookfield, Vt.: Edward Elgar Publishing Company, 1995), pp. 225–74.
3. Charles Holt Carroll, Organization of Debt into Currency and Other Papers, ed. Edward C. Simmons (Princeton: D. Van Nostrand Company, Inc., 1964), p. 333.
4. Ibid., p. 91.
5. Francis A. Walker, Political Economy (New York: Henry Holt and Company, 1888), p. 151.
6. Ibid., p. 171.
7. Edwin Walter Kemmerer, High Prices and Deflation (Princeton: Princeton University Press, 1920), p. 3.
8. Ibid., p. 4.
9. Timberlake, “Money in the 1920s and 1930s,” p. 38. For Rothbard’s explanation and defense of his broader definition of the money supply, see Murray N. Rothbard, America’s Great Depression (Los Angeles: Nash Publishing Corporation, 1972 [1963]), pp. 83–86.
10. I say “apparently,” because he states that “No basis exists for a more inclusive money stock than M2” (ibid., p. 42, n. 3). It should be pointed out that, since February 1980, savings accounts of savings and loan associations and credit unions have been included, along with savings deposits of commercial and mutual savings banks in the new M2, an official Fed statistic that is today considered to be the most reliable indicator of movements in the money supply by many economists.
11. John G. Ranlett, Money and Banking: An Introduction to Analysis and Policy (New York: John Wiley & Sons, Inc., 1969), p. 251.
12. Paul A. Meyer, Monetary Economics and Financial Markets (Homewood, Ill.: Richard D. Irwin, Inc., 1982), pp. 31–32.
13. Walter A. Haines, Money, Prices, and Policy (New York: McGraw-Hill Book Company, Inc., 1961), pp. 249–50.
14. Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton: Princeton University Press, 1963), p. 4, fn. 4. The essential economic—as opposed to the technical legal—identity between commercial bank deposits and all kinds of instantaneously cashable savings accounts held at the various nondepository or thrift institutions was established many years before Friedman and Schwartz wrote, in 1937, in a brilliant but neglected article by Lin Lin (“Are Time Deposits Money?” American Economic Review, March 1937, pp. 76–86). This article was not cited by Friedman and Schwartz but greatly influenced Rothbard.
15. Haines, pp. 253–54, 31–32.
16. M. L. Burstein, Money (Cambridge, Mass.: Schenkman Publishing Company, Inc., 1963), p. 111.
17. Albert Gaylord Hart and Peter B. Kenen, Money, Debt, and Economic Activity (Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1961), pp. 4–6; Thomas F. Cargill, Money, the Financial System and Monetary Policy (Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1979), p. 11.
18. I have based this calculation on Rothbard’s data. See Rothbard, America’s Great Depression, p. 88.
19. Timberlake, “Money in the 1920s and 1930s,” p. 38.
20. Rothbard, America’s Great Depression, pp. 94–100.
21. Timberlake, “Money in the 1920s and 1930s,” p. 40.
22. On the Fed’s discount policy in the 1920s, see Rothbard, America’s Great Depression, pp. 111–16.
23. For an analysis of the factors involved in the development of the monetary inflation of the 1920s, see ibid., pp. 101–25.
24. On the desire to help Great Britain restore the gold standard at an overvalued gold parity without having to endure the consequences of deflating its economy as an important motive driving the Fed’s inflationary monetary policy in the 1920s, see ibid., pp. 131–45.
25. Kenneth Weiher, America’s Search for Economic Stability: Monetary and Fiscal Policy Since 1913 (New York: Twayne Publishers, 1992), pp. 48–49.
26. Timberlake, “Gold Policy in the 1930s,” p. 36.
27. On the factors responsible for the monetary deflation of the early 1930s, see Rothbard, America’s Great Depression, pp. 186–295 passim.
28. Weiher, pp. 75, 79–82.
29. F. A. Hayek, Monetary Nationalism and International Sta-bility (New York: Augustus M. Kelley Publishers, 1971 [1937]), pp. 25–32.
30. These figures are calculated from Timberlake’s data. See Timberlake, “The Reserve Requirement Debacle,” p. 27.
31. Ibid., p. 29, n. 11.
32. Ibid., p. 27.
33. Richard K. Vedder and Lowell E. Gallaway, Out of Work: Unemployment and Government in Twentieth-Century America (New York: Holmes and Meier, Publishers, Inc., 1993), pp. 129–36. For a similar explanation of the 1937 slump, see Benjamin M. Anderson, Economics and the Public Welfare: A Financial and Economic History of the United States, 1914–1946 (Indianapolis: LibertyPress, 1979 [1949]), pp. 432–38.
34. Timberlake, “The Reserve Requirement Debacle,” p. 27.
35. Weiher, pp. 75–86.

The Austrian theory of the business cycle describes how expansion of money and credit can cause recession or depression. Perhaps under political pressure to cut interest rates, the monetary authorities expand bank reserves. Business firms find credit cheaper and more abundant. These signals suggest, incorrectly, that people have become more willing to save and thereby free resources for investment projects. Firms put more resources into interest-sensitive projects that will take relatively long times to ripen into consumer goods and services. Actually, investable resources have not become more abundant through voluntary saving. Competition for resources grows more intense among long-term and short-term capital-goods industries and consumer-goods industries. This becomes especially true as workers employed on the artificially stimulated long-term projects try to spend their increased incomes on current consumption.

Sooner or later, however, the falsified appearances must bow to reality. Shortages or increased prices of resources necessary for completing the capital-construction projects force abandoning some of them, at least partially wasting the resources they embody. A tightening of money and credit may play a part in this return to reality, for continuing to expand them would threaten unlimited inflation. Cutbacks in long-term investment mean laying off workers and canceling some orders for machines and materials and some rentals of land and buildings. The downturn is under way.

Sophisticated Austrians do not claim that this scenario accounts for all recessions and depressions, but it is the one most often recited in Austrian circles. Though conceivable as a scenario, as a general theory it has long seemed implausible to me—incomplete yet unduly specific. However, it suits the Austrians’ methodological and ideological predilections. The Austrians cite observed facts that are compatible with their account; but practically never, to my knowledge, do they present evidence that favorably discriminates between it and rival theories. (I find the “monetary-disequilibrium” or “monetarist” theory in better accord with standard economic theory and with statistical and historical evidence from many times and places.) The Austrian school has much of value to teach the world, but its favorite emphasis in business-cycle theory is an embarrassment that it would well be rid of.

Tyler Cowen now joins the attack on this “old Austrian perspective,” as he calls it. He finds it strange that business investors, despite weeding-out and discipline by profit and loss, should repeatedly be fooled by artificially and unsustainably low interest rates. His long list of further reasons why the Austrian theory is implausible—his protracted flogging of a dead horse—becomes tedious.

Cowen offers his own “new perspective,” his “risk-based” theory, as a modification of the one he rejects. Whereas the Austrian theory requires “volatile inflation” rather than steady inflation, volatile inflation under his theory “produces an immediate contraction and downturn, rather than an expansion of malinvestment.” (By “inflation,” Cowen usually seems to mean money-supply expansion rather than price inflation.) His theory “is not committed to pinpointing the nature of expectational errors from inflation, as does [sic] the traditional Austrian theory.” It does not require that a bust always follow an inflationary boom. “Either increases or decreases in long-term investment may set off downturns.” It does not rely on specific types of misperception, forecast error, or malinvestment; it can accommodate a variety of them.

It is pointless to go on trying to summarize Cowen’s theory. Although it does invoke a tradeoff between risk and expected yield on investments, it is not really a theory. It is a farrago of disorganized lists of how risk, investments of various kinds, sectoral shifts, various misperceptions and errors, and monetary volatility might somehow affect business conditions. Cowen repeatedly speaks of what “may” happen and occasionally of what “may or may not” happen.

All this is vague and iffy. To add complexity—to multiply the factors taken into account—is no virtue in its own right. On the contrary, a good theory penetrates beyond fringe complications to emphasize decisive circumstances and relations. It reveals significant uniformities amidst apparent diversities. The old Austrian account, though wrong as a general theory of cycles, arguably at least helps focus thinking and research on its subject matter. Cowen’s new theory does not rise even to that level; to borrow a phrase from the physicist Wolfgang Pauli, it is “not even wrong.”

One style of argument, for which it would be convenient to have an agreed name, overwhelms the reader with miscellaneous dates, figures, historical details, names, and even personality sketches, as if in hopes that the reader will be so impressed with the author’s erudition as not to notice that all this material fails to make a coherent argument about the points at issue. Cowen employs a variant of this style: he spews forth, almost as if at random, numerous theoretical terms and concepts and numerous summaries of other authors’ articles. Occasionally economists try to make a splash in their own field by importing concepts and techniques from philosophy or engineering or whatever. Cowen, with one foot still in the Austrian school that nurtured him, writes as if—I say no more than “as if”—attempting a similar splash by importing sophisticated terminology (more so than substance) from advanced economics and econometrics. He does not adequately test his theory against its rivals; the many potted summaries of econometric studies in his concluding chapter do not serve that purpose. He himself concludes by claiming no more than that his risk-based approach is compatible with microeconomic theory and with some observed facts and can provide a basis for future research.

Who might appreciate this book? Not the general reader who might be sympathetic to libertarian political philosophy and have an amateur interest in economics, for too many inadequately explained technicalities will repel him. Not the mainstream economist who likes to think of himself as working at the “frontier” of research, for he will find no contribution to the technical topics so blithely mentioned, and Cowen’s lack of rigor will irritate him. (I reject knee-jerk demands for “rigor” and “explicit models”; but Cowen’s loose style will arouse sympathy for such demands.) Nor will Cowen find much resonance among economists of the Austrian school, for his tacit parade of superiority rankles.