On the Gold Standard & the Federal Reserve

The Financial Times published a report yesterday citing parts of the Republican party platform that I find quite alarming.  Specifically, they note:

“Drafts of the party platform, which it will adopt at a convention in Tampa Bay, Florida, next week, call for an audit of Federal Reserve monetary policy and a commission to look at restoring the link between the dollar and gold.”

I’ll make this short and sweet because no one in their right mind wants to read about the Federal Reserve and the gold standard for more than 5 minutes.  The rationale behind the existence of the Federal Reserve system is really rather brilliant.  And moving off of the gold standard wasn’t brilliant, it was necessary.

First the Fed. The way the monetary system works is essentially with a two tiered money system.  You have inside money or bank money (banks deposits – most of our money supply).  And you have outside money or government money (cash, notes & reserves).  Most of the money is inside money or bank money.  Bank money can be inherently unstable just like the business cycle so it helps to have an entity that backs this system up in time of inevitable instability.

Back in the days before we had a central bank the banks were basically just issuing money and settling payments between themselves as they wished.  The problem was that when JP Morgan issued JPM notes for a big railroad project and Joe Schmo used those notes to buy a drink at his local bar after hammering rail track for 9 hours the bar owner would look at the notes and sometimes say “sorry friend, but my bank doesn’t take JPM notes any longer because they’re worried about them thar railroad companies and the related financing”.  Okay, I am probably simplifying things way too much there, but that’s essentially what happened on a massive scale during the 1800’s.  It was literally the wild wild west of banking.  And the result was 6 depressions and persistent banking crises.  Then the Fed comes along and creates the reserve system which was basically a way of helping banks settle payments (well, it was implemented for much more than that, but this was one of the primary issues it resolved).

So banks could settle payments in what is called outside money or bank reserves.  It’s kind of like having one big banking system rather than a bunch of different banks.  The reserve system streamlined the settlement process and helped stabilize inside money to an enormous degree.   When you understand the inner workings of the Fed it’s actually quite a remarkable construct and makes a great deal of sense.  The persistent calls to “end the Fed” and such are built on a misunderstanding of the monetary system and what is really a call to empower private banks even further and bring back the wild wild west of banking.  It doesn’t make sense.

As for the Fed auditing – well, they do get audited.  So I don’t know why we need to keep harping on that….

As for the gold standard – well, that’s basically what Europe has going on right now.  It’s a really lovely monetary construct that involves no floating exchange rates, a single currency, ties the hands of the government and results in persistent trade imbalances (oh, and results in depressions!).  See, Europe has no floating exchange rates because they all use the same currency.  And there’s no fiscal entity (like the US Treasury) that can offset the fiscal imbalances by distributing funds to those who need it.  No floating FX and no Treasury means the trade imbalances must be rectified through market pricing mechanisms.  The problem is, the market mechanism doesn’t work like all those neoclassicals wish it did.  So the trade imbalances persist, the underlying economic imbalances persist and you get a result that’s a lot like Europe where depression basically makes itself nice and cozy.  It’s a total disaster and trying to go back to a  system like that is madness.