The Federal Reserve & US History — BS vs Reality

George Selgin weighs in:

.. national bank notes had to be backed by government bonds.  That requirement, designed to bolster the Union’s finances while the [civil] war raged on, proved disastrous afterward, when government surpluses led to a halving of the federal debt, and to a corresponding shortage of bonds for securing bank notes. The resulting currency panics – in 1873, 1884, 1893, and 1907 – prompted the Fed’s establishment.  Until 1907, prominent reformers favored simply abolishing Civil War-era restrictions on banks’ freedom to issue notes and allowing all banks to branch nationwide to ease the mopping-up of unwanted paper money.

They drew inspiration from Canada, where a similar “asset currency” arrangement had been working smoothly for decades. Between the panic of 1893 and that of 1907, Congress considered more than a dozen “asset currency” measures But none got anywhere, thanks to local bankers’ determination to block any proposal for branch banking that would threaten their cozy monopolies.

It was only once these deregulatory efforts failed that reformers fell back on the plan of establishing a “central reserve bank.” The resulting Federal Reserve Act was, in essence, merely a plan to allow 12 new banks to do what other banks were prevented from doing themselves, namely, establish branch networks and issue currency backed by commercial assets.

But the Federal Reserve plan proved to be a poor substitute for deregulation. By granting monopoly privileges to the Federal Reserve banks, it allowed them to inflate recklessly: By 1919, the US inflation rate, which had cleaved close to zero ever since the Civil War, was close to 20 percent! Yet the Fed was also capable of failing to supply enough money to avert crises. The first downturn over which it presided – that of 1921 – was among the sharpest in US history. Still it was nothing compared to the unprecedented monetary contraction of 1929-1933.

Would asset currency have been any better? Canada’s was: Between 1929 and 1933, for instance, 6,000 US banks failed, and a third of the US money stock was wiped out. In contrast, and despite a fixed Canadian-US dollar exchange rate, Canada’s money stock shrank by just 13 percent, and no Canadian bank failed.

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