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A Magazine of Ideas

Central Bank Dreams, Monetary Realities

Tuesday, January 8, 2013

The legislative creators of the Fed would be surprised to discover that the Fed today is one of the biggest owners of real estate loans, with more than $900 billion of mortgage-backed securities on its books.

There was a time when there was no Federal Reserve.

Before the Fed, there was the National Banking Era of 1863–1914, for which the key legislation was the National Banking Act, originally called the National Currency Acts of 1863 and 1864, during the Lincoln administration. Exactly like the foundation of the Bank of England in 1694, which was created to finance King William III’s wars, a central purpose of the National Currency Acts was to finance the Civil War. In both cases, banks were given the power to issue paper currency in exchange for lending the government money.

The new national banks could issue their own paper currency, but 100 percent of this currency had to be secured (or “backed”) by U.S. government bonds. This was a handy way of raising debt for the war, but it was also statement of an essential banking principle: that money should be necessarily tied to claims on some safe asset. Stated as a question: What is the asset that can legitimately back the issuance of money? After the resumption of gold payments in 1879 under the Resumption of Specie Act, the government bonds backing the national bank currency were payable in gold.

What institutions are there today which are most like national banks as conceived in 1863?  How many of them are there? The answer is 12: the 12 Federal Reserve Banks. They buy government bonds and issue paper money, just as the original national banks did. They are very useful in financing the government. Only now do we have a monopoly of currency issuance by the Fed, instead of every national bank having that power.

What could the original national banks not do? They could not make any real estate loans.  These were viewed as too illiquid and risky to serve as assets for the issuers of currency.

Real estate loans were forbidden to national banks until 1913, when, along with the founding of the Fed, the banks were granted a limited ability to make farm mortgage loans. This power was extended to urban real estate loans in 1916 and was expanded in 1927, with a limit to these loans of only 50 percent of the value of the property; in other words, a maximum LTV of 50 percent.

Real estate loans were forbidden to national banks until 1913.

The legislators who created these real estate loan prohibitions and limits would doubtless be exceptionally surprised, as would the legislative creators of the Fed, to discover that the Fed today is one of the biggest owners of real estate loans, with over $900 billion of mortgage-backed securities on its books. We can imagine the gentlemen of 1863 or 1913 frowning severely down from congressional Valhalla at this, although John Law, wherever he is, might be smiling with approval.

A historical and current criticism of the National Banking Era is that it was marked by financial crises and panics — notably, the panic of 1907, which led to the creation of the Fed. 

The Fed was intended to cure this problem, and faith that it would was evident. The Comptroller of the Currency opined in 1914 that with the creation of the Fed, “financial and commercial crises or ‘panics’… seem to be mathematically impossible.” The American Banker of December 27, 1913 proclaimed about the signing of the Federal Reserve Act, “There will be supreme satisfaction with the thought that from this time forward the financial disorders which have marked the history of the past generation will pass away forever.”

Needless to say, these were supremely bad predictions. In fact, we have discovered that with the Fed we can have plenty of financial crises and panics, partially reflecting both the inflationary and deflationary mistakes of the Fed itself.
We are more than four decades into a massive, global monetary experiment which started in August 1971, when the United States reneged on its last commitment to gold redemption of the dollar. This experiment has put the whole world unto fiat currencies with floating exchange rates — a central bank heaven, one might think. 

What is the result in terms of crises and panics? We know only too well about the great financial crises of the 21stcentury. Let’s extend our view a few decades back. International economist Robert Z. Aliber, who updated Charles Kindleberger’s classic history of Manias, Panics, and Crashes, has observed, “The monetary turmoil of the last 30 years has been more extensive than at any previous comparable period. There have been four waves of financial crisis.” Especially notable during this period have been real estate busts and crises.

How can this be? I believe it reflects at the most fundamental level the reality of Uncertainty: that as Frank Knight famously said, not only do we not know the future, we also do not know the odds of future events, and moreover, we cannot know them. Therefore, mistakes by everybody, including central banks, are inevitable. Can’t we make this uncertainty go away?  Knight correctly answers:  no, we can’t.  Moreover, and particularly relevant to central banking, “the use of resources in reducing uncertainty is an operation attended with the greatest uncertainty of all.”

We have discovered that with the Fed we can have plenty of financial crises and panics, partially reflecting both the inflationary and deflationary mistakes of the Fed itself.

The key institutions in the post-1971 financial world are governments, which have increasingly used permanent deficit financing; central banks which issue, against the governments’ debt they buy, irredeemable paper currencies (accompanied by coins which clunk instead of ringing if you drop them on a table); and commercial banks which issue deposits redeemable only in the central banks’ fiat currencies. This arrangement has resulted in the general acceptance of permanent inflation and the redefinition of “price stability” to mean a more or less stable rate at which the purchasing power of the fiat currency depreciates (a pretty remarkable example of Newspeak).

It is a sobering thought that this entire system depends on trusting the foresight, wisdom, and knowledge of the managers of the key institutions.

An objection to such trust had previously been voiced by George Bernard Shaw. He was hardly a qualified economist, but it is hard to improve upon the wit of his objection: “You have to choose between trusting to the natural stability of gold and the natural stability of the honesty and intelligence of the members of the government.”

In my opinion, neither of these choices, and indeed no financial construct, is perfect, and all will experience inevitable problems. As there were problems in the National Banking Era, we cannot fail to observe that there are vast problems with the global fiat money system of the last four decades, which trusts to the knowledge, foresight, wisdom, and “natural stability” of government officers and especially central bankers.

We may consider the central dilemmas of central banking to be these:

-As Knight said, trying to reduce uncertainty can create uncertainty.

-Trying to reduce instability can create instability.

-Or, more specifically, trying to reduce financial instability through monetary manipulation can create financial instability.

This helps explain why putting things into the hands of Platonic Guardians at fiat currency central banks has led not to the dreams of 1913, but to the extensive and ongoing monetary turmoil described by Professor Aliber. At the same time, we must admit that the central banks remain exceptionally effective at lending money to their governments and issuing paper money.

We have not yet answered Juvenal’s ancient question: “Who will guard the guardians?”

Alex J. Pollock is a resident fellow at the American Enterprise Institute. He was president and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004. This article is based on a talk given to the Committee for Monetary Research and Education on October 18, 2012.

FURTHER READING: Pollock also writes “The FHA and the Rectification of Names,” “Recovery, but No Resolution,” and “Does Interest Rate Risk Matter If You’re the Fed?” John H. Makin contributes “The Fed and QE3+ Explained” and “All That Glitters: A Primer on the Gold Standard.” Stephen D. Oliner asks "As His Fed Tenure Comes to a Close, What Should Bernanke's Legacy Be?"

Image by Dianna Ingram / Bergman Group