The solemn Washington Post editorial warned against the Federal Reserve being forced to make economic policy decisions that are the “product of political pressure, not economic data.” It argued “that the world’s most powerful central bank makes decisions based on economic conditions, not short-term political considerations.” It warned that the Fed “is a critical national asset” and worried that President Donald Trump’s political policy “is eroding it in ways that could be bad for the country and his own agenda.”
It is true that academic myth (with AI confirmation) proclaims that the Federal Reserve was created in 1913 under the leadership of progressive icon President Woodrow Wilson with the mission to provide independent expertise, to professionalize economic policymaking, to rationalize the economy, and to free the nation from parochial state-level politicized banking.
But, in fact, the economic impetus for the reform began as a result of Great Britain’s attempt to manipulate the then worldwide gold banking system and failed; caught up in the economic insecurity leading to World War I. That insecurity pushed the other major gold nations of the time — especially France and the U.S. — into adopting strategies to offset the negative monetary results. And one of the new tools of national response was America’s Federal Reserve.
But as early as 1914 to the Great War’s end in 1917, the new Fed could not keep the U.S. from Europe’s hyperinflation and recession. The Federal Reserve’s main contribution was to discount the value of U.S. War Bonds. For the full period of 1914 to 1920, the data show that “the U.S. price level roughly doubled, and inflation averaged 12.2 percent per year.” This was not a very auspicious beginning for the critical national asset.
Since then, the Fed has suffered through 16 recessions — 1920, 1929, 1937, 1945, 1948, 1953, 1957, 1960, 1969, 1973, 1980, 1981, 1990, 2001, 2007, and 2020. The Great Depression of 1929 lasted 43 months, 1937 was 13 months, 1973 was 16 months, 1981 was 16 months, and the Great Recession of 2008 was 18 months.
The problem from the beginning was not states and private banks but national governments manipulating the gold system, and the final adoption of a pure fiat money system. As UC Berkeley’s Barry Eichengreen explains, following WW I and its major nations exhaustion of capital, the major powers formed a new system that was “a hybrid, neither a pure gold standard like that which prevailed in various countries prior to World War I nor a fiat money system like that which succeeded the breakdown of Bretton Woods” after WW II. (RELATED: A Road to Prosperity)
When the new standard met trouble meeting monetary convertibility in 1931,
central banks alarmed by fluctuations in the foreign-exchange value of reserve currencies rushed to liquidate their foreign asset positions. It is argued that the consequent reduction in global reserves constrained money supplies in countries required to maintain statutory ratios of reserves to notes and deposits, heightened the difficulties of gold bloc countries attempting to defend their gold standard parities, and exacerbated the monetary deflation associated with the deepening of the post-1929 slump.
Under the weak “gold exchange” standard, countries were “required to maintain convertibility between domestic currency and gold and to leave international gold movements unfettered. But they were permitted — indeed encouraged — to hold international reserves in the form of foreign exchange,” introducing “a new psychological element never present before the war.” By 1932, French gold reserves had recovered, but their gold dominance forced Germany and Britain “to give up convertibility altogether.”
Even with the world dollar price back to standard, America’s experts were not able to recover from a stock market crash that eventually led to the Great Depression. Many economists blamed the Fed for the crash, but even skeptic Hu McCulloch believes it was not the direct cause, but that the U.S. was driven into the Depression by reacting to European errors. But even he concedes that Herbert Hoover’s and Franklin Roosevelt’s New Deal policies greatly extended the Depression, and that the earlier 1930 Smoot-Hawley Tariff compounded its severity and length.
Roosevelt obviously reacted politically to end the Great Depression, but it was supported by his expert progressive allies. His Gold Reserve Act, signed in January 1934, forbade any private monetary use of gold and increased the official price of gold from $20.67 to $35 per troy ounce. This reduced the gold value of the dollar by an incredible 59 percent from its previous worth. Then there was WW II and the resulting spending and lack of monetary competitors finally allowed a U.S. recovery.
As WW II was ending, 44 countries met in New Hampshire to create the Bretton Woods system, where countries agreed to keep their currencies fixed “but adjustable in exceptional situations” to the dollar, with the dollar at least theoretically linked to gold.
Since 1958, when the system became operational, countries settled their international balances in dollars, and U.S. dollars were convertible to gold at a fixed exchange rate of $35 an ounce. The United States had the responsibility of keeping the dollar price of gold fixed and had to adjust the supply of dollars to maintain confidence in future gold convertibility.
Since by then the U.S. held about three-quarters of the world’s official gold reserves, the system seemed secure. But in 1971, President Richard Nixon, Federal Reserve Chairman Arthur Burns, Treasury Secretary John Connally, and experts generally argued that excessively high levels of inflation, an unacceptable unemployment rate, and the difficulty of managing gold convertibility required radical reform. The solution was to close the gold window completely, with even foreign governments no longer able to exchange dollars for gold; and, in effect, turning the world’s monetary system into a fiat one.
The Fed has been in full charge ever since, with an immediate 16-month recession two years after Nixon cut any convertibility to gold, followed by five others over the next 35 years, including an 18-month great recession.
In place of a monetary system based on an independent measure of value like gold, today’s Fed fiat system is managed by sophisticated econometric forecasting models that are accessible to a few experts and understood by fewer. The non-experts can agree about their sophistication but cannot avoid noticing their record of recession failures. But the non-experts can notice how the Fed itself understands its critical national asset.
Consider this view of the expert Fed process by one of the top Federal Reserve Chairmen, Alan Greenspan. In his memoir The Map and the Territory: Risk, Human Nature and the Future of Forecasting, he explained his reaction at the Fed to the then-forthcoming 2008 Great Recession. Greenspan noted that
It all fell apart, in the sense that not a single major forecaster of note or institution caught it. The Federal Reserve has got the most elaborate econometric model, which incorporates all the newfangled models of how the world works — and missed it completely. I was actually flabbergasted. It upended my view of how the world worked.
It is almost embarrassing to record his naiveté. But this is how the fiat financial world really works — and the record is clear that the newfangled models do not work very well in the real world. As long as there is a fiat money system tethered to nothing, politics of some sort will determine how the economy will work — and unfortunately, more often for the bad than the good, regardless of who is in charge.
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Donald Devine is a senior scholar at the Fund for American Studies in Washington, D.C. He served as President Ronald Reagan’s civil service director during his first term in office. A former professor, he is the author of 11 books, including his most recent, The Enduring Tension: Capitalism and the Moral Order, and Ronald Reagan’s Enduring Principles, and is a frequent contributor to The American Spectator.