As part of a project for Capital Matters, called Capital Writing, I’ll be interviewing authors of economics books for the National Review Institute’s YouTube channel. This time, I talked to monetary scholar Robert Hetzel about his book, The Federal Reserve: A New History. Below you will find an edited transcript of a few key parts of our conversation as well as the full video of our interview.

Dominic Pino: You titled the book The Federal Reserve: A New History. What’s wrong with the existing histories, and why do we need a new one?

Robert Hetzel: Let me step back just a minute and talk about the general intellectual and political environment that makes such an update to the Friedman and Schwartz Monetary History of the United States necessary. We lose historical perspective. As a society, we can’t seem to learn the lessons of the past, no matter how dramatic they are. The world made extraordinary progress in the 19th century, led by Great Britain and its liberalism. The world moved toward the free exchange of ideas, free movement of people, general movement toward free markets. All that ended with World War I. The world tried to put itself back together again after the war. It was making progress, and sadly enough, as much as anything, the disastrous policy of the Federal Reserve System, which was highly deflationary and spread through the gold standard, brought the world economy down, and with it brought down the banking system — and because people associate capitalism with banks, discredited capitalism. And we almost ended Western civilization in the first half of the 20th century.

In the second half of the 20th century, we did things basically right and resurrected Western civilization, and that had a lot to do with the creation of a modern central bank that, initially, until it went badly off track in the Seventies, provided a stable framework in which markets and capitalism could operate. The United States led the movement that resurrected the liberalism that existed before World War I. We moved toward free trade and free movement of people and ideas, and we were doing very well. Now, unfortunately, we seem to be moving back in the other direction. The world is fragmenting into blocs. Primarily, China and Russia are responsible for that. Their dictators have realized they can’t create a society organized as a giant prison and also have free markets, so they’ve moved away from free markets. But the United States is not helping. The Democrats have lost the blue-collar working man to the Republicans, they want him back, but how are they trying to get him back? Through protectionism, through populist measures. The country spent huge amounts of effort trying to get rid of “buy American” rules; we’re now moving back toward that now.

Central banks are not helping, particularly the Fed. With the Great Recession, which was not necessary, with the extraordinary intervention of the Fed in credit markets and allocating credit that started with Ben Bernanke and has continued with Jerome Powell. The Fed is aiding the movement back towards an interventionist, state-directed economy. I feel very much that there’s a need for a book in the spirit of Friedman and Schwartz to revive the debate we had in the 1970s between Keynesians and monetarists and make the case for a stable monetary framework to enhance the ability of markets to work.

DP: You brought up the point about populism today, but obviously populism has been around for a long time, and it was around at the creation of the Federal Reserve in the early 1900s, and you talk about that in the book. Could you speak a little bit about the role of populism in the creation of our central banking system?

RH: Just to start with a little bit of background, the Fed was created in 1913 when the gold standard was in full operation. With the gold standard, the supply of gold and the markets determine the behavior of the price level. It’s not the responsibility of the central bank. With that system, you did have instability, but you had a long-run nominal anchor for the price level. The price level after the Napoleonic Wars was about the same as it was before World War II. With the end of World War I, gold initially flowed out but then flowed into the United States, and we had most of the world’s monetary gold. The Fed knew that if it allowed that to increase the money stock, that would create inflation. The Fed did not follow the rules of the gold standard after World War I. It knew it was going to have to replace those with something else. What it replaced them with was called “real bills.” That is the idea that the role of the central bank is to prevent speculative excess, the collapse of which is presumed to cause deflation and recession. In the process, the Fed became a modern central bank. It became a creator of fiat money through open-market purchases, through bookkeeping operations.

Now, I’m finally going to get back to your question. There was a populist tradition in the United States, personified by William Jennings Bryan and the agrarian interests, who thought of the eastern financial establishment, the big banks, as exploiting them through lending at high interest rates. When the world went back to the international gold standard in the early 1870s, the world economy was growing, but there wasn’t a lot of gold production, so there was steady deflation. The Bryan people thought that if they changed the monetary standard — sort of through the backdoor with bimetallism, basically they were going to create money — that would help their constituency, the farmers who had borrowed from the financial system.

The Fed people didn’t understand that they were responsible for the behavior of the price system with this new fiat-money standard, and they didn’t understand the idea of a banking system whose deposits rested on the basis of the paper reserves the Fed had created. The Fed still had a gold-standard mentality, and they thought of the Bryan populists as the barbarians at the gate, who were going to come in and destroy the gold standard and destroy the eastern financial system.

Why is that important? It’s important because, in reality, the populists were right, that we were on a fiat-money standard, we were responsible for money creation, we were responsible for maintaining the reserve base of the banking system, but the Fed policy-makers really didn’t understand that responsibility.

There had been monetary standards that were fiat money before, but they were all associated with monetizing government debt, to provide revenue for the government. For the Fed, the most recent examples were the hyperinflations in Hungary, Germany, and Austria. The Fed didn’t understand that it was not the kind of central bank like the Reichsbank or the Bank of England that had existed in the gold standard. It was really something different. It was really a modern central bank that was responsible for the creation of fiat money. For it to have realized that and accepted that, and accepted the corollary that it was responsible for the price level, in their mind, that would have been crossing this chasm and giving in to the populist barbarians who wanted to destroy the financial system through inflation.

DP: That’s different from the conventional wisdom that people might have. Usually people say that the U.S. was on the gold standard until 1933 under Franklin Roosevelt or until the 1970s under Richard Nixon. What you’re saying is that the switch to fiat money happened much earlier, but the problem was that the Federal Reserve didn’t realize that and didn’t deal with it properly, and that helps explain a lot of the mistakes they made in the Great Depression.

RH: That’s important, it was a huge source of confusion. At the end of World War I and going into the Twenties, the Fed had almost all of the world’s monetary gold stocks. So, what we could do, even through a war, was peg the price of gold. In fact, it was a commodity-stabilization scheme. We had all this gold, we could just run down or build up our gold reserves and peg the price of gold. But we weren’t following the rules of the gold standard. We weren’t changing the discount rate based on the inflows and outflows of gold. So it looked like we were on the gold standard, it looked like the market would determine the price level and it wasn’t the Fed’s responsibility, but in fact it was like a commodity-stabilization scheme for wheat, where the government has a huge amount of wheat and can buy and sell to peg the price.

Let me say one other thing about why this book is important. The Fed wants you to believe it’s following the evolution of the economy and it’s always getting things right and if something bad happens there’s this external shock that caused it. The way I like to put it is that it likes to see itself as an inflation-fighter, not an inflation-creator. Well, the issues that arise today are also echoes of the earlier issues. Sure, we understand some things better than we did in the 1920s, we’ve made some progress, but a lot of the issues we really haven’t learned from.

I used to visit Milton Friedman every year, and he was an incredible letter-writer. I’ve got bins and bins of his letters that I copied. There’s one very interesting exchange between him and the National Bureau of Economic Research. After he and Anna Schwartz finished the Monetary History — it was a National Bureau project — they submitted it, and they got a very negative reaction. The head guy there was somebody named Geoffrey Moore. He was the world’s leading expert on the business cycle, a very preeminent economist. He and the directors were very much opposed to Friedman and Schwartz. Why? Because they argued that the Great Depression was the result of speculation, and it was the collapse of that speculation that led to the Great Depression, and there was really nothing the Fed could do about it. The speculation had supported this unsustainable level of economic activity, and there had to be this period of liquidation.

Well, think about today, think about how people think about the Great Recession. Sort of the standard newspaper story, which is of course encouraged by the Fed because it lets them off the hook, is that there was a housing boom — no question about that, but they don’t talk about the fact that the government tried to drastically increase the share of homeownership — housing prices rose and then they came down starting in 2007. The story that the Fed wants you to think about the Great Recession, which started in December 2007, is that there was a housing collapse that interfered with financial intermediation because it impacted negatively the capital of banks, so we needed TARP and all these interventions in credit markets. Go back and think about the Great Depression: How did the country deal with that? Through credit-market interventions. We had Fannie Mae, we had the Reconstruction Finance Corporation, we had the Farm Credit Administration — it was viewed as a failure of the financial system. As I said earlier, the public associates the large banks with capitalism, and the failure of the banking system was carried over to the presumed failure of capitalism.

Doesn’t that sound a lot like what we went through in the fall of 2008 when it became clear that the world was in a recession? The Fed reinvented itself as a combination central bank-GSE. It was Fannie Fed. Even in this earlier period, the Fed was very concerned about separating monetary policy, even though it got monetary policy wrong, from credit policy. It insisted that the banks be helped with the Reconstruction Finance Corporation, which was financed separately from the Fed. We didn’t even have that constraint in the fall of 2008, and the Fed became very involved in credit markets. Then in March 2020 and the pandemic, the Fed put that on steroids. The general point is that a lot of these issues recur, and we still go back and reinvent the same sort of myths as we did earlier. So there’s a need for a history that explains how these issue recur and how we need to learn from the earlier experience, rather than just thinking, “Oh, that was a hundred years ago, we’re a lot smarter than those guys.” The reality is that we have a lot to learn about the importance of a liberal world order and a monetary system that supports free markets rather than overriding them.