One of the few political issues that has lasted since America’s founding is the nature and role of the central bank. This institution is often seen as the enemy of markets and capitalism and has become the villain of the libertarian leaning conservatives. However, the history of the institution and role in economic growth shows that it is not wicked or a necessary evil, just necessary. Central banks help control inflation because low inflation is categorically important for economic growth.
Alexander Hamilton, the first secretary of the treasury and architect of the America’s industrial economy, became the most vociferous advocate of a central bank in the nascent country. During the first year of the United States, the nation did not have any of the key parts of a modern financial system, including tax revenues, a stable currency, financial institutions, and corporations. Although Hamilton was able to help create a revenue source, begin paying debts, and established a currency, it is really his advocacy of a central bank that became most controversial. He believed that the bank would be constitutional based on the Necessary and Proper Clause of the Constitution. This was eventually upheld by the Marshall Court in 1819 when Justice Marshall issued his opinion on McCulloch v. Maryland.
Upon Hamilton’s recommendation, the Congress passed legislation in 1791 to create the Bank of the United States. This allowed Americans to borrow money and began what would become the capitalist economy. However, Presidents Jefferson and Madison wanted to dismantle this effort during their administrations from 1801-1817. In 1811 President Madison allowed the charter of the Bank of the United States to expire, but he soon realized his mistake. Following the War of 1812 American currency began to fluctuate wildly and experienced high inflation. Businesses wanted stability in the market, which is what led Madison to sign the charter for the Second Bank of the United State in 1816. Yet populist fervor rose again during the presidency of Andrew Jackson, and he vetoed the re-charter of the bank in 1832 because he thought the bank curtailed liberty and common man.
During the 19th and early 20th century America experienced several financial crises and after the Democrats took power in 1912, they passed legislation to create the Federal Reserve System. The primary duties of the Fed are to control inflation and promote employment, which it has successfully done several times. Although many have argued against the Fed because they see it as promoting instability and recessions need to understand the importance of low inflation on economic prosperity. Stagflation during the 1960’s and 1970’s practically disproved the economic model of Keynesianism. For instance, inflation reached over 13% in 1980 while unemployment was about 7.5%. Keynes held that inflation and unemployment have an inverse relationship; that is when inflation increases unemployment decreases. When more people are out of work, there is less pressure on prices and wages. This formed part of the basis for his promotion of increased government spending during recessions.
It is true that the Fed has contributed to some economic woes, but this was primarily due to Keynes’ influence before Paul Volcker became chairman of the Fed. Milton Friedman, the eminent economist from the Chicago school and promoter of free markets, did not believe the Fed should stand. Even though did not think it the best policy to have a central bank, he argued that the Fed could be used to control inflation by controlling the money supply. His macroeconomic theory became known as monetarism.
There are several examples of the Fed improving economic conditions when they took a monetarist approach to inflation. Volcker worked with President Reagan to control the rabid inflation that was happening. Through his raising of interest rates and tightening the money supply, Volcker was able to reduce inflation from over 13% in 1981 to just above 3% in 1983. Another prime example comes from Alan Greenspan’s tenure as chairman of the Fed. Greenspan and the Federal Open Markets Committee decided to raise the fed funds interest rate to 3.25% in February 1994 and to 5.5% by the end of the year. They tightened the money supply to prevent overheating of the economy and to attempt a “soft landing” of the inevitable downturn in the business cycle. This is exactly what happened. The economy had grown in 1994 by 4%, but in 1995 the economy began to slow down. However, through the Fed’s tightening the downturn in 1995 was a full blown recession. Rather the economy still grew, less than 1%, and began to pick back up in 1996. Combined with the fiscal restraint of President Clinton and Speaker Gingrich the 1990’s saw incredible amounts of economic growth. So much so that it was actually envisioned that American repayable debt could be paid off by 2006.
Conservatives are right to have skepticism of centralizing power in the federal government. They justly do not want a planned economy; free markets lead to prosperity, not collectivism. The Federal Reserve, though, promotes free markets when it takes a monetarist stand on inflation. Paul Volcker and Alan Greenspan are excellent examples of this. Criticism of the Fed is appropriate when the board does not take inflation seriously, but conservatives should understand a central bank is absolutely necessary to stabilize currency and prevent increased pressure on wages and prices. When inflation is low the purchasing power of workers increases and promotes a higher standard of living. Rather than calling for the abolishment of the Fed, conservatives need to promote a monetarist approach and continuously seek to limit inflation as a means to promote free markets.