Simon Johnson Wrong on Ron Paul and The Fed

The following is a draft for LvMIC:

If there is one silver lining that emerged out of the bursting of the U.S. housing bubble and subsequent financial crisis, it has been the unprecedented scrutiny targeted at the Federal Reserve.  Never before in the central bank’s almost century long existence has it faced such criticism not only from Congress but also the general public.  Undoubtedly the Fed’s largest critic has been Texas Congressman and presidential candidate Ron Paul.  Paul, whose book End the Fed debuted at #6 on the New York Times best seller list, has incorporated his Austrian economic views into a grassroots movement to preach the dangers of centralized banking and its causing of the business cycle.  While the media is now paying close attention to Paul’s views, their misunderstanding of the operations of a market economy prevents many commentators from imagining what a financial system would look like in absence of a regulatory central bank.

Simon Johnson, former chief economist at the International Monetary Fund, is one of those who, despite his economic credentials, is totally clueless to how a system of free, decentralized banking would work.  Writing in the New York Times economic blog Economix, Johnson is concerned over the plausibility of Paul's ideas:

Mr. Paul also has a clearly articulated view on the American banking system, laid out forcefully in his 2009 book, “End the Fed.” This book and its bottom-line recommendation that the United States should return to the gold standard – and abolish the Federal Reserve System – tend to be dismissed out of hand by many. That’s a mistake, because Mr. Paul makes many sensible and well-informed points.

But there is a curious disconnect between his diagnosis and his proposed cure, and this disconnect tells us a great deal about why this version of populism from the right is unlikely to make much progress in its current form.

Would abolishing the Fed really create a paradise for entrepreneurial banking start-ups, enabling them to challenge and overthrow the megabanks?

Or would it just concentrate even more power in the hands of the largest financial players? It is hard to find a moment of greater inequality of power than that of the Gilded Age of the late 1800s – with the gold standard and the associated credit system firmly working to the advantage of J.P. Morgan and his colleagues.

Again, this seems to mistake the true nature of power both in modern American society and in a world without any limit on the scale and nature of banks. Laws and rules do not drop from the sky; they are shaped in minute detail by an intense and very expensive lobbying process.

First things first, the myth of the Gilded Age caused by capitalism run amuck in the late 19^th century is just that; a myth.  The so-called robber barons, outside of those who openly sought government intervention to limit the threat of competitors, made their riches off satisfying consumers through the lowering of prices.  What often goes unmentioned in historical recounts of this period is the fact that the standard of living for the average American grew at a faster rate than any other time in the country’s history.  Not only did prices fall, but immigration flourished, industrial output grew, and advances in technology allowed for more efficient production.  The culmination of these factors set the stage for the consumer economy that dominated the 20^th century.  Writing in his essay The Transformation of the American Economy, 1865-1914, economic historian Robert Higgs documents the phenomena:

The economy grew spectacularly in the half century following the war. Real GNP per capita advanced at an average rate of 2 percent per year, and on the eve of World War I it stood at about three times the 1865 level…Total output expanded even more astoundingly: real GNP grew at an average rate of more than 4 percent per year, increasing about eightfold over the period. Never before had such rapid growth continued for so long.

So while wealth inequality did exist in the latter 1800s, as it always exists in a market economy, the layman still benefited economically.  This era of “inequality and power” was mainly the result of government intervention in the market to the benefit of certain industries.  Contrary to Johnson’s claim, the period preceding the Fed’s inception was not absent key aspects of central banking.  The National Currency Act of 1862 and National Banking Acts of 1863-64 established national charters for a federal banking system to exclusively issue currency notes.  Murray Rothbard called the National Banking Act “a halfway house to central banking” that required state-chartered banks “to keep deposited with the national banks permitting them to pyramid inflationary credit.”

Johnson’s account of history is not only misleading but mischaracterizes the gold standard of aiding JP Morgan when excessive regulation at the federal and state level put a burden on entrepreneurial competitors. 

In a true free banking environment, limits always exist on the “scale and nature of banks.”  Like any industry selling a good or service, competition plays a necessary role in allowing consumers to have a choice between those companies which meet demand adequately.  

Bank A is engaging in unscrupulous business practices?  Bank B, C, and D are there to scoop up market share by attracting unhappy customers of Bank A.  

Rigorous competition between private banks issuing their own currency also provides a necessary check on the ability of any one bank to inflate.  If Bank A issuing “James E. Millers” to be redeemed for gold (assuming gold took its place as the free market’s choice of money) decides to expand credit not backed by sufficient gold deposits, Banks B, C, and D may get wind of this or suspect as much and refuse to accept “James E. Millers” as deposits.

Johnson’s confusion on how a free market in banking actually works leads him to dismiss Paul’s advocacy for abolishing the Fed as not being satisfactory.  Taking away the ability of the big banks to fall back on the central bank’s printing press, ala the financial crisis, would go along way in weeding out those institutions deemed “too big to fail.”  Ridding the financial sector of moral hazard is not only necessary for a sustainable banking system but also to keep taxpayers off the hook from attempts to socialize losses.  For it is the centralized banking cartel that has consolidated power in the hands of the few banking elite; not a lack of regulation.  One look at the origins of the Federal Reserve reveals as much.  A true free market would have the opposite effect.

To address Johnson’s last claim, no not all rules and laws “fall from the sky.”  But the law of scarcity is ever-present in the sphere of human affairs.  Laws against coercion and protecting private property are not functions of a lobbying process but essential building blocks for an economically thriving society.  As the great French political philosopher Bastiat observed “Life, liberty, and property do not exist because men have made laws. On the contrary, it was the fact that life, liberty, and property existed beforehand that caused men to make laws in the first place.”

Though it’s a pleasant surprise to see the former chief economist of the IMF open to ending central banking, Simon Johnson misses the key aspects of an uninhibited market which allow it operate successfully.  It is not Paul’s theory that is lacking but Johnson’s understanding on why the Federal Reserve System is solely responsible for cartelizing market power.  Doing away with the Fed would eliminate the chokehold just a few elite bankers have on an industry that is essential for capital accumulation and the division of labor.

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This isn't complete but it's a start.