Would dismantling the Fed prevent financial crises? Nope

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I watched Ron Paul’s questioning of Ben Bernanke yesterday, and it got me thinking. “The Federal Reserve, in collaboration with giant banks, has created the greatest financial crisis ever seen,” Paul said. This particular crisis certainly has the Fed’s fingerprints all over it. But if we dismantled the Fed, as Paul advocates, would the economy be freed of financial crises?

Well, no. Here’s a quote from The Origin of Financial Crises, an excellent new(ish) book by London money manager George Cooper that I’ve been meaning to plug here for a while:

Those advocating the abolition of central banks in the hope of reestablishing financial stability would likely be disappointed. The question of which came first—financial instability or central banking—is not a chicken and egg question; history shows quite clearly that financial instability came before central banking.

In fact, central banks were invented to battle financial instability—the creation of the Federal Reserve in 1913 was a direct response to the Panic of 1907. Of course, we still have financial instability, so it hasn’t been what you could call an unmitigated success. Back to Cooper:

In a crisis the central bank helps to stabilise the financial system, especially if the central bank is believed to have endlessly deep pockets. But between crises the presence of a central bank promotes more risky lending practices and therefore greater levels of debt.

Also, when the central bank is unmoored from any outside limit on how much money it can create—as the Fed was after Richard Nixon broke the link between the dollar and gold in 1971—your economy can come to be plagued by what Cooper calls the Inflation Monster. From the early 1980s through 2000, the Fed was pretty successful at taming that monster. But now that its priorities are elsewhere, who knows?

So the Federal Reserve isn’t responsible for the existence of financial crises. We used to have financial panics, followed by depressions, once every decade or two before the Fed was created. The Fed’s presence does allow the imbalances (debt levels, mainly) that lead to a crisis to get much larger than they ever did in the pre-Fed world. And aggressively battling the aftereffects, as the Fed is doing now, runs the risk of eventually igniting really high inflation. Cooper’s prescription—and it’s starting to catch on among some at the Fed—is that central banks need to add actively reining in credit creation (a.k.a. lending) in boom times to their list of tasks. To think that’s a good idea you need to believe in the competence and good intentions of the Fed. Which I guess is why Ron Paul would rather rein in excess credit creation by just letting financial panics happen every few years.