The Monster That Ate America
The Fed: Inside the Federal Reserve, the Secret Power Center That Controls the American Economy, by Maxwell Newton, New York: Times Books, 1983, 323 pp., $17.65.
New York Post financial columnist Maxwell Newton is not happy with the Federal Reserve system, and this polemic against the Fed could well have been subtitled "The Monster That Ate America." The Fed, claims Newton, "has proven a highly destructive force in the economic and financial affairs of America. It has been the unique source of America's financial crisis today.…Single-handedly it has brought economic growth in the United States to a halt."
In support of this condemnation Newton displays an impressive array of facts and figures. What it comes down to is approximately this: The Fed is a body surrounded by a self-generated aura of independence from the nation's political processes. Its seven governors serve 14-year terms. They have enormous leeway to employ the sweeping powers conferred upon the Fed by Congress in pursuit of whatever goals they find desirable. Those powers include the power to create money out of thin air through credit purchases of securities in the marketplace, to lend money at below-market rates to member banks, to require banks to maintain non-interest-bearing reserves in the Fed's custody, and to enforce countless regulations of the banking industry.
In exercising these powers until October 1979, the Fed bought securities from the banking system in an attempt to keep key interest rates within a narrow range. This, however, generated massive increases in the money supply, which in turn signaled increasing inflation, the fear of which put sharp upward pressure on interest rates, which required the Fed to create even more money to keep interest rates within its prescribed range.
Although, in a celebrated action, the Fed then disavowed stabilization of interest rates and embraced stabilization of the money supply as its guiding policy, Newton shows how in practice the old policy crept in through the back door. Three years later, in October 1982, the Fed abandoned its money-growth targets, muttering excuses about "financial innovation" making it too difficult to keep track of monetary aggregates.
Newton correctly brands the 1980 banking deregulation act a "vicious" and "abominable" piece of regulation. This act sucked all depository institutions into the Fed's regulatory web, not just the larger member banks, and imposed a substantial tax on them through non-interest-bearing reserve requirements. This envelopment of previously excluded banks, savings and loans, and credit unions was a desperate effort to maintain the Fed's control of money in an economy steadily inventing new money substitutes precisely to escape government regulation.
Newton fails to mention one of the most calamitous provisions of the act—the section now allowing the Fed to use even worthless foreign government securities as collateral for a flood of new money. This provision may soon become useful to the Fed in escorting the nation's largest banks through their self-made Third World debt crisis, at the expense of everyone else.
Mexico, for example, could issue worthless peso bonds to its US bank creditors. The banks would then sell the bonds to the Fed at an unrealistically high exchange rate. The Fed would credit their reserve accounts, and the banking system would translate the higher reserves into another inflationary surge. When the Mexican bonds eventually defaulted, the Fed would simply create more inflationary money. The original lending banks would long since have gotten off the hook.
Newton offers a clear explanation, too, of a crucial point. Unlike the old days (before 1963), the production of new money by the Fed no longer works to lower interest rates. After a decade and a half of wild inflation and uncertainty, traders in the financial market now react differently from the classic model. They see the creation of new money not as an increase in supply that eases interest-rate pressure but as a forerunner of a new inflationary burst. So they respond to money creation by demanding higher interest rates to protect against the expected inflation.
But with all of his facts and figures, all of his incisive indictments of the Fed's behavior, and all of his accurate descriptions of the effects of monetary uncertainty on the nation's economy, there are certain points in Newton's work that are confusing, to put it mildly.
Consider the vaunted "independence" of the Fed. Newton writes that "one of the most important single justifications of the so-called independence of the Federal Reserve was and is to remove it from control by the administration and thus to oblige the administration to finance its expenditures by taxation, rather than by demanding cash from the Federal Reserve." On the final page of the book, however, Newton looks with favor upon the incorporation of the Fed into the Treasury Department, so that "monetary policy could be integrated with the other economic policies of the administration." What makes Newton think this will lead to more-responsible behavior? The only possible improvement would be that the president could then be held responsible for the Fed's errors, but that is small comfort when one contemplates the possible magnitude of the errors.
Then there is the matter of zero money growth. Newton thinks this is the "ideal arrangement." Three hundred pages earlier, however, he describes the May–October 1981 period of zero money growth and ruefully observes that "the American economy collapsed, under the influence of money starvation." Then he hastens to add that he doesn't think that this freeze-and-collapse scenario indicated any kind of mistake by the Fed. He only wants to show that zero money growth will reduce interest rates. So, one might add, will a total collapse of the economy.
Like all monetarists, Newton is convinced that there is something out there that can be measured and called "money." For him, it is M1, the sum of cash and checking accounts in the nation's banks. Others have made the point that, with the many new varieties of money substitutes now in increasing use (largely as a result of the market's need to escape economically foolish and burdensome government regulations), controlling M1 alone is a fool's errand, and trying to control everything leads to a Soviet-style controlled economy.
Not so, says Newton. If M1 becomes an inaccurate indicator, the Fed can simply adjust its M1 growth targets to compensate. So Newton ends up at the same place as those whose every action for the past 15 years he finds defective. If the Fed can't hit its targets, well, then, define some new targets.
Newton is profoundly uninterested in gold or any other economic mechanism for disciplining the money-creation machine. Indeed, the existence of gold is barely mentioned in the book, and reading The Fed, one would have no reason to suspect that the ending of gold convertability had anything at all to do with the Fed's subsequent running wild.
On one page of his book—the last—Newton decides that the "incorrigible" Fed should be eliminated. He notes correctly, but so briefly as not to persuade the uncommitted, that the Fed's principal functions either could be provided by the marketplace or would be better left unprovided. He cites Hong Kong and 19th-century Scotland and America as places where economic growth took place without the benefit of a central bank.
But his argument seems too tentative and far too brief. One gets the impression that his death threat against the Fed is only a tactic to pressure it to adopt the monetarism Newton so enthusiastically embraces.
The lack of any historical treatment of the Fed, the ignoring of the role of gold, and the confusion about remedies mar Newton's work. But as a trenchant commentary on the failures of the Fed over the past two decades, The Fed is useful and, indeed, devastating. If it persuades its readers that there has to be a better way, it will have served admirably in accelerating a vital national debate. Max Newton's brays are bonny, if not his proposals for change.
John McClaughry is a former policy adviser to President Reagan.