The end of the Fed?

A brief look at the history of money can help explain the debate surrounding the future of the US Fed

Last week the US senate voted to give Ben Bernanke another four years as Chairman of the US Federal Reserve. However, Bernanke has many enemies. Thirty senators voted against his confirmation - the largest number in the thirty year history of the vote. Bernanke has been blamed for failing to predict the financial crisis and for continuing the policy of his predecessor, Alan Greenspan, of keeping interest rates low, which led to a credit bubble. The Fed itself faces an uncertain future. The Texan senator, Ron Paul, author of End the Fed - a book which started a popular national movement - has introduced two bills into congress designed to reform the institution. Critics of the Fed believe it exercises too much undemocratic power. The decision to take billions of dollars of toxic debt onto its balance sheet, and to pump public money into private institutions has reinforced this view. The legislative campaign against the Fed wants to see it subjected to independent audits and stripped of its powers of bank supervision and consumer protection.

Paul's "Audit the Fed" bill has gained the support of well over seventy per cent of the House of Representatives. After repeated attempts to stall its progress by the Democratic House leadership, many of its provisions were eventually passed in the form of amendments to a bill, which also gave the Fed new powers to supervise systemic risk.

Dr. Paul's Free Competition in Currency Act has received much less media attention and almost no political support. The bill would scrap legal tender laws and double taxation on the use of objects other than Federal Reserve Notes as money. It would allow counterparties to choose a method of payment that best suits them. This radical proposal would effectively "end the fed". To understand what this would mean in practice it is first necessary to look back at the previous monetary systems.

The system of representative money replaced the ancient custom of using commodities (usually precious metals) as tender. Instead individuals made payments using paper notes issued by banks, which promised to exchange an equivalent amount of gold or silver upon receipt of the notes. The theory is that at any one time, only a small number of people will want to trade in their notes for physical commodities. This means that the banks can issue several times as much in promissory notes as they hold in reserve. This enables them to lend money and generate profits.

This system evolved into the "Gold standard" and was used up until the early twentieth century. However, it was vulnerable to bank runs. In the mid-nineteenth century this led to the establishment of central banks. Countries could temporarily suspend the gold standard (banning the conversion of notes into gold), which they often did during wartime. It was finally abandoned after the Second World War, in favour of the Bretton Woods system, in which currencies were backed against each other at fixed rates of exchange. A small amount of gold was used in this system to provide security for the currencies of smaller nations. Struggling to pay the bills for the Vietnam War and Lyndon Johnson's "Great Society" reforms, Richard Nixon dismantled Bretton Woods in 1971. This finally ended the role of gold in backing international currencies, with Nixon announcing that: "We are all Keynesians now".

Paul's proposals would allow private banks to compete openly with the Fed in printing money and setting interest rates. If implemented today, it would cause significant turbulence initially. However, Paul argues that increased competition between currencies would prevent cheap money from encouraging excessive speculation, providing greater stability in the markets.