Excerpted in American Banker on 9/27/12:

The Cure for the Banking Industry, Part I: End the Fed, or at Least Rein it In

The fundamental issue underlying the boom-and-bust cycle in the financial industry is the lack of sound money.

Unfortunately, the Federal Reserve is constantly manipulating the value of the dollar. The Fed is charged with two goals: controlling the price level and maintaining full employment. In practice, the full-employment goal almost always has priority. This is because the Fed is a political institution (despite its theoretical independence) and because Congress cares more about full employment than about price levels. (Ironically, a debased dollar will ultimately undermine the Fed’s full-employment policy goal.)

The most fundamental cure for this crisis and future financial crises would be to eliminate the Federal Reserve. The United States has already had two failed central banks. Between 1870 and 1913, the United States experienced the greatest economic boom in his-tory without a central bank. While there were economic corrections during this period, none were as destructive as the Great Depression or even the current lingering Great Recession. Other countries have grown successfully without a central bank.

The transition to a private banking system would be complex, but it is achievable. The private banking system would operate on a market-selected monetary standard, which would probably be gold. There is nothing magical about gold. However, it is rare, hard to find, expensive to dig up, and therefore difficult for politicians to manipulate.

As long as the federal government can print money at will, the politicians (both Democrats and Republicans) will accumulate debt until the United States experiences a financial collapse. The real issue is not the efficiency of a central bank and the inefficiency of gold or the related technical arguments. The real question is, do you expect politicians to exercise self-discipline before our economy faces major problems? Based on unquestionable historical evidence, it is irrational to trust politicians. The political forces underlying the Fed’s decision making will ultimately result in economic disaster.

If the Fed cannot be closed and a private banking system created for political reasons, then the second best solution is to make the dollar convertible in a fixed exchange rate to a quantity of gold. The conversion ratio would be based on current market prices with time allowed for the market to adjust to the announcement.

For example, an ounce of gold might be worth $1,600. It is enlightening to realize that when Roosevelt took the United States o?ff the gold standard in the 1930s, an ounce of gold was worth $32. The Fed has rapidly destroyed the value of the dollar. Gold has not become more valuable; the dollar has become materially less valuable.

The United States effectively operated on a gold standard for many years. As was discussed earlier, the gold standard was falsely accused of being a major contributor to the Great Depression. The benefit of the gold standard is that it limits the ability of politicians and government bureaucrats to debase the value of the dollar.

After World War II, the U.S. dollar became the reserve currency of the world and foreign governments could ask the United States to convert dollars to gold. Under Lyndon Johnson, the Fed printed so many dollars that the U.S. Treasury did not have enough gold to make the dollar-to-gold conversion. For this reason, Richard Nixon completely decoupled the dollar from gold in 1971. For the first time in 5,000 years, there was no connection of the world’s base currency to a naturally occurring standard (such as gold) that could not be manipulated by politicians.

Of course, politicians had found other ways to cheat, but, at least, with a gold standard debasing the currency was harder.

We have been running a high-risk experiment since 1971 by relying on government bureaucrats to self-discipline. The problems with the euro reflect the risk in this experiment. Should the U.S. dollar lose its status as the world’s reserve currency, the consequences would be severe. The Fed’s radical expansion of the money supply in reaction to the recent financial crisis is a form of Russian roulette. It may work but is very risky.

It is noteworthy that most liberal economists treat the advocates of the gold standard without any respect. Yet, the gold standard was fundamentally successful for long periods of time. The fact is these economists and their political cronies do not want to be disciplined by the rationality of markets. They want to wish away the laws of economics based on theories that are detached from reality.

There has been a great deal written about the gold standard. I refer you to the work of George Selgin at the University of Georgia and Larry White at George Mason University. A private banking system or a gold standard for the dollar are the best alternatives. However, if these options are not politically achievable, Milton Friedman proposed an alternative that would move us in the right direction.

By law (probably a constitutional amendment), the Fed should be required to grow the money supply at a fixed rate of, for example, 3 percent. This concept would take away the Fed’s ability to manipulate the money supply for short-term reasons. Since the Fed has consistently made major errors in its short-term management of the money supply, this proposal is not very risky.

Friedman proposed a number of exceptions to this rule. I would not allow exceptions, because the exceptions will become the rule and because stable money is the foundation for long-term prosperity.

If none of these “radical” solutions is acceptable in today’s political context, there is an achievable set of steps that would greatly reduce the risk of economic cycles and buy us time to move toward a private banking system, which I will outline in my next post.


John Allison is the president and CEO of the Cato Institute and the former chairman and CEO of BB&T. This article is adapted from his forthcoming book, “The Financial Crisis and the Free Market Cure: Why Pure Capitalism is the World Economy’s Only Hope.”