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Fatal Conceit and the Question That’s Never Asked

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Keynesian central planners suffer from what Peter Schmidt calls “fatal conceit.” Paul Krugman serves as the poster child for central planning arrogance. But it’s the Federal Reserve that gives the central planners power, as Schmidt highlighted in the first article in a series highlighting this fatal conceit. Schmidt built on this theme in the second article, telling the story of Benjamin Strong and his role in blowing up the 1920s stock market.  In this third installment of the series, Schmidt tackles the question no one dares to ask.

The following was written by Peter Schmidt. Any views expressed are his own and do not necessarily reflect the views of Peter Schiff or SchiffGold. 

From an economic standpoint, the most remarkable thing to observe is all the attention afforded to the Fed’s Open Market Committee (FOMC) immediately before they announce their interest rate policy.  For example, CNBC will assemble several “experts” to discuss what the FOMC should do, and why they should do it.  Among these experts are people like Jim Cramer, Austan Goolsebee, Steve Liesman and Jeremy Siegel – all of whom have well-earned positions on the Confederacy of Dunces list.  In spite of all the times these discussions have taken place, the one question that begs to be answered never even gets asked – Does it make sense for the FOMC to set the most important price in the economy, the price of money?

Fed apologists never recognize this as a legitimate question.  Instead, Fed apologists – CNBC’s Steve Liesman is the archetypal example – implicitly accept the notion that a handful of PhD economists can control the economy merely by manipulating interest rates.  It is this false and unchallenged notion that lies at the core of all the power the Fed has disastrously exerted on the US economy.  What better defense of today’s disastrous status-quo could there be then the establishment’s reflexive dismissal of any questioning of the Fed’s enormous power as the ramblings of the “tin-hat crowd.”

It wasn’t always this way. And it certainly wasn’t this way when the Fed was founded in 1913.  The event singularly responsible for the Fed’s formation was the Panic of 1907.  In this financial panic, Wall Street speculators – as they are want to do – got way ahead of themselves, and gambled as if there was no tomorrow.  Tomorrow – as it always does – came.  Speculators everywhere tried to sell at once.  However, with everyone already fully invested in stocks and securities, there were no buyers.  Prices collapsed and the entire national economy suffered as a result of Wall Street speculation run amok.

After the dust settled, it was argued – not incorrectly – that if there was a lender of last resort organized along the lines of the Bank of England, then sound positions could be salvaged without suffering a panic selling.  The Bank of England had an operating rule that was succinctly summarized by Walter Bagehot as, “in a crisis a central bank can lend freely, but only against good collateral and only at high rates of interest.”  The idea was that a central bank organized this way would make it possible for sound investments to ride out market panics but unsound investments would have to be liquidated.  However, as described in the previous blog post, the Fed, led by Benjamin Strong, couldn’t leave well enough alone.  Strong took it upon himself to actively control the US economy.  This attempt at active control via central bank policy reached its zenith at the July 1927 conference of central bankers on Long Island.  In a little over two years the US and world economies lay in shambles – all as a direct result of the Fed going way beyond its mandate and trying to actively control the economy.

Writing just after World War II – which never would have occurred without the Fed-fueled Great Depression as a precursor [i] – Dr. Benjamin Anderson correctly observed how the Fed’s policy of active credit manipulation compared so unfavorably with everything that had come before;

In the United States, with our inelastic currency system, we had several unnecessary money panics.  The panics of 1873 and 1893 were complicated by many factors, but the panic of 1907 was almost purely a money panic. Our Federal Reserve legislation of 1913 was designed to prevent phenomena of this kind and, wisely handled, could have been wholly (beneficial).  It is noteworthy however, that the money panic of 1907 had nothing like the grave consequences of the collapse of 1929.  The money stringency of 1907 pulled us up before the boom had gone too far.  There was no such qualitative deterioration of credit preceding the panic of 1907 as there was preceding the panic of 1929.  The very inelasticity of our prewar system made it safer than the extreme ductility of mismanaged credit under the Federal Reserve System in the period since early 1924.” [ii]

Writing much later, another PhD economist, Fischer Black, said the same thing.  However, Black wasn’t just any PhD economist.  He played a major role in developing the theory around options pricing, and his ideas form the basis of trillions of dollars in trades every year.  Black is clearly a firm believer in the power of applying complex mathematical models to investing, but is deeply skeptical of using the same mathematics as a basis for a central bank to set policy.  Here is Black on the impossibility of a government (central bank) actively trying to control the US economy,

 I believe that in a country like the United States, with a smoothly working financial system, the government does not, cannot, and should not control the money stock in any significant way.  The government does, can only, and should simply respond passively to shifts in the private sector’s demand for money.  Monetary policy is passive, can only be passive and should be passive.  The pronouncements and actions of the Federal Reserve Board on monetary policy are a charade.” [iii]

While it is beneficial to have the input of learned economists when evaluating today’s Fed, to a certain extent this input is unnecessary.  The American people are in a position very much like Dorothy was at the end of the Wizard of Oz.  Once the curtain had been pulled back, Dorothy realized the ‘great and mighty wizard’ was really a weakling and consummate fraud.  In the case of the American people, the proverbial curtain has not been pulled back on the Fed.  However, the American people have the benefit of something even more telling than that to conclude today’s “active” Fed is as fraudulent as the Wizard of Oz ever was; all the damage inflicted by the Fed.  Perhaps one day, the Dunces at CNBC will consider this a topic worth discussing.

NOTES

[i] In 1928, one of the fringe parties in Germany was the National Socialist German Workers Party.  It received 2% of the vote in national elections that year.  In September 1930, support increased to 18%.  The Great Depression was a veritable lifeline to what came to be known as the Nazi party.

[ii] Benjamin M. Anderson, Economics and the Public Welfare – A Financial and Economic History of the United States, 1914 – 1916, Liberty Press, Indianapolis, 1979, p. 24

[iii] Fischer Black, Business Cycles and Equilibrium, John Wiley and Sons, New York, 2010, p. 99

PS – If you like what you read, please register at my site the92ers.com.  This will give you complete access to the entire Confederacy of Dunces list as well as the Financial Crisis Timeline.  Both of these are a treasure trove of information on the crisis and the long-running problems that led to it.

Peter Schmidt served six years in the Air Force and has spent the rest of his professional life in the petrochemical, oil refining and power generation industries. Peter has BS and MS degrees in mechanical engineering from Lehigh University and is a licensed professional engineer in California and Louisiana. Peter is finishing up his book, “Elites in Name Only – the Financial Crisis,” a comprehensive look at the people behind the 2008 financial crisis. He also runs the website the92ers.com, which provides an overview of the 50 people most responsible for causing the 2008 crash.

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