President Trump's next Federal Reserve pick could pose an existential problem for the central bank.
Judy Shelton, a former economic advisor to Trump, has not been officially nominated. But her opinions are already making waves. She wants to return to some sort of a gold standard. And in a recent interview, Shelton described the Fed's power to set interest rates as a kind of Soviet-style central planning: "How can a dozen, slightly less than a dozen, people meeting eight times a year, decide what the cost of capital should be versus some kind of organically, market supply determined rate?" she asked, "We might as well resurrect Gosplan," referring to the agency of the Soviet government that ran its economy.
That's all brought Shelton plenty of criticism. "She falls well below [Herman] Cain or [Stephen] Moore as a potential Federal Reserve governor," said Lawrence Summers, a prominent economist and former Obama advisor. Herman Cain and Stephen Moore were Trump's two previous potential picks, who so horrified the mainstream they never even got nominated. "Hers would be a dangerous appointment," Summers continued.
He's right about that last part. Shelton's ideas would be catastrophic if implemented. But her extremism is also clarifying: She's prodding, however clumsily, at a fundamental paradox in modern western economies — one that even mainstream experts like Summers are loath to face directly.
Free markets are supposed to allocate goods and economic activity through self-regulating price signals. But money itself is not just another commodity on the markets — it's the medium of exchange by which price signals are communicated. It also has to come from somewhere. Money's just a token, which someone has to create and issued into the economy. And whoever has that power is unbound from market forces; they don't have to obey price signals, because they can create as much money as they want. For the believer in free markets, this creates a profound tension: Unless money itself is also distributed by self-regulating price signals, how can you have a genuine market in anything?
The point of the gold standard is to "fix" this problem.
Basically, how gold standards worked in the past is that people would dig up gold, and then the government — in our case the U.S. mint — would then press it into coins for them for a small fee. Then the person would deposit those coins with a private bank — the gold became the bank's reserves — and get a paper IOU from the bank in exchange. Private banks succeeded or failed on how much customers trusted the bank to manage its own internal finances. For a trusted bank, its paper IOUs, usually called "banknotes," were themselves traded as money.
Crucially, banks could also create banknotes from nothing, which is what they did (and still do) when they made loans. Ultimately, a bank's ability to create banknotes wasn't limited by their reserves of gold; they could issue as many as they wanted. They just needed to keep enough reserves on hand to meet however many banknotes people traded in for gold at a given time. Banks loaned gold to one another — with interest of course — to meet those needs. If a bank failed at this balancing act, it suffered a run and collapsed.
Gold standards were hardly consistent over time. But up until 1913, this was more or less how it worked in the United States. (Though the U.S. government did standardize all banknotes into a single paper currency with the National Banking Act of 1963.)
For purists like Shelton, this time period is the closest we've ever gotten to "true" markets in money. Banknotes were issued for gold according to a fixed price per unit of weight. This imposed scarcity on the supply of money itself, forcing banks and everyone else to trade money among themselves when they needed it, for a price — i.e. interest rates. It brought what Shelton would call "monetary clarity."
This time period was also a complete economic disaster.
The riskier a bank behaved, the more profit it could make, so banks regularly did fail to manage this balancing act. And when they failed, they brought huge swaths of the economy down with them. The recessions and unemployment spikes in the 1800s were massive compared to those of the post-World War II era.
Eventually, policymakers decided the situation was untenable, and created the Federal Reserve system in 1913. The Fed took all the gold from the private banks and filled the banks' reserves with Fed-issued banknotes instead. These days, banks no longer issue paper banknotes — they've been replaced with the deposits we all trade back and forth with checks and credit cards and debit cards and iPhones. Meanwhile, the Fed-issued banknotes — the things banks hold in reserve and that we can get in exchange for our deposits with them — are just the U.S. paper dollars we're all familiar with. But like the banks' ability to issue limitless banknotes against their gold reserves, the Fed could issue unlimited quantities of its own banknotes. The Fed became a bank for the banks; a lender of last resort who could prevent bank runs. The central bank's only concern was if a critical mass of U.S. citizens wanted to trade in too many of the Fed's own banknotes at once for actual gold — a pretty far-fetched scenario.
This setup also meant that the Fed had to manage the interest rates at which banks lend to each other. (When we talk about the Fed setting interest rates, that's the tool it uses.) A catastrophic increase in the interest rates at which banks lent reserves to one particular bank is how the old bank collapses happened. By the very fact that it issues reserves to the private banks, the Fed must manage these rates. Shelton's argument that the Fed should step back and allow the "market" to set interest rates is literally a conceptual impossibility. "The Fed cannot somehow withdraw and leave interest rates to be determined by 'the markets,'" as former Fed Chair Ben Bernanke put it. "The Fed's actions determine the money supply and thus short-term interest rates; it has no choice but to set the short-term interest rate somewhere. So where should that be?” The only way to bring back a "market" in interbank interest rates would be to eliminate the Fed entirely.
Unfortunately, this new system only protected private banks from illiquidity, but not from insolvency — a sudden collapse of their assets relative to their liabilities. The worst economic collapse of all, the Great Depression, was still to come. When it hit, the necessary fix was a massive expansion in the money supply, with an accompanying increase in federal deficit spending. Arguably, the Fed already had the power to do this. But to kickstart the needed institutional revolution, President Franklin Roosevelt scuttled the gold standard as well in 1933.
Later, the post-World War II Bretton Woods system brought back the gold standard in name only. The Fed had so much gold on hand it put no practical upper limit on the money supply. And as soon as the U.S. economy grew so big that the gold supplies once again began to bite, President Nixon ended the gold standard entirely. Since 1933, the economy has still gone through bad collapses, such as 2008's Great Recession. But nothing even close to the scale of what we endured before.
What's the point of all this?
Partly that Shelton's political project is a hopelessly utopian one. The economic historian Karl Polanyi argued that certain key parts of society — labor, land and finally money itself — cannot be treated as commodities to be traded on markets. To force them to behave as such imposes such continuous, violent changes on actual human individuals, families and communities that the social fabric gets shredded. The story of how America created the Federal Reserve and abandoned the gold standard is the story of how we slowly learned this lesson through horrifically painful trial and error.
But the point is also that Shelton may see these changes more clearly than most. True, she views them as a tragic falling away from pure markets. But most mainstream experts and economists would be reluctant to admit that we already do not have a financial "market" in any meaningful way, and have not for more than a century.
The reality is that our financial system is an ad hoc public-private hybrid, and all private banks already operate as de facto public utilities, backstopped by the money-creating power of the Federal Reserve — which is just an agency of the federal government. But no one wants to acknowledge this fact: we still treat banks and the financial industry as if they're run by competition and private profit motives for the sake of shareholders. Which probably goes a long way towards explaining why we've allowed the American financial system to become such a bloated, predatory, destructive mess.
Thus, Shelton's extremism also invites a question: If the financial system is already basically public — if we've already fallen from the pure market faith — then shouldn't finance be for the public good, by public and democratic decision-making?