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This article argues that two alternative hypothetical central bank scenarios could have improved upon the Federal Reserve’s track record with respect to financial stability and possibly overall macroeconomic performance in its first century. The first scenario is to assume that the charter of the Second Bank of the United States had not been revoked by Andrew Jackson in 1836 and the Second Bank survived. The second scenario takes as given that the Second bank did not survive and history evolved as it did , but considers the situation in which the Federal Reserve Act of 1913 was closer to the original plan for a central bank proposed by Paul Warburg in 1910.

The Federal Reserve’s Centenary will be in 2014. It is time to reflect on how the institution has done in its first 100 years—on its successes and failures. Much has been written on the history of the Federal Reserve. The key books are by Milton Friedman and Anna Schwartz in the A Monetary History of the United States (1867–1960) and Allan Meltzer, A History of the Federal Reserve (2003) and (2009) and two recent books are also important: John Wood, A History of Central Banking in Great Britain and the United States (2005) and Robert Hetzel, The Monetary Policy of the Federal Reserve: A History (2008). The general thrust of the evaluation of the Fed’s performance is that it did well in the 1920s, the 1950s, and from the mid 1980s to 2006 (the Great Moderation) but that it performed badly in the Great Depression of the 1930s and the Great Inflation from 1965 to 1980. Many also have criticized the Fed for its performance during the recent financial crisis and Great Recession (e.g. Meltzer, 2009, Taylor, 2009 and Hetzel, 2012) but it will take more time to conclude that this experience should be ranked as badly as the Great Depression and Great Inflation. This literature is critical of the Fed for following flawed doctrine, for its lack of independence from political pressure and for flaws in its structure. However despite its serious failures the consensus would argue that the Fed during its 100 years has exhibited the ability to learn from its past errors. Selgin et al. (2010) go farther than the main stream view. They argue that the Fed has never done better with respect to price stability, real economic stability and financial stability compared to the regime which preceded it – the classical gold standard, national banking, US Treasury and Clearing House regime. This paper does not directly engage into the debate over how well or badly the Fed did in its first 100 years. Rather I focus on whether the track record of economic performance could have been improved if the development of a US central bank had followed two quite different historical paths which were presented at key conjunctures in the past. The first scenario is to assume that the charter of the Second Bank of the United States had not been revoked by Andrew Jackson in 1836 and the Second Bank had survived. This is not a totally unrealistic scenario since absent Jackson’s veto the Bank would have survived and the Congress came reasonably close to overriding the veto. The second scenario takes as given that the Second Bank did not survive and history had evolved as it did, but considers the situation in which the Federal Reserve Act of 1913 was closer to the original plan for a central bank for the United States proposed by Warburg (1910a). Both of these scenarios would have led to greater financial stability than we had in the 20th century and possibly better overall macro-performance and price stability. Section two develops the Second Bank counterfactual. Section three considers the Warburg scenario. Section four speculates on whether these alternative arrangements would have given us better overall financial, macroeconomic and price stability performance throughout the 20th century than we had. Section five concludes with some policy relevant lessons from history.

In this paper I have argued that had the Second Bank of the United States not been destroyed in 1836 that the US could have had a better history with respect to financial stability, price stability and overall macro-performance. Had history played out as it did and the Second Bank been terminated then a second more modest counterfactual which assumes that a US central bank closer to the Warburg plan of 1910 would also have done better than the Fed throughout much of the 20th century. These hypothetical central banks had several key features which were crucial to their hypothetical success. The first was adherence to a commitment to a credible nominal anchor, the gold standard, and then a fiat money standard operated on lines like the gold standard. The second was following a rule to preserve financial stability—following Bagehot’s rule as interpreted by the Bank of England in the second half of the 19th century—to provide liquidity freely to the money market in the face of a panic. Third was independence from the fiscal authorities which was a key tenet of the classical gold standard. The Fed departed from these rules over much of its history. It learned to be a lender of last resort after the Great Depression but has pushed that notion way beyond what the framers expected of it, to protect the integrity of the payments system. Today it has expanded its mandate to the guarantee of the stability of the entire financial system. The Fed achieved price stability in the 1920s, 1950s and between 1985 and 2007. It also learned from its bad behavior in the Great Inflation to follow a credible rule like commitment to maintain low inflation during the Great Moderation. It then followed a period of keeping interest rates too low for fear of deflation between 2002 and 2006 which added fuel to the fire of the subprime crisis and since the recession has ended may have kept policy too loose to not avoid future inflation. The Fed was granted considerable independence at its inception. It abused this independence during the 1930s and from the mid 1930s to 1951 it effectively became a branch of the Treasury. It regained its independence in the 1951 Treasury Federal Reserve Accord but under Chairmen McChesney Martin, Arthur Burns and G. William Miller it again allowed monetary policy to become subservient to the needs of the Treasury. Since Paul Volcker became chairman in 1979 the Fed’s independence has been restored and the Fed between 1985 and the early 2000s has conducted monetary policy as good as any contemporary or historic central bank. Its record since 2007 once again suggests that its independence has been sacrificed. It is too soon to tell how permanent this will be. The hypothetical examples that I have constructed suggest that the US could have had a better central bank. The actual history of the Federal Reserve suggests that with considerable effort that the Fed by the early 2000s had learned from its past mistakes and had moved closer to these history based hypothetical examples. It may have regressed in the run up, the management, and the aftermath of the recent Financial Crisis and the Great Recession. Whether it will return to this path is an open question.