Boom and Bust Banking—Causes and Cures

The twenty-first century opened with optimism, as first the technology sector and then the housing sector boomed. But then came the financial crisis and the Great Recession—the worst economic malaise since the 1930s. Why, after several decades of economic stability, did the business cycle return with such force? Most attempts to answer this question have neglected the impact of the most powerful economic actor on the world stage today: the Federal Reserve. In the new Independent Institute book Boom and Bust Banking: The Causes and Cures of the Great Recession, editor David Beckworth and eleven other economists remedy this deficiency by explaining why the U.S. central bank bears most of the blame for the calamity. After explaining how the Fed created the Great Boom and the Great Recession, the book proposes fundamental reforms—monetary regime change—to avoid future cycles of boom and bust.

The Federal Reserve, the book shows, precipitated an unsustainable housing bubble; the misaligned incentives in the financial system merely amplified the effects of the Fed’s easy monetary policy. The Fed also took the wrong tack when the economy began to contract: it tightened monetary policy at a time when the demand for money was increasing rapidly. Instead of dealing with this increase in money demand, the Fed focused on becoming “lender of last resort” on a scale so vast that it became a central planner of credit allocation. Because the Federal Reserve is a monetary superpower with global influence, its policies contributed to the boom and bust cycle in other countries. The book’s detailed examination of these and related topics illuminates issues that most analysts and policymakers have misunderstood.

If we are to avoid repeats of the Fed’s mistakes, we must adopt a better approach to monetary policy. Exactly what that approach should be is a matter of debate. Some contributors to Boom and Bust Banking argue that the U.S. central bank should adopt a monetary rule aimed at stabilizing total current-dollar spending, a policy that might have avoided the Great Boom and Great Recession. Others are skeptical that such a rule would be adequate to prevent future banking crises, given the information constraints and political incentives of central banks as well as the public’s perception that large insolvent banks would continue to be bailed out. The final chapter makes the case for a radical alternative to central banking: free banking with competitive note issue. Under such a system, individual banks would know on a daily basis, via the level of interbank clearings, whether to increase or decrease their issuance of banknotes in response to changes in money demand; and collectively their actions would tend to stabilize total current-dollar spending.

Boom and Bust Banking is a serious book for anyone who has a serious interest in learning why the financial meltdown of 2008 occurred, and what kind of reforms would be necessary to assure that we don’t experience a repeat episode.” —Jerry L. Jordan, former President, Federal Reserve Bank of Cleveland

Boom and Bust Banking: The Causes and Cures of the Great Recession, edited by David Beckworth (The Independent Institute, 2012)

Read the book summary.

Read the Introduction by David Beckworth (pdf).

[This post appeared first in 5 Sept. 2012 issue of The Lighthouse, the Independent Institute’s weekly newsletter. To subscribe, enter your email address here.]

Carl P. Close is a Research Fellow at the Independent Institute, Assistant Editor of The Independent Review and editor of Independent’s weekly e-mail newsletter The Lighthouse.
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