Something Had Gone Wrong with the Steering Mechanism of Federal Reserve Policy and It Behooves Us to Know Why

The reason why all this deserves attention is that we now know that the Titanic of the US financial system in 1923 was even then on course for the iceberg of 1929. Something had gone wrong with the steering mechanism of Federal Reserve policy and it behooves us to know why. At several points in his review of US monetary policy in the early 1920s (chapter 2, this volume), Hayek raised warning flags, particularly in section six, which points to the lack of a coherent theoretical foundation. 

What went wrong? The Reserve Board was no longer able to use changes in the reserve ratio as the steering mechanism. “Under the present conditions, with gold embargoes in force in most foreign countries and the United States practically the only free gold market of the world, the movement of gold to this country does not reflect the relative position of the money markets nor does the movement give rise to corrective influences, working through exchanges, money rates, and price levels, which tend to reverse the flow. The significance which movements in the reserve ratios formerly possessed rested upon the fact that they were the visible indicators of the operation of the nicely adjusted mechanism of international finance. With this mechanism now inoperative, the ratios have lost much of their value as administrative guides. It has therefore been necessary for banking administration even in those countries that have been most successful in maintaining a connection with the gold standard to develop or devise other working bases.”

—Stephen Kresge, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 5, Good Money, Part I: The New World, by F. A. Hayek (Indianapolis: Liberty Fund, 1999), 22.