Sunday, May 20, 2012

Ben Bernanke Goes Back to School

[Note: A version of this article is available as a video commentary.]

In the opening chapter of his book Essays on the Great Depression, Fed chairman Ben Bernanke tells readers, “I am a macroeconomist rather than a historian.”  Though the book was published in 2000, his recent statements about the classical gold standard and the origins of the federal reserve suggest the vast revisionist literature pertaining to U.S. economic history is still largely unknown to him.[1]  His comments, in fact, sound like they were pulled uncritically from a public high school teacher’s manual: Why did the government institute a central bank?  To rein in the gold standard, which was creating crises.

This approach proved not to be a problem, though, when he lectured George Washington University students on March 20, 2012 about the Fed and gold.   On that day he told the class that
in the period after the Civil War until World War I and really all the way into the ‘30s, the United States was on a gold standard.  [28:43]
Never mind that there were two different gold standards before and after World War I, and never mind that both functioned under the thumb of government in vastly different ways.  Bernanke, the macroeconomist, aggregated them both into one category, calling it “a gold standard.” 

He continued:
There was more volatility in the economy, year to year, under a gold standard than there has been in modern times.  So, for example, movements in output variability was much greater under a gold standard, and even year-to-year movements in inflation, the volatility was much greater under a gold standard.  [31:56]
Earlier, he defined a gold standard as
a monetary system in which the value of the currency is fixed in terms of gold.  So for example by law, in the early twentieth century, the price of gold was set at $20.67 an ounce. . .  [Though central banks managed the gold standard to some extent,] a true gold standard creates an automatic monetary system.  [29:38]
On this last point he’s correct, a true gold standard is “automatic” in the sense that it works without, and only without, government intervention, [Mises, p. 280] though that’s a distinction that somehow eluded him.  Even Milton Friedman, never a champion of monetary freedom, admitted that,
If a domestic money consists of a commodity, a pure gold standard or cowrie bead standard, the principles of monetary policy are very simple. There aren’t any. The commodity money takes care of itself. [Salerno, p. 356; emphasis added]
A monetary system that “takes care of itself” would have no need of a Fed or a Fed chairman.  Central bank employees would have to find some other way to generate income.  Bernanke could always go back to being a college professor, but maybe not.  Who and what would he teach?  Thanks largely to Ron Paul, the Fed is suffering by far the worst criticism in its history, which was the main reason Bernanke was holding class at GWU.  If the Fed is abolished, it will put a huge blot on the resumes of FOMC members.  It’s one thing to lose one’s job because of shifting demand among consumers, but quite another to lose it because your policies caused major economic crises and helped put millions of those consumers out of work.

Over the centuries, people have chosen gold and silver as their preferred medium of exchange when these metals were available.  As economist Jörg Guido Hülsmann points out, there is a tendency in the market for the best monies to emerge. [p. 76]  Market participants would not select a money that was “unstable.”  If they did, they would switch to a more stable money, provided they were free to do so.

Yet, Bernanke suggests that the alleged volatility of the market under the government-tainted gold standard, and the periodic crises that emerged, means the market had made a bad choice and had no way of correcting it voluntarily.  Was there no better money available?  Is that why we ended up with paper as money and a board of bureaucrats determining how much of it we should have?

The public was told, in effect, that it was necessary to remove money from the monetary system to get it to work.  Why?  The Fed functions as a lender of last resort, and the Fed can’t lend something it doesn’t have.  It can’t lend money, so it lends printed pieces of paper or their digital equivalents and calls that money.  Whether we agree with this or not is irrelevant; we’re forced to use it or abandon the enormous benefits of indirect exchange.

We know that money created from nothing allows the user of the money to get something for nothing.  Paper money, therefore, acquires a new trait: no longer just a medium of exchange, it becomes a medium for wealth transfer.  Since the transfer lacks transparency for most people, it becomes the ultimate political tool.

Most monetary economists regard this arrangement as a good idea.  Of course, most of them have income arrangements with the Fed, as well.  [Hulsmann, p. 16]  

What do we know about paper money regimes?  Rothbard notes that they “were considered to be both ephemeral and disastrously inflationary.”  [p. 353]  But he was referring to the days of yore - what about modern times?  Bernanke’s predecessor delivered a now-famous speech in 2002 pointing out what happened to prices when the dollar was no longer anchored to gold domestically. 
In the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent overissuance of money.
If you’re going to balloon welfare, if you want to fund unpopular or undeclared wars, if you want to buy votes, buy the media, buy the economists, if you want to establish a massive military-security state, if you simply love power and pomp, then there’s no substitute for a central bank’s printing press.  Along the way it debilitates the middle class, creates a dependent, credulous electorate, makes moral hazard commonplace, eats away the economy’s capital structure, makes perpetual war the norm, and ultimately destroys the social order.  None of this, of course, was mentioned in Bernanke’s lecture.

Gold and prices

Instead, he tried to make the case that a gold standard is not the wealth guardian its proponents believe it is.
One of the strengths that people cite for the gold standard is that it creates a stable value for the currency.  It creates a stable inflation, and that’s true over very long periods.  But over shorter periods, maybe up to five or ten years, you can actually have a lot of inflation, rising prices, or deflation, falling prices, in a gold standard.  [36:56]

And the reason is, the amount of money in the economy varies with things like gold strikes.  So, for example, [in] the United States, if gold was discovered in California and the amount of gold in the economy goes up, that will cause an inflation, whereas if the economy is growing faster and there’s a shortage of gold, that will cause a deflation.  [37:11]
A sudden discovery of gold such as occurred in California in 1848 will, to the extent the new gold is used as money, reduce the effectiveness of each monetary unit.  However, unlike the paper dollars the Fed proliferates in abundance, gold has highly-valued nonmonetary uses competing with its monetary employment.  On the market, the production of money, like the production of all goods, is regulated by profit and loss, as economist Jeffrey Herbener pointed out to a House subcommittee recently.  As the demand for money increases, the value of monetary gold would increase.  If demand is strong enough, profit opportunities arise in mining and minting.  As profits increase the resources used in mining and minting rise because of increased demand for those resources.  As the price of resources increases, profits dissipate, and so does production.  Thus, a gold standard, because of market mechanisms, will not allow a “perpetual overissuance of money.”

A “shortage of gold” might lead to deflation, but what does that mean?  Price deflation results when the production of nonmonetary goods increases at a faster rate than the production of money, or when the demand to hold money increases.  But are falling prices an economic evil?  Herbener reports that
two of the periods of most rapid economic growth in US history were from 1820–1850 and 1865–1900. In each of these periods, the purchasing power of the dollar roughly doubled [meaning prices dropped].
A gradual decline in prices is the norm for a free market economy.  It encourages people to save, which builds up the economy’s capital structure.  It also encourages consumption because goods get cheaper.  The electronics industry today is probably the best example of how falling prices allow more people to enjoy the market’s bounty.

Herbener refers to the 2004 paper of Andrew Atkeson and Patrick J. Kehoe  in which they examined evidence for empirical links between deflation and depression across 17 countries for a period of 100 years.  Atkeson is an economics professor at UCLA, and Kehoe is an economist with the Federal Reserve Bank of Minneapolis. Their conclusion:   
A broad historical look finds more periods of deflation with reasonable growth than with depression, and many more periods of depression with inflation than with deflation. Overall, the data show virtually no link between deflation and depression. [emphasis added]
In a speech given in November, 2002, a month before Greenspan’s talk about the Fed’s inflation habit, Bernanke promised an audience that the Fed would make sure deflation wouldn’t happen here.  He made that promise because as a supposed expert on the Great Depression, he believes the Fed followed a deflationary policy that deepened and prolonged the crisis.

But there are serious problems with this analysis.  For the countries for which they had data (all except Chile), Atkeson and Kehoe report that
In 1929—34, all 16 countries had deflation, 8 had deflation and depression, and the other 8 had deflation but no depression.
That alone makes the deflation charge suspect.  But even worse, as economist Robert Murphy has written, if deflation (as a fall in prices) is so harmful, how do we explain U.S. prosperity of the period 1926-1928 in which consumer prices fell 2.2, 1.1, and 1.2 percent, respectively?

True, the deflation of the early 1930s was far greater but it was still less than the deflation of a decade earlier.  Murphy:
From their peak in June 1920, prices fell 15.8 percent over the next twelve months, a one-year deflation that was 50 percent more severe than any 12-month fall during the Great Depression. And yet, the 1920–1921 depression was so short-lived that most Americans today are unaware of its existence. [emphasis added]
 Fractional-reserve banks are prone to runs

In the 19th century, notes and demand deposits issued without gold backing created bubbles that alarmed note holders and depositors.  When they came to the banks in large numbers to claim their property, and the banks were unable to deliver, a crisis resulted.   

Bernanke cites the movie It’s a Wonderful Life as an example of what happens during a bank run.  [15:27]  In the story Jimmy Stewart owns a bank and finds the lobby filled with townspeople clamoring for their money.  Problem: His bank doesn’t have nearly enough money to pay them off.  Why not?  Bernanke:
No bank holds cash equal to all their deposits.  They put that cash into loans.  So the only way the bank can pay off its depositors, once it gets through its minimal cash reserves, is to sell or otherwise dispose of its loans.  [17:13]
“Minimal cash reserves”?  Why is the bank making loans with funds it promised to make available on demand?  Does that not qualify as embezzlement?  The people asking for their money were depositors, not creditors.  If they had loaned the bank money by opening a savings account at interest or purchasing a CD, there would be no obligation to redeem their accounts in full on demand.  But as depositors, they had the right to expect their money to be there when they came to get it, and the bank should’ve been charging them a fee for safeguarding it.

Jimmy Stewart’s bank was solvent, he says, but merely illiquid. [20:10]  But is this true?  The deposits the bank held were liabilities due on demand.  An institution is solvent if it is “able to pay all debt obligations as they become due.”   As we see in the film, Jimmy Stewart’s bank could not pay all obligations as they became due.  His bank, as with all fractional-reserve banks, was insolvent. 

But Bernanke doesn’t see it that way.  He blames the depositors, calling their run a “self-fulfilling prophecy.” [17:32]  If only they had believed and never lost confidence, the bank’s fraud would never have been exposed. 

Bernanke goes on about how a central bank could’ve spared Jimmy Stewart  much grief by loaning him the funds to pay off the depositors  [20:00] - “funds,” of course, meaning printed bills, not gold, since no bank can conjure gold into existence.  But having a central bank as a rescuer is a moral hazard, a way of keeping insolvent banks operating while postponing the calamity that results from fractional reserve banking.


The gold standard has been blamed for problems that in fact were caused by government meddling in the monetary system.  Fractional-reserve banks should’ve been allowed to fail, but instead government often came to their rescue by allowing them to suspend specie redemption while permitting them to stay in business and collect debts owed to them.  In supporting fractional-reserve banks, the government was guaranteeing moral hazard and future crises.  The public was misled into believing the gold standard was unstable and that a central bank was the path to monetary deliverance.  With gold as the scapegoat, it was fairly easy to get rid of it.  History and theory tells us that abandoning gold means embracing inflation and big government, while putting liberty and sustainable prosperity on the chopping block.

Ben Bernanke should be back in school, but not as a teacher. 


1.  See for example Gabriel Kolko’s Triumph of Conservatism and Murray Rothbard’s The Case Against the Fed.

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