Fiscal Cliffs and Monetary Mountains

On September 13, economist Frank Shostak had an article on Mises.org about the upcoming “fiscal cliff,” which he explains this way: 

The "fiscal cliff" refers to the impact of around $500 billion in expiring tax cuts and automatic government-spending reductions set for 2013 as a result of successive failures by Congress to agree on some orderly alternative method of reducing budget deficits.

The impact, according to the CBO, is that the federal deficit could fall by nearly half (43%), from $1.128 trillion in 2012 to $641 billion in 2013. 

How should we interpret this projection?  The IMF and CBO think it’s a looming disaster.  But the IMF and CBO are not staffed by Austrian economists.  Shostak:

Ultimately what matters for the economy is not the size of the budget deficit but the size of government outlays — the amount of resources that government diverts to its own activities. Note that, because the government is not a wealth-generating entity, the more it spends, the more resources it has to take from wealth generators. This means that the effective level of tax here is the size of the government and nothing else.

The projected decline in government spending for 2013 is $9 billion, which follows a projected decline of $40 billion for 2012.  You would think commentators would zero in on 2012’s decline rather than 2013, Shostak notes.

But wait - if it’s true government takes things out of the pot without putting anything in, why would so many people be afraid of a reduction in government outlays?  If the “pot” represents a snapshot of a society’s total wealth, with net revenue streams feeding it, wouldn’t it make sense to slap government’s hands for scooping up whatever it wants?  Yes, it would if the dominant economic theories were free market instead of Keynesianism.  In the Keynesian world, government doesn’t have to do anything useful to create jobs and prosperity, since, as Paul Krugman says, we’re in a liquidity trap.  By paying people to dig holes and fill them back up it puts real food on the table because those hole-workers will spend their money and induce farms and factories to grow more corn and produce more razor blades.  It’s not just the dirt diggers powering the recovery, either - it’s everyone they trade with, thanks to the Keynesian spending multiplier.  As economist George Reisman notes, “The multiplier and its benefits are allegedly restrained only by the disappearance of funds into the ‘leakage’ constituted by saving.”

Shostak then addresses the issue of expiring tax cuts - will we have less purchasing power in 2013?  You might think the answer is straight-forward: More for government means less for us.  But given the expected reduction in government outlays, Shostak argues, the tax increase will be “like a tight monetary policy.”

A tighter monetary stance in this respect should be seen as positive for wealth generators since it weakens various bubble activities that sprang up on the back of past loose monetary policies.

By this logic if you end up paying more in taxes next year you have reason to feel good, sort of.  You may not be able to save as much or go out to dinner as often, but on net you’re better off because the sub-group of market participants who qualify as wealth-generators will have a lighter economic burden because of the decline of certain bubble activities.

One supposes that if the tax increase were greater yet, more bubble activities would cease, and the result would be even more positive for wealth generators.  But if taxes continue to rise, at some point the monetary stance would become so tight it would strangle the process of wealth-generation.  The tax increase, therefore, is harmful to all economic actors, with the possible except of the government. 

Put another way: If the taxed individuals are wealth generators they will have less money with which to invest in capital goods.  Other things equal, they will produce less, not more.  Taxes may put the bubbles on the sidelines, but they also hurt the wealth generators.

It’s hard to see how a tax is a net positive, at least for the taxpayer.

Here Comes Hyperinflation?

Another issue to surface this past week was inflation, the scary kind, as in destruction of the currency.  On September 12 Greg Hunter published an interview with Shadowstats founder John Williams, who predicted a dollar sell-off leading to digital wallpaper by 2014.  When Ben Bernanke announced a day later that the Fed would run the printing presses until the unemployment rate improved, it seemed like fulfillment of a prophecy. 

But will Bernanke print until the currency is no longer money?  Does that statement square with Williams’ acknowledgement that the Fed’s primary concern was “propping up the banks”?  How does turning the U.S. dollar into wallpaper help Citibank or Bank of America?  How does it help businesses produce, hire, and innovate when money becomes so plentiful it is more profitable to use as toilet paper?

More likely Bernanke will print and print, and print some more, then stop.  He will stop short of killing the dollar.  The bankers want to be able to buy things with their billions.  He will stop, and by then smart investors will be perched atop foreign currencies and precious metals as they watch the politicians flog the lifeless horse that was once our economy. 

Bernanke may be acting suicidal but I don’t believe he’s thinking that way.  He’s merely thinking like the Keynesian he is.  More spending is the great panacea.  People will not sit on cash if they think it’s getting worthless.

Paul Krugman says Bernanke is behaving in a manner consistent with his advice to “credibly promise to be irresponsible.”  By this he means Bernanke cannot get people spending unless they expect higher prices.  Monetary policy, therefore, should seek to instill this expectation.  Promising to print an additional $40 billion a month indefinitely might get them shopping in a panic.

But if they shop for precious metals, their strategy will have backfired.

Conclusion

Keynesians have been running things since the 1930s.  They are blind to oncoming train wrecks and spin their chronic failures with “too little, too late.”  The business cycle is a mystery they blame on the market rather than past interventions.  For them, the heart of the economy is a government-supported banking cartel that proudly distorts prices and a profligate Congress that blows the roof off its debt limits.  They are the enablers of a government that is growing more intrusive in every area of our lives.  Keynesians are bringing civilization to its knees, while being called on to save it.

I occasionally find it helpful to recall the words of my instructor, Dr. Robert P. Murphy, as he concluded a Mises Academy course on Keynes, Krugman, and the Crisis last year:

Ask yourself: What would the world look like if Keynesians were totally wrong?

It would look like it is today.

Still propagandized after all these years

I got a call from a young friend the other day complaining of writer’s block.  It wasn’t that he couldn’t think of anything to write, exactly; he couldn’t think of anything to satirize. 

“You’re crazy,” I said.  “What’s not to satirize?”

Brief silence.  “I can see you don’t know a thing about satire.“  He sighed.  “Satire requires an audience who would appreciate it.  Look, you don’t tell jokes to yourself, right?  You tell them to others.  If no one gets them, they’re not jokes.”

“Well--”

“They’re not jokes -- trust me.  Satire’s a little more complicated.  You want them to laugh, but when they’re done you want them to see what or who you’re picking on and agree with you.  You want them to take action.  If it’s political satire, you want them to overthrow the government.  Satire’s serious business.  You need to know what’s right, to laugh at what’s wrong.  But that’s the problem.  People don’t know.”

“Oh, yeah?  Tell that to the cast of Saturday Night Live.  Or Jon Stewart.  You’re burned out, man.  Let the field lie fallow.  You’ll get your touch back.”

“It’s not a case of lost touch.  Suppose you wanted to lampoon this stuff that passes for money, the fiat outpourings of the central banks.  Among the commentariat money is an issue, at least since the crisis of 2008.  At least on the internet.  But it’s not an issue with the middle class.  They still don’t get it.  They’ve been savaged by the bankers and politicians but they still don’t understand how it happens.  They have no freaking idea of what role gold has traditionally played in keeping these guys off their backs and out of their wallets.  They hear bright people say it’s barbarous, that to support it is like calling for the return of the biplane, and that serious discussion centers around whether Bernanke should impose another QE.   And if a few of them do get curious about gold as money, crowned experts like Bernanke slam the door in their faces.  He tells them that in the 1930s, the smart countries dumped gold before the others did.  Or that all those infamous panics of the 19th century were gold’s fault, that it forced bankers to redeem their notes for something of value.  So what if they issued more notes than they had gold on deposit?  That was acceptable practice and always has been.  If only people would simply believe that paper issued under a monopoly arrangement with the government was something valuable, everything would be fine.  The fact that we’ve had perpetual inflation and war since paper was crowned king is a fact lacking visibility.  To the general population.”

“No, you’ve lost your touch.  The material for a spoof of fiat money is there in abundance.”

“You could spoof it only for a select few.  The rest would be bored.  Okay, let’s try this: Suppose you wanted to satirize the War on Terror.  A ripe topic, right?”

“Over-ripe.”

“So what do you do?  You might say we’re winning the war and show the number of terrorists we have locked up in prison.  Yea for our side!  We’re number one!  But wait -- these guys don’t look like terrorists.  They’re not al-Zawahiri or al-Umari or al-Salada or something -- they’re al-Johnson or al-Jones or al-Richardson.”

“Great!”

“No, it isn’t.  No one on main street would laugh.  Half these prisoners are drug users.  They may not know it but they fund terrorism.  Their partners are the real ‘als’ planning the next attack.”

“Nooo!”

“That’s what people believe.  If you’re in jail, you’re a bad guy.  Bad guys support terrorists.  So you can’t satirize the War on Terror.”

“You just did!”

“Then why didn’t you laugh?”

“Your readers will, once you polish it.”

“They won’t.  My readers are the ‘als’ in prison.”

“Then dig deeper.  Hit the War on Drugs.”

“How?  By writing about soccer moms signing out kiddie aspirin at their local pharmacy, all the while chattering about their latest trip to the shore?”

“That’s a start.”

“Or a hospital scene depicting a shriveled old guy strapped to his mattress, his face a rictus of pain, while a canned video plays on his overhead TV detailing the evils of marijuana?”

“That’s good.  Dark, but good.”

“Of course there’s the old standby, cops armed with controlled substances to plant on troublemakers they want to send up.”

“That’s satire?”

“It might be if a cop’s kid gets hold of the stuff and is collared by some dick in another city.”

“You’re on a roll, man.  You need to hang up and get this stuff down.”

“You still don’t understand.  You know that puzzle about a tree falling in a forest with no one there -- would it make a sound?  I would be like that tree.  It’s not that there’s no one around.  They’re here but they’re lobotomized.  Regular people no longer think critically about the government.  Today’s normal is yesterday’s outrage, with the outrage removed.  Satire would play on that outrage, but it’s not there.  They’ve made peace with it in a psychotic sort of way.  They live in Huxley’s world without knowing it.  They love their servitude and call it freedom.  They still have their ball games and fishing trips, their malls and sitcoms.  Water still runs downhill, the sun rises and sets.  They can even speak freely, because their words are powerless.  In this blissful metamorphosis Julian Assange is the problem, not the corrupt governments.  You satirize that, they won’t laugh.  Satire’s not just humor, it’s an instrument of change.  Its fuel is outrage.”

“You’ve overlooked the elephant in the living room, my friend.  People have been screaming about the banks and Wall Street for at least four years.  They may not understand gold, but anti-Fed sentiment is all over the place!”

“Someone’s already tested the water on your elephant, buddy.  In this case a Brazilian elephant.  You say such animals don’t exist?  I say they’re invisible -- to the middle class.  They’re invisible to the middle class because they believe in the rightness of central banking.  Which, as I said earlier, is why they’re going broke.

“No satire I could ever write could top this.  It seems the staff of Brazil’s central bank is on strike.  They’re demanding a 23 percent pay increase.  Why?  Because of inflation.  They want the pay increase to cover the inflation they’ve created since 2008.”

“You’re making that up.”

“The Brazilian bank violated the first law of institutional counterfeiting: It didn’t take care of its own.  But who noticed?  No one.  Who cares?  No one.  Stand at the entrance to your local grocery store on a Saturday morning and ask the SUVs and mini-vans coming in if they’ve even heard of the strike . . or the central bank . . . or if they know what a central bank is.  Or if they have heard of a central bank, ask them if they think it’s an inflation fighter.  They’ll probably say yes.  ‘Thank God we have a central bank in the U.S., keeping a lid on inflation.  Unlike those boobs in Brazil.’  And if you stand there too long the store manager will order you off the premises, because he noticed you’re not selling girl scout cookies.”

“Look, you can’t expect political satire to ignite a revolution among everyday grocery shoppers.  If you were to conduct a survey you’d scare half of them and leave the rest thinking you’re a kook.  There’s an audience for your satire.  Not everyone’s been cleansed of outrage.  You need to find those people.”

“Yeah.  I believe they’re called ‘the choir.’  By definition you can’t change them.”

“That’s right -- and for the rest you need to be a teacher.  Satire isn’t a good teaching tool.  You build outrage with sound arguments.  Satire coaxes that outrage to the surface in the form of humor.  But you have to build it first.”

“But they’re lobotomized.”

“A better word would be ‘propagandized.’  It’s treatable.”

Then quietly, “Yeah,” followed by another silence so long I started to wonder if the connection broke.  Finally, to my surprise: “Yeah.  Yeah, that might work.  Talk to you later.”

Does the Fed really monetize government debt?

If monetizing debt is understood to mean printing money to pay for government deficits, then the Fed is guilty.

The basics are quite simple.  The federal government issues and the Fed buys interest-bearing debt certificates.  The Fed pays for these securities by creating digits on a computer that represent dollars.  In this Age of Ron Paul, more people are learning that the digits do not represent savings borrowed from the public.  The Fed is not a financial intermediary; it is a money factory.  And while factories under capitalism produce for the benefit of the masses, this factory cranks out dollars for the politically-favored, to the detriment of the masses.   The Fed is thus an anti-capitalist, anti-free market institution.  The 12 members of the FOMC decide how much money they need and create the digits on-the-fly, from nothing.  The idea of Bernanke or other Fed chairmen printing money is a metaphor, but an accurate one.  It’s simply more convenient for the Fed to create digits than to print money. 

It might be objected that this is not the equivalent of printing money because fiat money is not an interest-bearing asset.  By purchasing government bonds, the argument runs, the Fed collects interest from the Treasury, thus providing an additional windfall for the central bank, which also collects the principal.  The government would’ve been better off issuing a service order to its “money factory” and having it print the amount demanded and avoid the interest payments.  In other words, instead of Bernanke creating digits, have Geithner create them.

Simply printing money to pay one’s debts, though, even when done by a legitimate government, runs the risk of being seen as such.  Even eight-year-olds know a counterfeiter is a crook who prints money then spends it.  It’s always possible kids today would survive government schools to adulthood, still believing the emperor is stark naked, and that could lead to revolution.  Most adults, of course, have little interest in where money comes from as long as it buys things at the mall, and most economists have a habit of not biting the hand that feeds them, and thus lend support for an “independent” Fed.

If cheating is the goal, what’s needed is a circuitous means of printing money to keep the public befuddled and indifferent, and this is the reason for having a central bank.  It’s true, the Fed collects interest on the government securities it holds, but it gives most of it back to the Treasury.  After deducting for operating and other expenses, it pays member banks a 6% dividend on the stock they hold in their reserve banks, which in 2010 amounted to $1.5 billion.  (By law, member banks must subscribe to stock in the Federal reserve bank of their district equal to 3% of their capital, at a fixed rate of $100 per share, with another 3% subject to call of the Board of Governors.  See here.)  The remaining balance of the Fed’s interest receipts, including interest from assets other than U.S. bonds, is remitted to the Treasury at the end of each fiscal year.  In 2010, this amounted to $79.3 billion.  (See the 2010 annual report, pg. 130, Table 4 for details.)  Thus by giving the Treasury all the revenue it receives after deducting for expenses and dividends, the Fed in effect is granting the government loans at nearly zero interest.  As for the principal, the Fed simply keeps it on their books.  It could demand payment from the government, but so far it hasn’t.  If the Fed ever decides to defend the value of the dollar, unrestrained government as we've known it is doomed.

As we can see the government, in issuing bonds, is getting money for virtually nothing, then spending it.  As kings of old did when they literally ran the printing presses to pay for expenses beyond what they collected in taxes, today’s government does the same but through the esoteric world of central banking.

Why would bankers agree to such an unprofitable arrangement?

The commercial banks make their profits through the protection afforded by the government cartel of central banking.  Fractional-reserve banking has been the norm in banking for thousands of years, but while it can be very profitable it is also subject to instant disaster when banks over-inflate.  Under central banking in a fiat paper money regime, member banks inflate at a uniform rate and thus avoid currency drains from other banks and runs from the public.  And since money is paper or digits representing paper, the central bank, with its monopoly of the note issue and commodity money outlawed, can generate as much money as needed should problems arise.

As cozy as this arrangement is, most bankers don’t seem to recognize that central bank inflationary policies (“easing” or “accommodative”) will eventually bring an end to their scheme.  The money will become so worthless people stop using it.

The solution is to separate money and banking from the government, completely and permanently.

Honest money in dishonest hands

People are always looking for better ways of doing things, and this includes a better way of imparting a message to a misinformed American public.  In particular, if a layman wanted to learn about the nature of our money and banking system I would direct them to Murray Rothbard’s What Has Government Done to Our Money?  In my view Rothbard’s classic has always been the best introduction to the topic.  But Gary North has written an elementary work called Honest Money that held my interest not merely for its economic reasoning, but for the many original touches I found throughout.  Would North’s book reach more people than Rothbard’s?

I must point out that Honest Money is subtitled, “The Biblical Blueprint for Money and Banking,” and each chapter begins with references to the Bible and Christian ethics.  In the introduction he says his book asks a question:

What violations of the principles of the Bible did the West commit that led us into this mess [referring to the crisis of 2008 and its aftermath]? It also asks this question: What should we build on the ruins of the present system after the collapse?

For those who would find relief knowing the Bible sanctions honest money, North’s work will come as a godsend (no pun intended).  Even for those reprobates who forswear a religious worldview, his book will provide a solid grounding in monetary theory and history.  North’s vast understanding of money and banking coupled with his lean, no-jargon writing style takes the labor out of reading.  His narrative carries us on a journey from the development of money in its innocent youth, where it was used solely as a means of facilitating trade, to money in its corrupt maturity, where today it also serves to facilitate power and profit for a ruling elite. 

Very importantly Honest Money also includes numerous bullet points at the end of each chapter covering the main ideas.  I found these bullets indispensable.  More good news: The book can be read comfortably in one evening.

Crusoe’s Choices

North begins with the familiar star of economic analysis, Robinson Crusoe.  But rather than the usual pedestrian account of how Crusoe will budget his time, North dramatizes the situation somewhat, as would be appropriate for someone recently shipwrecked on an unknown island.  He writes:

Say that [Crusoe] has a pile of goods to take from the ship. He has put together a crude and insecure raft that he can use to float some goods back to shore. The ship is slowly sinking, so he has limited time. A storm is coming up over the horizon. He can’t grab everything. What does he take? What is most valuable to him? Obviously, he makes his decision in terms of what he thinks he will need on the island. . . .

The value of a tool as far as he is concerned has nothing to do with the money it cost originally. He might be able to pick up a sophisticated clock, or an expensive musical instrument, but he probably won’t. He would probably select some inexpensive knives, a mirror (for signaling a passing ship), a barrel (for collecting rain water), and a dozen other simple tools that could mean the difference between life and death.

In short, value is subjective. . .  the value of the [tools he selects] is completely dependent on the value of [their] expected future output. . .  Then he calculates how much time he has until the ship sinks, how much weight each tool contributes, how large his raft is, and how choppy the water is. He selects his pile of tools and other goods accordingly.

There are objective conditions on the island, and the various tools are also objective, but everything is evaluated subjectively by Crusoe. He asks the question, “What value is this item to me?” His assessment is the sole determining factor of what each item is worth.

North then wonders: What if Crusoe knew the captain had a chest full of gold coins?  Would he go back to the captain’s quarters and drag the chest to the edge of the ship and attempt to lower it onto his raft?  Unless he expected to be rescued soon, he would not.  Gold coins would be of no help to a man marooned indefinitely on a desert island.  In Crusoe’s case,

Gold isn’t wealth. It’s heavy. It displaces tools. It sinks rafts. It’s not only useless; it’s a liability.

This is how North introduces the reader to the distinctions between objective reality and subjective preferences, and to the fact that money arises only in a social context.  With no one to trade with, poor Crusoe had no need of it.

What is money and where did it come from?

In subsequent chapters he builds on these ideas.  Money is a universally-accepted medium of exchange.  Originally, it was not imposed from above but evolved from competition with all other goods on the market, as the good most acceptable in trade.  Over the centuries, gold and silver became the most commonly used monies.

We know what money is worth right now because we observed what it could buy yesterday, and for this reason we expect it to have purchasing power tomorrow.  If we march back in time, (following Mises’ argument, as articulated by Robert P. Murphy) we can use the previously observed purchasing power component of this commodity we call money to explain the derived expectations of it.  If we continue going back, day after day, we reach the point at which this commodity was just a widely accepted medium of exchange (not yet money).  Going back further still, we reach the point where the first person accepted it as a medium of exchange.  From there, it became more acceptable because someone had previously accepted it not for consumption but to trade away for something else.  Prior to that, this commodity that is now money was valued strictly for its use in direct exchange.

Thus, money evolves from a commodity used in direct exchange, to a good used in indirect exchange, to a widely used medium of exchange, to a universally accepted medium of exchange.   

What about the supply of money?  Who determines that?

If we have honest money, the market controls its supply.  In today’s world it’s a committee.  Just as we wouldn’t want a committee to set prices for us, North says, “why should it be allowed to control the supply of money in which all prices are quoted?”

There’s another question. How do we know that the committee will act only in behalf of us citizens? How can we be sure that the committee won’t start fooling around with the money supply in order to feather its own economic nest?

Fooling around with the money supply was more difficult when money was a precious metal.  Yet, fraudsters found ways to cheat.  Normally, the weight of the money would be far lower than the weight of the item being purchased, and the seller could adjust the scales to make the money even lighter and the product heavier.  Interestingly, North tells us that God delivered men from bondage and has the power to enslave them again if they cheat in money matters.  For Christians, is central banking an expression of God’s wrath?  Whether it is or not, our arrangement with the Fed is a form of enslavement.

Fraudulently adjusting the scales is an attempt to get something for nothing.  Coin clipping and coin debasement are likewise early entries in the cheaters‘ bible.  Paper money issued as pseudo-receipts for commodity money inaugurated a new era of theft: “A counterfeit coin . . . can be weighed.  A piece of paper looks just like other pieces of paper.” And the biggest cheat of all are the government-issued fiat paper currencies that have proliferated the world since August 15, 1971. 

A complacent public

But what about the hapless public through all this?  Will they ever revolt?

Not very often. The public decides that paper money is money, not pieces of shiny metal. If paper is acceptable by the store down the street, then who cares? Who cares if prices go up, year after year? What’s “a little” price inflation? We’re all doing better, aren’t we? . . . .

“Inflation can’t hurt anyone too badly” is a delusion of fully employed younger workers. It can hurt everyone who isn’t staying ahead of it with pay increases, and I mean after-tax pay increases.

Inflation acts as a turbocharger for the progressive income tax.  The latter was passed in 1913 with rates so low and applied to incomes so high that almost no one worried, just as no one worries about a little inflation.  The average family made $1,000 a year, but the tax didn’t kick in until the $20,000 level, and even there it was only 1%.  Those few who made $500,000 or more were “soaked” at only 7%.

But once the law was in place the politicians changed the rules.  Imagine that.  In 1916, while Woodrow Wilson was bragging to voters about keeping us out of war, the top rate was bumped to 15%.  The following year, while Wilson was shipping American men “over there,” the bottom bracket plunged from $20,000 to $2,000 while the top rate reached 67%, then 77% a year later. 

Here was their plan: lower the level of taxable income, and increase the rate of taxation in every bracket. Next, inflate the money supply, so that everyone is pushed into higher and higher taxable brackets. The higher your money income, the larger the percentage of your income gets collected by the State.

And as Rothbard has noted,

As luck would have it, the new Federal Reserve System coincided with the outbreak of World War I in Europe, and it is generally agreed that it was only the new system that permitted the U.S. to enter the war and to finance both its own war effort, and massive loans to the allies; roughly, the Fed doubled the money supply of the U.S. during the war and prices doubled in consequence. [p. 120]

Inflation is another name for counterfeiting.  Counterfeiters create money from nothing then spend it.  The private counterfeiter and the government counterfeiter have the same goal: to get something for nothing.

The public doesn’t trust private counterfeit money. The public does trust government counterfeit money, at least for a long time, until people’s trust is totally betrayed (mass inflation).

What is the difference in principle between private counterfeiting and government counterfeiting? None.

A Tale of Three Counterfeiters

One of the most memorable parts of Honest Money is North’s tale of the counterfeiters.  Counterfeiting is evil, right?  It’s an act of swindling others.  But it acquires a high moral luster if it’s practiced in plain sight by the right people.

In North’s tale three men counterfeit and are discovered.

The first one is a businessman with an offset printing press who prints 500 $20 bills and spends them into circulation. 

The second man is an employee of the Bureau of Engraving and Printing who prints a million $20 bills, and the government spends them into circulation.

The third is the chairman of a major New York bank that has loaned a billion dollars of fractional-reserve money to Pemex, the oil company owned by the Mexican government.  Pemex cannot meet interest payments on the loan because the price of oil has collapsed.

What happens to these three men?

The businessman is convicted of counterfeiting and sent to prison.

The government employee continues to print money until he reaches age 65, when he retires and collects a pension.

The bank chairman calls the Fed, who in turn calls the Mexican government to get them to issue a bond for $25 million.  The Fed subsequently creates $25 million to buy the bond.  The Mexican government sends the money to Pemex, which then sends it to the New York bank to meet its quarterly interest payment.  “The chairman of the New York bank gets a round of applause from the bank’s board of directors, and perhaps even a $100,000 bonus for his brilliant delaying of the bank’s crisis for another three months.”

The $25 million then multiplies through the U.S. fractional reserve banking system, creating millions of new commercial dollars in a mini-wave of inflation.

The World’s Most Powerful Insurance Company

Counterfeiters need protection if they are to succeed.  The biggest counterfeiters, the major banks, sought and established the protection they wanted in 1913, with the Federal Reserve System.  The details of the Fed were developed in a highly secret meeting of banking elites and a U.S. senator held at Jekyll Island, Georgia in 1910.  For years, the Fed’s defenders not only denied the meeting took place, but regarded any suggestion that it did as laughable.  In 2010, the denials were long forgotten when Fed officials met at Jekyll to celebrate its founding. 

The Fed’s public purpose was to prevent banking panics, as recessions were once called.  It was to create an elastic currency to meet the needs of business, through dispassionate and skillful management of the money supply.

The elasticity has stretched mostly in one direction - expansion - as the bank has created many hundreds of billions of dollars out of nothing since it began operations in 1914.  Under its watch, the economy has experienced at least 11 recessions over the last century, including the longest one on record, 1929-1945.

From 1930-1933 6,000 banks failed, only one of which was considered a major bank, The Bank of the United States.  Unlike the other big banks, it was not an “insider’s” bank, but was financed mostly by small merchants, especially Jewish merchants.  The state of New York shut it down in 1930, North tells us.

One of the greatest services the Fed does for government is monetize its debt.  When the federal government can’t raise taxes without facing a tax revolt and borrowing from private sources would entail high interest rates, it calls on the Fed to buy its debt on the cheap. 

The Treasury creates the debt certificates (usually on a computer entry: liability). The central bank buys them by creating another entry: money. The computer blips are swapped. . . .

The money is then used by the government to buy whatever it wants (mainly votes). This new money goes through the economy. If the banking system is a fractional reserve system, the money multiplies many times over. This is the process of legalized counterfeiting we call inflation.

The Fed doesn’t buy the government securities directly.  It buys them from a select group of about 20 banks and securities trading firms in New York City, who collect commissions from the trades. 

Question: Why doesn’t the Fed buy these bonds directly? Answer: because it couldn’t generate commissions for the favored 20 banks.

Conclusion

Honest money is not necessarily a gold - silver standard, North says.  “The only standard that matters is the no fractional reserves standard, coupled with the no false balances standard.”

Honest money is the product of honest people.  “[It] requires honest law and people who are self-disciplined. Let the people have what they want, just so long as it is morally valid, non-fraudulent, and non-coercive.”

As long as the Fed is around, we will never have honest money.  The purpose of the Fed is to inflate for the benefit of its friends: the big banks and government.  Honest money is a rare commodity and as such is an inflationist’s nightmare.  In light of this situation we should never question the success of government schooling.  Even today, there is widespread belief that the Fed is the nation’s number one inflation fighter, and few people would know how to disagree, including trained economists.

My recommendation: Give John Q copies of Rothbard and North.   Like me, he just might get hooked.

Very bad exchanges

An election in today’s welfare-fiat world is somewhat like gangs of people pushing on a big sow in different directions, trying to get it to move their way.  So who won the pushing contest Sunday in Greece?  The media tells us it’s the conservatives, who will stay the course and keep the sow on an austerity diet once they form a new government.  But the losers are not without influence, and they don’t like this frugality business, so maybe the new government will only mostly stay the course.  They will negotiate with creditors.  They will attempt to exchange their present deal for something more pleasing to the also-rans.

In the perpetual crisis of modern banking and sovereign states it may seem that economics is an arcane art beyond man’s comprehension.  Yet, its mystery is purely man-made.

In its broadest sense, economics can be thought of as the study of exchanges.  This is how it is defined by Robert Murphy, author of an unusual textbook called Lessons for the Young Economist.  It’s unusual in that it’s methodical without being tedious.  In fact, it’s downright fascinating.

The economists who were blindsided by the 2008 crisis were neck-deep in charts, aggregates, and bad theory they believe in to this day.  They tell us no one saw the train coming, so if everyone was blind, no one was blind.  The train wreck was just an unfortunate reminder that economics is hard stuff.  Better to leave it to the experts at the Fed and other places where high IQs run rampant.   

Problem is, economists of the Austrian school, such as Murphy, saw the train coming as soon as it left the station.  Every train that leaves the interventionist station has its fate written in economic law, as expounded in the works of Mises, Hayek, Rothbard, and others, including Ron Paul.  Everything that has happened in the past decade, and longer, has had all the suspense of a bad novel - for Austrians.

Did the Fed inflate pre-crisis?  Like mad.  Perhaps at Paul Krugman’s suggestion, Alan Greenspan created a monster housing bubble to replace the dot-com bubble.  Did it inflate in response to the bust?  Bernanke spiked the monetary base.  Are investors calling for even more monetary pumping?  The ones calling for QE3 are.  And there are countless nervous others hovering around the panic button ready to join them.  Will this pattern ever end?  Yes - and there’s an unspoken terror behind that thought. 

Murphy’s book, though geared to bright middle schoolers, provides the tools for understanding what the interventionist crowd seems unable to grasp, which is this: Unhampered markets have built-in regulatory mechanisms that keep the train on the tracks.  And the issue at stake could not be more critical.   As we read on page 9:

Unlike other scientific disciplines, the basic truths of economics must be taught to enough people in order to preserve society itself. It really doesn’t matter if the man on the street thinks quantum mechanics is a hoax; the physicists can go on with their research without the approval of the average Joe. But if most people believe that minimum wage laws help the poor, or that low interest rates cure a recession, then the trained economists are helpless to avert the damage that these policies will inflict on society.

The world’s policymakers as well as the people who suffer under them could benefit enormously from committing that passage to memory.  We have, in essence, exchanged sound economic principles for very bad ones - ancient fallacies framed in modern jargon - and are now wondering why the economic outlook is so threatening.

The idea of “exchange,” though, is not limited to the trading activities of individuals in which goods and services are traded for money or for other goods and services.  In every aspect of our lives we’re confronted with the possibility of exchanging the status quo for something else.  The exchange can be performed by an individual in isolation, such as the shipwrecked fictional character Robinson Crusoe who must build a one-man economy, or the change can be brought about by people acting together . . . as Greek voters did recently. 

Exchanging education for state indoctrination

In the early 19th century educational reformers began “exchanging” the Jeffersonian system of voluntary parental education for a more collectivist approach inspired by the despotic Prussian system.  Jefferson was a strong advocate of public schools for the poor, but an equally staunch opponent of compulsion in education.  Yet, by the end of the 19th century almost every state had compulsory public schools in which the “virtues” of obedience, equality, and uniformity were inculcated, sometimes violently, while independent thinking was discouraged or punished.

Given the educational system, should we be surprised that government inroads into the economy and our private lives take place without much resistance?

In 1913, we exchanged a high tariff for the income tax.  Then got the high tariff again later.

In 1917, we exchanged peace for war.  Then peace for war again a generation later.  And finally peace for perpetual war.

In 1933, we exchanged economic liberty for economic fascism.  It still bears the name of “free market capitalism,” though, which is useful for confusing people when the fascists in power screw things up.

After 2001, we exchanged freedom for security and are getting less of both.

But the biggest disaster has been the exchange of market money for political money, initiated in 1933 and completed in 1971.  Every American and dollar holder is now at the mercy of bureaucrats instead of Mother Nature.

In economics, all voluntary exchanges are win-win agreements at the time of the transaction.  Both sides to the trade believe they’re improving their lot, otherwise they wouldn’t agree to make it.  When politicians take to making exchanges for our benefit, however, we’re almost always on the losing side.  Someone must be winning, but in the end it’s not clear who. 

Peter Schiff on avoiding the brick wall

Peter Schiff, who was famously ridiculed for calling the crisis of 2008, steps up as a prognosticator again in his new book, The Real Crash: America’s Coming Bankruptcy - How to Save Yourself and Your Country.  We had way too much government and cheap credit leading up to 2008, he says, and even more government and cheap credit since then, which is why the next crisis will be the real haymaker. 

His book is divided into two main sections.  Part I addresses the problems, while part II, which is by far the lion’s share of his discussion, presents solutions.  In a nutshell, the problem is government, and the solution is to take an ax to it - again and again.   Since this view is currently unacceptable to policymakers and the public at large, we can only hope reality will win out before calamity hits.

The Real Crash is encyclopedic in its coverage and highly readable in its presentation.  Is there a government agency that truly serves the interests of all Americans?  He finds few.  What about services people actually want, such as K-12 education: Could they be done better at the state or local levels?  Or better still by the free market?  In most cases the answer is a profound “Yes!” to both.

Living on Bubbles

Our problems stem from a love of bubbles and the flawed economic theory that blesses them.

During Alan Greenspan’s reign at the federal reserve we had a savings and loan bubble, followed by a tech bubble, followed by a housing bubble.   Now with Ben Bernanke at the Fed, we have a government bubble, meaning the Fed is creating money that the banks are then lending to the Treasury to expand government.  “If you keep replacing one bubble with another, you eventually run out of suds. The government bubble is the final bubble.”

When the dot-com and housing bubbles burst we at least had something to show for them - “a few good Internet companies and some pretty nice McMansions, [but] no such benefits will remain when the government bubble pops.”

The Fed, Schiff says, should let interest rates rise so people can start saving again.  The Fed’s low rates discourage savings, which are

the key to economic growth, as it finances capital investment, which leads to job creation and increased output of goods and services. A society that does not save cannot grow. It can fake it for a while, living off foreign savings and a printing press, but such “growth” is unsustainable— as we are only now in the process of finding out.

But for politicians and central bankers, rising interest rates are an abomination.  The cost to service the national debt would go through the roof, while the economic contraction that would likely result would raise the deficit.  The federal government would have to spend less, and many of the country’s biggest companies depend on government spending, through contracting, subsidies, or consumption.

But rising rates and the terrible pain it would cause is the good news; the bad news, if the Fed continues to hold rates low, is the economy will eventually go into hyperinflation.  “Rising interest rates will be productive pain— like medicine,” he writes, “while hyperinflation will be destructive pain.”  If we stay the course and pretend everything will somehow work out, we could be facing a crisis worse than the Great Depression.

Bernanke on the Great Depression

Chairman Bernanke, of course, is well-known as an “expert” on the Great Depression, and many people are betting the farm that he and his Keynesian staff have the skills to steer us back to sunny beaches and bikinis.  Bernanke’s approach is to keep asset values from falling by any and all means.  One of the reasons the depression of the 1930s became great, he believes, is because the Fed allowed the money supply to fall following the Crash.  With less money in the economy, prices nosedived.  People didn’t consume as much, consequently businesses didn’t profit as much, therefore employees got fired, and the economy headed south in a self-perpetuating spiral. 

“Sustained deflation can be highly destructive to a modern economy and should be strongly resisted,” Bernanke said in a 2002 speech that inspired his nickname.  And by deflation, he means “falling prices.”

Schiff explains what’s wrong with this analysis.

First, for 100 years prior to the 1929 Crash, bank deposits actually gained value each year.  In other words, we had a century of deflation, that much-feared condition that Bernanke has vowed to avoid at all costs.

Second, from mid-1921 to mid-1929, the Fed increased the money supply by 55 percent, giving rise to a real estate and stock bubble.  Most but not all economists missed the bubble and its inevitable consequences because rising productivity kept consumer prices fairly stable.  Even as stock prices were falling only days before the Crash, Irving Fisher said stocks had reached a “permanently high plateau,” and he expected to see “the stock market a good deal higher than it is today within a few months.”  In 1928, Ludwig von Mises had published a full critique of Fisher’s monetary theory, claiming that Fisher’s reliance on price indexes would bring about the Great Depression.  Nonetheless, Fisher’s stable price theory carried the day, and when the sky fell the Fed, along with Hoover, “did something,” as Schiff explains:

Hoover’s Fed actually boosted the money supply by 10 percent in the two weeks following the 1929 crash. Repeatedly throughout Hoover’s term, the Fed created more money. But the money supply fell because people began hoarding cash, and banks stopped lending out their money.

Also,

Deposits went down by 30 percent, but most of that was due to people pulling their money out.

In other words, the money supply shrank despite the Fed’s interventions, not because of its inactions.

Did a falling money supply promote massive unemployment?

Not by itself.  Hoover insisted on keeping wages high, and during his re-election bid in 1932 boasted that the wages of U.S. workers were “now the highest real wages in the world.”  They probably were, and by not allowing wages to fall along with other prices, unemployment soared.

Had Hoover simply allowed the free market to function, the recovery would have been so strong that he likely would have been elected to a second term, and Teddy would have been the last Roosevelt to occupy the White House. Instead he handed the Keynesian baton to Franklin Delano Roosevelt . . .

None of this, as we know, is even close to the standard view of the Depression.  Instead, we’re told

that government needs to play a bigger role in battling downturns, and the Fed needs to pump in cash to jump-start the economy. This bad lesson stays with us today, and beginning in the early 1990s, this way of thinking started the cycle of bubbles that put us where we are now.

End Keep the Fed

The one puzzling part of Peter Schiff’s masterpiece is his view that the federal reserve, as originally conceived, was a good idea.  He describes the Fed as “reckless,” the “biggest culprit in discouraging savings,” and insists “we never should have trusted the Fed to respect its boundaries.”  But he also says:

The original intention of the Fed was something I might have supported had I been around back then. In theory, it was an agent of stability that could also promote economic growth. . . .

The Fed would increase the money supply as the economy expanded, and then reduce the money supply as the economy contracted. . . .

In theory the Fed was a good idea. It’s just that in practice it did not work, because politicians quickly abused it.

He argues that before 1913, banks were issuing their own currencies backed  “by assets, such as gold, and by the banks’ loan portfolios.”  If “you traveled to California, your bank note from Connecticut might not be honored by other merchants or the California banks.”

Thus, he concludes, it was natural “for bankers to hatch an idea of a “banks’ bank.  Banks could deposit some of their assets— commercial paper or gold— with the Fed, and the Fed in return would issue its own bank notes to the individual bank.”

While this may sound plausible, questions arise as to (1) why the “banks’ bank” needed “guns and badges” (i.e., government cartelization) to make it work; (2) why loan portfolios or commercial paper can be assumed to be an acceptable substitute for gold coin; (3) why a central bank is needed to expand and contract the money supply - in other words, why assume the supply/demand relation of the free market fails when the good in question is commodity money; (4) why the historical record of central banks acting as an agent of stability and sustainable economic growth is short on examples; and (5) why did the Fed, at its creation, possess a massive inflationary structure if it was sold as a means to promote stability?

I believe central banking, by its nature, is a means of institutionalizing, centralizing, and cartelizing moral hazard.  It is my view that the Fed was never a good idea, but one of the absolute worst ever brought to fruition. 

These concerns notwithstanding, his critique of the Fed as it currently exists is emphatically on the money.  Though he doesn’t support its abolition he does say, “In an ideal world, there would be no Fed, and I think the nation would be better off if the Fed had never been created.”

How we can save ourselves

Readers of his book don’t have to be swept up in the impending disaster.  Unlike the crash of 2008 when investors flocked to the dollar as a safe haven, he believes the dollar and U.S. bonds will collapse before the U.S. economy goes under.  He devotes a chapter to crisis investing based on the observation that since Americans have been living beyond their means, many others have been living beneath their means. 

Elsewhere in the world there are more creditors than debtors, and there is pent-up demand and excess production. In the future, these economies will see a surge in demand, while ours will see demand fall. . . .

Bottom line: purchasing power is shifting. You should try to invest in companies that will benefit from this shift. These will primarily be foreign companies. Of course, many foreign companies sell to the United States. These aren’t the businesses I’m talking about.

He describes his investment strategy as

a stool with three solid legs: (1) quality dividend-paying foreign stocks in the right sectors; (2) liquidity, and less volatile investments, such as cash and foreign bonds; and (3) gold and gold mining stocks. 

Of particular interest to this reader was his section on the poor man’s investment strategy.  If consumer prices head for the moon the government will likely impose price controls, thereby creating shortages.  Solution: buy in bulk now and stock up.  One advantage is that

any returns are tax free. For example, if you buy a box of cornflakes today and eat it two years from now when the price of a new box is 40 percent higher, that’s a 40 percent tax-free return.

His writing is full of fresh and sometimes bold insights on long-standing issues.  Readers will find his discussions on drug prohibition, marriage, abortion, guns, health care, and prostitution especially engaging, I believe.  His detailed historical and legal discussion of the income tax is the best I’ve ever read, nor does he pull punches in describing it:

It’s hard to imagine a tax more destructive of productivity, more destructive of entrepreneurship, more destructive of our lives, more difficult and costly to comply with, more subject to gaming, or more absurd in its logical consequences. Congress should immediately, fully, and permanently abolish the income tax, and the Internal Revenue Service (IRS) along with it.

He would replace the tax with a revenue-raising tariff on imports.

Yes, tariffs suck. But they suck less than income tax. In fact, they might be preferable to a national sales tax.

Conclusion

Peter Schiff has written a riveting guide on what to do about our snowballing social, financial, and economic problems.  Inasmuch as he recommends freeing people from government, his solutions are far from pain-free and consequently will not be popular with the political class or their dependents.  Well, it’s time they got over it.  As Schiff writes in his introduction, it’s as if we’re headed down an icy hill with politicians in the driver’s seat accelerating toward the bottom. 

We need a grown-up to grab the wheel and steer us into the ditch on the side of the road. That won’t be pretty, but it’s better to go into the ditch at 80 miles an hour than crash into a brick wall at the bottom of the hill at 120.

The Real Crash is a must-read.

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.

Conclusion

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. 


Notes:

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