The last time there was talk about this issue was more than 30 years ago, after the devastating inflation of the late 1970s robbed an entire generation of their savings, upended American family life and launched a debt addiction that has destabilized economies all over the world. The Nixon administration promised a rose garden after the paper dollar; the results were very different.

The crisis in our times is not (yet) hyperinflation, but it is just as serious. The problems of the Fed-managed paper dollar system are too many to name, but they can be reduced to three that hit the average person most seriously.

First, it is no longer possible to earn a conventional return on saving money. That reality pretty much undermines the whole practice and ethics that built prosperity as we know it. The reason is directly related to the quality of money: Lacking any independent substance at all, its value and yield is managed by a small group of technocrats in a marble palace. They have used that power to impose the ultimate price control on the relationship between time and money.

Second, the problem of unemployment and the ever-shrinking labor participation rate has hit the young generation in a way that we’ve never seen before. This has terrible economic effects but just as devastating cultural ones. It attacks the core hope that people have for the future. Again, the paper dollar, as the generating force behind the bust and boom, is a cause.

Third, there is a growing movement against the power, secrecy and insider racketeering by the Federal Reserve, which prints and throws around inconceivable volumes of loot to its friends and clients in total disregard for the political process or the fate of the American middle class. This angers people of all political persuasions. The opening up of the records and dealings of the Fed has not calmed people down, but rather has confirmed the worst possible fears.

In the 1970s, writers like Henry Hazlitt struggled mightily to get people to see the connection between monetary policy and the falling value of the dollar. While the Ford and Carter administrations lashed out at business and speculators, Hazlitt and others pointed to the real cause. His message stuck. By 1980, even the Republican platform included a call for a sound dollar. Congress formed a gold commission.

The connection between the Fed’s paper money and our economic plight is even more difficult to make this time around. But the intellectual foundations have been in place for years, and they have been given voice in the relentless hammering away at this issue by Ron Paul in interview after interview. He never misses a chance to talk about this previously unspeakable subject.

A tricky issue for the movement now is dealing with the diverse political coalition coming together against the current monetary system. The biggest critics of the Fed, for example, agree that the current system is a mess but don’t seem to agree about what to do about it.

This week in D.C., I debated Dean Baker of the Center for Economic and Policy Research. The setting was fantastic: a speak-easy environment sponsored by the beautifully named Empire Unplugged. Baker is a strong critic of the Fed for reasons both good and bad. On the good side, he is as appalled as Ron Paul at the insider racketeering of the central bank. On the bad side, he would like to see its powers transferred to a body with more political oversight and democratic influence.

This is the exact opposite of what I argued for: the complete depoliticization of the entire system. We went back and forth for an hour on these topics, agreeing on the great evil, but disagreeing on what should replace it. As is typical of progressive critics of the Fed, he raised fears that market control of money and banking would revive the wildcat banking of the 19th century. This camp conveniently forgets that the age of the gold standard (which was never perfectly adhered to) also happened to produce history’s largest and most-positive economic transformation, propelling the creation and entrenchment of what is called the middle class.

Do these debates matter that much? On the level of theory, yes. In practice, not so much. These mirror the kinds of debates in the middle stages of the collapse of socialism in Eastern Europe. Recall that the movement against Polish central planning began not as a movement for private ownership of capital, but rather as a labor union protest against power and privilege of state-connected oligarchs.

This tendency made the champions of free markets squeamish, for good reason. Replacing a state monopoly with a state-protected labor monopoly does not necessarily look like improvement. But that’s not what ended up happening in Poland. Solidarity was the major vehicle that wrecked the regime as it stood. At one point, the major labor organization Solidarity had 9.5 million members. That mass movement upended history. Today, Solidarity is a normal union like any other, with membership at half a million and declining and no serious power. The result was not a labor monopoly, but a beautifully prosperous market society.

The lesson here: Sometimes you have to topple the system that exists and see what happens. This is why Ron Paul has been tolerant of a wide divergence of views within the anti-Fed movement. He is right to be so. Writers at The Wall Street Journal and elsewhere wring their hands about the dangers of political control of money in the post-Fed age. But history shows that the reform is not so easily managed. Breaking up the current monopoly is the most-important priority right now.

If the Fed were an Eastern European socialist government, the year would be about 1987. If the economy takes another dive after the fake boomlet that Bernanke’s printing presses have manufactured, he should make sure that the helicopter on the roof is in good working order.

Regards,

Jeffrey Tucker

The Great Monetary Debate was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

In today’s world, burying that money might have been the better idea. Otherwise, the servant would have paid fees for depositing, withdrawing and transferring and would have earned no interest at all, and the money would have depreciated in value the whole while. It’s enough to cause you to weep and gnash your teeth.

That parable has had a long life because earning interest on deposits is a universal feature of the human experience in any finance economy. Until now. The Fed has announced that it will work to keep interest rates at zero for the next several years, all with the supposed goal of refurbishing the economy. Or so Bernanke tells us at great length.

But here’s the problem: This very strategy of driving interest rates to zero has been a feature of the period in which the Fed has managed the post-meltdown world. The result has been what The Wall Street Journal accurately described as a five years of missing economic progress: The economy today is barely larger than it was at the end of 2007, despite a rising population and a gigantic explosion in technology. Household income is still sinking, and an entire generation has readjusted its expectations for the future.

What has the Fed done? It has moved to create and guarantee some $13 trillion in phony assets to prettify the balance sheets of financial institutions that would have otherwise gone belly up. Those fake assets have served as substitutes for real reserves to create the illusion of balanced books. It has made its own discount rate vanish as a way of opening up its own reserves to the banking system to keep it floating. Finally, it has made it clear that it stands ready to be the lender of last resort for just about everything, removing the risk premium that would normally be attached to longer-term loans.

Altogether, this strategy has nearly abolished the banking system’s capacity to function, in effect turning banks into public utilities to serve themselves and governments, instead of depositors and lenders. Private industry seeks funding outside the official banking system, investors are scrambling for some other option and banks themselves have turned to other pursuits, like interest rate arbitraging and lending to other financial institutions, hedge funds, insurance companies and real estate.

During the 1930s, New Deal policies tried to revive agriculture and economic activity generally by telling farmers to plough under their crops and kill their livestock. Today, Fed policies are trying to revive real estate, banking and economic activity generally by undermining the capacity of the loan markets to function with any degree of normalcy.

Michael Hudson insightfully explains the problem:

“People used to know what banks did. Bankers took deposits and lent them out, paying short-term depositors less than they charged for risky or less-liquid loans. The risk was borne by bankers, not depositors or the government…Banking has moved so far away from funding industrial growth and economic development that it now benefits primarily at the economy’s expense in a predatory and extractive way, not by making productive loans.”

Even if Bernanke were telling the truth that this is all about inspiring recovery, there is no hope that it can work. The real estate markets are still an amazing mess, with one-quarter of the existing mortgages contracts marked above their market value. It fights against gravity to keep trying to lift up what wants to go down the instant that artificial stimulus recedes. And it should be obvious by now that ever lower rates don’t stimulate lending in this environment, but rather the reverse.

As the Austrian tradition has long explained, the basis of future prosperity is capital accumulation and deferred consumption in the form of real savings. These policies punish both. Worse: They make conventional savings nearly impossible. These policies encourage ever more consumption and debt accumulation and do nothing to address the core problem that brought about the artificial boom and the resulting bust.

But is Bernanke really telling the truth? No. In the balance between restoring growth and saving the banking system from the consequences of its own irresponsible policies, the Fed has chosen the latter. This is the unavoidable conclusion.

Otherwise, we would have to believe that the Fed is utterly blind to the recently proven results of its own policies. It is not managing the Fed in the public interest, but in the interests of the banks and the governments that are in hock to them. That you can’t earn a reward from saving money anymore is a microeconomic indication of a much-larger problem.

Consider the opportunity costs of these policies. We are living in a time of unprecedented innovation, thanks to digital media, the Internet and daily improvements in the production, management and distribution of information. Vast swaths of the commodifiable world have left the realm of scarcity to enter the sector in which infinite reproducibility is not only possible, but a regular feature of daily life.

With a healthy economic foundation, society should be getting get wealthier and wealthier at a pace that exceeds even that of the Gilded Age, when 10% and 15% growth was common and the human population began to thrive as never before. The digital age has given us economizing technologies that make all that have come before look like mere warm-ups. Instead, we are being denied those benefits and that growth, thanks to catastrophic policies of governments backed by central banks and dependent financial institutions.

What is the scenario under which normalcy returns? From Bernanke’s point of view, there is no end to this. It means ongoing stagnation for no good reason. For this reason, there has never been a more urgent time to abolish the Fed, institute a free market system and let a new monetary system emerge on a sound foundation. At the same time, the Fed has never faced more reason to keep alive the system that is killing future prosperity.

If the Parable of the Talents could be retold today, it would need a different ending, with a different gang of thieves thrown into the darkness to face weeping and gnashing of teeth.

Regards,

Jeffrey Tucker

The Transformation of Banking was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

They all ask some version of the same question, in any case. It’s the cocktail-hour question asked of every economist: What does the future hold and what should be done about it? The problem is that Bernanke doesn’t know more about the future than the markets know. Actually, looking at the transcripts of the 2006 FOMC meetings, the Fed knows much less than the markets know.

But at least we now know what Bernanke thinks he knows. A short summary of the flurry of news from the Fed yesterday: The economy is still in the tank, it will stay that way for years, interest rates will be held at zero and savers can go to hell.

That last part we can glean from the most-interesting question posed to Bernanke yesterday. Greg Robb of MarketWatch pointed out to him that he has some severe Republican critics. The Fed has been a major issue in the debates and on the campaign trail. Mr. Robb had a theory about why: Many Republican voters lived on fixed incomes that depend on some return on their money. For this crowd, zero interest rates are a disaster. Robbery, really.

Bernanke’s first response was to say that he was not going to involve himself in politics because he “has a job to do.” It is a credit to the press corp that they did not double over in laughter at the ridiculous claim that the Fed’s job has nothing whatever to do with politics! After 100 years of Fed service, it is pretty obvious that the Fed serves two clients: the big banks and the government. The Fed certainly doesn’t serve the class of people who save and invest.

So how did Bernanke deal with the second part of the question? This was interesting. He said that he was very sorry for savers and those who depend on interest income, but they need to understand that they too have a long-term interest in a healthy economy. If investment and productivity are rising, they create the conditions for growth down the line, and surely this is good for everyone.

That’s some crazy kind of circuitous reasoning going on there. It’s a bit like the thief who steals the silverware and then explains to the former owners that a wider distribution of beautiful tableware is surely good for everyone in the long run. Even if you buy the argument, it would be nicer if the owner had some choice in the matter.

And there’s another problem that is so incredibly obvious that no one at the press conference even dared point it out. The problem is that the zero-interest-rate policy has not worked to boost economic growth. What possible basis is there for thinking that two more years of this extermination of the saving class is going to do what the last three years have not done?

Of course, it depends on what you mean by “worked.”

Let’s say that the Fed wants to drive all investors away from government bonds and into riskier instruments in an attempt to artificially boost financial markets. Check.

Let’s say that the Fed wants to punish anyone who wants to sock away money for a rainy day and, instead, prod them into buying more plasma TVs, digital gizmos and summer homes. Check.

And let’s say that the Fed wants to artificially suppress the government’s own costs of borrowing in order to reduce pressure on the political class. Check.

In all these ways, abolishing interest rates works for the Fed and the political elites. But there are at least three downsides.

First, banks depend on interest payments for profitability, and low interest removes the financial incentive for banks to lend money in a normal way. This is why commercial bank loans remain low, with the latest data showing the volume at mid-2007 levels. One might suppose that this is contrary to the Fed’s aims, but it is a price that it is willing to pay.

Second, a low interest rate agenda requires that the Fed try to control not just the short-term rates over which it has the most influence, but also rates across the entire yield curve. This means removing risk premiums on longer-term loans by implicitly guaranteeing bailouts, just like those of 2008-10. This entrenches more moral hazard and drives a wedge between risk and result.

Third, this policy of low rates is similar to — but even worse than — the very policies that created the bubble of the 2000s that burst in 2008 and prompted the worst financial and economic calamity of many generations. The Fed has learned absolutely nothing from even its own most-recent history. If people can’t earn money through interest, financiers will find some other way to market risk, leading to crazy investments schemes and misallocated capital.

As David Malpass writes in The Wall Street Journal:

Near-zero interest rates penalize savers and channel artificially cheap capital to government, big corporations and foreign countries. One of the most fundamental principles of economics is that holding prices artificially low causes shortages. When something of value is free, it runs out fast and only the well-connected get any. Interest rates are the price for credit and shouldn’t be controlled at zero. It causes cheap credit for those with special access but shortages for those without — primarily new and small businesses and those seeking private-sector mortgages.

The big take-away from the Fed’s day in the news is its new policy benchmark of keeping inflation at 2%. This is sheer silliness. There is no such thing as a price level, as even recent CPI releases illustrate. Some prices went up (food, education, health), and some prices went down (oil, software, services). Mash them together and you get a single number that applies to absolutely nothing in particular.

In any case, the Fed can’t control prices in this way. It is always driving while looking in the rearview mirror. When the crash comes, there is nothing the Fed can do about it, despite Bernanke’s repeated promises to rescue the world from any bad effects of his policies.

As Bloomberg’s Caroline Baum says, it’s almost as if the Fed itself has completely forgotten the existence of the “long and variable lag” that separates its policies from their effects. She recalls Milton Friedman’s own analogy of the “fool in the shower” who keeps turning the water from all hot to all cold and wonders why he is either scalded or frozen.

Baum concludes that under Bernanke’s own plan, we would have “eight years of 0% interest rates. There will be a revolution in this country before then if the economy is lousy enough to warrant 0% interest rates for that long.”

Really? One would hope.

Regards,

Jeffrey Tucker

Zero Percent Uber Alles was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

It’s sounds new, but it is not. Following the Second World War, John Maynard Keynes pushed hard for a global paper currency administered by a global central bank. This was his proposed solution to the problem of national currency disputes. Let’s just take the inflation power away from the national state and give it to a world authority. Then we’ll never have to deal with a lack of coordination again.

The idea didn’t fly, but the institutions that were supposed to administer such a system were nonetheless created: the International Monetary Fund and the so-called World Bank. It didn’t work out that way. Instead, nation-states retained their monetary authority, and the new institutions became glorified welfare providers, conduits for transfer payments and loads to developing nations.

The dream lived on, however. The creation of the euro and its central bank was a step in that direction. So was the Nixon’s closing of the gold window. Each new currency crisis has created the excuse for further steps toward what Murray Rothbard calls the Keynesian dream.

Why hasn’t it happened yet? Many reasons. Nation-states do not want to give up power. The World Bank and the IMF are institutionally unsuited to the task. Many people in the banking world are also downright squeamish about the idea, with full knowledge of the ravages that unchecked inflationary credit can bring to the world economy. Mostly, there hasn’t been a crisis big enough to warrant such extreme measures.

However, that crisis might have finally arrived. Since 2008, the Fed has demonstrated that among all the world’s central banks, it alone is brave enough to embrace gigantic inflationary measures without wincing. The European Central Bank is under some strictures to not act as a monetary central planner. China is unconverted to the inflationary faith. The same holds true for England.

Ben Bernanke, however, is different: He is revealing himself to be an unreconstructed Keynesian with an unlimited faith in the power of paper money to solve all the world’s problems.

What this means is that it is left to the Fed alone to bail out the world. There is a perverse logic to this. After all, if you are going to be a world empire, operating under the assumption that nothing on the planet is outside your political purview, you bear certain responsibilities as well. Foreign aid and troops in every country are just the beginning. You must, eventually, embrace your financial responsibilities, too. A globalized economy addicted to debt needs an institution willing to step up and guarantee that debt, and provide the liquidity necessary to get us through the hard times.

As soon as the announcement of the new Fed measures came, the smart set of the World Wide Web lit up with the obvious observations that these measures come with massive risk of setting off a global inflationary crisis. It could lead to the final crack-up boom.

The Fed assures us otherwise. It “bears no exchange risk” in undertaking such actions. But as economist Robert Murphy explains:

“Strictly speaking, this isn’t true. If the Fed gives $50 billion in dollars to the ECB, which (at those market prices) gives $50 billion worth of euros to the Fed, then the ECB lends out the dollars to private banks, and before they repay the loans, the euro crashes against the dollar…then the ECB has no means of acquiring dollars to repay the Fed. Even though the ECB has a printing press, it is configured for euros, not dollars.”

He further states what everyone knows but no one is will to say:

“The current round of interventions will not solve the problem. Down the road — probably much sooner, rather than later — the central banks of the world will engage in some further extraordinary measures, again, lest the whole world fall apart. Even so, printing money doesn’t fix the underlying problems. No matter what they do, eventually, the whole financial world will fall apart.”

The speed at which all of this is happening is startling to behold. It was only 36 hours ago that we heard the first public worries about the drying up of credit in Europe. Large corporations were seeing their credit lines tightened. Banks were starting to become more scrupulous in their operations, which is hardly a surprise, given that zero interest rates have made it nearly impossible to make a profit in conventional lending operations.

Where in the fall of 2008, the Fed let the worries about tight credit grow to the point of international mania before it acted, this time, it jumped in to anticipate the inevitable warnings about the imminent death of civilization. Only trillions in paper money can save us now! The Fed saw what was coming and decided to do the deed, even before the demand came.

But rather than settle markets down, the real effect is the opposite. If you go to the doctor with a head cold, and he rushes you to the hospital for surgery, you don’t merely congratulate him for being thorough. You figure that he knows something that you don’t, namely that your condition is way more serious than you thought. Your family is likely to fly into a panic.

For this psychological reason alone, this action is likely to roil markets in crazy ways. The Fed is now paper money printer for the entire world. It’s a new world, and a brave one. If you think that a new era of prosperity, peace and stability awaits, you have been living under a rock for at least a century. There’s not a soul alive who will sleep soundly knowing that Ben Bernanke has elected himself the loan officer of the entire globe.

Regards,

Jeffrey Tucker

Leaping Toward the Keynesian Dream was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

What is a bank? According to a helpful little essay on banks for students at ThinkQuest helpfully titled “What is a Bank?”, a bank is a financial organization in which people deposit their money. A bank is a business. According to the aforementioned essay, “each bank tries to make THEIR bank look better than all of the other banks by offering services that some other banks might not have.” That is to say, banks compete in a market. This is true, conceptually at least, and also true to some extent in reality, although numerous banking laws seriously alter the market and the competition. But it is the pure idea we are after here, and in the pure idea, a bank is a business that competes in a market.

I won’t analyze every “central bank” in the world. I don’t have to because their setup is more or less the same everywhere. I’ll use the Federal Reserve System (the Fed) to represent all of them.

Historically, the Fed and other “central banks” came to be called “central banks” for several reasons. First, they are financial organizations. Second, they hold deposits of other banks and governments. Third, their assets are largely financial assets. Fourth, they make advances or loans to other banks on collateral. Fifth, the government has made them to be at the heart or center of the banking industry and the monetary system. Sixth, government power is itself centralized or national. All of these statements are factual.

Now, this is an imposing array of reasons why “central banks” are called “central banks.” But the most important of these reasons is the fifth reason, which is that the government has used its power to make the “central bank” central. And because the government has used its power to create the “central bank” and make it central, we know that the “central bank” is not a free market institution.

This is the main ground upon which I challenge the notion that a “central bank” is a bank. The concept of “central bank” fails to distinguish a free market business and a bureau created by government power. The term “central bank” undermines this distinction between free market and government. Indeed, it erases it altogether.

The Fed is not a business. It has powers that no ordinary bank has. It has privileges that no ordinary banks have. It doesn’t compete with other banks. The government created the Fed. The government gave it power to create fiat money. The government can alter the Fed’s organization and powers at any time. The Fed’s so-called independence from the government is mythological. It is that of a dog on a long leash. The only independence the Fed has is from the public.

Let’s go back for a moment to the essay on banks that I just cited, because it displays this erasing of any distinction between the free market and government. After defining the term “bank,” it lists the kinds of banks. Quite suddenly, it introduces the term “central bank” in the same breath as ordinary banks that have national or state charters. It says, “There are different kinds of banks. There are national banks, state banks and central banks. The Federal Reserve Bank is the United States government’s central bank. The Bank of England is England’s central bank.”

Suddenly, what this essay told us earlier disappears. We were told that a bank was a business that competed with other banks. But now we are told that the Fed “decides how much money is in circulation” and that it “may tell the [ordinary] banks to charge more interest or keep more money in ‘reserve.’”

Obviously, if the “central bank” has such powers, it gets them from the government. Just as obviously, the “central bank” is not a business and not in competition with other banks if it exercises these and other powers over ordinary banks.

Furthermore, distinctions between monies that ordinary free market banks deal in and the fiat money that central banks produce are completely glossed over and erased.

This essay is representative of the usual thought in the field of economics. Banks are businesses. But then, all of a sudden, there is another so-called “bank” that has an array of powers that business banks do not have. This “bank” is actually a government bureau. Its fiat money is made into legal tender by the government. The government states that it stands behind this money. This “bank” has powers to control and organize the ordinary banks into a cartel.

The facts I’ve pointed out are widely recognized. There is a Wikipedia article titled “Central Bank” that confirms this:

“A central bank, reserve bank or monetary authority is a public institution that usually issues the currency, regulates the money supply and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries. In contrast to a commercial bank, a central bank possesses a monopoly on printing the national currency, which usually serves as the nation’s legal tender.”

This too makes it very clear that a “central bank” is not a bank, but a powerful Monetary Authority and Fiat Money Administration.

However, the same Wikipedia article almost immediately contradicts itself when it states: “Central banks in most developed nations are independent in that they operate under rules designed to render them free from political interference.”

How can a bureau that is established by the government and possesses extraordinary powers be independent and free from political interference? The “central bank” embodies political interference!

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And to the extent that a Monetary Authority such as the Fed has been granted powers that it can exercise free of political interference, how can such an institution be held accountable? How can it operate without being responsible to the government and, indirectly, to the people?

“Central bank” independence is to a large extent a myth, that is, in the essence of the institution and in those activities in which it is not mythical, it is an unaccountable power.

It may seem as if I am splitting hairs, but what I see is that the common explanations of central banking confuse banking as might occur in free markets with so-called banking as executed by a “central bank” that is empowered by government. They are two entirely different kinds of operations. A thoughtful or questioning reader is bound to feel a degree of discomfort when he encounters these explanations that blur important distinctions.

A “central bank” is a government department. It is a government bureau. It is the government’s fiat money bureau. The “central bank” is the government’s money-printing machinery or money-printing organization or money-printing bureau or money-printing agency. As contrasted with monies produced in a free market, the Fed’s money is state-produced “money.” In the sense of comparing the Fed’s money to free-market money, it is counterfeit. It is held up by the force of government law and power. It is imposed on the public.

A more accurate term for the Fed might be the “Fiat Money Administration.” Perhaps the term “Monetary Authority” would be more accurate. It would be more accurate if the latter were the official name. In the U.S. Constitution, at least, it is clear that there is no power to create a Monetary Authority, and if there were such a power, it could not possibly be delegated in such a way as to make that Monetary Authority independent.

The “central bank” is not a real bank. Everything about it is permeated with government power. At the heart of the financial and monetary system of a nation that is supposed to be an exemplar of free markets is a government money-bureau.

Regards,

Michael S. Rozeff

Michael S. Rozeff is a retired professor of finance living in East Amherst, New York. He is the author of the free e-book Essays on American Empire: Liberty vs. Domination and the free e-book The U.S. Constitution and Money: Corruption and Decline.

Central Banks Aren’t Banks was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

It will get mass inflation at some point: anywhere from 15% per annum to 30%. But it is not going to get 50% or 100% or more.

Why not?

1. The temporary nature of the payoff

2. The fear of getting blamed

3. The boom-bust cycle

4. The employees’ vested pension fund

1. THE TEMPORARY PAYOFF

Hyperinflation lasts only a few years. People in the hard-money camp ought to know this, but they tend to forget.

Those economic forecasters who keep telling us the dollar will fall to zero forget the obvious: big banks are creditors. Bankers lose when a currency falls to zero. Never forget this. If you believe, as I do, that the Federal Reserve is the enforcement arm of the largest commercial banks, then stop worrying about hyperinflation. But don’t stop worrying about Congress.

Ever since All the President’s Men — the movie, not the book — we have been told to follow the money. So, let us follow the money.

The four big U.S. banks — maybe three, with Bank of America on the skids — make their money by lending money. As with all fractional reserve banks, they borrow short (low rates) and lend long (higher rates).

Under hyperinflation, long-term interest rates skyrocket. This forces down the discounted present market value of bonds and mortgages. Nobody wants to lend long. Who gets killed? Banks and insurance companies that have lent long.

What saves them from bankruptcy is fake accounting. They are allowed to keep their bonds on the books at face value. But, sooner or later, bankers get paid off in fiat money. Their portfolios are locked into bad investments. They can’t sell them without reporting losses. So, they hang on. Month by month, the value of these assets falls.

Hyperinflation is bad for the super-rich. Why? Because they own their assets outright. The super-rich own land and homes. These go up in nominal value, but rich people don’t pay off their debts by selling a gold coin or two. They have no debts to pay off. They are the creditors. They own bonds and fixed-income investments.

When we read of the great hyperinflations, we find that urban people got ruined. Farmers did very well. They paid off their mortgages by selling a few dozen eggs. Wealth moved from cities to rural areas.

Bankers were in big trouble. Farmers were in hog heaven.

Has it ever occurred to you that there have been no hyperinflation periods in Great Britain? The Brits have gone through wars of their own making. Their elite ran an empire from 1700 until 1946. Yet for all the crises, they never had price inflation above 30%. You know why? Because the Bank of England would not allow it. The BoE was privately owned from its creation in 1694 until the government nationalized it 1946. Even after 1946, the bank would not allow hyperinflation.

The Bank of England inflated often. This created the boom-bust cycle on numerous occasions, but never got seriously blamed for any of the busts. This is because not enough people understood the Austrian theory of the business cycle, which was discovered in 1912 by Ludwig von Mises. Even today, hardly anyone knows about it, and of those economists who do, almost none believes it.

Which are the famous hyperinflations? In Western Europe, Germany, Austria, and Hungary after World War I. They had lost the war. There was Hungary in 1946 — the worst inflation ever. It was a Communist nation.

There was China in 1947-48. The nationalist government fell; Mao took over. No more hyperinflation.

There are Latin American examples over and over. These are not major industrial economies. If we count Brazil as industrial, it had a long, severe hyperinflation, 1981-95: That was the longest hyperinflation on record.

I know of only one major hyperinflation in the industrial West: the State of Israel, 1980-86. I went there in 1985 to study it. Life went on. Tourism brought in Western currencies. So did agricultural exports. The experience did not last long. This was the longest hyperinflation in modern times. Wikipedia describes it.

“Inflation accelerated in the 1970s, rising steadily from 13% in 1971 to 111% in 1979. From 133% in 1980, it leaped to 191% in 1983 and then to 445% in 1984, threatening to become a four-digit figure within a year or two. In 1985 Israel froze most prices by law and enacted other measures as part of an economic stabilization plan. That same year, inflation more than halved, to 185%. Within a few months, the authorities began to lift the price freeze on some items; in other cases it took almost a year. By 1986, inflation was down to 19%.”

This is the central fact: hyperinflations do not last long. The currency is ruined fast. Then there is a currency reform. The central bank starts over: boom-bust, boom-bust.

If you time things perfectly, and sell assets to pay off debt, you win. But hardly anyone does. They buy inflation hedges, thinking it will go on for years and years. It ends a lot sooner than the late-comers think.

Then there is a recession. The inflation hedges fall in price. In that period, cash is king. If you have money to lend, you are in fat city. You buy up assets at a discount. In short, you get out in time.

There are few winners in hyperinflation, and they do not win for long. Then the recession hits, and things go back to normal.

2. THE FEAR OF GETTING BLAMED

Ben Bernanke is under fire as no FED chairman ever has been. The critics are in the millions. This is historically unprecedented. There is a cause: Ron Paul. Ron Paul has focused millions of voters’ attention on the FED and Bernanke. Bernanke cannot escape scrutiny any longer.

If there is hyperinflation, millions of voters will know who did it: Bald Ben the Beard and his crew of yes-men on the Board of Governors. Investors know more about the FED today than they did in 2007. This knowledge will increase.

Then there is the Internet. The mainstream media cannot control the flow of information any longer. Word gets out, and you may have noticed, not much of it is favorable to the FED.

The FED is desperate to avoid an annual audit by the Government Accountability Office. This is good. It means that people other than Ron Paul are calling for such an audit.

Rick Perry used the word “treasonous.” Michelle Bachmann has called for a FED audit. Ron Paul is still running. The FED is today the target of Republican Presidential candidates’ sound bites. This has never happened before. This is terrific. They are trying to steal Ron Paul’s favorite issue. I say more power to them. Come one, come all! Pile on!

Milton Friedman made this line famous: “Inflation is always and everywhere a monetary phenomenon.” He was correct. This insight has been resisted by Keynesian economists from day one, but the Keynesians find that the phrase has gotten into the thinking of millions of voters. Keynesians today are calling for larger deficits and Federal Reserve accommodation, but that is because consumer prices are rising very slowly. If prices were rising at 20% per annum, the Keynesians would find it difficult to conceal the source of the problem: the Federal Open Market Committee. The FOMC could not hide.

This is the central political fact facing the FED today: “It can run, but it can’t hide.”

Bureaucrats want to avoid blame. This is their #1 concern. Second is to increase the number of subordinates, in quest of a promotion. Third is to increase the bureaucracy’s funding. But the #1 concern is to avoid blame.

Bernanke will not be able to avoid blame for hyperinflation. He will therefore not adopt policies that produce it.

The FED could be nationalized. Congress could take over. Then all bets are off. But if we are talking about the existing Federal Reserve, with government-appointed academic economists visibly in charge and the privately owned and operated FOMC making the decisions — which will favor large banks — there will be no hyperinflation.

3. THE BOOM-BUST CYCLE

In Western industrial nations, including Japan, the central banks have always ceased inflating whenever consumer prices climbed close to 20% per annum. It has only happened once in U.S. peacetime history: 1977-80. Consumer prices rose in 1979 and 1980 by about 11% per annum. Jimmy Carter took the heat. He pressured the utterly incompetent G. William Miller to quit after only 18 months in office, and Paul Volcker replaced him in late 1979.

Volcker slowed the rate of monetary base growth. T-bill rates soared to 22%. The result was a recession. Carter lost the 1980 election as a result. Then Reagan took a hit: the 1981-82 recession. But prices started slowing, and interest rates began an 18-year decline.

Volcker wound up as a hero. He is still around. He is still beyond reproach. I can think of no person in power in the Carter-Reagan era who has a more distinguished reputation. Yet he oversaw two recessions.

He talked tough. He smoked cigars. Congress did not lay a finger on him.

This lesson is not lost on Bernanke. Bernanke does not talk tough. He does not smoke. But he knows this much: G. William Miller oversaw mass inflation, and never recovered. He is forgotten. He is forgotten because he left the office and made a hasty retreat to become Treasury Secretary — a no-power office. Then he disappeared. Had he held on, he would have become the fall guy: a pariah.

Here is the lesson learned by every Western, industrial central banker: the post-inflation bust will reduce price inflation. The bust can be justified as the necessary requirement to save the economy, save the currency, and save the social order.

Then the dog-and-pony show starts over.

Remember this: the FED will save the largest banks, That is its #1 unofficial task. Central banks all save the largest banks. The rest of the market can drop by 50% or more. The largest banks then re-finance on the new terms, meaning post-mass inflation terms.

As long as the largest banks are saved, the FED can put on the brakes and let the economy move into a recession.

This is the story of all central banks in large Western industrial nations ever since 1900, with only the exceptions of defeated Germany and Austria-Hungary.

The reason why Americans should not take seriously the scenarios of Germany-Austria in 1921-24 is because we are not defeated. There is no way, short of some sort of biological warfare-induced plague, that we will suffer what Germany suffered in 1921-24. In any case, during a plague, there would not be hyperinflation. There would be martial law, price controls, and rationing.

The Patriot Act offers this single advantage: it will make hyperinflation unnecessary.

Boom-bust, boom-bust, boom-bust: this is the pattern. Do not plan your future as if it will be broken.

What follows every hyperinflation? A recession. But, during hyperinflation, bankers are impoverished. So, if the result is the same at the end of the hyperinflation — a bust — why not call it to a halt early, in the mass inflation stage?

It worked for Volcker. It worked for every western, industrial banker in the 20th century except in Germany after the war.

4. THE EMPLOYEES’ VESTED PENSION FUND

The Federal Reserve System offers its employees a retirement plan. It is not as good as Congress’s, but it is better than yours. It is detailed in a 79-page document.

I regard this plan as the best payoff money in America. It is the equivalent of the Mob’s protection money. If you pay it, you receive protection… from the Mob.

We pay this money by letting the FED keep some of the money from interest payments on bonds that the FED bought with digital money created out of nothing. It can cover its operating expenses. Part of these expenses is the pension system.

This pension fund money is our protection money. The FED is not going to create hyperinflation, which would wipe out the value of its pension fund.

How big is this fund? Large and growing fast.

Contributions to the System Plan are actuarially determined and funded by participating employers. In 2010, the System made $580 million in contributions to the System Plan; the contributions may be adjusted upon completion of the 2011 actuarial valuation.

What is the fund invested in? I have provided an extract from the so-called independent audit for 2009. It was 53% in U.S. stocks, 13% in foreign stocks, and 34% in bonds — not non-marketable Social Security Treasury bonds.

Hyperinflation will play havoc with 34% of this portfolio: bonds. Stocks will not keep pace with consumer prices: 53% at risk. Only the foreign equities portion of the portfolio would not be devastated. Maybe.

This is why I do not think we are facing hyperinflation… at least not until Congress nationalizes the FED.

CONCLUSION

Whenever you hear that hyperinflation is inevitable, keep your hand upon your wallet and your back against the wall.

Hyperinflation is a policy option. It has been adopted only once by a Western, industrial nation’s central bank in peacetime since 1946: Israel’s. That is a small nation. Its leaders have not made that policy error since 1985.

If we get hyperinflation, it will not last long: a few years at the most. It will be a great disruption in the lives of most Americans, but if the government does not impose price controls, there will not be devastation. There will be losses. People will have to scramble. They will adjust. They will get poorer. They will consume capital. But they will survive.

If the government imposes price controls, as it probably will, there will be serious shortages for several years. There will be a large increase in the number of bankruptcies. Unemployment will rise. Families will be squeezed badly. But it will not last. The voters will not tolerate it. Without a war, voters will demand a reform. There are too many economists, even Keynesians, who know that price ceilings create shortages.

Hyperinflation is what Ludwig von Mises called the crack-up boom. It cannot last long because the currency system is rapidly destroyed. It no longer serves as a tool of economic calculation. People switch to gold coins, silver coins, and barter. Output falls. Capital is consumed rapidly. But then it must end. When the government cannot buy votes with worthless money, it stops inflating.

Ron Paul has performed a great public service in alerting the voters to the danger of the Federal Reserve System. He has exposed the source of mass inflation and hyperinflation. He has exposed the source of the boom-bust cycle.

The FED cannot escape. Its policies must lead to booms and busts. This is inherent in all central banking. The FED will choose a repetition of the boom-bust cycle rather than impose hyperinflation, for which it can no longer escape blame. Too many people have heard Ron Paul’s warning.

Regards,

Gary North

Gary North is the author of Mises on Money.

Mass Inflation, Yes; Hyperinflation, No was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

No one I spoke to would venture a guess as to how high gold would rise before it hit its peak. But most stressed that people forgot that gold’s value was driven by sentiment.

“Gold doesn’t have any intrinsic value,” said Larry M. Elkin, president of the Palisades Hudson Financial Group in Scarsdale, N.Y. “It’s this era’s wampum. At one point you could buy Manhattan for beads.”

(Mr. Elkin said what bothered him the most about investing in gold was how irrational it was, unlike buying a blue-chip stock whose value rises and falls based on what the company produces.)

That said, having gold in a portfolio is still a good buffer against swings in other markets. Mr. Fisher calculated that over a 43-year period ending in June 2011, the average annual increase for gold, accounting for inflation, was 3.82 percent compared with 4.92 percent for the Standard & Poor’s 500-stock index. Gold, however, was 28 percent more volatile.

“The smoother the ride, the more likely the investor is going to stay in his strategy,” Mr. Fisher said. “That produces a better result.”

He said that from the perspectives of both return and volatility, a better strategy would have been to put 10 percent in gold and split the rest 60-40 between stocks and five-year Treasury bonds. Rebalancing the portfolio to maintain those ratios would have meant an average annual return of 4.66 percent, with more than half of the volatility of gold alone.

For those who fled to gold and Treasuries, the hardest part will be deciding when to get back into other securities. The best way in uncertain markets may be to go slowly in small chunks — a practice known as dollar-cost averaging.

They might have asked us. We have lots to say on the matter!

First, gold isn’t supposed to “do” anything. That’s why we like it and why it has been used for money for as long as there’s been the need for money. It is a store of value, not a value-creating business or a head of cattle or an acre of fertile land

And during times when the government and central bank have been doing plenty…running unpayble deficits, artificially inflating asset values by means of interest rate manipulation and by expanding debt and the currency supply…you want something that will “do” nothing.

Second, gold buying based on sentiment? And irrationality? Yet lending money to the government or buying overpriced stocks are both reasonable acts?

Lending money to the U.S. government to protect your savings is like running to an armed assailant for comfort. The government is doing everything in its power to make sure you are paid back in dollars that are worth less than the ones you lent…at an interest rate that doesn’t begin to make up for the rate at which your purchasing power is being destroyed.

Stocks meanwhile may represent ownership in productive businesses…but the costs of those earnings are currently too dear. They are not a good buy. Eventually those earnings will be on sale again. If you buy now, that means you are almost certain to lose money.

It’s about more than smoothing out volatility. It’s about recognizing what’s happening now. It’s about giving the Fed’s actions their due respect and a wide berth.

You have to understand that the very existence of a central bank is the problem. Minus a central bank and government propaganda, gold and silver are very naturally perceived as money, while economic growth is based on savings that aren’t discouraged in the first place by inflation.

With a central bank mucking around with the price and supply of both currency (we hesitate to call it money) and credit, you’re bound to get booms with the busts baked in and all the attendant distortions. You get bubbles moving through asset classes: through the currency, then stocks, then real estate, then commodities and precious metals.

This makes the advice about a having a “balanced portfolio” a bit of a joke. That’s like telling you to inject yourself with both steroids and Ebola and hoping the two will balance each other out. When you have a busybody central bank creating serial bubbles, you need to move from one investment class to the next.

You should have been trading your rising stocks for sleeping gold for the past decade. You should have been selling off your real estate and buying silver too.

We’re going to keep trumpeting the “do nothing” metal and its more industrious companion silver. Especially as the New York Times quotes experts who scratch their heads at this gold thing.

Gold has gone from under $300 to nearly $2000 in the last decade. What has the Dow done? It was around 10,000 ten years ago. It’s around 11,000 now. Yet these guys are still rolling their eyes at the people who were “all in” with gold, the price of which is now around sixfold more.

Sure there were a couple of dips in the Dow in the past ten years. You might have made a little money if you bought and sold at just the right time.

Gold took a lot less timing and a lot less effort. Those recommending gold were begging people to take advantage of gold’s years of dormancy. They begged them to keep accumulating while gold was cheap.

The price of gold is more than mere “sentiment”. That price is trying to communicate something. Gold’s price is declaring that fiscal policy stinks, that government deficits are no laughing matter, and that the stock market on the whole is a sucker’s game right now.

Regards,

Gary Gibson
Managing editor, Whiskey & Gunpowder

Gold Still A Better Idea Than Mainstream Asset Allocation was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Case in point: The July 13, 2011 exchange between the Austrian-schooled Republican who “gets it” Whiskey bar favorite Congressman Ron Paul and the Fed chairman.

What strikes me is not Bernanke’s struggle to explain the monetary function of gold, but something else. It’s something that scares the living bejesus out of me whenever I hear Bernanke testify.

Before I say what it is, let me stress that I don’t much like the widespread demonization of the Fed chairman. I think he was sincere when he said that he never cared about the management or the shareholders of the Wall Street firms he invariably bailed out and is generously subsidizing. He really believes that what he is doing is helping the U.S. economy and the U.S. people.

The problem is not that he is evil or dumb – I think he is neither – the problem is much bigger. You can deal with people who are evil and dumb. Deeply-convinced do-gooders in positions of almost unchecked power, those are the ones we should worry about. The good intentioned can suffer from tunnel-vision, incurably in awe of their own theories and are incapable of even grasping how what they are doing could make things worse.

Market manipulations — keeping rates artificially low and bank reserves expanding – are creating momentous dislocations, vast problems with as-yet incalculable consequences – even if they do not generate instant hyperinflation or intolerable expansion in the wider monetary aggregates.  This only looks deceptively harmless through Bernanke’s narrow prism of national account statistics.

Mr. Bernanke suffers from a blind side: He can’t see that ‘elastic’ money is always destabilizing. In my forthcoming book, Paper Money Collapse, I show how any expansion in the money supply (including bank reserves) distorts relative prices, always and everywhere. Even if some fortuitous rise in money demand cushions some inflationary impact and if inflation measures therefore remain contained.

Every money injection disrupts the market’s setting of interest rates, thus disorienting the process of coordination between true savings and investment and capital formation.

Bottom line: Interest rates are market prices, Mr. Bernanke, and you interfere with them at your peril!

I didn’t discover this, of course. I owe much to Ludwig von Mises and the young F.A. von Hayek. Ron Paul understands them, Bernanke doesn’t.

Bernanke: Man on a Mission – To the Wrong End

Bernanke upholds the original mission of the Federal Reserve: to avert credit contraction and debt deflation at all costs. During the Q&A, he reminded the laissez-faire Congressman Paul of the bank runs of the 19th century. Instability in banking — and in the wider economy as a result of banking — should come as no surprise to anybody who understands the practice of fractional-reserve banking.

Today, banks are money-producers. But here’s the problem: whenever the economy slows, the nervous public ditches deposit money for ‘real’ money. In fact, we want money that is not somebody else’s liability, such as gold or, even, state paper tickets. The banks then have to contract the supply of deposit money — shrinking the supply of what is used as money in the economy — thus exacerbating the recessionary forces in the economy.

The Fed Reserve wanted to avoid recessions — or shorten them –and avoid credit contraction. What they thought was needed is some form of elastic money so that in economically challenging times the banks do not have to contract the supply of credit.

It is almost comical how Mr. Bernanke seems to say, why are you criticizing me? I am spending all this money, but it doesn’t add to the federal deficit. I am printing this myself. I just press a button. Money printing is costless. And I can help the economy.

The Austrians know that such a powerful threat to the banks is brought about by the banks themselves! The lowering of reserve ratios and the creation of deposit money leads to a credit boom which always creates imbalances — in the saving-investment equation — and thus must end in bust.

What the Fed is trying to do is destined to fail. It cannot solve the problem. It must exacerbate the problem. Bernanke believes that with his all-powerful printing press he can always buy another recovery. For him his job appears to require an astute balancing act between the two things his macro-tunnel vision allows him to see: the trade-off between growth and inflation, both — so he believes — neatly observable with macro-statistics (the fetish of the economics profession). He cannot grasp the distortions in prices he creates, the misallocations in capital he furthers, and the accumulation of debt he encourages. None of them register on his statistical radar.

The debt-ceiling debate in the U.S. is trivial. What matters is this: as long as there is a Federal Reserve and as long as it is run by men like Mr. Bernanke — dedicated, smart but hopelessly committed to a flawed belief system — the economy will not be a capitalist one, benefiting fully from saving, entrepreneurship and true capital accumulation but will always be addicted to easy money, cheap credit and propped up asset markets.

What Will Happen Next?

Like a little hamster in his hamster wheel, Mr. Bernanke will only run faster and faster. Next, the interest rates that banks get on their deposits at the Fed will be cut to encourage more lending. The Fed will conduct QE3, and then QE4, and so forth. Maybe they will not call it that, but in effect that is what the Fed chairman’s own belief system will force him to do.

The size of the accumulated dislocations is already too gigantic today to allow any politically acceptable correction. Nobody had the stomach for it during Lehman. Nobody has the stomach for it today. In the monetary environment the Fed maintains, deleveraging will never be accomplished. Mr. Bernanke digs himself deeper into a hole that he won’t get out of when the market demands higher interest rates to maintain confidence in the paper dollar.

Paper money systems collapse — and they have all collapsed, throughout history and without exception — not because the money printers don’t understand inflation. They simply always reach a point when they fear the immediate impact of turning off the monetary tab more than the further printing of money. Of course, the disaster in the end is only bigger.

Bernanke is no James Bond villain out for world domination or even a big Wall Street payout. He is more the mad  professor in some sci-fi B-movie, unwittingly in cahoots with the forces of destruction not out of mean-spiritedness but out of intellectual hubris and infatuation with his own theories and technical wizardry.

Utterly convinced that he has worked out all the effects of his manipulation of the money supply and of interest rates, Bernanke can’t see why anybody would not want him to go on manipulating. In the meantime, debasement of paper money continues…

Regards,

Detlev Schlichter

The Bernanke Blind Side was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

None of this should surprise those conversant with Austrian economics. The “fundamentals” of the economy have been and remain awful because the government and Federal Reserve are consistently doing the wrong things. The apparent recovery, fueled by Bernanke’s sheer money creation, has been bogus all along.

Bubble, Bubble, Bubble

For some reason, people still cling to the vague hope that – at least if we wait long enough – the market always goes up, and “buy and hold” is a great strategy. Let’s look at a long-term chart of the S&P 500:

Does the above chart really look like the US stock market is in store for smooth sailing? Just about everyone except Chicago School economists now recognizes, after the fact, that the United States obviously went through a tech and dot-com bubble in the late 1990s and then a housing bubble a few years later. Is it really so difficult to understand that trillions in government budget deficits over the past few years, coupled with unprecedented inflation by the central bank, have set the economy up for yet another crash?

Alan Greenspan’s low-interest-rate policy in the wake of the dot-com crash spawned the housing bubble. Greenspan’s Fed didn’t actually eliminate the need for a recession, but instead postponed the crisis and made it fester. When reality hit in September 2008, Ben Bernanke was in charge of the Fed and implemented his predecessor’s failed approach times ten.

No matter how many pundits and famous economists declare otherwise, Bernanke did not save the day with his interventions. He has simply postponed the day of reckoning yet again, and we can expect the final crisis to be much worse than the mere collapse of a few major investment banks. (The short documentary Overdose makes the case in a chilling fashion.)

Ben Bernanke Engineered the “Recovery,” All Right

In a perverse way, the pundits are correct in crediting Ben Bernanke’s extraordinary programs for “rescuing” the stock market. If we zoom in on the chart of the S&P 500 and superimpose the monetary base, we can see how closely the two have moved since the crisis began.

Although the above chart shows a decent fit, in reality the stock market responded very quickly to changes in the expectations of Fed expansion. Specifically, the sharp upswing in the S&P 500 in March 2009 coincided with the announcement of the Fed’s full strategy for (what we now call) QE1, and the market rally in the late summer of 2010 began as knowledgeable Fed officials made it clearer and clearer that QE2 would kick in after the fall elections.

Of course, those economists who believe Bernanke is engaging in a tight-money policy would point to the above as evidence in their favor – the Fed just needs to print more, because it’s worked twice already! But if one believes that showering trillions of newly created dollars into the financial sector (with the specific aim of bailing out the very parties who made reckless loans and investments during the housing bubble) is notconducive to a healthy recovery, then the booming stock market of the last few years should have been an ominous sign. Note that this isn’t 20/20 hindsight; other Austrians and I have been warning that this “recovery” has been bogus all along, and that the stock market could collapse at any time.
Inflation Lifts All Boats

None of the above analysis implies that investors should dump all equities immediately. It is true that the prospects for real economic growth are terrible – especially in the Western countries – over the next decade, because of increased regulations and swollen government debt loads. But at the same time, various central banks, especially the Federal Reserve, have been all too willing to create new money as an apparent solution to every crisis. (A case in point was the absurd proposal for the Treasury to issue two trillion-dollar platinum coins to evade the statutory debt ceiling.)

In this environment, someone relying on fixed-income investments (such as private annuities or, heaven forbid, government retirement checks) could be wiped out by massive price inflation. As awful as the US real-estate and stock markets might be in the short and medium run, holding a portion of one’s wealth in assets not denominated in fiat currency may turn out to be a very wise defensive move. (The problem with shooting the moon on precious metals is that for all we know the dollar will crash next year and Obama will make it illegal to buy and sell gold.)

Conclusion

The US economy still needs to recover from the festering malinvestments that accumulated during the previous two booms. By pushing interest rates down to zero and bailing out the very people who made such bad financial decisions in the first place, the Fed and Treasury are doing everything they can to exacerbate the problem.

In this volatile world economy, investors can expect continued volatility in the stock market. The only thing we can really be sure of is that the government will use each new crisis to justify further extensions of its power. At some point the feds will probably seize the highly volatile 401(k)s and other stock-market holdings from citizens and replace them with “safe” government annuities.

Knowledge of Austrian economics doesn’t render someone an expert investor, but it certainly gives advance warning of the major trends in the economy. Those investors who rely on the Keynesians featured at CNBC think that another stimulus package or QE3 might do the trick.

Why Is the Stock Market Crashing? was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

In discussing the Fed’s most recent expansion, QE2, Meyer states,

You may wonder how the Fed pays for the bonds and other securities it buys. The Fed does not pay with paper money. Instead, the Fed pays the seller’s bank using newly created electronic funds, and the bank adds those funds to the seller’s account. The seller can spend the funds or can simply leave them in the bank. If the funds stay in the bank, then the bank can increase its lending, purchase more assets, or build up the reserves it holds on deposit at the Fed. More broadly, the Fed’s securities purchases increase the total amount of reserves that the banking system keeps at the Fed. Whether the Fed’s purchases lead to an increase in the amount of money circulating in the economy depends on what banks do with the new reserves and on what sellers do with the funds they receive. As it happens, the money supply has not grown unusually rapidly since the Fed began its first round of asset purchases. If anything the money supply has been growing more slowly than normal.

Any student of money and banking recognizes the sophistry in saying that “the Fed does not pay with paper money.” If the video viewers are the simpletons that Meyer presumes, he could have explained that the Fed purchases bonds in much the same manner as you or I purchase items using our debit cards. No paper money is involved; the ownership of a deposit (call it a demand deposit, checkbook deposit, or debit-card deposit) is transferred electronically. The difference is that while you and I transfer existing deposits, the Fed has created new deposits (i.e., “newly created electronic funds”).

These deposits can be converted to cash at any time. There is nothing to prevent Meyer’s bond sellers from using an ATM like anyone else. The electronically created deposits are turned into Federal Reserve notes; ipso facto the Fed has paid with paper money.

Suppose, as Meyer suggests, that the bond sellers do not spend their new deposits: “If the funds stay in the bank then the bank can increase its lending, purchase more assets, or build up the reserves it holds on deposit at the Fed.” Only in the latter instance does money creation stop, and the expansion of money is then limited to the purchases from the original bond sellers. The increase in excess reserves largely matches the balloon in total reserves, suggesting that this has been the case. However, if the banks make additional loans (i.e., purchase additional assets), then new demand deposits are created. While the ratio may be disputed, some of these new deposits will be exchanged for paper money. Whether the Fed creates the new deposits or the banks create the new deposits, there will be some conversion into paper money.

Meyer states,

More broadly, the Fed’s securities purchases increase the total amount of reserves that the banking system keeps at the Fed. Whether the Fed’s purchases lead to an increase of the amount of money circulating in the economy depends on what banks do with the new reserves and on what sellers do with the funds they receive.

This is true only if banks are the bond sellers and if they sit on the proceeds from the bond sale. To the extent that the bond sellers are members of the nonbank public (i.e., anyone other than the banks, the Fed, or the US Treasury), the money supply, by any definition, has increased. Furthermore, to the extent that the bond sellers withdraw cash from their new deposits, there is an increase in paper money.

While proponents of Keynesian economics might view this parsing as nitpicking, the raison d’être of the video is to dispel the frequent charge that the Fed is “running the printing presses” and courting the attendant danger of price inflation.

Meyer recognizes this, saying that “If the Fed were to continue buying securities even as banks eventually expand their lending then the money supply could increase too rapidly and inflation could become too high; Fed policymakers are determined to avoid that outcome.” While Meyer is equally concerned about deflation, the purchasing power of money (i.e., the price of money) takes a back seat to the price of credit in Keynesian prescriptions. This attitude is best reflected in the WGBH video “The Commanding Heights” when, reflecting upon Depression-era financing, John Kenneth Galbraith said, “you didn’t worry about accumulating debt, or, more precisely, you worried about it, but did it anyway.”

Whenever the Fed purchases securities on the open market, there is monetary inflation. This increase in the supply of the money commodity will decrease the price of money (i.e., a decrease the purchasing power of money), ceteris paribus. An increase in the demand for money by the nonbank public may offset this increase in supply such that price inflation is not reflected in any measure of prices (e.g., the consumer price index). But as Bastiat would point out, the price inflation resulting from the monetary inflation would have been higher had there been no increase in the demand for money.

It is not the goal of this article to delve into the efficacy of Keynesian prescriptions. But mainstream economists fall silent when pressed on the Fed’s ability to control of the price of credit (i.e., interest rates). When it comes to the supply of credit, the Fed is a small fish in a big pond. No one disagrees that the Fed can control the supply of US dollars. At the same time, all agree that there is no optimal quantity of money. As a medium of exchange, a small amount of high-priced money can do the same job as a large amount of low-priced money. Perhaps the best we can say is that the existence of “add a penny, take a penny” cups suggests that too much money has been created, while the chopping up of Spanish dollars into “pieces of eight” hints that too little money exists.

Regards,

Pete Kerr

Pete Kerr is a professor of economics at Southeast Missouri State University in Cape Girardeau. His work has appeared in various publications including theJournal of Economic Education, Applied Economic Letters, and theSouthern Economic Journal.

Digitized Money Inflation was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.