Mises Daily Articles
Bad Monetary Policy Is Redundant
A great thinker once wrote that "all things useful are of such a nature that where there is too much of them they must either do harm, or at any rate be of no use, to their possessors."1
Having experienced the harmful results of a paper currency manufactured at will, early US statesmen tried to forbid it from ever happening again. Article I, Section 10 of the Constitution specified that no state shall "make any Thing but gold and silver Coin a Tender in Payment of Debts," while the
US Coinage Act of 1792, consistent with the Constitution, provided for a US Mint, which stamped silver and gold coins. One dollar was defined by statute as a specific weight of gold. The Act also invoked the death penalty for anyone found to be debasing money.2
For 120 years the dollar, though at times volatile, maintained its value: $1.01 in the year 1912 has the same "purchase power" as $1 in the year 1792.3
A different trend began in 1913 when Congress and Woodrow Wilson, at the behest of the country's most powerful bankers, forced a banking cartel on the economy. The claim was that not only would this institution preserve the value of the dollar but it would also protect the economy against inflation and prevent violent swings in market activity.
Inflation was to be understood as a rise in prices rather than an increase in the money supply. By this definition, the country experienced a noninflationary 1920s, and the leading experts assured that the good times would roll indefinitely — though perhaps with an occasional dip every now and then.
When market money was finally outlawed, the Fed could create as many paper notes as it wanted and not worry about annoying dollar holders demanding redemption of the IOUs they held. The result? Alan Greenspan noted that
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.4
In other words, with the dollar no longer defined as a weight of gold or other metal, the Fed's "monetary policy" depreciated its purchasing power by 91 percent in 60 years, from 1933–1993.
As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess.5
Central bankers merely "witnessed" the "half-century of chronic inflation" that followed their "monetary policy." The same Fed spokesman encouraged us to be optimistic:
The record of the past twenty years appears to underscore the observation that, although pressures for excess issuance of fiat money are chronic, a prudent monetary policy maintained over a protracted period can contain the forces of inflation.6
Yes, a prudent monetary policy could "contain the forces of inflation," but what in fact happened? Using an inflation calculator, we find that Consumer Price Index (CPI) price inflation nearly doubled. Apparently, Greenspan and his Fed buddies didn't witness this inflation.
Policymakers Are Inflationists
But what is this mysterious "monetary policy" that Greenspan mentioned that has so ravaged the dollar? The Fed tells us that
[t]he term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. The Federal Reserve Act of 1913 gave the Federal Reserve responsibility for setting monetary policy.7
By contrast, Jörg Guido Hülsmann explains that "natural monies," the kind originating on a free market,
owe their existence exclusively to the fact that they satisfy human needs better than any other medium of exchange. As soon as this is no longer the case, the market participants will choose to discard them and adopt other monies. This freedom of choice assures, so to speak, a grass-roots democratic selection of the best available monies — the natural monies.8
Natural monies are regulated by the market. There is no chronic pressure for "excess issuance" of natural monies. They are not issued. Their supply is determined by market forces, and they serve to promote the welfare of the people who use them, not the collectivist notion of "national economic goals." In the United States, natural monies, in spite of government meddling, kept inflation at bay for over a century. Then the policymakers took over.
Because an inflationary boom bears some resemblance to real prosperity, policymakers can look brilliant for awhile. And their brilliance, based on the idea that "this time it's different," makes headlines. Thus, on September 26, 2002, Britain's Queen Elizabeth II bestowed an honorary knighthood on a former Juilliard clarinet student for his "contribution to global economic stability." Such a prestigious award would not be granted to someone who had been reckless in violating Aristotle's observation about too much of something causing harm, it would seem.
Fed printers, meanwhile, were busy creating an illusion:
[P]olicy accommodation — and the expectation that it will persist — is distorting asset prices. Most of this distortion is deliberate and a desirable effect of the stance of policy.9
"Policy accommodation" means low interest rates, which means too much money is available. Economic activity increased to the point that asset prices were distorted. This was far from being seen as a mistake and a problem, and Kohn admitted it was "deliberate and desirable."
In this case, the distortion was a false account of housing prices. How distorted were they?
During the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006. This housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation.10
Since the money supply increase was at the bottom of the price distortion, the Fed decided to close the curtain:
In March 2006, the Federal Reserve ceased to make public M3, arguably the most reliable means of measuring the money supply. … M3 had increased past 9 percent in the three months prior to the move, and a total 17 percent inflation in the past year.11
Not that this move alarmed the true believers. Gerard Baker, for example, declared that "[h]istorians will marvel at the stability of our era."
With dollars being multiplied at will, the results were predictable:
Since 2002, the US dollar has depreciated over 40 percent against a basket of major currencies, weighted by their countries' trade with the United States. Over the past two years, the trade-weighted dollar has fallen by 15 percent.12
Whatever happened to the Fed's promise of a stable dollar?
The [American Institute for Economic Research] report points out that in 1978, legislation asked the Fed to have 'stable prices' as a goal when conducting monetary policy. Yet the CPI has tripled since then.13
Does this fact bother Donald Kohn? No. A sinking dollar is Fed strategy.
Low market interest rates should continue to induce savers to diversify into riskier assets, which would contribute to a further reversal in the flight to liquidity and safety that has characterized the past few years.14
People were diversifying into riskier assets during the happy days of the housing boom, when they were buying houses at 4–5 times their annual household income and personal debt reached unprecedented levels:
The debt service-to-income ratio — the percentage of a household's disposable income that goes to service that debt — rose to a historical high of 13.9 percent in the third quarter of 2007.15
While Kohn waits for the low interest rates to ignite another debt orgy, do these lower rates and their detrimental effect on the dollar bother other members of the Fed?
Asked whether the depreciation of the dollar might be considered a barometer of the Fed's credibility as the protector of the purchasing power of the US currency, [Richmond Federal Reserve Bank President Jeffrey Lacker] said, "Our central objective is and always has been the domestic purchasing power of the US currency."16
Logically, the central objective can be either to preserve or destroy the dollar's purchasing power. Lacker somehow forgot to say which.
Through Fed monetary policy, then, the dollar is cheapened to produce an economy on steroids that eventually breaks down. Free-lunch economists react to the breakdown with stunned disbelief because they had been assuring us that "this time it's different." When reality sets in, they confess to their former blindness.
No One Saw It Coming
The Austrian theory of the trade cycle explains why the Fed's below-market interest rates invariably lead to a correction known as the bust, or most recently, a meltdown. This theory is not new. Why is it so relatively unknown or out of favor with most economists?
When Queen Elizabeth attended the opening of a new building at the London School of Economics in November 2008, she asked the academics, "Why did nobody notice it?" How could a global financial meltdown sneak up on the crème de la crème of the economics profession? One professor's answer: "At every stage, someone was relying on somebody else and everyone thought they were doing the right thing."
An inquisitive layman could get a picture of mounting trouble such as the one sketched above with ordinary web searches. How could this professor and others like him proclaim intellectual innocence when the works of Austrian masters — which have been available for decades and are currently offered in electronic form for the price of a free download — flatly contradict his assertion that "everyone thought they were doing the right thing"?
Nor could he complain that the Austrian school is too obscure for serious scholarship, given that one of its members was a 1974 Nobel Laureate.
The lady who knighted Greenspan for his contribution to "global stability" might like to know that Austrian theory provided the crystal ball that helped numerous commentators announce the train wreck well in advance of its arrival — and that according to Austrian theory only a train wreck can occur when money grows on trees. If someone had briefed her on the Austrians before her visit, she might have had the new building razed rather than dedicated. Given that her portfolio lost £25 million, the professor is lucky to have his head.
Books by Rothbard, Mises, Hayek, de Soto, Hülsmann, Paul, and Sennholz, among others — and all published before the meltdown — explain in detail what happens when government officials and bankers get together and take over the country's money supply. In brief, they subject everyone to an unaccountable monopoly called a central bank, enact legal-tender laws to force acceptance of the central bank's fiat paper notes, and abolish or cripple through regulations the autonomous market monies, gold and silver.
Under modern central banking, an economy endures chronic monetary inflation, wealth redistribution, trade cycles, an obsession with Fed rhetoric, confiscation of savings, malinvestment of resources, impoverishment of the poor and middle class, enrichment of the politically connected, institutionalized moral hazard, mass delusion as a norm, and mushrooming government growth. The central-banking system and its spurious currency amount to a doomsday machine that could topple civilization itself.17
Why Are Central Banks Still on the Job?
Official rhetoric aside, central banks exist to ensure the profits of the largest commercial banks and to feed government growth. As with any successful racket, central banks are not without a veneer of legitimacy.
First, there are and have been many influential writers who believe the money supply must grow as production increases. Central banking grows the money supply while offering protection to the growers through bailouts and the government's prohibition on competition.
Pumping money into the economy has well-known political consequences as well. Other things equal, if the money supply stays flat as production rises, prices will tend to fall, nudging real wages higher. While this is certainly beneficial, politicians resent it because they can't buy votes when the market makes people richer: the political way is to distribute free lunches through the banking system's printing press.
Second, it is naive to expect root criticism of central banking from trained economists, most of whom get at least some of their daily bread from the government. As Hülsmann has written:
It is one of the home truths of the economics profession that virtually all of its members are government employees. Even more to the point, a great number of monetary economists are employees of central banks and other monetary authorities; and even those monetary economists who are "only" regular professors at state universities derive considerable prestige, and sometimes also large chunks of their income, from research conducted on behalf of monetary authorities.18
And Gary North adds:
In the field of economic theory, the academic economists' support of central banking is the best example of how political power, control over money, and the use of this money to silence academia by hiring thousands of economists as advisors have combined to neuter an entire profession.
Third, a central bank, as Vera Smith wrote long ago, "is not a natural product of banking development. It is imposed from outside or comes into being as a result of government favors." Central banks return the favors by giving politicians an ATM machine that will seemingly never run dry, thus ensuring central banks' immortality. Without the government,
No bank would be able to give its notes forced currency by declaring them to be legal tender for all payments, and it is unlikely that the public would accept inconvertible notes of any such bank except at a discount varying with the prospect of their again becoming convertible.19
How entrenched is the US central bank? As Gary North observed, it "is beyond legal constraints. It is beyond market constraints. It answers to no one. It is autonomous."
And fourth, on the Fed's website we find this mantra:
The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system.
This statement is mostly unchallenged in mainstream circles. Those who proclaim that the Fed is quite different, that it is in fact a creature devouring civilization, are marginalized or ignored.
As a central bank, the Fed is widely regarded as the hallmark of an advanced civilization. It's a distinguished banking-government institution that has done its patriotic part in helping to fight World War I, World War II, and various other conflicts far from our shores; it has provided a fatherly hand in steering us through inflation, recessions, depressions, stagflation, stock-market crashes, the S&L crisis, the Asian crisis, the dot-com bubble, the Y2K scare, the 9/11 shock, and now the morning after the housing bubble. It is forever on guard to see that we never walk into stores and find prices permanently lower than they were. The current Fed chairman is a family man — he's one of us — and was Time's Person of the Year in 2009. Why would such a man go around creating economic calamity?
To see what life was like without the Fed, we're told, we need only look at pre-1913 American history when "financial panics plagued the nation, leading to bank failures and business bankruptcies that severely disrupted the economy," as the federal reserve website informs us.20 Rather than tolerate these mysterious "plagues," Congress and the big bankers got together and passed a law called the Federal Reserve Act, the provisions of which included the power "to furnish an elastic currency," and "to establish a more effective supervision of banking in the United States."
It's patently untrue to say government doesn't work,21 since the plague of panics has ceased since President Wilson signed the act into law. We now have meltdowns, but hold off on the blame — only recently has the Fed been given the power to deal with those.22 Whatever the Fed's shortcomings, we need to be as loyal to it as abused dogs to a cruel master who means well. We need to accept the premise that the Fed is our partner in prosperity and our savior during times of crisis.
When Greenspan was extolling prudent monetary policies as the key to controlling inflation, he was saying it, to paraphrase Rothbard, while vigorously pouring on increases in the money supply. Since central bankers are gleaned from the brightest humanity has to offer, there's no reason to assume monetary inflation constitutes an imprudent monetary policy. That the monetary pumping was followed by a meltdown was simply another event that central bankers "witnessed."
Let the Fed Defend Its Mantra
The Fed and its many friends refused to allow its operations to be thrown open to the public, but maybe it would be willing to do more than toss us a few crumbs about Fed independence. "I don't think the American people want Congress running monetary policy," Bernanke said. They don't, but that's not the issue. The issue is monetary policy itself. By enacting monetary policy, the Fed claims to provide "the nation with a safe, flexible, and stable monetary and financial system." How can a monetary system be regarded as "safe" when monetary policy has stripped the dollar of 95 percent of its value?
But that's only the beginning. Other questions have been circulating that challenge the Fed's purpose.
Why did the CPI take off in earnest following FDR's gold confiscation order of April 5, 1933, and Nixon/Volker's leap of faith to a world of pure fiat paper on August 15, 1971?
Why did the value of the dollar, though volatile at times, nearly double between 1865 and 1912, a period when "monetary policy" was rudimentary at best and Fed monetary policy was only a pipe dream for a few?
What historical data underlie the Fed's contention that massive money creation and huge deficits are the medicine needed to treat a bust? (Robert Higgs has rebutted the World War II argument about hyper-Keynesianism bringing prosperity.) Why was the depression of 1920–1921 in the United States short-lived in the absence of such interventions? Why is accommodation so highly regarded when Japan, in the same period, intervened to keep prices from falling but prolonged their recession for seven years?
What is the connection between the rise of central banking and the numerous hyperinflations in the twentieth century? What role did central banks play in making the European war that began in 1914 a world war? In what ways did Germany's post-war hyperinflation foment World War II?
Given the presence of money in virtually all economic transactions, that money "is the nerve center of the economic system," how can Bernanke justify saying, "I don't think that monetary policy was a particularly important source of the crisis"?
Why is a government-enforced monetary cartel somehow good for the public, when public cartels are generally recognized as harmful?
If gold is such a "barbarous relic" and too inflexible to be used as money, why is the Fort Knox Bullion Depository, home of the gold Roosevelt confiscated in the 1930s, so heavily protected that only an invasion — or Fed policy — could threaten its security? Why does gold require such protection but not the stuff the Fed issues?
Why is it that if a private individual or firm prints money they're engaged in the high crime of counterfeiting, which is another name for inflation, whereas when the Fed prints money it's called "monetary policy" and is considered our best tool for avoiding inflation?
The only good monetary policy is no monetary policy.
- 1. Aristotle, Politics 7.1.
- 2. M.A. Nystrom, "The Last Great Bubble — Counterfeiting the Dollar." Emphasis in original.
- 3. Purchasing Power of Money in the United States from 1774 to 2009.
- 4. Alan Greenspan, "Issues for Monetary Policy," Remarks before the Economic Club of New York, December 19, 2002.
- 5. Ibid.
- 6. Ibid.
- 7. Board of Governors of the Federal Reserve System, Federal Open Market Committee, "About the FOMC."
- 8. The Ethics of Money Production, p. 27.
- 9. Donald L. Kohn, (Meeting of the Federal Open Market Committee) FOMC transcript, March 16, 2004. This document was released in April 2010.
- 10. Wikipedia, "Financial Crises of 2007–2010."
- 11. Wikipedia, "History of the Federal Reserve System."
- 12. Frederic S. Mishkin (Fed Governor), "Exchange Rate Pass-Through and Monetary Policy," a speech given at the Norges Bank Conference on Monetary Policy in Oslo, Norway (March 7, 2008).
- 13. Mary Pilon, "The Buying Power of a Dollar, on a Downswing."
- 14. "The Economic Outlook," a speech given at the National Association for Business Economics, St. Louis, Missouri (October 13, 2009).
- 15. Yang Liu (Research Associate, Federal Reserve Bank of St. Louis), "A New Trend for US Household Spending."
- 16. Reuters, "Fed eyes impact of dollar on mandate-Fed's Lacker" (November 17, 2009).
- 17. See Ludwig von Mises, Human Action, p. 763.
- 18. The Ethics of Money Production, p. 16.
- 19. Vera C. Smith, The Rationale of Central Banking and the Free Banking Alternative, p. 170.
- 20. See p. 1 of Federal Reserve System: Purposes and Functions.
- 21. Harry Browne, Why Government Doesn't Work.
- 22. See Restoring American Financial Stability Act of 2010.