The Case Against the Fed

Suppose that a precious metal such as gold becomes a society’s money, and a certain weight of gold becomes the currency unit in which all prices and assets are reckoned. Then, so long as the society remains on this pure gold or silver “standard,” there will probably be only gradual annual increases in the supply of money, from the output of gold mines. The supply of gold is severely limited, and it is costly to mine further gold; and the great durability of gold means that any annual output will constitute a small portion of the total gold stock accumulated over the centuries. The currency will remain of roughly stable value; in a progressing economy, the increased annual production of goods will more than offset the gradual increase in the money stock. The result will be a gradual fall in the price level, an increase in the purchasing power of the currency unit or gold ounce, year after year. The gently falling price level will mean a steady annual rise in the purchasing power of the dollar or franc, encouraging the saving of money and investment in future production. A rising output and falling price level signifies a steady increase in the standard of living for each person in society. Typically, the cost of living falls steadily, while money wage rates remain the same, meaning that “real” wage rates, or the living standards of every worker, increase steadily year by year. We are now so conditioned by permanent price inflation that the idea of prices falling every year is difficult to grasp. And yet, prices generally fell every year from the beginning of the Industrial Revolution in the latter part of the eighteenth century until 1940, with the exception of periods of major war, when the governments inflated the money supply radically and drove up prices, after which they would gradually fall once more. We have to realize that falling prices did not mean depression, since costs were falling due to increased productivity, so that profits were not sinking. If we look at the spectacular drop in prices (in real even more than in money terms) in recent years in such particularly booming fields as computers, calculators, and TV sets, we can see that falling prices by no means have to connote depression.

But let us suppose that in this idyll of prosperity, sound money, and successful monetary calculation, a serpent appears in Eden: the temptation to counterfeit, to fashion a near-valueless object so that it would fool people into thinking it was the money-commodity. It is instructive to trace the result. Counterfeiting creates a problem to the extent that it is “successful,” i.e., to the extent that the counterfeit is so well crafted that it is not found out.

Suppose that Joe Doakes and his merry men have invented a perfect counterfeit: under a gold standard, a brass or plastic object that would look exactly like a gold coin, or, in the present paper money standard, a $10 bill that exactly simulates a $10 Federal Reserve Note. What would happen?

In the first place, the aggregate money supply of the country would increase by the amount counterfeited; equally important, the new money will appear first in the hands of the counterfeiters themselves. Counterfeiting, in short, involves a twofold process: (1) increasing the total supply of money, thereby driving up the prices of goods and services and driving down the purchasing power of the money-unit; and (2) changing the distribution of income and wealth, by putting disproportionately more money into the hands of the counterfeiters.

The first part of the process, increasing the total money supply in the country, was the focus of the “quantity theory” of the British classical economists from David Hume to Ricardo, and continues to be the focus of Milton Friedman and the monetarist “Chicago school.” David Hume, in order to demonstrate the inflationary and non-productive effect of paper money, in effect postulated what I like to call the “Angel Gabriel” model, in which the Angel, after hearing pleas for more money, magically doubled each person’s stock of money overnight. (In this case, the Angel Gabriel would be the “counterfeiter,” albeit for benevolent motives.) It is clear that while everyone would be euphoric from their seeming doubling of monetary wealth, society would in no way be better off: for there would be no increase in capital or productivity or supply of goods. As people rushed out and spent the new money, the only impact would be an approximate doubling of all prices, and the purchasing power of the dollar or franc would be cut in half, with no social benefit being conferred. An increase of money can only dilute the effectiveness of each unit of money. Milton Friedman’s more modern though equally magical version is that of his “helicopter effect,” in which he postulates that the annual increase of money created by the Federal Reserve is showered on each person proportionately to his current money stock by magical governmental helicopters.

While Hume’s analysis is perceptive and correct so far as it goes, it leaves out the vital redistributive effect. Fried-man’s “helicopter effect” seriously distorts the analysis by being so constructed that redistributive effects are ruled out from the very beginning. The point is that while we can assume benign motives for the Angel Gabriel, we cannot make the same assumption for the counterfeiting government or the Federal Reserve. Indeed, for any earthly counterfeiter, it would be difficult to see the point of counterfeiting if each person is to receive the new money proportionately.

In real life, then, the very point of counterfeiting is to constitute a process, a process of transmitting new money from one pocket to another, and not the result of a magical and equi-proportionate expansion of money in everyone’s pocket simultaneously. Whether counterfeiting is in the form of making brass or plastic coins that simulate gold, or of printing paper money to look like that of the government, counterfeiting is always a process in which the counterfeiter gets the new money first. This process was encapsulated in an old New Yorker cartoon, in which a group of counterfeiters are watching the first $10 bill emerge from their home printing press. One remarks: “Boy, is retail spending in the neighborhood in for a shot in the arm!”

And indeed it was. The first people who get the new money are the counterfeiters, which they then use to buy various goods and services. The second receivers of the new money are the retailers who sell those goods to the counterfeiters. And on and on the new money ripples out through the system, going from one pocket or till to another. As it does so, there is an immediate redistribution effect. For first the counterfeiters, then the retailers, etc., have new money and monetary income which they use to bid up goods and services, increasing their demand and raising the prices of the goods that they purchase. But as prices of goods begin to rise in response to the higher quantity of money, those who haven’t yet received the new money find the prices of the goods they buy have gone up, while their own selling prices or incomes have not risen. In short, the early receivers of the new money in this market chain of events gain at the expense of those who receive the money toward the end of the chain, and still worse losers are the people (e.g., those on fixed incomes such as annuities, interest, or pensions) who never receive the new money at all. Monetary inflation, then, acts as a hidden “tax” by which the early receivers expropriate (i.e., gain at the expense of) the late receivers. And of course since the very earliest receiver of the new money is the counterfeiter, the counterfeiter’s gain is the greatest. This tax is particularly insidious because it is hidden, because few people understand the processes of money and banking, and because it is all too easy to blame the rising prices, or “price inflation,” caused by the monetary inflation on greedy capitalists, speculators, wild-spending consumers, or whatever social group is the easiest to denigrate. Obviously, too, it is to the interest of the counterfeiters to distract attention from their own crucial role by denouncing any and all other groups and institutions as responsible for the price inflation.

The inflation process is particularly insidious and destructive because everyone enjoys the feeling of having more money, while they generally complain about the consequences of more money, namely higher prices. But since there is an inevitable time lag between the stock of money increasing and its consequence in rising prices, and since the public has little knowledge of monetary economics, it is all too easy to fool it into placing the blame on shoulders far more visible than those of the counterfeiters.

The big error of all quantity theorists, from the British classicists to Milton Freidman, is to assume that money is only a “veil,” and that increases in the quantity of money only have influence on the price level, or on the purchasing power of the money unit. On the contrary, it is one of the notable contributions of “Austrian School” economists and their predecessors, such as the early-eighteenth-century Irish-French economist Richard Cantillon, that, in addition to this quantitative, aggregative effect, an increase in the money supply also changes the distribution of income and wealth. The ripple effect also alters the structure of relative prices, and therefore of the kinds and quantities of goods that will be produced, since the counterfeiters and other early receivers will have different preferences and spending patterns from the late receivers who are “taxed” by the earlier receivers. Furthermore, these changes of income distribution, spending, relative prices, and production will be permanent and will not simply disappear, as the quantity theorists blithely assume, when the effects of the increase in the money supply will have worked themselves out.

In sum, the Austrian insight holds that counterfeiting will have far more unfortunate consequences for the economy than simple inflation of the price level. There will be other, and permanent, distortions of the economy away from the free market pattern that responds to consumers and property-rights holders in the free economy. This brings us to an important aspect of counterfeiting which should not be overlooked. In addition to its more narrowly economic distortion and unfortunate consequences, counterfeiting gravely cripples the moral and property rights foundation that lies at the base of any free-market economy.

Thus, consider a free-market society where gold is the money. In such a society, one can acquire money in only three ways: (a) by mining more gold; (b) by selling a good or service in exchange for gold owned by someone else; or (c) by receiving the gold as a voluntary gift or bequest from some other owner of gold. Each of these methods operates within a principle of strict defense of everyone’s right to his private property. But say a counterfeiter appears on the scene. By creating fake gold coins he is able to acquire money in a fraudulent and coercive way, and with which he can enter the market to bid resources away from legitimate owners of gold. In that way, he robs current owners of gold just as surely, and even more massively, than if he burglarized their homes or safes. For this way, without actually breaking and entering the property of others, he can insidiously steal the fruits of their productive labor, and do so at the expense of all holders of money, and especially the later receivers of the new money.

Counterfeiting, therefore, is inflationary, redistributive, distorts the economic system, and amounts to stealthy and insidious robbery and expropriation of all legitimate property-owners in society.