The Economics of Liberty
2. Debunking the Bankers
Bring Back the Bank Run!
James Grant
The banking dilemma seems eternal, like the monetary dilemma, the tax dilemma, and the marital dilemma. The essence of the banking dilemma, however, is that the depositors’ money is not in the vault awaiting the depositors’ decision to withdraw it. Instead it is out on loan or invested in the money market or in mortgage-backed securities.
Some of the money is in the vault or on deposit with the Federal Reserve—these funds are called bank reserves—but only a few cents of every dollar. Depending on the specific management, depositors, and financial markets, the average bank may be prepared to accommodate a sudden demand for repayment by a sizable minority of its depositors. Almost no bank in modern times, however, has been able to accommodate a sudden demand for repayment by a majority of its depositors.
Murray N. Rothbard, the economist and libertarian philosopher, has a forcible view on the institutions of fractional-reserve banking: It is “a giant Ponzi scheme in which a few people can redeem their deposits only because most depositors do not follow suit.”
Some features of the modern banking dilemma are new, notably the socialization of credit risk during the Reagan years. It was decided that no money-center bank would be allowed to fail and that no depositor, even a sophisticated one, would be allowed to lose his money in a failure, if it could possibly be helped. But other problems are cyclical and still others are chronic. Reading up on the subject, one becomes fatalistic about it.
In gaslight days, before the “Too-Big-To-Fail” doctrine and other modern banking improvements, national banks were bound to hold reserves amounting to 25% of demand deposits. By our standards, this was a lavish margin of safety, even if, as Rothbard notes, capital reserves were often tied up in government bonds (“...banks were induced to monetize the public debt,” he has written, “state governments were encouraged to go into debt and government and bank inflation were intimately linked”).
Reserve requirements were reduced to 18% with the advent of the Federal Reserve System in 1913 and stand at 12% today. Loans as a percentage of assets are higher today than they used to be, however. And off-balance sheet liabilities—such as standby letters of credit, interest-rate swap commitments, and futures-markets trading—are higher, too.
The rise in the risks attached to banking prompts numerous questions about the nature of lending and the credit cycle. How has the regulatory and monetary climate of the 1980s affected bank lending? If, as seems obvious, it has inflated it, what will be the consequences of it?
If anything is new about banking our epoch, it is the substitution of federal guarantees for the liquidity of individual banks. It is the policy that, in the case of the 11 or so largest banks, failure will not be allowed and that, even in smaller institutions, depositors will be protected. It is this regulatory sea change that distinguishes the current debt expansion from so many earlier ones.
Years ago, when weak banks suffered runs by public depositors, instead of seizure by the Federal Deposit Insurance Corporation, a liquid balance sheet constituted a competitive advantage. When James (“Sunshine Jim”) Stillman, National City’s dour chairman, correctly forewarned his associates in early 1907 to prepare for a panic that fall, he was able to anticipate a competitive silver lining: “What impresses me as most important is to go into next Autumn ridiculously strong and liquid, and now is the time to begin and shape for it. If by able and judicious management we have money to help our dealers when trust companies have suspended, we will have all the business we want for many years.”
If, however, one’s institution is beyond failure, it hardly makes business sense to build reserves against an unpredictable day of reckoning. What it makes sense to do is lend, and so banks have lent.
Economist Rothbard has written a brief ode in prose to the bank run: “It is a marvelously effective weapon because (a) it is irresistible, since once it gets going it cannot be stopped, and (b) it serves as a dramatic device for calling everyone’s attention to the inherent unsoundness and insolvency of fractional reserve banking.”
The Federal Reserve Act of 1913 was hailed as a gift to the nation, in part because it seemed to promise a run-free future. Because the reserve banks would lend in times of crisis, commercial banks could afford to become a little less liquid—a little more expansive—in good times.
Things did not work out exactly that way, and the 1930s saw a marathon of bank runs. Rejecting conservative counsel, the Roosevelt administration created the Federal Deposit Insurance Corporation to furnish still more federal assurances to bankers and depositors. Over the next several decades, the conviction took root that enlightened legislation had eliminated the possibility of another national banking crisis.
The strategy has worked, and it hasn’t worked. There has been no great deflation, no national bank holiday, and no prairie-fire run on the members of the New York City Clearing House Association. On the other hand, there has been the thrift snafu and the Third World crisis. Each is an emblematic event, as each has lingered for years, not months, and the cost of each is measured in the scores of billions of dollars, nothing less. It is hard to imagine a free banking system getting itself into scrapes like those in the first place.
Commenting on some of these trends some months ago was none other than the Chairman of the Federal Reserve Board. Alan Greenspan delivered an unusual speech at a remarkable time. The date was October 16, 1989, the Monday following Friday the 13th, and the audience was the American Bankers Association. Greenspan proceeded to describe the 150-year odyssey by which American banks have become more leveraged and less liquid.
What was notable was the chairman’s historical perspective (even if, for professional reasons, he did not share Rothbard’s view that fractional-reserve banking is a fraud). In banking and credit terms, Greenspan admitted, the 20th century has been an age of relaxation. While not deploring this trend, he did not ignore it either. “Although leverage was important in the past, as now, the amount of leverage historically was much less than we see today.” Despite the addition of $14 billion in equity capital by national banks in 1988 and the first half of 1989, “capital levels for the industry remain at the low end of their broad historical range.”
In other words, by historical standards, the banks are loaned up. More than that, they are stuffed (many of them) with loans that were once considered inappropriate for the balance sheet of a commercial lending institution. The most prevalent specimen of this class of dubious assets is loans against speculative commercial real estate. As banks withdrew from business lending, they turned to property.
Like Greenspan, Robert L. Clarke, Comptroller of the Currency, adopts a non-Rothbardian world view. He recently testified that “the national banking system is fundamentally sound. That conclusion is based on a substantial increase in capital levels, especially equity capital levels, relatively strong earnings, and an improvement in overall credit quality among the majority of national banks during the past 18 months.”
He evidently rejects Professor Rothbard’s theory that a run-resistant, semi-socialized, fractional-reserve banking system is a house of cards.
What has been lacking in American banking in recent years is the run. And when it has not been lacking—as in the rescue of Continental Illinois in 1984—it has been frightening. With the wholesale substitution of federal promises, actual or implied, for conservative banking practices, the caliber of lending has inevitably suffered. Sunshine Jim Stillman, were he to return to Wall Street for a day, would very probably wish that he hadn’t.
Is the banking dilemma eternal? It doesn’t have to be. We could desocialize credit risk and let the bank runs take their toll. Absent federal meddling, the bottom line would be simplicity itself. The proof that banks have created excess credit would be found in the action of markets. It would be a fascinating picture if not a pretty one.
Nick and Jim Dandy to the Rescue
Bradley Miller
Could I interest you in buying some of the external debt run up by the Mexican or Philippine government? Could I interest you in buying anything from the Mexican or Philippine government? And if not, how in the world am I going to get you to lend anything to the Mexican or Philippine government?
Such are the questions confronting Treasury Secretary Nicholas Brady as the Bush administration and creditor banks try to figure out how to collect some half a trillion bucks in outstanding debt from the Third World. And his answer is the inevitable fallback of governments unwilling, for political reasons, to call to account those responsible for messes: stick taxpayers with a sizable chunk of the bill, bank on their ignorance, and realize that if they wake up in the long run, in the long run we’re all dead.
Brady wants the World Bank and the International Monetary Fund to “guarantee” repayment in exchange for reduced claims. Many think this is a swell idea. Harvard economist Jeffrey Sachs, for example, a U.N. adviser to Latin American governments, writes in the New York Times that “the debt load should fall by half or more.” Financing the guarantee of the remaining half of the debt, Sachs says, should come not only from the World Bank and the IMF, but also from “creditor governments and from collateral provided by the debtor governments themselves.”
“Government” means taxpayers. It usually means taxpayers getting stuck to make the world worse toward the end of creating a bigger and safer playpen for bankers, bureaucrats, and spendthrift politicians.
Saying the IMF or World Bank will bail out banks—or, “guarantee” their loans—is prettier than saying taxpayers will bail them out. And of course it is American taxpayers who are the chief bankrollers of the World Bank and IMF.
This is consistent with free-market capitalism in the same way that shrieking “Heil Hitler” on a Berlin street in 1940 is consistent with free speech.
True freedom includes the freedom to fail, just as true freedom of speech means the freedom to say offensive as well as popular things. But however popular the phrase “free market” has become in speeches, some savvy souls unburdened by excessive concern for the commonweal have had this figured out for a long time. “Freedom” in today’s allegedly free American marketplace means freedom from failure—as long as you remember one thing: fail big.
If your restaurant goes under, you’re a gone goose. If you renege on your $3,000 personal loan, your credit is ruined. But those who run up millions of dollars of debt manage to continue living like sultans as their creditors “carry” them forever, and indeed extend them more loans. I haven’t noticed Jim and Tammy Bakker slaving in salt mines or sleeping in tents to pay back their monstrous debts. Perhaps the IMF should define Heritage USA as a Third-World country and impose austerity measures.
If your failure is big enough, the federal government itself—again, read “taxpayers”—will ride to your rescue, as it did for Chrysler and Lockheed, as it is about to do for the savings and loan industry (to the tune of more than $100 billion), and as Brady wants it to do for large commercial banks that made reckless loans to the Third World. You’d think this would make it hard for Washington’s wizards to keep a straight face when they talk about the American dream and the entrepreneurial spirit.
Compassion for monstrous flops is not, of course, limited to the economic realm. Geopolitics sets the pace in this regard. Kill a gas-station clerk and you’ll have the community, led by the mayor and editorial writers, howling to fry you. Commit physical and cultural genocide, as a series of Communist and Third-World government dictators have done, and dignitaries will flock to your funeral to gush about your statesmanship.
At least genocides are easier to explain. They tend to be effective in silencing political opposition. But what purpose is served by lending billions to prop up basket-case collectivist regimes, many of which specialize in oppression and anti-capitalism? What purpose is served by taxpayer guarantees of such loans?
The purpose is to bail out powerful special interests, i.e., the banks, by thinning the wallets of the ignorant, unorganized, and hence powerless, i.e., most taxpayers.
What’s going on is a shell game designed to shield special interests from competitive risks. Fear of failure is one of the driving forces of vibrant capitalism. The government should no more bail out banks for bad loans than it should bail out restaurants for bad food.
Subsidize failure and you get more failure. Tax wealth-production and you get less wealth. That’s why, if you really want to change things, it won’t work simply to chant “free-market reform” while you keep the gravy train running, as Brady’s predecessor James Baker tried to do (while, be it noted, ladling his own gravy through Treasury-caused stockmarket increases in his millions of dollars of big-bank stock.)
Too many Third World countries—Mexico is perhaps the most egregious case—have subsidized failure and taxed wealth so much for so long that they no longer have enough wealth left to continue the game on its own. So they turn to Uncle Sam and others almost as gullible.
“It’s time [Latin American debtor nations] were introduced to the real world,” growled a justly piqued Pat Buchanan. But in the real world, economic outrages lead to political profits, as the Swiss bank accounts of Mexican politicians attest. If the presidents of several free-lending U.S. banks are now on food stamps, I stand corrected.
Q&A on the S&L Mess
Murray N. Rothbard
Q. When is a tax not a tax?
A. When it’s a “fee.” It was only a question of time before we would discover what form of creative semantics President Bush would use to wiggle out of his “read my lips” pledge (bolstered by the Darman “walks like a duck” corollary) never ever to raise taxes. Unfortunately, it took only a couple of weeks to discover the answer. No, it wasn’t “revenue enhancement” or “equity” or “closing of loopholes” this time; it was the good old chestnut, the “fee.”
When Secretary of the Treasury Brady came up with the ill-fated “fee” proposal for all bank depositors to bail out the failed, insolvent S&L industry, President Bush likened it to the user fee the federal government charges for people to enter Yellowstone Park. But the federal government—unfortunately—owns Yellowstone and, as its owner, may arguably charge a fee for its use without it being labeled a “tax” (although even here problems can be raised since the government does not have the same philosophical or economic status as would a private owner). But on what basis can someone’s use of his own money to deposit in an allegedly private savings and loan bank be called a “fee?” To whom, and for what?
No, in the heartwarming firestorm of protest that arose, from the general public, and from all politicians and political observers, it was clear that to everyone except the Bush Administration, that the proposed levy on savers looked, talked, and waddled very much like a tax-duck.
Q. When is insurance not insurance?
A. When you are trying to “insure” an industry that is already bankrupt. Sometimes, the tax that is supposedly not a tax is called, not a “fee” but an “insurance premium.” When the barrage of public protest virtually sank the “fee” on savers, the Bush Administration began to backpedal and to shift its proposal to a levy on other banks that are not yet officially insolvent, this new tax on banks to be termed a higher “insurance premium.”
But there are far more problems here than creative semantics. The very concept of “insurance” is fallacious. To “insure” a fractional-reserve banking system, whether it be the deposits of commercial banks, or of savings and loan banks, is absurd and impossible. It is very much like “insuring” the Titanic after it hit the iceberg.
“Insurance” is only an appropriate term and a feasible concept when there are certain near-measurable risks that can be pooled over large numbers of cases: fire, accident, disease, etc. But an entrepreneurial firm or industry cannot be “insured,” since the entrepreneur is undertaking the sort of risks that precisely cannot be measured or pooled, and hence cannot be insured against.
All the more is this true for an industry that is inherently and philosophically bankrupt anyway: fractional-reserve banking. Fractional-reserve S&L banking is pyramided dangerously on top of the fractional-reserve commercial banking system. The S&Ls use their deposits in commercial banks as their own reserves. Fractional-reserve banks are philosophically bankrupt because they are engaged in a gigantic con game: pretending that your deposits are there to be redeemed at any time you wish, while actually lending them out to earn interest.
It is because fractional-reserves are a giant con that these banks rely almost totally on public “confidence,” and that is why President Bush rushed to assure S&L depositors that their money is safe and that they should not be worried.
The entire industry rests on gulling the public, and making them think that their money is safe and that everything is OK; fractional-reserve banking is the only industry in the country that can and will collapse as soon as that “confidence” falls apart. Once the public realizes that the whole industry is a scam, the jig is up, and it goes crashing down; in short, the whole operation is done with mirrors, and falls apart once the public finds out the score.
The whole point of “insurance,” then, is not to insure, but to swindle the public into placing their confidence where it does not belong. A few years ago, private deposit insurance fell apart in Ohio and Maryland because one or two big banks failed, and the public started to take their money out (which was not there) because their confidence was shaken. And now that one-third of the S&L industry is officially bankrupt—and yet allowed to continue operations—and the Federal Savings and Loan Insurance Corporation (FSLIC) is officially bankrupt as well, the tottering banking system is left with the Federal Deposit Insurance Corporation (FDIC). The FDIC, which “insures” commercial banks, is still officially solvent. It is only in better shape than its sister FSLIC, however, because everyone perceives that behind the FDIC stands the unlimited power of the Federal Reserve to print money.
Q. Why did deregulation fail in the case of the S&Ls? Doesn’t this violate the rule that free enterprise always works better than regulation?
A. The S&L industry is no free-market industry. It was virtually created, cartelized, and subsidized by the federal government. Formerly the small “building and loan” industry in the 1920s, the thrifts were totally transformed into the government-created and cartelized S&L industry by legislation of the early New Deal. The industry was organized under Federal Home Loan Banks and governed by a Federal Home Loan Board, which cartelized the industry, poured in reserves, and inflated the nation’s money supply by generating subsidized cheap credit and mortgages to the nation’s housing and real-estate industry.
FSLIC was the Federal Home Loan Board’s form of “insurance” subsidy to the industry. Furthermore, the S&Ls persuaded the Federal Reserve to cartelize the industry still further by imposing low maximum interest rates that they would have to pay their gulled and hapless depositors. Since average people, from the 1930s through the 1970s, had few other outlets for their savings than the S&Ls, their savings were coercively channeled into low-interest deposits, guaranteeing the S&Ls a hefty profit as they loaned out the money for higher-interest mortgages. In this way, the exploited depositors were left out in the cold to see their assets decimated by continuing inflation.
The dam burst in the late 1970s, however, with the invention of the money-market mutual fund, which allowed the fleeced S&L depositors to take out their money in droves and put it into the market-interest funds. The thrifts began to go bankrupt, and they were forced to clamor for elimination of the cartelized low rates to depositors, otherwise they would have gone under from money-market fund competition. But then, in order to compete with the high-yield funds, the S&Ls had to get out of low-yield mortgages, and go into swinging, speculative, and high-risk assets.
The federal government obliged by “deregulating” the assets and loans of the S&Ls. But, of course, this was phony deregulation, since the FSLIC continued to guarantee the S&Ls’ liabilities: their deposits. An industry that finds its assets unregulated while its liabilities are guaranteed by the federal government may be, in the short-run, at least, in a happy position; but it can in no sense be called an example of a free-enterprise industry. As a result of nearly a decade of wild speculative loans, official S&L bankruptcy has now piled up, to the tune of at least $100 billion.
Q. How will the federal government get the funds to bail out the S&Ls and FSLIC, and, down the road, the FDIC?
A. There are three ways the federal government can bail out the S&Ls: increasing taxes, borrowing, or printing money and handing it over. It has already floated the lead balloon of raising “fees” on the depositing public, which is not only an outrageous tax on the public to bail out their own exploiters, but is also a massive tax on savings, which will decrease our relatively low amount of savings still further. On borrowing, it faces the much ballyhooed Gramm-Rudman obstacle, so the government is borrowing to bail out the S&Ls by floating special bonds that would not count in the federal budget. An example of creative accounting: if you want to balance a budget, spend money and don’t count it in the budget!
Q. So why doesn’t the Fed simply print the money and give it to the S&Ls?
A. It could easily do so, and the perception of the Fed’s unlimited power to print provides the crucial support for the entire system. But there is a grave problem. Suppose that the ultimate bailout were $200 billion. After much hullabaloo and crisis management, the Fed simply printed $200 billion and handed it over to the S&L depositors, in the course of liquidating the thrifts. This in itself would not be inflationary, since the $200 billion of increased currency would only replace $200 billion in disappeared S&L deposits. But the big catch is the next step.
If the public then takes this cash, and redeposits it in the commercial banking system, as they probably would, the banks would then enjoy an increase of $200 billion in reserves, which would then generate an immediate and enormously inflationary increase of about $2 trillion in the money supply. Therein lies the rub.
Q. What’s the solution to the S&L mess?
A. What the government should do, if it had the guts, is to ‘fess up that the S&Ls are broke, that its own “insurance” fund is broke, and therefore, that since the government has no money which it does not take from the taxpayer, that the S&Ls should be allowed to go under and the mass of their depositors to lose their nonexistent funds.
In a genuine free-market economy, no one may exploit anyone else in order to acquire an ironclad guarantee against loss.
The depositors must be allowed to go under along with the S&Ls. The momentary pain will be more than offset by the salutary lessons these depositors will have learned: don’t trust the government, and don’t trust fractional-reserve banking. One hopes that the depositors in fractional-reserve commercial banks will profit from this example and get their money out posthaste.
All the commentators prate that the government “has to” borrow or tax the funds to pay off the S&L depositors. There is no “has to” about it; we live in a world of free will and free choice.
Eventually, the only way to avoid similar messes is to scrap the current inflationist and cartelized system and move to a regime of truly sound money. That means a dollar defined as, and redeemable in, a specified weight of gold coin, and a banking system that keeps its cash or gold reserves 100% of its demand liabilities.
Inflation Redux
Murray N. Rothbard
Inflation is back. Or rather, since inflation never really left, inflation is back, with a vengeance. After being driven down by the severe recession of 1981–82 from over 13% in 1980 to 3% in 1983, and even falling to 1% in 1986, consumer prices in the last few years have begun to accelerate upwards. Back up to 4–5% in the last two years, price inflation finally drove its way into public consciousness in January 1989, rising at an annual rate of 7.2%.
Austrians and other hard-money economists have been chided for the last several years: the money supply M-A increased by about 13% in 1985 and 1986; why didn’t inflation follow suit? The reason is that, unlike Chicago School monetarists, Austrians are not mechanists. Austrians do not believe in fixed leads and lags. After the money supply is increased, prices do not rise automatically; the resulting inflation depends on human choices and the public’s decisions to hold or not to hold money. Such decisions depend on the insight and the expectations of individuals, and there is no way by which such perceptions and choices can be charted by economists in advance.
As people began to spend their money, and the special factors—such as the collapse of OPEC and the more expensive dollar—began to disappear or work through their effects in the economy, inflation has begun to accelerate in response.
The resumption and escalation of inflation in the last few years has inexorably drawn interest rates ever higher in response. The Federal Reserve, ever timorous and fearful about clamping down too tightly on money and precipitating a recession, allowed interest rates to rise only very gradually in reaction to inflation. In addition, Alan Greenspan has been talking a tough line on inflation so as to hold down inflationary expectations and thereby keep down interest yields on long-term bonds. But by insisting on gradualism, the Fed has only managed to prolong the agony for the market, and to make sure that interest rates, along with consumer prices, can only increase in the foreseeable future. Most of the nation’s economists and financial experts are, as usual, caught short by the escalating inflation, and can make little sense out of the proceedings. One of the few perceptive responses was that of Donald Ratajczak of Georgia State University. Ratajczak scoffed: “The Fed always follows gradualism, and it never works. And you have to ask after a while, ‘Don’t they read their own history?’”
Whatever the Fed does, it unerringly makes matters worse. First it pumps in a great deal of new money because, in the depth of recession, prices go up very little in response. Emboldened by this “economic miracle,” it pumps more and more new money into the system. Then, when prices finally start accelerating, it tries to prolong the inevitable and thereby only succeeds in delaying market adjustments.
Apart from a few exceptions, moreover, the nation’s economists prove to be duds in anticipating the new inflation. In fact, it was only recently that many economists began to opine that the economy had undergone some sort of mysterious “structural change,” and that, as a result, severe inflation was no longer possible. No sooner do such views begin to take hold, than the economy moves to belie the grandiose new doctrine.
Ironically, despite the gyrations and interventions of the Fed and other government authorities, recession is inevitable once an inflationary boom has been set into motion, and will occur after the inflationary boom stops or slows down. As investment economist Giulio Martino states: “We’ve never had a soft landing, where the Fed brought inflation down without a recession.”
We can see matters particularly clearly if we rely on M-A (for Austrian), rather than on the various Ms issued by the Fed which are statistical artifacts devoid of real meaning. After increasing rapidly for several years, the money supply remained flat from April to August 1987, long enough to help precipitate the great stock market crash of October. Then, M-A rose by about 2.5% per year, increasing from $1,905 billion in August 1987 to $1,948 billion in July 1988. Since July, however, this modest increase has been reversed, and the money supply remained level until the end of the year, then fell sharply to $1,897 billion by the end of January 1989. From the middle of 1988, then, until the end of January 1989, the total money supply, M-A, fell in absolute terms by no less than an annual rate of 5.2%. The last time M-A fell that sharply was in 1979–80, precipitating the last great recession.
This is not an argument for the Fed to expand money again in panic. Quite the contrary. Once an inflationary boom is launched, a recession is not only inevitable but is also the only way of correcting the distortions of the boom and returning the economy to health. The quicker a recession comes the better, and the more it is allowed to perform its corrective work, the sooner full recovery will arrive.
Faustian Economics
John V. Denson
One expects to be warned by good economists that inflation must result if the issuance of paper money is not limited by its redeemability in gold. However, it’s a pleasant surprise to find such advice in one of the classics of world literature: J.W. von Goethe’s philosophical poem, Faust.
During Goethe’s long life he achieved an Olympian status with achievements not only in literature and poetry, but also in science and government (as well as his much publicized love life!). He also practiced law (although not very successfully) and studied medicine. In 1775, he became an administrator in the small German state of Weimar and later its major official, supervising natural resources, mining, finances, arms, and education. During this time, Goethe abandoned literature, but became very knowledgeable about how government works. Or doesn’t work.
Goethe was writing Faust during the French Revolution, when the government issued paper assignats allegedly redeemable in real estate rather than gold. He also witnessed the resulting hyperinflation and misery of the French people, which might have been his inspiration for the warning in Faust that governments should not issue paper money that cannot be redeemed by gold.
The legend of Faust was well known to the German people before Goethe began his version. It described the erudition of Faust and his pact with the demon, Mephistopheles, to receive power and pleasure in return for agreeing that his soul would go to Hell after a long, full life on earth.
Goethe’s warning about inflation is one of his additions to the myth. It all begins in his poem at a meeting of the State Council. Mephistopheles appears as the new court fool and suggests that mining for hidden gold will solve all the political problems of the state. The Emperor then signs a proclamation to issue inflationary paper money:
Chancellor:
“To all whom it concerns, let it be known:
Who hath this note, a thousand crowns doth own.
As certain pledge thereof shall stand Vast buried treasure in the Emperor’s land.
Provision has been made the ample treasure,
Raised straightway, shall redeem the notes at pleasure.”
Emperor:
“I sense a crime, a monstrous, cheating lure!
Who dared to gorge the Emperor’s signature?
Is still unpunished such a breach of right?”
Treasurer:
“Remember, Sire, yourself it was last night That signed the note. You stood as might Pan,
The Chancellor came and spoke in words that ran:
‘A lofty festal joy do for thyself attain:
Thy people’s weal—a few strokes of the pen!’
These did you make, then thousandfold last night Conjurors multiplied what you did write;
And that straightway the good might come to all,
We stamped at once the series, large and small:
Tens, twenties, thirties, hundreds, all are there.
You can not think how glad the people were.
Behold your city, once half-dead, decaying,
Now full of life and joy, and swarming, playing!
Although your name has blessed the world of yore,
So gladly was it never seen before.
The alphabet is really now redundant;
In this sign each is saved to bliss abundant.”
Emperor:
“My people take it for good gold, you say?
In camp, in court, sufficient as full pay?
Although amazed, still I must give assent.”
Steward:
“The flight of notes we could nowise prevent;
Like lightning notes were scattered on the run.
The changers’ shops open wide to everyone;
And there all notes are honored, high and low,
With gold and silver at a discount, though
From there to butcher, baker, tavern hasting,
One-half the world seems thinking but of feasting,
The other in new raiment struts and crows;
The draper cuts the cloth, the tailor sews.
In cellars ‘Long live the Emperor!’ is the toasting;
There platters clatter, there they’re boiling, roasting.”
The people are ecstatic with their new found “wealth” of unlimited paper money, which causes a spending frenzy and drastic price increases. As expected, the joy eventually turns to grief and financial destruction of the Emperor’s kingdom.
While this work of art became a part of German culture, it did not prevent the massive paper money explosion of 1923. One wonders how and when this wisdom concerning inflation, paper money, and gold will become a part of the common sense of the common man, rather than the statement of genius in literature or the province of good economists.
A Gold Standard For Russia?
Murray N. Rothbard
In their eagerness to desocialize, the Soviets have been calling in Western economists and political scientists—trying to imbibe wisdom from the fount of capitalism. In this search for answers, the host of American and European Marxist academics have been conspicuous by their absence. Having suffered under socialism for generations, the East Europeans have had it up to here with Marxism; they hardly need instruction from starry-eyed Western naifs who have never been obliged to live under their Marxist ideal.
One of the most fascinating exchanges with visiting Western firemen took place in an interview in Moscow between a representative of the Soviet Gosbank (the approximate equivalent of Russia’s Central Bank) and Wayne Angell, a governor of the Federal Reserve Bank in the U.S. The interview, to be published in the Soviet newspaper Izvestia, was excerpted in the Wall Street Journal.
The man from Gosbank was astounded to hear Mr. Angell strongly recommend an immediate return of Soviet Russia to the gold standard. It would, furthermore, not be a phony supply-side gold standard, but a genuine one. As Angell stated, “the first thing your government should do is define your monetary unit of account, the ruble, in terms of a fixed weight of gold and make it convertible at that weight to Soviet citizens, as well as to the rest of the world.”
Not that the Gosbank man was unfamiliar with the gold standard; it was just that he had imbibed conventional Western wisdom that the gold standard only be restored at some indistinct point in the far future, after all other economic ills had been neatly solved. Why, the Soviet financial expert asked Angell, should the gold standard be restored first?
Wayne Angell proceeded to a cogent explanation of the importance of a prompt return to gold. The ruble, he pointed out, is shot; it has no credibility anywhere. It has been systematically depreciated, inflated, and grossly overvalued by the Soviet authorities. Therefore, mark or even dollar convertibility is not enough for the ruble. To gain credibility, to become a truly hard money, Angell explained, the ruble must become what Angell, with remarkable candor, referred to as “honest money.”
“It is my belief,” Angell continued, “that without an honest money, Soviet citizens cannot be expected to respond to the reforms,” whereas a “gold-backed ruble would be seen as an honest money at home and would immediately trade as a convertible currency internationally.”
With the ruble backed solidly by gold, the dread problem of the inflationary “ruble overhang” would wither away. The Soviet public is anxious to get rid of ever-depreciating rubles as soon as consumer goods become available. But under a gold standard, the demand for rubles would greatly strengthen, and Soviets could wait to trade them for more consumer goods or Western products. More goods would be produced as Soviet workers and producers become eager to sell goods and services for newly worthwhile rubles.
Without gold, however, Angell warned that the Soviet reform program might well collapse under the blows of rampant inflation and a progressively disintegrating ruble.
The man from Gosbank was quick with the crucial question. If the gold standard is so vital, why don’t the United States and other Western countries adopt it? Angell’s reply was fascinating in its implications: that the dollar and other Western currencies “have at least a history of gold convertibility” which enabled them to continue through the Bretton Woods system and launch the present system of fluctuating fiat currencies.
What, then, is Mr. Angell really saying? What is he really telling the Soviet central banker? He is saying that the United States and other Western governments have been able to get away with imposing what he concedes to be dishonest money because of the remnants of association these currencies have had with gold.
In contrast to the ruble, the dollar, the mark, etc., have still retained much of their credibility; in short, their governments are still able to con their public, whereas the Soviet government is no longer able to do so. Hence, the Soviets must return to gold, whereas Western governments don’t yet need to follow suit. They can still get away with dishonest money.
It would have been instructive to ask Mr. Angell about the myriad of Third World countries, particularly in Latin America, who have been suffering from severe currency deterioration and hyperinflation. Aren’t those currencies in nearly as bad shape as the ruble, and couldn’t those countries use a prompt return to gold? And perhaps even we in the West don’t have to be doomed to wait until we too are suffering from hyperinflation before we can enjoy the great benefits of an honest, stable, noninflatable, money?
The Source of the Business Cycle
Jeffrey A. Tucker
Policy makers at the Federal Reserve sometimes find themselves in the public-policy equivalent of a cleft stick. When interest rates and inflation are rising, and the economy is sliding into recession, the Fed’s policy options are drastically limited. How can the Federal Reserve keep the economy out of recession and tame price inflation at the same time? This is the problem of “stagflation,” the one most economists found so baffling in the mid-1970s.
The experts don’t even agree on the root cause of inflation. Is inflation caused by an “overheating economy,” as the media like to say? If so, how could we see rising prices even while the economy is “slowing down” into a recession? Others blame the deficit. But big deficits are commonplace in U.S. policy. Why are their alleged inflationary effects so rarely seen?
With confusion like this, everybody’s a potential target for political scorn: selfish workers, greedy capitalists, speculators, corporate raiders, and the over-consuming public. Yet these endless disputes are a distraction. They overlook the monetary origins of business cycles and inflation.
The Austrian school gained early recognition for its business cycle theory, which points to credit expansion as a necessary and sufficient cause of inflation and the boom-bust cycle. And despite the theorists that proclaim the “End of Economics,” the theory explains as much today as it did in 1912, when Ludwig von Mises wrote The Theory of Money and Credit.
All during the 1920s, Mises wrote and lectured on business cycle theory, and he established the Austrian Institute for Business Cycle Research in Vienna, appointing his student F. A. Hayek as the director because, according to one AIBCR secretary, Mises “wanted to help Hayek find the right start in life.”
By the time Mises published his Monetary Stabilization and Cyclical Policy in 1928, he had already become, Hayek writes, “the most respected and consistent exponent of the monetary theory of the Trade Cycle” in the German-speaking world. Unfortunately, this book, along with other early works on monetary theory, were inaccessible to English-speaking academic audiences as late as 1978.
Hayek also wrote a series of scholarly studies on the business cycles beginning in 1928 with Monetary Theory and the Trade Cycle. In that book, he argued that business cycles find their origin in monetary phenomenon, especially central-bank credit expansion. This and other books won him fame and four years later, Hayek became a professor of economics at the London School of Economics (LSE).
While at the LSE, Hayek developed a cadre of followers, including then-Misesian Lionel Robbins, who later became a famous Keynesian. Robbins arranged the English translation and publication of Monetary Theory and the Trade Cycle in 1933. This book and Hayek’s Prices and Production became the leading volumes on the Austrian business cycle theory in the English-speaking world.
In the late 1930s, however, the Keynesian revolution swept all opposition from its path, as the industrialized world fell to fascist and socialist ideologies and centralized control. This environment was hardly conducive to a business-cycle theory that blames money and credit inflation, and the Austrian theory was ignored, although never refuted.
The climate changed, however, in 1974 when Hayek won the Nobel Prize for his work on the monetary origins of the business cycle. For a small, largely unrecognized group of Austrian economists, it was an exciting event, and it led to a revival in Austrian thought. A new generation of economists sought out the perspective of Austrian school economists such as Carl Menger, Eugen von Böhm-Bawerk, F.A. Hayek, and Hayek’s teacher and mentor, Ludwig von Mises.
Hayek’s 1928 book, Monetary Theory and the Trade Cycle, remains a reasoned, readable, and persuasive account that points to problems in other theories of cyclical economic behavior and presents a coherent, alternative explanation. Non-monetary theories of the business cycle postulate, for example, that the business cycle can be explained by psychological factors, by a failure in the level of saving or investment, or by a failed type or method of production. Unanswered in all these theories is the question of how the economy comes to fail in its ability to coordinate consumer’s preferences with production decisions.
When the price system is working properly, Hayek shows, the “structure of production” allows for “intertemporal coordination,” that is, the fulfillment of producer’s and consumer’s plans over a long period of time. It is the institution of money that makes this possible by allowing calculation to take place through time. Business cycles, then, must have originated as a failure in the monetary system.
Central-bank credit expansion sends incorrect pricing signals to entrepreneurs by artificially lowering the rate of interest. This leads entrepreneurs to make unwarranted investments, mainly in the capital sectors, errors which later become evident when the central bank stops expanding credit. The malinvestment created by distorted interest rates “corrects” and the economy enters a downturn. This is the essence of the business cycle.
Hayek rejects the idea that the goal of monetary policy should be “stable prices,” a theory popular in the 1920s that made a comeback in the 1980s. He shows that prices can be stable even while credit expansion does unseen damage to the structure of production, that is, the market relationship between consumption goods and production goods. Prices were stable all throughout the twenties, but the damage done by credit expansion led to the Great Depression.
The world economy has seen a recession since the early eighties. The opening of Eastern Europe and the Soviet Union, and the innovations in financial instruments, may postpone one even longer. But if Hayek and Mises are right, the business cycle has not been permanently shelved. We cannot know its timing, what sectors it will most affect, or how long it will last. We only know that “So long as we make use of bank credit as a means of furthering economic development,” as Hayek says, “we shall have to put up with the resulting trade cycles.” The only answer to this problem is to end the distortions caused by central banking, a goal which may be decades away. But a new recession, and a new look at Mises’s and Hayek’s work, can create the right intellectual climate.
The Key to Sound Money
Edwin Vieira, Jr.
Every thinking American knows that our country lacks “sound money” and “honest banking.” And there is no shortage of good books that explain the economic, political, and moral justifications for free-market money, and catalog the objectives all Americans committed to monetary freedom should strive to achieve. These include a return to silver and gold coinage, an end to central banking and fraudulent fractional-reserve banking schemes, and so on.
Confusion arises, however, as to how we can restore sound money and honest banking. A recurrent theme seems to be that government is responsible for irredeemable fiat currency, the inherently fraudulent Federal Reserve System, abusive legal-tender laws, and the other paraphernalia of the present system. One author, for example, tells us that “sound money” and “honest banking” are “not impossible; they are merely illegal.” This kind of thinking assumes a great deal: specifically, that whatever those in temporary control of public offices may do is “the law.” But nothing could be further from the truth.
Strictly speaking the “government” of the United States (or of any state or locality) is a kind of “legal fiction.” It is not the individuals elected or appointed to office, the physical buildings they occupy, or the actions they take per se. Rather, the government, rightly understood, is the actions duly elected or appointed officials take consistent with the Constitution. If an action is inconsistent with the Constitution, it is unlawful and nongovernmental by definition. Such an unconstitutional action may be defined as “usurpation” or “tyranny,” but never as a truly governmental function. Simply put, our government has no authority to act outside of or against the Constitution; and when public officials do so, they are not acting as agents of government, but as lawbreakers or outlaws.
For that reason, before we assume that sound money and honest banking are illegal today, we had better first determine what the constitutional powers of government are with respect to money and banking, and whether the present system has any constitutional validity. When we do this, we immediately see that, if sound money and honest banking are illegal today (in the sense that public officials say they are), it is not because the Founding Fathers licensed government in the Constitution to foist unsound money, monopolistic central banking, and chronic inflation upon the American people. To the contrary, the United States now suffers from the ravages of a monetary system based on irredeemable, legal-tender Federal Reserve notes and unlimited central-bank credit expansion precisely because, during the past century, every branch of the national government has neglected to enforce, or knowingly violated, the Constitution in the monetary and banking fields.
Themselves eye-witnesses to the economically catastrophic inflation that followed emission of the paper Continental currency during the War of Independence, the Founding Fathers carefully structured the Constitution to prevent the repetition of such a calamity. They established as the nation’s money a parallel system of silver and gold coinage, based on the silver dollar as the unit of account; outlawed any form of legal tender other than silver and gold coin; and deprived the government of the abusive power to issue paper money of any kind.
Indeed, under the Constitution as written, and as the Founders and their immediate descendants unerringly applied it until the Civil War, every objective of a sound monetary system that free-market economists recommend is not only attainable, but also mandated.
Rightly understood, the Constitution authorizes—and, indeed, requires—the government to mint silver and gold coins denominated only by weight and fineness, but denies it any power to emit paper money (Article I, Sec. 8, cls. 2 and 5; Article I, Sec. 10, cl. 1). It denies the government any power to enact legal-tender laws (except for “gold and silver Coin”), or laws preventing specific performance of private contracts (Article I, Sec. 8, cl. 5; Article I, Sec. 10, cl. 1; Amendments V and XIV). It permits private banks to issue their own nonfraudulent monetary notes, and deal honestly in deposits denominated in silver, gold, or foreign currencies (Article I, Sec. 8, cl. 3; Amendments IX and X). It permits free entry into private banking, throughout the United States (Article I, Sec. I, cl. 3; Article IV, Sec. 2, cl. 1; Amendments V, IX, X and XIV). It outlaws any governmentally sponsored banking monopoly or banking cartel, such as the present-day Federal Reserve System (Amendments V and XIV). And it disables the government from levying discriminatory taxes on privately issued money (Amendments V and XIV).
Thus, in the most fundamental sense, the United States needs no reform law, or restoration law, to return to sound money. For the necessary law already exists, in the Constitution itself. What stands in the way of monetary freedom—and of all forms of individual freedom that our Constitution guarantees under the phrase “the Blessing of Liberty”—is not law, but lawlessness. In a free society, government must be fully subject to the constraint of law—to constitutional limitations on its powers. Where public officials disregard these limitations, they render their own acts illegitimate, immoral, and unworthy of popular allegiance.
Therefore, sound money and free banking are not illegal in the contemporary United States; for what the Constitution guarantees, no congressional statute, presidential order, or court decision can lawfully nullify, set aside, overrule, or condemn to obsolescence. Yet, history teaches the sad lesson that “public servants” will impose upon the citizenry as much tyranny as the people are willing to bear. So, ultimately, what freedoms the Constitution guarantees—in the monetary field as in every other—are only those freedoms that the American people force their elected and appointed officials to respect.
Money and banking are in the best condition when they enjoy the greatest degree of liberty. But money and banking are no different or separable from all other aspects of a free society. And no society can be free, in any aspect, where its laws do not recognize the value of freedom, where its public officials do not enforce the preconditions for freedom, and where its people do not exercise the vigilance in defense of freedom that led our forbearers first to take up the sword to wrest their liberties from the clutches of tyrants, and then to take up the pen to secure those liberties in the fundamental law of the Constitution.
This country will enjoy a rebirth of monetary freedom if and when it experiences a revitalization of constitutionalism, in the broadest sense: namely, the recognition that there are inherent, ineluctable limits on governmental action beyond which lie economic, political, social, and moral disaster. When that day comes, the people will know where to look for the legal formula necessary to restore sound money and honest banking—to the Constitution, where it has always been, and is now, for those with eyes to see.
Foreclose on the World Bank
R. Cort Kirkwood
There are a bunch of capitalists [there] taking steps in the right direction.” That’s how a World Bank official described Ethiopia a day after the New York Times reported that its communist government drove 350,000 people from their homes during an offensive that included napalm and cluster bombs.
The baffling mindset that gives rise to statements like that about Ethiopia demonstrates why U.S. taxpayers should not be forced to “contribute” their hard-earned income to the World Bank’s coffers. The Bank does not provide any tangible benefits to the recipients of its largesse or to those whose taxes are confiscated to support its operations. First, in distributing loans to developing countries, the bank supports socialism. Second, it steadfastly refuses to reform its lending practices and divulge the terms upon which its loans are made and evaluated. Third, its chief beneficiaries are American corporations, whose products are purchased by countries using World Bank loans.
An examination of each of these problems shows why the United States should not be a member of the World Bank.
Reason 1: The World Bank Supports Socialism.
Ethiopia is the principal example of the World Bank’s abysmal failure to fulfill its mandate. At the height of Col. Mengistu Haile Mariam’s forced resettlement program, which by conservative estimates killed 100,000 people, the World Bank provided his communist regime with nearly $150 million. Ignoring his new plan to resettle 350,000 hapless Ethiopians in 1989, the World Bank dished out another $103 million during the fiscal year. Mengistu’s collectivist farm policies have continued with increasing assistance from the World Bank.
The World Bank’s International Finance Corporation, which is supposed to promote private sector development, has invested in government-controlled enterprises in Zambia, Zimbabwe, Ghana, and Pakistan. The IFC’s fastest growing beneficiary is the Soviet Union and Eastern Europe. And half of all IFC loans go to state-owned enterprises, which helped to forestall the collapse of socialism in those countries.
Obviously, the World Bank energizes statism and retards private-sector development.
Part of the reason the bank does so much harm in places like Ethiopia is that its “population experts” accept at face value the hoary socialist canard that high population growth in the Third World inhibits economic growth, spreads poverty, and blunts the effectiveness of World Bank loans. “I realize that population policy touches upon sensitive cultural and religious values,” World Bank president Barber Conable said at the recent World Bank-IMF conference in West Berlin. “But the societies in which population is growing so fast must accept that many—perhaps most—of these new lives will be miserable, malnourished, and buried. With today’s population growth, badly-needed improvement in living standards cannot be achieved, public resources for necessary services are overstretched and the environment is severely damaged.”
Mr. Conable’s words reflect a bogus economic theory dating to Thomas Malthus. In fact, population growth leads to economic development. Indeed, the facts show that many countries with high population densities are economically prosperous, while those with low population densities are squalid dungeons of economic despair.
Red China’s population density is 110 people per square mile, while Taiwan’s is 1,396; but the PRC’s per capita income is $273 annually, whereas Taiwan’s is $6,010. Ethiopia has only 95 people per square mile with a per capita income of $117. Yet Singapore, with 10,357 people per square mile, has a per capita income exceeding $7,286. A similar picture emerges in comparing the two Koreas. The salient difference in the two sets of figures lie in the fact that Taiwan, Singapore, and South Korea have freer economies, whereas Red China, Ethiopia, and North Korea are Communist countries.
In collaborating with the Communist world in promulgating the population growth myth, Mr. Conable is providing prestigious cover so its entrenched despots can avoid admitting their policies are by nature totalitarian, visiting economic and social misery upon their subjects.
Reason 2: There is no hope for reform.
The World Bank’s new Multilateral Investment Guarantee Agency (MIGA) would provide insurance for companies operating in less-developed countries, which will promote increased investment in LDCs by shielding Third World Marxists from the consequences of nationalizing foreign-owned industries, which of course discourages new investment. The top recipients of structural adjustment loans are countries that don’t need them like Turkey ($2.5 billion), while others like Argentina ($850 million) keep getting loans on the collateral of flimsy promises to reform their economies. In Berlin, World Bank President Barber Conable promised $1.25 billion to Argentina (which received $626.5 million in fiscal 1988), just enough to keep stoking the boilers on its ill-managed state-owned railroads.
The bank’s documentation for its loans are “classified” from the appraisal to evaluation stages on the grounds that divulging such information would compromise the ability of the bank to carry out its operations.
Reason 3: American taxpayers don’t benefit from U.S. membership in the World Bank.
At the urging of the Reagan Administration, Congress approved a $14 billion taxpayer bailout for the World Bank in the form of a general capital increase (GCI). It would be enlightening to ask what U.S. taxpayers got for their $14 billion and how many of them support continued U.S. membership. The answers are not something the World Bank’s myrmidons in Washington would want to hear.
Sure, there may be few Congressman genuinely concerned about development in poverty-stricken countries, which is laudable even if their policies for development are misguided. But the evidence suggests that congressional support for the World Bank exists only to the degree that it subsidizes U.S. exports. In fiscal 1987, at least 915 U.S. companies (IBM, Dresser Industries, Monsanto, Exxon, and Ingersoll Rand, to name a few) earned more than $1.7 billion from the World Bank. This makes it easy for Congress to say that Bank’s loans “create” jobs and “boost” exports.
In reality, taxpayers pay for the whole kit and caboodle: the loans, exports, jobs, and bureaucrats that make them happen. The money merely goes on a round trip to Kwanda or Zambia to make it look like something legitimate is going on.
Indeed, it seems like the only people who support the World Bank are big businessmen operating through fronts like the Bretton Woods Committee, which boasts a membership list of luminaries from soy-bean tycoon Dwayne Andreas to money magnate David Rockefeller. (Not coincidentally, the GCI appropriation language requires the United States to “initiate discussion” about the possibility of extending loans to countries so they can make payments on unsound loans from big U.S. banks.)
The World Bank is supposed to spur development in less-developed countries. It has not fulfilled that mandate. It is not a bank in the usual sense; it is an international welfare agency manned by government bureaucrats (whose high salaries are exempt from all taxes) whose purpose is to increase their “lending” portfolio to whatever country they work with. Their success isn’t measured by the profitability of the loans they make, but by the amount of money they “lend” and the amount of power they accrue. In this respect, they are like government bureaucrats everywhere.
The World Bank is only a slick way for fat cats in the United States and corrupt despots in the Third World to fleece American and Western taxpayers under the guise of promoting economic development. Instead of expanding funding for the World Bank, as Secretary of State James Baker urges, the United States should get out.
