Milton Friedman and the Monetary "Rule" for Economic Stability. 92. 5 ... Free Banking and the Economic Case against Central Banking. 119 .... They were told the federal government was injecting cash into the banking system with a purchase .... Or in Keynes's own words, "A movement by employers to revise money-wage.
Monetary Central Planning and the State
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Monetary Central Planning and the State Richard M. Ebeling
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Copyright © 2015 All rights reserved. No portion of this book may be reproduced without written permission from the publisher except by a reviewer, who may quote brief passages in connection with a review. The Future of Freedom Foundation 11350 Random Hills Road, Suite 800 Fairfax, VA 22030
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Table of Contents Title Page Copyright Table of Contents Acknowledgments Introduction 1. A Little Bit of Inflation Never Hurt Anyone. Right? 2. The Rationale of a Stable Price Level for Economic Stability 3. The Federal Reserve and Price Level Stabilization in the 1920s 4. Benjamin Anderson and the False Goal of Price-Level Stabilization 5. The Austrian Economists on the Origin and Purchasing Power of Money 6. Ludwig von Mises and the Non-Neutrality of Money 7. Friedrich A. Hayek and the Destabilizing Influence of a Stable Price Level 8. The Austrian Theory of Capital and Interest 9. The Austrian Theory of the Business Cycle 10. Austrian Business Cycle Theory and the Causes of the Great Depression 11. The Great Depression and the Crisis of Government Intervention 12. The Austrian Analysis and Solution for the Great Depression 13. FDR’s New Deal 14. The New Deal and Its Critics 15. John Maynard Keynes and the "New Liberalism" 16. Keynes and Keynesian Economics 17. Keynesian Economic Policy and Its Consequences 18. Say’s Law of Markets and Keynesian Economics 19. Savings, Investment, and Interest and Keynesian Economics 20. Keynesian Economics and the Hubris of the Social Engineer 21. The Keynesian Revolution and the Early Critics of Keynes 22. The Chicago School Economists and the Great Depression 23. Henry Simons and the "Chicago Plan" for Monetary Reform 24. Milton Friedman’s Framework for Economic Stability 25. Milton Friedman and the Demand for Money 26. Milton Friedman and the Monetary "Rule" for Economic Stability 5
3 4 5 7 8 12 16 19 22 26 29 32 36 39 42 46 50 53 56 59 62 65 68 71 74 77 80 83 86 89 92
27. Milton Friedman’s Second Thoughts on the Costs of Paper Money 28. The Chicago and Austrian Economists on Money, Inflation, and the Great Depression 29. The Gold Standard in the 19th Century 30. The Gold Standard as Government-Managed Money 31. Ludwig von Mises on the Case for Gold and a Free Banking System 32. Friedrich A. Hayek and the Case for the Denationalization of Money 33. Murray N. Rothbard and the Case for a 100 Percent Gold Dollar 34. Free Banking and the Political Case against Central Banking 35. Free Banking and the Economic Case against Central Banking 36. Free Banking and the Competitive Limits to Monetary Expansion 37. Free Banking and the Market Demand for Money 38. Free Banking and the Coordination of Savings and Investment 39. Free Banking and the Benefits of Market Competition 40. Towards a System of Monetary and Banking Freedom About the Author The Future of Freedom Foundation
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95 98 101 104 107 110 113 116 119 122 125 128 131 134 138 139
Acknowledgments The publication of this volume in its present form has been made possible with the support and effort of my dear and long-time friend, Jacob G. Hornberger, founder and president of The Future of Freedom Foundation. Jacob and I first met in the early 1980s when I had accepted a position at the University of Dallas and he was practicing law in that city. We soon became fast friends, sharing parallel views on virtually every political and economic issue. It was my privilege to serve as the vice-president for academic affairs at the Future of Freedom Foundation after Jacob established it in 1989, until I accepted the position of president at the Foundation for Economic Education for the period between 2003 and 2008. It is a delight to be, once again, collaborating with him in bringing Monetary Central Planning and the State to a wider audience. I also wish to thank all my "Austrian" friends, two of whom are discussed at length in this volume, Lawrence H. White and George Selgin, whose writings on competitive free banking have opened an entire field of study in monetary theory and policy. I also owe an immeasurable thanks to my wife, Anna, who continues to provide encouragement and support in all that I do, and without whom my life would be impossible.
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Introduction For over a decade now, the American economy has been on a rollercoaster — an economic boom between 2003 and 2008, followed by a severe economic downturn, and with a historically slow and weak recovery from 2009 until the present (2015). Before the dramatic stock-market decline of 2008–2009, many were the political and media pundits who were sure that the "good times" could continue indefinitely. This included some members of the Board of Governors of the Federal Reserve, America’s central bank. When the economic downturn began and then worsened, many were the critics who were sure that this proved the "failure" of capitalism. These so-called experts resurrected long-questioned or -rejected theories from the Great Depression years of the 1930s that argued that only far-sighted and wise government interventions and regulations could save the country from economic catastrophe and guarantee we never suffer from a similar calamity in the future. Not only is the capitalist system not responsible for the latest economic crisis, but all attempts to severely hamstring or regulate the market economy only succeed in undermining the greatest engine of economic progress and prosperity known to mankind. The recession of 2008–2009 had its origin in years of monetary mismanagement by the Federal Reserve System and misguided economic policies emanating from Washington, DC. For the five years between 2003 and 2008, the Federal Reserve flooded the financial markets with a huge amount of money, increasing the total amount in the economy by 50 percent or more by some measures. For most of those years, key market rates of interest, when adjusted for inflation, were either zero or even negative. The banking system was awash in money to lend to all types of borrowers. To attract people to take out loans, these banks not only lowered interest rates (and therefore the cost of borrowing), they also lowered their standards for creditworthiness. To get the money, somehow, out the door, financial institutions found "creative" ways to bundle together mortgage loans into tradable packages that they could then pass on to other investors. It seemed to minimize the risk from issuing all those subprime home loans, which were viewed afterwards as the housing market’s version of high-risk junk bonds. The fears were soothed by the fact that housing prices kept climbing as home buyers pushed them higher and higher with all of that newly created Federal Reserve money. At the same time, government-created home-insurance agencies like Fannie Mae and Freddie Mac were guaranteeing a growing number of these wobbly mortgages, with the assurance that the "full faith and credit" of Uncle Sam stood behind them. By the time the federal government formally took over complete control of Fannie and Freddie 2008, they were holding the guarantees for half of the $10 trillion American housing market. Low interest rates and reduced credit standards also fed a huge consumer-spending boom that resulted in a 25 percent increase in consumer debt between 2003 and 2008, from $2 trillion to over $2.5 trillion. With interest rates so low, there was little incentive to save for tomorrow and big incentives to borrow and consume today. But according to the U.S. Census Bureau, during that five-year period average real income only increased at the most by 2 percent. People’s debt burdens, therefore, rose dramatically. The easy money and thus the government-guaranteed house of cards all started to come tumbling down in 2008, with a huge crash in the stock market that brought some indexes down 30 to 50 percent from their highs. The same people in Washington who produced this disaster then said that what was needed was more regulation to repair the very financial and housing markets their earlier actions so 8
severely undermined. That included, at the time, a shotgun wedding between the U.S. government and the largest banks in America. The wedding was conducted in October of 2008, when the heads of those financial institutions were commanded to come to Washington, D.C., for a meeting with then secretary of the Treasury Henry Paulson and former Federal Reserve chairman Ben Bernanke. They were told the federal government was injecting cash into the banking system with a purchase of $245 billion of shares of bank stocks in the financial sector. The banking CEOs present — some of whom made it clear they neither needed nor wanted an infusion of government money — were basically told they would not be allowed to leave the Treasury building until they had signed on the dotted line. (The money was eventually returned to the Treasury, with bank buybacks of the shares in which the government had "invested.") The Federal Reserve, in the meantime, turned on the monetary spigot, increasing the monetary base (cash and bank reserves) between 2007 and 2015 from $740 billion to around $4 trillion, brought about through a series of monetary-creation policies under the general heading of "quantitative easing." A variety of key interest rates, as a consequence, when adjusted for inflation, have been in the negative range most of the time for seven years. Nominal and real interest rates, therefore, cannot be considered to be telling anything truthful about the actual availability of savings in the economy and its relationship to market-based profitability of potential investments. Interest-rate manipulation has worked in a way similar to price control — keeping the price of a good below its market-determined clearing level. It has undermined the motives and abilities of some people to save on the supply side, while distorting demand-side decision-making in terms of both the types and time horizons of possible investments to undertake, because the real scarcity and cost of borrowing for capital formation has been impossible to realistically estimate in a financial market that lacks market-based interest rates. Markets have been distorted, investment patterns have been given wrong and excessive directions, and labor and resources have been misdirected into various employments that will eventually be shown to be unsustainable. Keynesians and other supporters of "stimulus" policies have argued that there has been no need to fear "excesses" in the economy because price inflation has been tame — running less than 2 percent a year practically the entire time since 2008. First, it needs to be remembered that this measurement of price inflation is based upon one or another type of statistical price index. This by necessity hides from view all the individual price changes that make up the statistical average, and which has seen in the last few years significant price increases in subsectors of the market. Second, the full impact of the massive monetary expansion has been prevented from having its full effect due to a policy gimmick that the Federal Reserve has been following since virtually the start of its quantitative-easing policies. The central bank has been paying banks a rate of interest slightly above the interest rate it could earn from lending to borrowers in the private sector. Thus, it has been more profitable for many banks to leave large amounts of their available reserves unlent as "excess reserves" that have been totaling almost $2.8 trillion of the nearly $4 trillion that Federal Reserve as created. Having created all this additional lending potential, the Fed has been manipulating interest rates, again, this time to keep a large amount of it from coming on the market. Third, particularly since 2014, the world has been increasingly awash in expanding oil supplies. This has resulted in dramatically lower prices for refined oil products of all types. The result most visible to the average consumer is a fall in the price to fill up one’s car with gasoline. Greater supplies of useful and widely used raw materials and resources at significantly lower cost should be considered a boon to all in the economy, in making production and finished goods less expensive, and thereby raising the standards of living of all demanding such products. 9
Instead, the Federal Reserve worries about "price deflation" as a drag on the economy, rather than as a market-based stimulus through supply-side plentifulness that, in the long run, reduces the scarcity and cost of desired goods and services. Central banks around the world have all gravitated to the idea that the "ideal" rate of price inflation that assures economic stability and sustainability is around 2 percent a year. Fixated on averages and aggregates, the central bankers continue to give little or no attention to the really important influence their monetary policies have on economic affairs: the distortion of the structures of relative prices, profit margins, resource uses, and capital investments. In Monetary Central Planning and the State, I explain the "Austrian" theory of money and the business cycle in contrast to both Keynesian economics and monetarism. Developed especially by Ludwig von Mises and Friedrich A. Hayek in the 20th century, the Austrian theory uniquely demonstrates the process by which central bank–initiated monetary expansion and interest-rate manipulation invariably set the stage for both an artificial boom and an eventual, inescapable bust. Their theory is explained in the context of an analysis of the most severe economic downturn of the last one hundred years, the Great Depression. The crash of 1929 and the depression that followed was the outcome of Federal Reserve monetary policy in the 1920s, when the goal was price-level stabilization — neither price inflation nor price deflation. But beneath the apparent stability of the statistical price level, Fed-induced monetary expansion and below-market rates of interest generated a mismatch between savings and investment in the American economy that finally broke in 1929 and 1930. The depth and duration of the Great Depression through the greater part of the 1930s was also not due to anything inherent in the market economy. Rather than allow markets to find their new, postboom market-clearing levels in terms of prices, wages, and resource reallocations, governments in America and Europe undertook a wide variety of massive economic interventions. The outcome was rising and prolonged unemployment, idle factories, unused capital, and vast amounts of economic waste caused by wage and price interventions, large government budget deficits and accompanying accumulated debt, uneconomic public works projects, barriers to international trade due to economic nationalism and protectionism, and the introduction of forms of government planning and control over people’s lives and market activities. Many of these rationales for "activist" monetary and fiscal policy emerged and took form under the cover of the emerging Keynesian revolution as first presented by British economist John Maynard Keynes. In Monetary Central Planning and the State, I also offer a detailed critique of the fundamental premises of the Keynesian approach and why its policy prescriptions in fact lead to the very boom-bust cycle the Keynesians claim to want to prevent. Furthermore, I show why it is that every essential building-block of the Keynesian edifice is based on faulty economic premises and superficial conceptions of how markets actually function. I also show why the end result of such a policy is more government control with none of the benefit of economic stability that the Keynesians say is their goal. Also, in spite of Milton Friedman’s valuable contributions to an understanding of the superiority of competitive markets in general, his own version of activist monetary policy through a "rule" of monetary expansion and "automatic" fiscal stabilizers was more an "immanent criticism" within the Keynesian macroeconomic framework, rather than a fundamental alternative such as the "Austrian" economists have offered. What, then, is to be done, in terms of the workings and the institutions of the monetary system? A good part of Monetary Central Planning and the State is devoted to explaining the inherent economic weaknesses and political shortcomings of all forms of central banking. In a nutshell, central banking suffers from a similar problem as do all other forms of central 10
planning. Central banking depends on the presumption that monetary central planners can ever successfully manage the monetary and banking system better than a truly competitive private banking system operating on the basis of market-chosen forms of money and media of exchange. I show how systems of private competitive banking could function if government central banking were brought to an end. This is done through a critical analysis of the proposals for a private monetary and banking system as found in the writings of Ludwig von Mises, Friedrich A. Hayek, Murray N. Rothbard, and the "modern" proponents of monetary freedom: Lawrence H. White, George Selgin, and Kevin Dowd. Monetary Central Planning and the State ends with a brief list of the steps that could and should be taken to begin the successful transition from central banking to a free-market monetary and banking system of the future. If the last one hundred years have demonstrated anything, it is that governments — even when in the hands of the well intentioned — have neither the knowledge nor the ability to manage the social and economic affairs of hundreds of millions, and now billions, of people around the world. The end result has always been loss of liberty and economic misdirection and distortion. A hundred years of central banking in the United States since the establishment of the Federal Reserve System in 1913 has equally demonstrated the inability of monetary central planners to successfully direct the financial and banking affairs of the nation through the tools of monopoly control over the quantity of money and the resulting powerful influence on money’s value and the interest rates at which savers and borrowers interact. It is time for a radical denationalization of money — a privatization of the monetary and banking system through a separation of government from money and all forms of financial intermediation. That is the pathway to ending the cycles of booms and busts, and creating the market-based institutional framework for sustainable economic growth and betterment. It is time for monetary freedom to replace the out-of-date belief in government monetary central planning.
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Chapter 1 A Little Bit of Inflation Never Hurt Anyone. Right? When I was an undergraduate majoring in economics in the late ’60s and early ’70s, several of my professors made much of the distinctions between "trotting," "galloping," and "creeping" inflation. Trotting inflation was usually defined as a 5 to 10 percent annual rate of increase in the general level of prices that, if not controlled, might accelerate into a galloping inflation of 10 to 20 percent a year; galloping inflation ran the risk of becoming a "runaway" inflation; runaway inflation could change into a hyperinflation; and hyperinflation might lead to a monetary collapse if not stopped in time. But creeping inflation, my fellow students and I were told, need not be a problem. Creeping inflation was a rate of general price increase of 1 to 5 percent a year. A creeping inflation of 3 to 5 percent could still significantly eat away at the purchasing power of money when continued over many years, but it was "manageable." Furthermore, a low creeping inflation could be good for the economy. After John Maynard Keynes wrote his famous book, The General Theory of Employment, Interest and Money, in 1936, the economists who became known as the Keynesians argued that workers suffer from "money illusion." Or in Keynes’s own words, "A movement by employers to revise money-wage bargains downward will be much more strongly resisted than a gradual and automatic lowering of real wages as a result of rising prices." Suppose that a general economic depression develops in an economy and prices, in general, fall by, say, 20 percent. If workers were to accept an equivalent cut in the general level of wages, employers’ labor costs would have declined in line with the prices they now receive for the products they sell. Employers could afford to maintain production and employ the same number of workers as they had before the depression began. Furthermore, workers would be no worse off in terms of their real incomes. It is true that their money wages would now be 20 percent lower, but so, too, would be the prices of the goods they bought with their smaller money incomes. At the lower level of money prices, their lower money incomes would still be able to buy the same quantities of goods and services as before the start of the depression. Keynes, however, argued that workers suffer from "money illusion." They think only in terms of the nominal dollars in their paychecks, not in terms of their "real wages," i.e., in terms of the real purchasing power of what their money wages can buy. As a consequence, workers would strongly resist any significant cut in their money wages, even if the result were to be high and prolonged unemployment. The answer, Keynes proposed, was to decrease real wages, and, therefore, the cost of hiring labor, through price inflation. Precisely because workers suffer from money illusion, they would not ask for higher money wages to compensate for the loss in their consumer buying power due to the rise in prices. Higher prices for products with relatively unchanged money wages would improve or create the profit margins out of which would come the incentives for employers to expand production and hire back the unemployed. In the Keynesian view, government budget deficits are the mechanism for bringing this about. Government would take in less tax revenue than it spent on goods and services. The net addition of government spending in the economy through money creation (or borrowing of "idle" savings accumulating in banks) to finance the budget deficit would be the device through which "aggregate demand" could be stimulated and prices "creepingly" pushed up. 12
Keynes’s argument for a little bit of managed inflation as a healthy stimulus to production and employment had, in fact, been made many times before him and had been criticized, as well, as a merely temporary panacea. For example, Francis A. Walker, one of the most prominent American economists of the late 19th century, argued in his book Money, Trade, and Industry (1889) that a "gradual … inflation upon profits is very direct and simple.… It gives a fillip to the zeal of the employing classes, and in the immediate present promotes production without necessarily inducing any [negative] reaction whatsoever.… It will have the maximum of good and the minimum of evil effects" as long as it is "a slowly progressive depreciation of money." But the belief that a permanent stimulus for greater production and employment can be secured by a steady and low rate of price inflation was criticized by the Swedish economist Knut Wicksell in his book Interest and Prices (1898): If a gradual rise in prices, in accordance with an approximately known schedule, could be reckoned on with certainty, it would be taken into account in all current business contracts; with the result that its supposed beneficial influence would necessarily be reduced to a minimum. Those people who prefer a continually upward moving to a stationary price level forcibly remind one of those who purposely keep their watches a little fast so as to be certain of catching their trains. But to achieve their purpose they must not be conscious of the fact that their watches are fast; otherwise they become accustomed to take the extra few minutes into account and after all, in spite of their artfulness, arrive too late. In the 20th century, first Irving Fisher and then Milton Friedman argued the same point as Wicksell. They pointed out that prices for finished consumer goods tend to be relatively flexible and responsive to changes in market demand. The prices of factors of production, such as labor, on the other hand, tend to be contractually fixed for longer periods of time. As a result, if there is an unexpected increase in general market demand due to inflation, prices of finished goods will begin to rise sooner and before the prices of the factors of production. Profit margins will be temporarily widened by the price inflation. But as contracts come up for renewal and general information about the rate of price inflation comes to be known, workers and other resource owners will bargain for higher wages and prices. Why? For two reasons. First, the attempt to expand production simultaneously in many sectors of the economy because of widened profit margins will strain the market for scarce factors of production, naturally resulting in a bidding up of their prices, including the wages of labor. Second, as workers and resource owners buy goods and services in the market, they soon learn that their money incomes no longer go as far as they used to in the face of rising prices. In their bargaining over wages and resource prices with employers, they naturally will demand money wages and money prices for resources that at least reestablish their previous real income. Both Fisher and Friedman argued that workers over time do not suffer from money illusion. Money, as a medium of exchange, is an abode of purchasing power, and those who use money are concerned with what it will buy in the marketplace. In other words, what matters for income earners are their real wages , not merely their money wages . Only if the rate of increase in the general level of prices were unanticipated — or not anticipated to the full extent — would the Keynesian gimmickry work. If the rate of general price inflation is correctly anticipated, then all contracts for wages and other resource prices will incorporate that information; resource prices, including wages, will tend to rise at the same average rate as the general price level. Profit margins will not be artificially widened, and there will be no permanent stimulus to greater production and employment. The amount of production and employment will reflect the actual, underlying market conditions of supply and demand existing in the economy. Only if the actual rate of price inflation is accelerated ahead of what people expect the inflation 13
rate to be will prices once again rise fast enough relative to the costs of production to make the Keynesian illusion temporarily reappear. But this means that if inflation is to have its stimulative impact, it must be accelerated from a "creep" to a "trot." When "trotting" inflation no longer does the trick, it must be speeded up to a "gallop." And when a galloping inflation no longer suffices, it must be allowed to "run away." When runaway inflation fails to deliver the desired level of employment.… The idea of a steady and successfully government-managed "creeping inflation" to ensure some desired rate of economic growth and increase in employment fell by the wayside in policy circles in the 1970s and 1980s under the attacks of monetarists such as Milton Friedman and another group of economists known as the rational-expectations theorists. But it seems that fallacious ideas never die — especially in economics; they just retreat into hiding to reappear some other day. As an example of this, the case for creeping inflation is back. In August 1996, the Washington-based Brookings Institution released a Policy Brief by George Akerlof, William Dickens, and George Perry, entitled "Low Inflation or No Inflation: Should the Federal Reserve Pursue Complete Price Stability?" They argue that if the board of governors of the Federal Reserve System follows a strategy of zero inflation, they will bring about unnecessary unemployment and less growth than would be possible otherwise. Constant changes in market conditions, the authors correctly point out, require appropriate adjustments in the distribution of labor among the various sectors of the economy as well as adjustments in the structure of relative wages, reflecting the changing patterns of employers’ demands for different types of labor. If price inflation is zero, they again correctly reason, some money wages will have to rise where the demand for labor is increasing and some money wages will have to decline where the demand for labor is decreasing. But the authors say, Employers almost never cut their employees’ wages because they fear that doing so would cause serious morale and staff retention problems.… Most people consider it unfair for a firm to cut wages, except in extreme circumstances.… Downward wage rigidity is indeed an important feature of the economy. As a result, in those sectors of the economy where money wages may have to fall but do not, employers "keep relative wages too high and employment too low." On the other hand, most workers "do not consider it unfair if a firm fails to raise [money] wages in the face of high inflation." On the basis of this reasoning, they propose a monetary policy of "moderate inflation." If market conditions change, the necessary adjustments in the structure of relative wages to attract workers into some sectors of the economy and away from others can occur without having to cut anyone’s money wage. Money wages can be kept the same in those parts of the economy where labor demand has gone down, while the increases in the money supply to generate the moderate price inflation can be used to cover a necessary rise in money wages in those sectors where workers need to be attracted. To avoid "serious morale" problems — the new explanation for the old Keynesian presumption of "money illusion" among workers — the Federal Reserve, therefore, should make a new version of "creeping inflation" the goal of monetary policy. In a September 30, 1996, commentary in the (London) Financial Times , entitled "Inflation Apologists," columnist Michael Prowse scathingly took these authors to task for resurrecting this fallacious building block of old-fashioned Keynesian economics. He pointed out: In a zero inflation world, people could learn to accept the need for occasional cuts in money wages, just as they now accept cuts in inflation-adjusted wages. To assume this is impossible is to assume that people are permanently irrational — a poor, if not insulting, assumption on which 14
to base any economic theory.… With zero inflation, relative price signals would be clearer than they are today.… Capitalism would function even more efficiently. And the jobless rate would tend to be lower, not higher. The pessimism of the new inflation apologists is quite unwarranted. Is zero-price inflation, therefore, the desirable target for a market economy and the free society? If it is, then this must imply that there remains, even in the free society, a monetary central-planning agency that has the power to implement the necessary monetary policy to bring it about. But if government central planning can be demonstrated to be economically irrational in all other aspects of economic life, on what basis can it be presumed to be able to work — and work correctly — in monetary matters? And if monetary central planning can be shown to be no less irrational than all other forms of central planning, then what should be the monetary system of a free society?
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Chapter 2 The Rationale of a Stable Price Level for Economic Stability One of the most influential economists during the first 30 years of the 20th century was Yale University professor Irving Fisher. In 1896, he published a book entitled Appreciation and Interest. He argued that price inflations and price deflations can have a disturbing effect on the relationship between debtors and creditors if the inflations and deflations are not correctly anticipated by borrowers and lenders. The rate of interest, he explained, is the price for borrowing money and having use of the resources and commodities that a sum of money can purchase over a period of time. Lenders are willing to part with their money for the period of the loan because they receive a premium — interest — along with return of their principal. The interest represents an additional amount of purchasing power for goods and services. It is the reward for the lender’s forgoing the use of his money during the loan period. Suppose that creditor and debtor have agreed on a rate of interest of, say, 5% for a loan covering a one-year period. Now suppose that during this one-year period, prices in general rise unexpectedly by 3%. When the loan is paid back with its 5% interest, the lender will discover that to buy the same quantity of goods that the principal of the loan had been able to purchase in the market a year earlier, he will now have to spend the principal plus 3% of his interest income. The real gain in buying power from having lent this sum of money, therefore, will not be 5%, but in fact only 2%. The unanticipated price inflation will have eroded three-fifths of the real value of his interest income. On the other hand, imagine that a similar type of agreement is made between creditor and debtor for a 5% rate of interest on a one-year loan, but prices in general unexpectedly decline by 3% during that year. When the loan is paid off at the end of the year, the lender will discover that because of the unanticipated price deflation, the principal he lent has 3% greater purchasing power than at the beginning of the year. The real gain in buying power from the lender’s point of view, therefore, is 8%, not merely the 5% interest contracted for in the loan agreement. In the first case — that of unexpected price inflation — the borrower will pay back his loan in depreciated dollars. The burden of his debt will be diluted because of the decline in the value of money during the period of the loan. In the second case — unexpected price deflation — he will pay back his loan in appreciated dollars, and the burden of his debt will have been increased because of the increase in the value of money during the period of the loan. Irving Fisher argued that if the rate of price inflation or price deflation could be correctly anticipated by the transactors to the loan agreement, then neither creditor nor debtor would gain or lose during the period of the loan. Why? Because knowing that money would either lose or gain some given percentage in purchasing power over this period of time, borrowers and lenders would adjust the terms of the loan to reflect the expected change in the general level of prices. In the case of the 3% price inflation, the nominal rate of interest would be set at 8%, so that when the loan is paid off, the lender still receives his gain of 5% in real purchasing power. And in the case of 3% price deflation, the nominal rate of interest would be set at 2%, so that when the loan is paid off, the lender receives his real gain of 5% in real purchasing power. In the real world, however, Fisher said, changes in the general level of prices are unlikely to be perfectly and correctly anticipated by lenders and borrowers. As a consequence, there is always the 16
possibility of unforeseen and unagreed-to gains and losses by creditors and debtors. Furthermore, Fisher argued, unexpected changes in the general level of prices can have disruptive effects on production and employment in the economy as a whole. This was a theme that he developed in his 1911 work, The Purchasing Power of Money, and that he popularized in a series of books, such as his Elementary Principles of Economics (1912), Stabilizing the Dollar (1920), and The Money Illusion (1928), and in dozens of articles he published throughout the 1920s. He said that during a period of unexpected price inflation or price deflation, prices for finished goods and services and the prices for resources and labor change at different times and to different degrees. As a result, profit margins between the prices for finished goods and the means of production can be artificially and temporarily increased or decreased, resulting in fluctuations in production and employment in the economy. Prices for finished consumer goods, Fisher explained, tend to be fairly flexible and responsive to changes in the level of market demand. On the other hand, resource prices, including the wages for labor, tend to be fixed for periods of time by contract. During periods of unexpected price inflation, the profit margins between consumer-goods prices and resource prices are artificially widened, creating an incentive for employers to try to expand output to take advantage of the increased return from sales. This, he argued, is the cause of the "boom," or expansionist, phase of the business cycle. But the boom inevitably comes to an end when resource prices, including wages, come up for contractual renegotiation. Resource owners and laborers, in a market environment of heated demand for their services, bargain for higher prices and money wages to compensate for the lost purchasing power they have suffered while their money incomes have been contractually fixed in the face of rising prices. The "bust" or contractionist phase of the business cycle then sets in, as profit margins narrow in the face of the new higher costs of production and as employers discover that they have overexpanded and overextended themselves in the earlier boom period. During periods of unexpected price deflation, profit margins between consumer-goods prices and resource prices are artificially narrowed or wiped out, as consumer-goods prices are declining while resource prices and wages temporarily remain fixed at their contractual levels. Employers have an incentive to reduce output to economize on costs and reduce loses, generating a general economic downturn. The diminished profits or losses are eliminated when resource prices (including wages) come up for contractual renegotiation. Rather than risk losing their businesses and jobs, resource owners and workers moderate their price and wage demands to reflect the lower prices in the marketplace for their products. Furthermore, since consumer-goods prices, in general, are declining, resource owners and workers can accept lower resource prices and money wages. In real buying terms, they will be no worse off than before the price deflation began. If price inflations and price deflations could be perfectly anticipated, the changes in the purchasing power of money could be incorporated into resource and labor contracts, with profit margins being neither artificially widened nor narrowed by the movements in the general level of prices. The business cycle of booms and busts would be mitigated or even eliminated. Unfortunately, Fisher again argued, such perfect foresight is highly unlikely. And unless some external force is introduced to keep the price level stable — to eliminate both price inflations and price deflations — Fisher concluded that, given the monetary institutions prevailing in most modern societies during the time he was writing, the business cycle would remain an inherent part of a market economy. Irving Fisher’s solution was to advocate a stabilization of the price level . What was needed, he insisted, was a monetary policy that would ensure neither price inflation nor price deflation. In Stabilizing the Dollar (1920), Fisher stated: 17
What is needed is to stabilize, or standardize, the dollar just as we have already standardized the yardstick, the pound weight, the bushel basket, the pint cup, the horsepower, the volt, and indeed all the units of commerce except the dollar.… Am I proposing that some Government official should be authorized to mark the dollar up or down according to his own caprice? Most certainly not. A definite and simple criterion for the required adjustments is at hand — the familiar "index number" of prices.… For every one per cent of deviation of the index number above or below par at any adjustment date, we would increase or decrease the dollar’s weight (in terms of purchasing power) by one per cent. How would the government do this? By changing the quantity of money and bank credit available in the economy for the purchase of goods and services. In his 1928 volume, The Money Illusion , Fisher praised the Federal Reserve Board — the American central bank’s monetary managers — for following a policy since 1922 close to the one he was advocating. Though only a "crude" beginning, "stabilization ushers in a new era for our economic life … adding much to the income of the nation," he claimed. The dollar … has been partially safeguarded against wide fluctuations ever since the Federal Reserve System finally set up the Open Market Committee in 1922 to buy and sell securities, especially Government bonds, for the purpose of influencing the credit situation.… When they buy securities they thereby put money into circulation.… When they sell, they thereby withdraw money from circulation. [Along with the Federal Reserve’s control over bank reserves and the discount rate at which it directly lends to banks, through Open Market Operations] the Federal Reserve does and should safeguard the country … against serious inflation and deflation.… This power, rightly used, makes the Federal Reserve System the greatest public service institution in the world. Through the power of the Federal Reserve System, Fisher happily pointed out, America had established a "managed currency," guided by the policy goal of a stable price level. Even on the eve of the great stock market crash that occurred during the last two weeks of October 1929, Irving Fisher declared on September 5, 1929, "There may be a recession in stock prices, but not anything in the nature of a crash." And on October 16, 1929, Fisher insisted: Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels.… I expect to see the stock market a good deal higher than it is today within a few months. The great American experiment in monetary central planning for price level stabilization during the 1920s ended in disaster. Along with the government’s interventionist responses to the economic crisis, first by the Hoover administration and then with even greater force during the Roosevelt administration’s New Deal, America’s monetary central planners created the decade-long Great Depression. What exactly had the Federal Reserve System done in the 1920s, in terms of monetary policy? Why, in fact, did this policy end up being a recipe for disaster? And why did the responses by the Hoover and Roosevelt administrations exacerbate the crisis, turning it into America’s Great Depression?
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Chapter 3 The Federal Reserve and Price Level Stabilization in the 1920s The Great Depression was not the result of "reckless capitalism" combined with "passive, indifferent government." The Great Depression was caused by monetary mismanagement by America’s central bank, the Federal Reserve System. And the Depression’s intensity and duration were the result of government interventionist and collectivist policies that prevented the required readjustments in the economy that would have enabled a normal recovery in a much shorter period of time. The roots of the Great Depression were laid with the establishment of the Federal Reserve System in 1913. While the American monetary system had many serious flaws before 1913 — practically all of them connected with federal and state regulations and controls over the banking industry — the Federal Reserve System became the mechanism for centralization of control over the monetary and banking structures in the United States. And those controls became the mechanism for monetary central planning that generated a large inflation during the period of the First World War, the illusion of "stabilization" in the 1920s, and the reality of the Great Depression in the early 1930s. In the first seven years after the Federal Reserve came into full operation in 1914, wholesale prices in the United States rose more than 240%. How had this come about? Between 1914 and 1920, currency in circulation had increased 242.7%. Demand (or checking) deposits had gone up by 196.4%, and time deposits had increased by 240%. With the establishment of the Fed, gold certificates began to be replaced with the new Federal Reserve Notes. Unlike the older gold certificates that had 100% gold backing, Federal Reserve Notes had only a 40% gold reserve behind them, enabling a dramatic expansion of currency. Member banks in the new system were required to transfer a portion of their gold reserves to the Fed to "economize" on gold in the system. At the same time, reserve requirements on deposit liabilities were lowered by 50% from the pre-1914 average level of 21% to 11.60%; and they were lowered even further in June 1917 to 9.67%. Reserve requirements on time deposits were set at only 5% and diminished still more to 3% in June 1917. The decreased reserve requirements on outstanding bank liabilities created a tidal wave of available funds for lending purposes in the banking industry. And, indeed, between 1914 and 1920, bank loans increased by 200%. Much of the additional lending ended up being in U.S. government securities, especially after American entry in the First World War in April 1917. Between March 1917 and June 1919, bank loans to the private sector increased by 70%, while investments in government securities went up by 450%. C.A. Philips, T.F. McManus, and R.W. Nelson explained in their important work, Banking and the Business Cycle: A Study of the Great Depression in the United States (1937): Had it not been for the creation of the Federal Reserve System, there would have been a [lower] limit to the expansion of bank credit during the War.… The establishment of the Federal Reserve System, with its pooling and economizing of reserves, thus permitt[ed] a greater credit expansion on a given reserve base.… It is in the operations of the Federal Reserve System, then, that the major explanation of the War-time rise in prices lies. The years 1920–1921 saw the postwar slump. Prices fell by about 40% during these two years, and 19
unemployment rose to a height of over 10%. But the depression, though steep, was short-lived. Why? Because the American economy still had a great degree of wage and price flexibility. The imbalances in the market created by the preceding inflation were soon corrected with appropriate adjustments in the structure of wages and prices to more fully reflect the new postwar supply-and-demand conditions in the market. But this postwar adjustment did not return prices to anything near the prewar levels. Prices in the United States were still almost 40% higher in 1922 than they had been in 1913. This was not surprising, since the money supply contracted by only about 9% to 13% during this period (according to Monetary Statistics of the United States by Milton Friedman and Anna Schwartz). Following 1921, the Federal Reserve System began its great experiment with price level stabilization, which Irving Fisher praised so heartily in 1928. That this was the Fed’s goal was confirmed by Benjamin Strong, chairman of the New York Federal Reserve Bank through most of the decade and the most influential member of the Federal Reserve Board of Governors during this period. In 1925, Strong said, "It was my belief … that our whole policy in the future, as in the past, would be directed toward the stability of prices so far as it was possible for us to influence prices." And in 1927, he once again emphasized, "I personally think that the administration of the Federal Reserve System since the [depression] of 1921 has been just as nearly directed as reasonable human wisdom could direct it toward that very policy [of price level stabilization]." Did the Federal Reserve succeed in its policy of price level stabilization? An index of wholesale prices, with 1913 as the base year of 100, shows that the average level of prices remained within a fairly narrow band: 1922 — 138.5; 1923 — 144.1; 1924 — 140.5; 1925 — 148.2; 1926 — 143.2; 1927 — 136.6; 1928 — 138.5; 1929 — 136.5. During the entire decade, wholesale prices on average were never more than about 7% higher than in 1922. And at the end of the decade, before the Great Depression set in (1929), wholesale prices, as measured by this index, were in fact about 1.5% lower than in 1922. Like Irving Fisher in his praise of Federal Reserve policy in 1928, John Maynard Keynes, in his two-volume Treatise on Money (1930), pointed to the Fed’s record during the decade, and said, "The successful management of the dollar by the Federal Reserve Board from 1923 to 1928 was a triumph … for the view that currency management is feasible." By how much had the Federal Reserve changed the supply of money and credit during the decade to bring about price level stabilization? The answer to this depends on how one defines the "money supply." Milton Friedman and Anna Schwartz, in their famous Monetary History of the United States, 1867–1960 (1963), estimate that between 1921 and 1929, the money supply increased about 45% or approximately 4.6% a year. They used a definition of money that included currency in circulation and demand and time deposits (a definition known as "M-2″). Murray Rothbard, in America’s Great Depression (1963), used a broader measurement of the money supply that included currency, demand and time deposits, savings-and-loan shares, and the cash value of life-insurance policies. Using these figures, Rothbard estimated that the money supply had increased by 61.8% between 1921 and 1929, with an average annual increase of 7.7%. While shares owned in savings-and-loan banks increased by the largest percent of any component of the money supply 318% between 1921 and 1929 it represented only between 4% and 8% of the total money supply during the period, as measured by Rothbard. The cash value of life insurance policies increased by 213% during the period; and it represented between 12.5% and 16.5% of the money supply, as measured by Rothbard. If the cash value of life insurance policies is subtracted from Rothbard’s measure of the money supply, and if deposits at mutual-savings banks, the postal-savings system, and the shares at savingsand-loans are added to Friedman and Schwartz’s definition (which, in fact, they do to calculate a broader money definition called "M-4″), the results practically coincide. The money supply, by both measurements, increased by about 54% for the period, with an average annual increase of approximately 5.5%. 20
During the decade, this monetary increase did not, however, occur at an even annualized rate. Rather, it occurred in spurts, especially in 1922, 1924–1925, and 1927, with monetary slowdowns in 1923, 1926, and late 1928 and early 1929. These were not accidents, but rather represented the "finetuning" methods of the Federal Reserve Board of Governors in their attempt to counteract tendencies toward either price inflation or economic recession, with price level stabilization as a crucial signpost of success. The two main Federal Reserve policy tools for influencing the amount of money in the economy were open-market operations and the discount rate. When the Fed purchases government securities, it pays for them by creating new reserves on the basis of which banks can expand their lending. The sale of government securities by the Fed drains reserves from the banking system, reducing the ability of banks to extend loans. The discount rate is the rate at which the Fed will directly lend reserves to member banks of the Federal Reserve System. Throughout most of the 1920s, the Fed kept the discount rate below the market rates of interest, creating a positive incentive for member banks to borrow from the Fed and lend the borrowed funds to the market at higher rates of interest, earning the banks a profit. Even when the Fed sold government securities at certain times during the 1920s, member banks were often able to reverse the resulting drains of reserves out of the banking system by borrowing them back from the Fed at the below-market discount rate. Increases in currency in circulation were a negligible fraction of the monetary expansion, representing less than 1% of the increase. Demand deposits increased by 44.6% and time deposits expanded by 76.8%. This fostered a major economic boom. As Philips, McManus, and Nelson explained in Banking and the Business Cycle : As a result of the plethora of bank credit funds and the utilization by banks of their excess reserve to swell their investment accounts, the long-term interest rate declined and it became increasingly profitable and popular to float new stock and bond issues. This favorable situation in the capital funds market was translated into a construction boom of previously unheard-of dimensions; a real estate boom developed, first in Florida, but soon was transferred to the urban real estate market on a nation-wide scale; and finally, the stock market became the recipient of the excessive credit expansion. Trying to rein in the stock market boom, the Fed all but froze the money supply in late 1928 and the first half of 1929. The monetary restraint finally caught up with the stock market in October 1929. But why did the stock market downturn develop into the Great Depression? Other than the boom in the stock market, there were few outward signs of an unstable inflationary expansion that would have suggested a need for a recessionary adjustment period to reestablish certain fundamental balances in the economy. The wholesale price index, as we saw, had remained practically unchanged between 1927 and 1929. Clearly, however, there were forces at work beneath the surface of a stable price level that were generating the conditions for a needed correction in the economy. But depressions had occurred before and recoveries had followed, usually not too long afterwards. Why, then, did this downturn become the Great Depression?
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Chapter 4 Benjamin Anderson and the False Goal of PriceLevel Stabilization Hardly any economists in America anticipated that price-level stabilization during the 1920s would lead to the economic depression that began in October 1929. One of the few who saw a danger in this policy of the Federal Reserve System was Benjamin M. Anderson. As the senior economist for the Chase National Bank of New York City throughout this period, Dr. Anderson authored the Chase Economic Bulletin, which was usually published four to five times every year. He offered detailed analyses of the economic currents in the United States, with special attention to monetary and banking policy and its likely effects on general market conditions. He also often critically evaluated the theories underlying Federal Reserve policy, most particularly the notion of stabilizing the price level as a guide for economic stability. The most insightful bulletins on this theme were "The Fallacy of ‘The Stabilized Dollar’" (August 1920); "The Gold Standard vs. ‘A Managed Currency’" (March 1925); "Bank Money and the Capital Supply" (November 1926); "Bank Expansion and Savings" (June 1928); "Two ‘New Eras’ Compared: 1896–1903 and 1921–1928″ (February 1929); "Commodity Price Stabilization as a False Goal of Central Bank Policy" (May 1929); and "The Financial Situation" (November 1929). He argued that the Federal Reserve had used its powers to reduce the reserve requirements of member banks, had set the discount rate at which member banks could directly borrow from the Fed below the market rates of interest, and had used "open-market operations" to inject new reserves into the banking system. The increase in bank reserves available for lending purposes as a result of these Fed policies had generated a huge increase in demand deposits and especially in time deposits. As a result, a large monetary inflation had been created by the Federal Reserve during the 1920s. But the price level had remained stable, producing, Benjamin Anderson said, a false sense of economic stability. In 1926 and 1928, he argued that the amount of bank credit created by Fed policy enabled the financing of new investments in excess of actual savings in the economy. Influenced by Joseph Schumpeter’s The Theory of Economic Development (1911), Anderson argued that monetary expansion in the form of bank credit lowered interest rates, which attracted additional borrowing for long-term investment projects. These additional bank loans with newly created money enabled investment borrowers to bid resources and labor away from consumption and other uses in the economy and redirect their use towards various types of capital formation. The monetary expansion, in other words, induced the undertaking of investment activities in excess of the actual voluntary savings upon which a stable pattern of investment is ultimately dependent. Thus, Federal Reserve policy was creating a serious imbalance in the savings-investment relationship of the American economy. Anderson estimated that between 1921 and 1928, demand deposits at Federal Reserve member banks had increased 33.8%, while time deposits (whose minimum reserve requirements had been set by the Fed significantly lower than those required for demand deposits) had increased by 135.1%. The resulting increase in lendable funds, he said, fed real-estate and construction booms and produced a dramatic rise in stock-market speculation. In February 1929, Anderson pointed out that "excessive bank reserves generate bank expansion, that bank expansion running in excess of commercial needs will overflow into capital uses and speculative employments, and that low interest rates and abundant credit will ordinarily reflect themselves in rapidly rising capital values." In Anderson’s view, these all pointed to the inevitability of 22
a corrective downturn. In May 1929, Anderson again explained that Federal Reserve policy had created a large bankcredit expansion during the decade through its discount-rate policy and its open-market operations. He admitted that the monetary expansion had not produced an absolute rise in the price level, "but I would maintain that our commodity price level would be lower today if this great expansion of bank credit had not taken place. The expansion has had its influence, not in raising commodity prices, but in maintaining them." During the decade of the 1920s, Anderson said, there had been a great increase in production, and many technological innovations and new cost-cutting efficiencies had been introduced into business. An index of the physical volume of production showed a 34.6% increase between 1921 and 1928. This would have tended to slowly lower prices in the American economy, as the increased supplies of goods and services were offered to the consuming public. But the increase in the money supply had counteracted this natural tendency for prices to have decreased. Argued Anderson: Such price changes are wholly beneficial, and should not be interfered with, and such price changes often involve not merely changes in particular prices, but also changes in the general price level of a country, if large groups of producers are involved.… ‘Right prices’ are prices which will move goods and clear the markets, but nobody knows in advance what prices will do this. Experimentation in the markets, with free prices and two-sided competition, is the only way to find out quickly and surely what prices are ‘right’.… To resist such price changes is to invite trade stagnation. And in Anderson’s view, the Fed’s policy of price-level stabilization and various other interventionist policies undertaken by the United States and other countries had prevented prices from telling the truth about actual supply-and-demand conditions. Instead, price-level stabilization had created imbalances that were inevitably going to require a correction. Right after the stock-market crash, in November 1929, Anderson wrote: Basically, our present troubles grow out of the excessively cheap money and unlimited bank credit available for capital uses and speculation from early 1922, with an interruption in 1923, until early 1928. During this period we expanded the deposits of our commercial banks by thirteen and a half billion dollars, and their loans and investments by fourteen and a half billion. There is no intoxicant more dangerous than cheap money and excessive credit.… [But] when old-fashioned voices raised in protest, calling attention to old landmarks and old standards, raising prosaic questions regarding earnings and dividends and book value, they were drowned out by an indignant chorus, which chanted that we were in a "New Era," in which book values no longer meant anything, and dividends little, and in which we might capitalize earnings in any ratio that the imagination saw fit to set.… To the student of economic history, it is all painfully familiar. He has seen it many times, and in many markets.… There is no point in assigning any particular cause for the [stock market] break’s coming at the particular time it did. It was overdue, and long overdue. A great collapse was certain the moment that doubt and reflection broke the spell of mob contagion, while the fantastic structure of prices was doomed the moment any considerable number of people began to use pencil and paper. The goal of price-level stabilization had all been a great illusion, Anderson argued. Furthermore, he pointed out in "Commodity Price Stabilization a False Goal of Central Bank Policy" in May 1929: The general price level is, after all, merely a statistician’s tool of thought. Businessmen and 23
bankers often look at index numbers as indicating price trends, but no businessman makes use of index numbers in his bookkeeping. His bookkeeping runs in terms of the particular prices and costs that his business is concerned with.… Satisfactory business conditions are dependent upon proper relations among groups of prices, not upon any average of prices. What is important in the market, Anderson was arguing, are the relative price relationships, i.e., the prices for consumer goods relative to the prices of factors of production; the rate of interest as a cost of capital relative to the expected future rate of return from an investment; and the prices of consumer goods relative to the prices for capital goods. It is the pattern of relative demands for goods in comparison to the pattern of relative supplies of those goods that generates the structure of relative prices in the market. And it is this structure of relative prices that creates the margins of profitability that guide entrepreneurial decision-making in the use and allocation of resources and labor for the production of various types of consumer goods and capital goods. The general price level of commodities in the market is a statistical averaging of a selected group of the individual prices of these goods. And as a statistical average, the general price level submerges beneath its surface all of the individual price relationships that actually influence the use of resources and the production of goods. Beneath the "stability" of the general price level of the 1920s, Federal Reserve policy had manipulated interest rates through monetary expansion and had distorted the profit margins between different types of investments and between the relative profitability of manufacturing consumer goods in comparison to capital goods. These artificial relative price relationships created by Fed monetary policy had generated imbalances in the economy that were going to require readjustment and correction. As Benjamin Anderson explained in a later bulletin, issued in June 1931, entitled "Equilibrium Creates Purchasing Power: Economic Equilibrium vs. Artificial Purchasing Power," production and prices were out of balance; costs, including wages, were out of balance with the selling prices of goods on the market; and asset and capital values were out of balance with actual market conditions. The imbalances in these price, cost, and production relationships were revealed by the Depression. But Anderson insisted: The restoration of equilibrium cannot be accomplished by government planning. The power does not exist, and the wisdom does not exist, to regulate economic life by governmental edicts. The adjustments must be accomplished piecemeal by individual enterprises seeking to make profits and avert losses, guided by market prices.… But this mechanism works well only when prices are free to move, and tell the truth. Artificial valorization of commodities, whether accomplished by a government or by a private combination of producers, perverts the machinery and prevents the necessary adjustments. For Anderson, it was price and wage rigidities supported or enforced by the government that caused the severity of the Great Depression. By preventing or delaying the necessary adjustments in prices, wages, and production — and the relationships between them — the government hindered the normal working of competitive market forces from bringing the economy back towards a path of balance and growth. While Benjamin Anderson was one of the few economists in America who questioned the idea that general economic stability would result from a policy of price-level stabilization, in Europe there was a larger number of economists who challenged the arguments of people such as Irving Fisher. The most important among them were the Austrian economists, the leading figures among whom were Ludwig von Mises and Friedrich A. Hayek. They undermined all the theoretical assumptions supporting the price-level stabilization idea and showed why the policies introduced by governments in the 1930s 24
prolonged and intensified what became the Great Depression.
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Chapter 5 The Austrian Economists on the Origin and Purchasing Power of Money Even before the First World War, a number of prominent American economists had criticized Irving Fisher’s proposal for stabilization of the price level through monetary manipulation by the government. Frank Taussig of Harvard University, J. Laurence Laughlin of the University of Chicago, and David Kinley of the University of Illinois had forcefully argued that implementing Fisher’s scheme would generate more, not less, economic instability. But it was the Austrian economists who reasoned most persuasively against a price-level stabilization policy in the 1920s. To understand their criticisms of price-level stabilization, it is necessary to begin with Carl Menger, the founder of the Austrian school. In his Principles of Economics (1871) and in a monograph entitled "Money" (1892), Menger explained the origin of a medium of exchange. Often there are insurmountable difficulties preventing people from trading one good for another. One of the potential trading partners may not want the good the other possesses. Perhaps one of the goods offered in exchange cannot readily be divided into portions reflecting possible terms of trade. Therefore, the transaction cannot be consummated. As a result, individuals try to find ways to achieve their desired goals through indirect methods. An individual may first trade away the good in his possession for some other commodity for which he has no particular use. But he may believe that it would be more readily accepted by a person who has a good he actually wants to acquire. He uses the commodity for which he has no direct use as a medium of exchange. He trades commodity A for commodity B and then turns around and exchanges commodity B for commodity C. In this sequence of transactions, commodity B has served as a medium of exchange for him. Menger went on to explain that, over time, transactors discover that certain commodities have qualities or marketable attributes that make them especially serviceable as media of exchange. Some commodities are in greater general demand among a wide circle of potential transactors. Some commodities are more readily transportable and more easily divisible into convenient amounts to reflect agreed-upon terms of exchange. Some are relatively more durable and scarce and difficult to reproduce. The commodities that possess the right combinations of these attributes and characteristics tend to become, over a long period of time, the most widely used and readily accepted media of exchange in an expanding arena of trade and commerce. Therefore, those commodities historically became the money-goods of the market because the very definition of a money is that commodity that is most widely used and generally accepted as a medium of exchange in a market. Money begins as one of the ordinary commodities of the market. But because of its particular marketable qualities, it slowly comes to be demanded for its usefulness as a medium of exchange, as well. And, indeed, over time, its use as a medium of exchange may supersede its other uses as an ordinary commodity. Historically, gold and silver came to serve as the most widely accepted media of exchange — the money-goods of the market. For Menger and later members of the Austrian school, this was a strong demonstration, both theoretically and historically, that money is not a creation or a creature of the state. In its origin, money naturally emerges out of the processes of the market, as individuals search for better and easier ways to satisfy their wants through trade and exchange. 26
A second question that the Austrians asked was: Once a money is in use, how does one define its purchasing power or value in the market? First Menger and then Ludwig von Mises, in his book The Theory of Money and Credit (1912; 2nd ed., 1924), devoted careful attention to this question. In a state of barter, when every commodity directly trades for all the others, each good on the market has as many prices as goods against which it exchanges. But in a money-using economy, goods no longer trade directly one for the other. Instead, each good is first sold for money, and then with the money earned from selling commodities, individuals turn around and purchase other goods they wish to buy. Each good comes to have only one price on the market — its money price. But money remains the one exception to this. Money is the one commodity that continues to trade directly for all the other goods offered on the market. As a result, money has no single price. Rather, money has as many prices as goods with which it trades on the market. The purchasing power of money, therefore, is the array or set of exchange ratios between money and each of the other goods against which it trades. And the actual value of money at any moment in time is that set of specific exchange ratios that have emerged on the market through the trading of money for each of those other goods in the economy. By definition, the purchasing power or value of money is always subject to change. Anything that changes people’s willingness and ability to sell goods for money or to sell money for goods will modify the exchange ratios between money and goods. If people have a change in their preferences such that they now want to consume more chicken and less hamburger, the demand for chicken on the market would rise and the demand for hamburger would fall. This would change the relative price between chicken and hamburger, as the price of chicken tended to go up relative to the price of hamburger. But at the same time, it would also change the purchasing power or value of money, since now the money price of chicken would have increased and the money price of hamburger would have decreased. The array or set of exchange ratios between money and other goods on the market would, therefore, also now be different from what they were before. Suppose, instead, that people had a change in their preferences and wanted to demand fewer goods and wanted to hold a larger amount of the money they earned from selling goods as an available cash balance for some future exchange purposes. The demand for goods would decrease and the demand for holding money as a cash balance would increase. The money prices of goods would tend to decline, raising the purchasing power or value of each unit of money, since at lower money prices, each unit of money would command a greater buying power over goods offered on the market. Unless people decreased their demand for goods proportionally, at the same time that the value of money was rising, the relative prices among goods would change, as well. Why? Because if the demand for, say, chicken decreased more than the demand for hamburger, then even at the overall lower scale of money prices, the money price of chicken will have tended to decrease more than the money price of hamburger. The structure of relative prices would have changed as part of the same process that had changed the scale or level of money prices in general. Irving Fisher’s proposal, therefore, to "stabilize, or standardize, the dollar just as we have already standardized the yardstick, the pound weight, the pint cup.…" was built on a false analogy. But the purchasing power or value of money is not a fixed unit of measurement. It is composed of a set of exchange ratios between money and other goods, reflecting the existing and changing valuations of the participants in the market about the desirability and their demand for various commodities relative to the attractiveness of spending money or holding it as a cash balance of a certain amount. In The Theory of Money and Credit and his later monograph, "Monetary Stabilization and Cyclical Policy" (1928), Ludwig von Mises also challenged Irving Fisher’s proposal for measuring changes in the purchasing power of money through the use of index numbers. A consumer price index, for example, is constructed by selecting a group of commodities chosen as "representative" of the normal 27
and usual types of goods bought by an average family within a particular community. The items in this representative basket of consumer purchases are then "weighted" in terms of the relative amounts of each good in the basket that this representative family is assumed to purchase during any normal period. The prices for these goods times the relative quantities bought of each one is then defined as the cost of purchasing this representative basket of consumer items The prices of these goods, multiplied by the fixed relative amounts assumed to be bought, are tracked over time to determine whether the cost of living for this representative consumer-family has increased or decreased. Whether or not the sum of money originally required to buy the basket at the beginning of the series is able to buy a larger, smaller, or the same basket at a later period is then taken to be a measure of the extent to which the purchasing power or value of money has increased, decreased, or stayed the same. Mises argued that the construction of index numbers, rather than being a supposedly precise method for measuring changes in the purchasing power of money, was in fact a statistical fiction built on arbitrary assumptions. The first of these arbitrary assumptions concerned the selection of goods to include in the basket and the relative weights to assign to them. Preferences for goods vary considerably among individuals, including among individuals in similar income and social groups or geographic locations. Which group of goods to include, therefore, can claim no scientific precision, nor can the judgment concerning the relative quantities labeled as "representative" in the basket. The second arbitrary assumption also concerns the "weights" assigned to the goods in the basket. It is assumed that over the periods compared, the same relative amounts purchased in the beginning period are purchased in future periods. But in the real world of actual market transactions, the relative amounts of various goods purchased are always changing. People’s preferences and desires for goods are constantly open to change. Even when people’s basic preferences for goods have not changed, in the real world the relative prices of various goods are changing. People tend to buy less of goods that are rising in price and more of goods decreasing in price or more of those not rising in price as much as others. The third arbitrary assumption is that new goods are not being offered on the market and that older goods are being taken off the market. But both occurrences are common and modify the types and quantities of goods in a consumer’s basket. The fourth arbitrary assumption concerns changes in the qualities of the goods offered for sale on the market. A good that improves in quality but continues to be sold at the same price is now a cheaper good, i.e., the consumer now gets more for his money. But the index records no increase in the value of the consumer’s dollar. A good may rise in price and, at the same time, be improved in its quality. But there is no exact way to determine how much of the higher price may be due to the product’s being better and how much may just be due to other changes in its supply and demand conditions that have occurred at the same time. Ludwig von Mises’s conclusion, therefore, was that there is no scientific way of knowing with any precision whether and by how much the purchasing power or value of money may have changed over a given period of time. Thus, the statistical method considered by Irving Fisher to be the key for guiding monetary policy for purposes of stabilizing the price level was fundamentally and irreparably flawed. But whether the construction and application of index numbers was flawed or not, stabilization of the price level became a guiding target for the Federal Reserve in the 1920s. And that policy became a prime ingredient for creating the imbalances in the market that resulted in the Great Depression.
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Chapter 6 Ludwig von Mises and the Non-Neutrality of Money In the late 1850s, the British economist John E. Cairnes published a series of articles analyzing the sequence of events that followed the gold discoveries in Australia. He explained that the increase in gold had its first impact on prices in the coastal towns and cities of Australia, where the miners first spent their new supplies of gold as money. The increased money demand for goods and services stimulated additional imports into Australia. The Australian merchants paid for these increased stocks of goods with the new gold paid to them by the miners. As the gold entered and then was spent in the European markets, prices for goods and services began to rise there, as well. Manufacturers in Europe, in turn, increased their demand for resources and raw materials from Asia and Africa, paying for them with portions of the new gold that had passed into their hands. Prices then began to rise in those other parts of the world. The increase in gold supplies had brought about a general rise in prices in various parts of the world. But the rise in prices had followed the particular pattern of where the additional gold supplies had first been introduced into the market; then it followed the sequence of expenditures and receipts that reflected the increases in the demand for commodities and resources in the actual order of who received the new gold-money first, second, third and so on, and for what market purposes the gold was spent by those groups of people through time. Changes in the quantity of money have long been understood as a primary long-run influence on the rise or decline of prices in general. But the particular method of analysis used by different economists has not only affected the explanation of money’s effects on an economy, it has influenced various policy conclusions drawn from this analysis as well. In The Purchasing Power of Money (1911) and many of his other works, Irving Fisher presented a rather "aggregated" analysis. As we saw earlier, Fisher argued that an increase in the supply of money tended to bring about a rise in selling prices in general, relative to the costs of production. The temporary increase in profit margins between selling prices and costs (due to input prices’ being fixed for a period of time by contract) acted as the stimulus for attempts to increase output. But when contracts came up for renewal and were revised upwards, profit margins would return to "normal" and the "boom" phase of the business cycle would end. It would be followed by a period of correction, in the wake of businessmen’s discovering that their over-expansive plans were unsustainable; this was the downturn or depression phase of the business cycle. Fisher concluded that the cause and sequence of the business cycle were the result of unanticipated increases in the money supply that made selling prices rise relative to cost prices. His policy prescription was to keep the price level stable. If that were done, he argued, price-cost relationships would be kept in proper order, at least to the extent they were influenced by monetary forces. And that, in turn, would mitigate, if not eliminate, the primary cause behind the business cycle. An alternative method of analysis for explaining money’s influence on prices and production was in the tradition represented by John E. Cairnes. In this alternative approach, the analysis is "disaggregated" into a study of money’s impact on the economy through tracing the particular path by which changes in the money supply are introduced into the economy and the sequence of events through time by which the change in the money supply passes from one individual to another and from one sector of the economy to another. 29
This alternative tradition of monetary analysis is the one followed by the Austrian economists, the leading expositor of whom was Ludwig von Mises. He developed this approach in The Theory of Money and Credit (1912, 2nd ed., 1924), in "Monetary Stabilization and Cyclical Policy" (1928), and in his comprehensive treatise on economics, Human Action (1949). If increases or decreases in the quantity of money brought about simultaneous and proportional increases and decreases in all prices, changes in the supply of money would be neutral in their effects on the economy. That is, neither the structure of relative prices nor the patterns of relative income shares earned by individuals and groups in the society would be affected by changes in the quantity of money. Money’s effect on the economy would be nominal and not real. Mises and the Austrians argued that money’s impact on the market was always non-neutral in its effects. Economists such as Irving Fisher reasoned that the non-neutrality of money was due only to the fact that changes in the money supply were less than fully anticipated, and as a result, resource and labor contracts did not completely incorporate the actual average rate of price changes into resource prices and wage negotiations. Hence, cost prices would temporarily lag behind selling prices, creating temporary profit differentials. The Austrians, on the other hand, insisted that money would be non-neutral in its effects even if resource prices and wages were as flexible as selling prices and even if market participants were to fully anticipate the average rate of change in the general price level as measured by a price index. The reason for that was the Austrians’ method of analysis. Mises pointed out that any change in market conditions must ultimately have its beginning in the circumstances of one or more individuals. Nothing happens in the market that does not start with the decisions and choices of acting individuals. If there is an increase in the supply of money, it must necessarily take the form of an increase in the cash holdings of particular people, who are the starting point of the resulting social consequences of a change in the quantity of money. Finding themselves with a greater amount of cash than they normally find it advantageous to hold, they will proceed to spend that "surplus" cash on the specific goods and services they find it attractive and profitable to buy. The demand for goods and services in the market now begins to rise because of the increase in the money supply. But it is not all demands that initially increase, but only the particular demands for the particular goods that the individuals with the additional cash balances wish to purchase in greater quantities. Prices start to rise, but in this "first round" of the process, it is only the prices of the particular goods for which there has been an increased demand. As the money is spent on those particular goods, the resulting sales become additional money receipts for the sellers of those goods. Those sellers now find their cash positions improved, enabling them to increase their demands for various goods and services offered on the market. There is now a "second round" increase in prices, but again the prices affected in this second round are those of the goods for which this second group of recipients of the new money wish to increase their demand. The money spent in the second round becomes additional money receipts for another group of sellers. These sellers, likewise, find their cash position improved, enabling them, in turn, to increase their demands for various goods and services on the market. That now results in a "third round" increase in prices, but once again for the particular goods for which they have increased their demand. The process will continue until the demand for all goods and services in the economy, in principle, will have been affected, with all prices to one extent or another having been changed by the monetary expansion. Prices in general will now be higher, but they will each have been impacted by the monetary increase in a particular sequence, to a different degree, and at different times in the process. The fact that the monetary change works its way through the economy in a particular temporal sequence means that relative price relationships in the market will have been modified. The sequential price-increase differentials modify the relative profitabilities of producing various goods, which in turn influence the demand for and the allocation of resources and labor among the various sectors of the 30
economy. As long as the inflationary process is working its way through the market, the patterns of demand for goods and services and the distribution of the factors of production are different from what they were before the inflationary process began and are different from what they will be when the inflationary process has reached its end. At the same time, the very fact that the prices for those goods and resources (including labor) are changing in a non-neutral manner means that income and wealth are redistributed among individuals and groups as an integral part of the monetary process. Those who receive the increases in the money supply earlier in the inflationary process are able to purchase more goods and services before the full price effect on the economy has materialized. On the other hand, those whose demands and incomes are only impacted by the monetary expansion much later in the sequential process find themselves having to pay higher prices for many of the goods they buy, while their own prices and wages have either not increased at all or not to an extent equal to the general rise in prices. That inevitably creates groups of net gainers and net losers during the sequential-temporal process following changes in the money supply. Any anticipation by the participants in the market of the increase in the average level of prices remains just that — a statistically calculated average of the individual price changes. Both during an inflationary (or deflationary) process and at its end, some prices will have increased (or decreased) more than the average and some less than the average. For money to be neutral during an inflationary (or deflationary) process, it would be necessary for each participant in the market to correctly anticipate when and to what extent the demand and the price for his particular resource (including labor services) would be affected by the monetary expansion (or contraction) in the particular temporal sequence of that historically distinct time frame. This clearly involves a greater degree of knowledge than can ever be possessed by agents in the market. Nor is the non-neutrality of money dependent upon the fact that the prices for many types of resources and labor services are fixed by contract for various periods of time. Even if they were not, in the temporal-sequential stages of an inflationary (or deflationary) process, the prices for different goods are affected at different times, necessarily modifying the relative profitabilities of producing those different goods. It is those price-differential effects that influence producers to change their production decisions during an inflation (or deflation) and not merely the fact that some prices and wages are fixed by contract. Likewise, it is not the unanticipated changes in the money supply per se that cause money to be non-neutral, and, therefore, to have real output and employment effects on the economy. Rather it is the fact that monetary changes work their way through the economy in a manner that necessarily cannot be fully anticipated and that actually modifies the relative prices of goods and the relative incomes positions among individuals and groups as an inherent part of any inflationary or deflationary process. If any monetary change is always non-neutral in its effect on the market, then changes in the money supply by the government’s monetary authority in an attempt to maintain a "stable" price level can itself be a destabilizing force in an economy. And this, in fact, was the argument made by Mises’s fellow Austrian economist, Friedrich A. Hayek.
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Chapter 7 Friedrich A. Hayek and the Destabilizing Influence of a Stable Price Level One indication of rising standards of living in a society is increases in the quantity and quality of goods available to the consuming public. For example, during the 20-year period from 1880 to the turn of the century, there occurred a dramatic increase in the productive capacity of the U.S. economy, matched by an equally significant expansion of goods and services. In their Monetary History of the United States, 1867–1960 (1963), Milton Friedman and Anna Schwartz pointed out: The two final decades of the nineteenth century saw a growth of population of over 2 per cent per year, rapid extension of the railway network, essential completion of continental settlement, and an extraordinary increase both in the acreage of land in farms and output of farm products. … At the same time, manufacturing industries were growing even more rapidly. As a result, between 1879 and 1897, real net national product increased at an average annual rate of about 3.7%, with per capita net national product increasing at a 1.5% annual average rate during this period. The improvements in productive capacity and output, of course, did not occur evenly year by year. During this period, the United States experienced several severe economic downturns, sometimes related to the uncertainties surrounding the political battles of the time concerning whether America would remain on a gold standard or shift to a bi-metallic standard of gold and silver. But what is also interesting about this period of rapid industrial growth and rising standards of living in American history is that it occurred during a time when prices in general were falling. Between 1865 and 1899, the average level of prices declined more than 45%. From 1880 to 1897, prices in general declined by more than 22%, or 2%-3% each year. "Economic growth," as Milton Friedman later observed, "was entirely consistent with falling prices." Assuming that there is neither an increase in the supply of money nor a decrease in the demand for money, it is inevitable that increases in productivity and output and, therefore, the quantities of goods and services offered on the market will result in the prices of those goods and services decreasing. Given the demand for any commodity, an increase in its supply will result in a decrease in its price if every good that is offered for sale is to attract enough buyers to take it off the market. If improvements in productivity and increases in output are occurring in many sectors of the economy more or less at the same time, then many prices will be decreasing, each one sufficiently so to bring supply and demand into balance in its respective market. If statistical averages of market prices are calculated before and after these increased supplies of goods have been placed on the market, they will show that there has occurred a decline in the general "price level" of goods and services. The market will have experienced a "price deflation." But it should be clear that there is nothing inherently harmful in this type of deflationary process. If an entrepreneur introduces a technological innovation to lower his costs of production, it is because he hopes to be able to make a commodity for less, so he can offer it for a lower price and still reap larger profits. The price decline is part of his plans. Even if it is competition over time from his market rivals that causes him to fully lower his price to his now-lower costs of production, there are no negative consequences for the economy. Competition will have done its job — to compete prices down to the lowest level consistent with the most efficient costs of manufacturing. 32
It is, of course, possible that an entrepreneur might overestimate the larger quantity that will be demanded at the lower price. As a consequence, his total revenue will be less than before he introduced cost efficiencies into his operation. This means that consumers value other goods on the market more than his particular product. For example, suppose his old price was $10 and he had been selling 100 units of his commodity each month. His monthly total revenue would have been $1,000. Suppose the new price is $9 and he sells 105 units per month; his total revenue would now be $945. Consumers would be buying more of his good but economizing $55 while doing so. The consumers would shift their saved dollars towards increased purchases of other things that previously they could not afford to buy. Suppose that an entrepreneur in another market has also introduced cost efficiencies into his line of production. Previously, he sold 200 units of his commodity each month at a price of $16 a piece, for a total revenue of $3,200. Now he prices the good at $15 and sells 217 units each month, for total revenues of $3,255. Consumers will be buying more of this second good, as well, and paying for the additional quantities bought with the $55 saved on the first good. Previously consumers spent a total of $4,200 on the two goods and obtained 100 units of the first good and 200 units of the second. After cost efficiencies in production have lowered prices, they still spend a total of $4,200 on the two goods, but now they are able to buy 105 units of the first good and 217 units of the second. Their standard of living has improved through an increase in the real buying power of the dollars in their possession. In the jargon of the economist, the demand for the first good was inelastic (at the lower price, total revenue was less than before), while the demand for the second good was elastic (at the lower price, total revenue was more than before). As a result, it may be necessary for some of the resources, including labor, to be let go in the manufacture of the first good and be reemployed in the market where the second good is produced. There is simply no way to get around this in the long run. Changes in demand or supply always carry with them the need to modify what goods are produced, where they are manufactured, and with what combinations of resources they are to be produced. It is part of the price people pay in a free society for improvements in the quantities and qualities of the goods and services offered on the free market. If there is an attempt to prevent prices from adjusting to their market-clearing levels in the face of cost efficiencies and greater supply, the result can only be imbalances and distortions in the market. Eventually the adjustments must conform to the reality of supply and demand. Delaying or retarding them only builds up a backlog of needed market changes that will be more severe and sharper in their effects than if the necessary incremental adjustments had been allowed to occur as they slowly manifested themselves through time. In the late 1920s and early 1930s, Austrian economist Friedrich A. Hayek argued that the policy of price-level stabilization was creating such imbalances in the market by preventing a fall in prices in the face of cost efficiencies and greater supplies of goods offered in the market. He made this case in an essay, "Intertemporal Price Equilibrium and Movements in the Value of Money" (1928), and in two books, Monetary Theory and the Trade Cycle (1929) and Prices and Production (1931) . Hayek said that if a proper balance between supplies and demands was to be maintained through time, then the price of each good had to reflect the actual supply and demand conditions in existence in the various markets during each time period. Any attempt to "stabilize" the price of a good or a set of goods at some given "level" across time, in spite of differing market conditions that might arise as time passed, would set in motion market responses that would be "destabilizing." If, for example, the supply of a good was going to be greater in the future than today because of the introduction of some productive innovation that would lower costs, and if equilibrium was existing in that future period as well as in the present period, then the price of that good in the future period (assuming given demand conditions) would have to be lower than the price in the present period. If the good’s future price was to be "stabilized" across time at the "level" that prevailed in the present, the 33
future expected profit margins would be greater than if natural market forces had been at work competing the price down to reflect the new, lower costs of production. The "stabilized" higher price in the future period would tend to induce an excess production of the good in comparison to what the "real" supply and demand conditions would dictate, and this "surplus" would eventually create a destabilizing effect in this market. What was true for any particular good would be true for a situation in which there is a general expansion of output due to falling costs across many markets. If each price in this situation is permitted to find its proper equilibrium level, then as measured by some statistical averaging, the general "price level" would decline. But the structure of relative prices would keep the various supplies and demands in balance across time. However, through most of the 1920s, the Federal Reserve expanded the money supply in an attempt to prevent prices from falling in the face of increasing supplies of goods resulting from cost efficiencies in the methods of production. The monetary expansion created a situation in which the prices for various goods and services in the market were above what they would have been but for the increase in the money supply. Suppose, using our previous example, that both of our two entrepreneurs had lowered their costs by $1 per unit, enabling them to lower their prices from $10 and $16 to $9 and $15 respectively. But now suppose that the government monetary authority increases the money supply by $322 and distributes this sum among consumers in a manner that enables them to buy 5 more units of the first good and 17 more units of the second good at the original prices of $10 and $16 respectively. The first entrepreneur will now earn total revenues of $1,050 instead of $945, and the second entrepreneur will earn total revenues of $3,472 instead of $3,255. Our two entrepreneurs would be earning, respectively, additional profits of $105 and $217, with total spending on the two goods being $4,522 instead of $4,200. The artificially maintained selling prices and the larger earned profits would now stimulate these entrepreneurs to try to expand their respective outputs to, say, 110 and 225 units. But for consumers to be able to buy these larger quantities at the original prices of $10 and $16, total consumer spending would have to be $4,700 ($1,100 for the first good and $3,600 on the second good). If the money supply was not expanded another $178 by the time the additional quantities of goods were offered on the market, the entrepreneurs would discover that they had increased their supplies on the market in excess of the consumers’ ability to buy them at the original prices of $10 and $16. Furthermore, in the process of attempting to expand their outputs because of the stimulus of greater profits, the entrepreneurs would have to attract resources and labor away from other sectors of the economy if they were to increase their levels of production. Part of the additional profits earned, therefore, would have to be expended as higher resource prices and wages to bid them away from their alternative employments in other parts of the economy. But unless there were to be a change in the patterns of consumer demand, when the resource owners and workers earned the higher input prices and wages, they would spend them not on buying the larger quantities of the two goods that were now available on the market, but rather on other goods they preferred to buy. As result, it would be discovered that too many of the two goods were being supplied on the market and too few of other commodities. The market would then have to go through a "correction" in which output was cut back in the two sectors of the economy that had originally experienced the cost efficiencies, and resources and labor would have to be reallocated back to other sectors of the economy where consumer demand was greater. The false appearance of economic stability with a stabilized "price level" would be hiding the fact that the monetary expansion that stabilized the price level was in fact distorting profit margins and creating imbalances in the relative supplies of various goods offered on the market. The Austrian economists then combined their theory of money with their theory of capital and 34
interest to develop what became known as the Austrian theory of the business cycle.
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Chapter 8 The Austrian Theory of Capital and Interest Time is an element inseparable from the human condition. Everything we do involves time. Just reading this chapter requires the use of a period of time. And the period taken up with reading it is not available to do other things that instead could be done with this slice of life. The importance of time in the processes of production and in the evaluation of choices has been especially emphasized by many of the members of the Austrian school of economic thought, beginning with Carl Menger, the founder of the school. But among the early members of the Austrian school, it was Eugen von Böhm-Bawerk who developed the first detailed analysis of the role of time in the processes of production and the process of human choice. The first two volumes of his master work on this theme, Capital and Interest, were published in the 1880s. The third volume, mostly replies to his critics, appeared in its final edition in 1914, shortly before his death. The other major contributor to the Austrian theory of time in the early years of the 20th century was the American economist Frank A. Fetter. His analysis of the process of "time-valuation" was presented in two treatises: The Principles of Economics (1904) and Economic Principles (1915). During the 1930s and 1940s, additional contributions were made by the following Austrian economists: Friedrich A. Hayek in Prices and Production (1931) and The Pure Theory of Capital (1941); Richard von Strigl in Capital and Production (1934); and Ludwig von Mises in Nationalökonomie (1940) and Human Action (1949). Every one of our actions requires us to think about time and to act through time. Whether it is boiling an egg or constructing a spaceship to the stars, we are confronted with the necessity of waiting for the desired result to be forthcoming. We apply various means at our disposal that seem most appropriate to the tasks at hand and we try to bring about the desired ends we have in mind. But the cause (the application of the means) always precedes the effect (the resulting end or goal); and between the initiating of that cause and its resulting effect, there is always a period of time, whether that time period is merely a few minutes or many years. Each of our plans, therefore, contains within it a period of production. Rarely, however, can our production plans be completed in one step. Usually the resources at our disposal must go through various transformations in a number of stages of production before the consumer goods that we want are ready for use in their desired, finished form. A tree must be chopped down in the forest. The wood must be transported to and cut in the lumber mill. The cut wood must be taken to the pulp factory and manufactured into paper. The paper must be boxed and shipped to the printing shop. The paper must be cut to size and the print must be applied to the separate pages to produce a book that gets into your hands after it has been sent to you through the mail. What is expressed in this simple example has its analog in every line of production for the manufacturing of every conceivable good. To undertake these processes of production, however, requires a certain amount of savings. Resources and raw materials that might otherwise have been used to satisfy some of our wants in the more immediate present must be freed for more time-consuming production activities. First, some of these resources must be available for transformation into capital goods — tools, machinery, and equipment — with which workers who are not employed in the more direct manufacture of consumer goods can combine their efforts in more time-consuming or "round-about" production processes. Second, resources and consumer goods must be available for use by those employed in the production 36
processes. The more savings there is, the more numerous the processes of production that can be undertaken in society-and the longer they can be. And as a result, the greater will be the quantities and the qualities of the goods that will be available for our consumption uses in the future. Why? Because other things being equal, the more time-consuming or "round-about" the production process, the more productive (usually) are the resulting methods of production. However, the longer the periods of production we utilize, the longer we have to wait for the desired goods we wish to use or consume. People, therefore, have to evaluate the sacrifice, in terms of waiting, they are willing to make to get a potentially greater and more desired effect that can only be attained by producing for a time further into the future. The sacrifices of time people are willing to make often differ among individuals. And these differing evaluations of time open up opportunities for potential gains from trade. Those who are willing to defer consumption and the uses of resources in the present may find individuals who desire access to a larger quantity of resources and goods than their own income and wealth provides them with in the present. And this second group of people may be willing to pay a price in the future for the use of those resources in the more immediate present. An intertemporal price emerges in the market as transactors evaluate and "haggle" over the value of time and the use of resources. The rate of interest is that intertemporal price. The rate of interest reflects the time preferences of the market actors concerning the value of resources and commodities in the present in comparison with their value in the future. As the price of time, the rate of interest brings into balance the willingness to save by some with the desire to borrow by others. But the rate of interest not only coordinates the plans of savers and investors. It also acts as a "brake" or "regulator" on the lengths of the periods of production undertaken with the available savings in the society. For example, suppose we were to ask, what are the respective present values of a $100 return on investment either one year, two years, or three years from now, with a market rate of interest of, say, 10%? They would be, respectively, $90.91, $82.64, and $75.13. Now, suppose that people in the society had a change in their time preferences such that they now chose to save more, with the resulting greater supply of savings available for lending purposes decreasing the rate of interest to 7%. What, again, would be the present values of that $100 return on investment one, two, and three years from now? The present values would be, respectively, $93.46, $87.34, and $81.63. The present value will have increased for all three of these potential investments, with their different time horizons. But the percentage increases in the present values of these three possible investment horizons would not be the same. On the one-year investment project, its present value will have increased by 2.8%. On the two-year investment project, its present value will have increased by 5.7%. And on the three-year investment, its present value will have increased by 8.6%. Clearly, the tendency from a fall in the rate of interest would be an increase in investments with longer periods of production. If, instead, time preferences were to move in the opposite direction, with people choosing to save less, with a resulting increase in the rate of interest, longer-term investments would become relatively less attractive. If the rate of interest were to rise from 7% to 10%, the present values on a $100 return either one, two, and three years from now would decrease, respectively, by 2.7%, 5.4%, and 8%. This would make investments with shorter periods of production appear relatively more attractive. In an economy experiencing increases in real income, decisions by income-earners to save a larger proportion of their income need not require an absolute decrease in consumption. Suppose incomeearners’ time preferences were such that they normally saved 25% of their income. Out of an income of, say, $1,000, they would be saving $250. If their preference for saving were to rise to, say, 30%, with a given income of $1,000, their consumption would have to decrease from $750 to $700 to increase 37
their savings from $250 to $300. However, if income-earners were to have an increase in their real income to, suppose, $1,100 and their savings preference were to increase to that 30%, then they would now save $330 out of their higher income. But consumption would also rise to $770. This is the reason why savings can increase for new capital formation and investments in even longer periods of production without any absolute sacrifice of consumption in a growing economy. Consumption increases with the higher real income, albeit less than it could have if income-earners had not chosen to save a greater percent of their income. But if there were a decline in the demand for consumer goods and an increase in savings, what would be the incentive for producers to invest in more capital and productive capacity? This was a criticism leveled against Böhm-Bawerk at the beginning of the 20th century by an economist named L.G. Bostedo. He argued that since it is market demand that is the stimulus for manufacturers to produce and bring goods to the market, a decision by income-earners to save more and consume less destroys the very incentive for undertaking new capital projects that greater savings is supposed to facilitate. Bostedo concluded that greater savings, rather than being an engine for increased investment, served to retard investment and capital formation. In 1901, in an article entitled "The Function of Savings," Böhm-Bawerk replied to this criticism. "There is lacking from one of his premises a single but very important word," Böhm-Bawerk pointed out. "Mr. Bostedo assumes … that savings signifies necessarily a curtailment in the demand for consumption goods." But, Böhm-Bawerk continued, Here he has omitted the little word "present." The man who saves curtails his demand for present goods but by no means his desire for pleasure-affording goods generally.… For the principle motive of those who save is precisely to provide for their own futures or for the futures of their heirs. This means nothing else than that they wish to secure and make certain their command over the means to the satisfaction of their future needs, that is over consumption goods in a future time. In other words, those who save curtail their demand for consumption goods in the present merely to increase proportionally their demand for consumption goods in the future. But even if there is a potential future demand for consumer goods, how shall entrepreneurs know what type of capital investments to undertake and what types of greater quantities of goods to plan to offer on the market in preparation for that higher future consumer demand? Böhm-Bawerk’s reply was to point out that production is always forward-looking — a process of applying productive means today with a plan to have finished consumer goods for sale tomorrow. The very purpose of entrepreneurial competitiveness is to constantly test the market, so as to better anticipate and correct for existing and changing patterns of consumer demand. Competition is the market method through which supplies are brought into balance with consumer demands. And if errors are made, the resulting losses or smaller-than-anticipated profits act as the stimuli for appropriate adjustments in production and reallocations of labor and resources among alternative lines of production. When left free, Böhm-Bawerk argued, the market successfully assures that demands are tending to equal supply and that the time horizons of investments match the available savings needed to maintain the society’s existing and expanding structure of capital in the long run.
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Chapter 9 The Austrian Theory of the Business Cycle The Austrian theory of the business cycle was first developed by Ludwig von Mises. He built the theory on the earlier contributions of his Austrian teacher, Eugen von Böhm-Bawerk, and the writings of the Swedish economist Knut Wicksell. We saw that the Austrian economists, especially beginning with Böhm-Bawerk, had emphasized that all production takes time and that every production process necessarily involves a period of production from the time a production process is undertaken to the time when a finished good is ready for sale and ultimate use by the consumer. The Austrians also explained that for time-consuming processes of production to be undertaken, savings was needed. Savings was needed to free up resources from more direct consumption uses so that they would be available for investment in the formation and maintenance of capital and for supplying goods and resources to sustain those employed in "roundabout" production processes. Savings arose out of the time preferences of market participants who were willing to forgo present uses and consumption of goods and resources and transfer them to those who wished to utilize those goods and resources in the processes of production. The market interactions of suppliers of and demanders for those resources generated market rates of interest that balanced savings with investment. At the same time, the available savings resulting from the intertemporal market exchanges set the limits on the periods of production that could successfully be undertaken and maintained, given the fund of savings available to sustain them in the long run. In 1898, Wicksell published Interest and Prices. He adapted Böhm-Bawerk’s theory of capital and time-consuming processes of production and took it a step further. Wicksell explained that in actual markets, goods do not trade directly one for the other. Rather, money serves as the intermediary in all transactions, including the transfer of savings to potential borrowers and investors. Individuals save in the form of money income not spent on consumption. They then leave their money savings on deposit with banks, which serve as the financial intermediaries in the market’s intertemporal transactions. Banks pool the money savings of numerous people and lend those savings to credit-worthy borrowers at the rates of interest that come to prevail in the market and that balance the supply of the savings with the investment demand for it. The borrowers then use the money savings to enter the market and demand the use of resources, capital, and labor by offering money prices for their purchase and hire. Thus, the decrease in the money demand and the lower prices for consumer goods due to savings — and the increased demand and the higher money prices for producer goods due to investment borrowing — act as the market’s method to shift and reallocate resources and labor from consumption purposes to capital-using production purposes. But Wicksell pointed out that precisely because money served as the intermediary link in connecting savings decisions with investment decisions, there could result a peculiar and perverse imbalance in the savings-investment process. Suppose that the savings in the society was just sufficient to sustain the undertaking and completion of periods of production of one year in length. Now suppose that the government monetary authority in that society were to increase the amount of money available to the banks for lending purposes. To attract borrowers to take the additional lendable funds out of the market, the banks would lower the rates of interest at which they offered to lend to borrowers. The lower market rates of interest due to the monetary expansion would raise the present value of investment projects with longer time-horizons until their completion. Now suppose that borrowers were consequently to undertake investment projects that involved a period of production of two years in 39
length. Because of their increased money demands for resources and labor for two-year investment projects, some of the factors of production would be drawn away from one-year investment projects. As a result, at the end of the first year, fewer consumer goods would be available for sale to consumers. With fewer consumer goods on the market at the end of the first year, the prices of consumer goods would rise and consumers would have to cut back their purchases of consumer goods in the face of the higher prices. Consumers, Wicksell said, would be forced to save, i.e., they would have to consume less in the present and wait until the second year had passed and the two-year investment projects had been completed to have any greater supply of goods to buy and consume. At the same time, the greater supply of money offered for resources and goods on the market would be tending to increase their prices and, as a consequence, the society would experience a general price inflation during this process. If the government monetary authority were to repeat its increase of the money supply time-period after time-period, there would be set in motion what Wicksell called an unending "cumulative process" of rising prices. In his book The Theory of Money and Credit (1912, 2nd ed., 1924), Ludwig von Mises accepted the general outline of Wicksell’s analysis of the effect of a monetary expansion on production and prices. But he took Wicksell’s idea further and demonstrated the process by which a monetary expansion of this type eventually created an "economic crisis" and generated the sequence of events known as the "business cycle." Mises distinguished between two types of credit offered on the market: "commodity credit" and "circulation credit." Mises’s student and early follower in applying the Austrian theory of the business cycle, Fritz Machlup, called these two types of credit "transfer credit" and "created credit." And it is this latter terminology that we will use because it more clearly designates the distinction that Mises was trying to make. If there were no increase in the money supply, then any money savings out of income would represent a real transfer of market control over resources and labor from income-earners to potential investors. Savers will have lent a quantity of real resources represented by the monetary value of those real resources in investment activities instead of using them more directly and immediately in the manufacture of consumer goods. This "transfer credit" of real resources for investment purposes would be returned to savers when the money loans were paid off with the agreed-upon interest. The returned sum of money would then have the capacity to purchase a greater quantity of real goods and services for consumption purposes. And the investment projects undertaken with the transfer credit would have time horizons consistent with the available savings and the period over which the loans were made. However, the government monetary authority has the capacity to disrupt this fairly tight fit between savings and investment that is kept in balance by the market-determined rates of interest. Through its ability to expand the money supply, the monetary authority has the power to create credit for lending purposes. The "created credit" is indistinguishable from transfer credit for purposes of market transactions. It represents additional units of the medium of exchange that are interchangeable with all other units of money offered on the market in trade for various goods and services. And thus those units are just as readily accepted in market transactions as the units of the money supply in existence before the monetary expansion. Yet, Mises argued, there is this important difference: there is no compensating decrease in consumer demand for goods, services, and resources that normally follows from a decision to save more than previously, to counterbalance the increased demand for the use of resources and labor by investment borrowers who have taken the created credit offered to them on the loan market. At this point, Mises applied his theory of the non-neutrality of money to explain the sequence of events that were likely to logically now follow. With the newly created credit, the investment borrowers would bid resources and labor away from the production of consumer goods and investment projects with shorter time-horizons to begin the undertaking of investment projects with lengthier periods of 40
production. To attract resources and labor into the more time-consuming investment activities, investment borrowers would have to bid up the prices of the required factors of production so as to draw them away from their alternative uses in the economy. The newly created credit now passes to those factors of production as higher money incomes. They become the "second-round" recipients of the newly created money. Unless those factors of production were to undergo a change in their time preferences, and therefore in their willingness to save, their real demand for consumer goods would be the same as it was before the increase in the money supply. They would, therefore, increase their money demand for finished goods and services in the same proportion out of income as before. As a result, the prices for consumer goods would start to rise as well. But because of the reallocation of resources away from consumer goods production, the quantities of such goods available on the market are smaller than before, which intensifies the rise in the prices of consumer goods. As the factors of production expend their higher money incomes on desired consumer goods, the sellers and producers of those goods become the "third round" recipients of the newly created money. Producers of consumer goods now increase their demand for the same scarce factors of production to draw them back into the consumer goods sectors of the economy and into investment projects with shorter timehorizons to more quickly try to satisfy the greater money demand for consumer goods. The factors of production drawn back into activities closer to the final consumer stage of production become the "fourth-round" recipients of the newly created money. Those who initially had taken the created credit off the loan market now find it increasingly difficult to continue with and complete some of their longer-term investment products in the face of the rising costs of continuing to employ the required quantities of factors of production that are moving back to the consumer goods sectors of the economy. A "crisis" begins to emerge as growing numbers of these longer-term investment projects cannot be financially continued. The demand for more additional lendable funds from banks to continue projects that were begun, pushes market rates of interest up, creating an even greater crisis in the investment sectors of the economy. The expansionary or "boom" phase of the business cycle now turns into the contractionary or "depression" phase of the cycle, as a growing number of the lengthier investment projects collapse, are left incomplete, and result in a malinvestment of capital in economically unsustainable lengthier processes of production. The only way some of those investment activities could be temporarily saved would be for the government monetary authority once again to increase the money supply in the form of more created credit. But that would merely set the same process in motion again with the same inevitable result further down the road. And if the monetary authority were to try to prevent this inevitable result through greater and greater increases in the money supply, the end result would be a higher and higher rate of price inflation that would threaten the destruction and collapse of the society’s monetary system. Mises’s conclusion from his analysis was that the causes of the business cycle in modern society are not to be found in some fundamental flaw in the market economy. Rather its basic cause is to be found in government manipulation and mismanagement of money and credit.
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Chapter 10 Austrian Business Cycle Theory and the Causes of the Great Depression In June 1931, British economist Lionel Robbins wrote a foreword for Austrian economist Friedrich A. Hayek’s new book, Prices and Production. Professor Robbins explained the "marvelous renaissance" the Austrian school of economic thought had experienced since the end of the First World War under the leadership of such economists as Ludwig von Mises. Among the Austrian school’s most important recent contributions, he said, was its theory of the business cycle, to which Hayek’s small volume was meant to be an introduction for the English-speaking world. Professor Robbins pointed out: Most monetary theorists seem to have failed utterly to apprehend correctly the nature of the forces operative in America before the coming of the [great] depression, thinking apparently that the relative stability of the price level indicated a state of affairs necessarily free from injurious monetary influences. The Austrian theory, of which Dr. Hayek is such a distinguished exponent, can claim at least this merit, that no one who really understood its principal tenets could have cherished for a moment such vain delusions. Historical events are never the result of one influencing factor, even a strongly dominating one. And this was no less true in the case of the political and economic influences at work before the Great Depression began in 1929. The First World War had disrupted all of the normal economic and political relationships around the globe. Vast quantities of physical capital and human labor were consumed and destroyed in the four years of war. Wartime and postwar inflations tore apart the social and cultural fabrics of several major countries in Europe, especially Germany and Austria. The institutions of civil and liberal society were severely weakened and replaced with interventionist and socialist political regimes that limited or abolished civil and economic liberties. New nations rose up in Central and Eastern Europe with the collapse of the German, Austrian, and Russian empires. All of them to one degree or another followed the path of economic nationalism — imposing protectionist trade barriers; subsidizing agriculture and various privileged industries; nationalizing entire sectors of the economy; instituting artificial foreign exchange rates and exchange controls; and establishing welfare-statist programs. Germany’s reparations payments were a peculiar mechanism of financial musical chairs, with the United States lending money to the Germans, so they could meet their payments to the Allied powers, including America: American and other European trade barriers had made it difficult for the Germans to earn the necessary sums through exports to fulfill all their financial obligations under the terms of the peace treaty that had ended the war. The monetary system of the world — the international gold standard — was fatally weakened by government inflationary policies during and after the war. In spite of all the weaknesses of the gold standard and in spite of abuses of the gold standard by the governments that managed it in the decades before 1914, it had brought about a high degree of monetary stability that had fostered a global economic environment conducive to savings, investment, international trade, and capital formation. In the 1920s, however, the monetary systems of the major nations of Europe were increasingly fiat currencies more directly controlled and manipulated by government, even when they remained nominally "linked" to gold. 42
In the United States, the establishment of the Federal Reserve System in 1913 created a new centralized engine for monetary expansion. In this setting, the American Federal Reserve System undertook its experiment in the monetary stabilization of the price level. In the 1920s, as we have seen, Ludwig von Mises had demonstrated the fundamental weakness in all attempts to stabilize an economy through price-level stabilization by explaining the inherent nonneutrality of money. Changes in the money supply necessarily arise from the injection of additional sums of the medium of exchange at some particular points in the market. These additions to the money supply then affect the rest of the economy through the particular temporal-sequential process through which the new money is spent by each individual and group of suppliers and demanders who receive it over time. The end result is a change in the general purchasing power or value of money. But in the process of bringing about that result, the structure of relative prices, wages, and income, as well as the allocation of resources, also are modified. And if the monetary injections occur through the banking system, a business cycle might very well be set in motion. But it was Mises’s young Austrian colleague, Friedrich A. Hayek, who detailed why stabilizing the price level could distort the structure of relative prices in such a manner that a business cycle was likely to be set in motion. In Monetary Theory and the Trade Cycle (1929), Hayek argued that the role of the rate of interest in a market economy was to ensure that the amount and the time horizons of investment activities were kept in balance with the available savings in the economy. Unless the rate of interest was permitted to perform its role on the basis of normal market-competitive forces, savings and investment could get out of balance. In an economy experiencing increases in productivity and capital formation, the resulting cost efficiencies and increased productive capacities in various industries would tend over time to put downward pressure on prices because of the increased supplies of goods offered to consumers on the market. The price of each of these goods would decrease to the extent required to ensure that the market in which each good was sold was kept in balance. In the markets in which consumer demand was fairly responsive, or "elastic," to the increase in the available supplies, the individual prices might have to decline only moderately. In other markets, in which consumer demand was noticeably less responsive, or "inelastic," to an increase in the available supplies, the individual prices would have to decrease to a greater extent to keep the greater supply in balance with the demand. Over time, the average level of prices as measured by some statistical price index would record that there had occurred a "deflation" of prices. But such a price deflation was not only not harmful in its effects, but was essential if the market-determined structure of relative prices was to keep the supply and demand for each individual good in balance with each other through time. But instead of allowing this downward trend in prices to naturally occur, the Federal Reserve increased the supply of money in the American economy to counteract the normal process of price deflation. In aggregate terms, the amount of money demand for goods and services was increased just enough to match the increase in the quantity of those goods and services offered on the market to maintain the general statistical average of prices at a fairly "stable" level throughout most of the 1920s, as measured by the wholesale price index. But, argued Hayek in Monetary Theory and the Trade Cycle, The rate of interest which equilibrates the supply of real savings and the demand for capital cannot be a rate of interest which also prevents changes in the price level. In this case, stability of the price level presupposes change in the supply of money.… The rate of interest at which, in an expanding economy, the amount of new money entering circulation is just sufficient to keep the price-level stable, is always lower than the rate which would keep the amount of available loan-capital equal to the amount simultaneously saved by the public: and thus, despite the 43
stability of the price-level, it makes possible a development leading away from the equilibrium position. Increases in the money supply, institutionally, are introduced in the form of increased reserves supplied to the banking system by the Federal Reserve, on the basis of which additional loans may be extended. But the only way banks can induce potential borrowers to take up the increased sums of lendable funds is to lower the rate of interest at which the banks offer to lend them. The lower rate of interest decreases the cost of borrowing relative to the expected rate of return from various investment projects. But the rate of interest is not only a measure of the cost of loans; it is also the factor by which the prospective value of an investment is capitalized in terms of its present value. The lower rate of interest also acts, therefore, as a stimulus for the undertaking of longer-term investment projects involving time horizons further into the future than would have been the case at the higher rate of interest that would have prevailed on the loan market if not for the increase in the money supply. Thus, in the 1920s, beneath the apparent calm of a stable price level, Federal Reserve policy was creating a structure of relative price and profit relationships that induced a number of longer-term investments that was in excess of actual savings to sustain them in the long run. Why were they unsustainable in the long run? Because, as the new money was spent on new and expanded investment projects, the additional money eventually passed into the hands of factors of production drawn into those employments as higher money incomes. As the higher money incomes were then spent in the market, the demands for consumer goods increased as well, acting as a counterpull to attract production and resources back to consumer goods production and investment projects with shorter time-horizons. Only with further injections of additional quantities of money into the banking system was the Federal Reserve able to keep market rates of interest below their proper equilibrium levels and thus able to temporarily maintain the profitabilities of the longer-term investment projects set into motion by the attempt to keep the price level stable. Finally, in 1928, under the pressure of this monetary expansion, the price level began to rise. The Federal Reserve, fearful of creating an absolute inflationary rise in prices, reined in the money supply. But with the end to the monetary expansion, interest rates began to rise to their real market-clearing levels. Some of the longer-term investment projects that either had been brought to completion or were still in progress were shown to be unprofitable at the higher rates of interest. The investment "boom" collapsed, with its first major indication being the "break" in the stock market in October 1929. In 1932, in an article entitled "The Fate of the Gold Standard," Hayek summarized what he considered to be the lessons of the 1920s: Instead of prices being allowed to fall slowly, to the full extent that would have been possible without inflicting damage on production, such volumes of additional credit were pumped into circulation that the level of prices was roughly stabilized.… Whether such inflation merely serves to keep prices stable, or whether it leads to an increase in prices, makes little difference. Experience has now confirmed what theory was already aware of; that such inflation can also lead to production being misdirected to such an extent that, in the end, a breakdown in the form of a crisis becomes inevitable. This, however, also proves the impossibility of achieving in practice an absolute maintenance of the level of prices in a dynamic economy. Corrective forces in the market were set in motion, once the monetary expansion had come to an end. But the depth and duration of the Great Depression turned out to be far greater and longer than would have normally seemed to be required for economy-wide balance to be restored. The reasons for the Great Depression’s severity were not, however, to be found in any inherent failure of the market 44
economy, but rather in the political ideologies and government policies of the 1930s.
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Chapter 11 The Great Depression and the Crisis of Government Intervention The Great Depression of the early 1930s was the most severe in modern history. Just in terms of the usual statistical figures, its magnitude was catastrophic. Between 1929 and 1933, Gross National Product in the United States decreased by 54%, with industrial production declining 36%. Between 1929 and 1933, investment spending decreased by 80%, while consumer spending declined by 40%. Expenditures on residential housing declined by 80% during this period. In 1929, unemployment had been 3.2% of the civilian work force; by 1932 unemployment had gone up to 24.1% and rose even further — to 25.2% in 1933. The wholesale price index decreased by 32% from 1929 to 1933, and the consumer price index decreased by 23%. American agriculture saw the prices paid by farmers for raw materials, wages, and interest decrease by 32%; but the prices farmers received for their output decreased by 52%. Between 1930 and 1933, 9,000 banks failed in the United States, causing tens of thousands of people to lose their savings. The money supply (measured as currency in circulation, demand deposits, and time deposits, or "M-2″ as it is called) decreased between 1929 and 1933 by more than 30%. Even if a larger measurement of the money supply is calculated (M-2 plus deposits at mutual-savings banks, the postal-savings system, and the shares at savings and loans, a measurement known as "M-4″), the supply of money still decreased between 1929 and 1933 by about 25%. Internationally, the Great Depression was also devastating. The value of global imports and exports decreased by almost 60%, while the real volume of goods and services traded across borders declined by almost 30%. Gross Domestic Product in Great Britain and France fell by 5% and 7% respectively between 1929 and 1933. From 1929 to 1932, industrial production fell 12%, 22%, and 40% in Great Britain, France, and Germany, respectively. Wholesale prices fell on average 25%, 38%, and 32% in Great Britain, France, and Germany, respectively. The declines in consumer prices were 15% on average in both Great Britain and France and 23% in Germany during this period. After the 1930s, most historians and many economists interpreted these numbers as a demonstration that the capitalist system had inherent flaws and tendencies towards cumulative instability that prevented a return to a normal economic balance within any reasonable period of time. The Great Depression, therefore, came to be viewed as a "crisis of capitalism" and proof of the failure of (classical) liberal society. This interpretation was not how the free market economists of the time viewed the early 1930s. For example, the German economist Moritz J. Bonn delivered the third Richard Cobden lecture in London, England, on April 29, 1931. His topic was "The World Crisis and the Teaching of the Manchester School." Professor Bonn told his audience: The free play of economic forces has been replaced everywhere, at least in part, by private monopoly or by Government monopoly, by tariffs, and by all sorts of price control, from wage fixing by arbitration boards to valorization by farm boards.… There is intervention now on a big scale, based on forecasting and bent on planning, and there is a crisis much bigger than any crisis the world has seen so far.… For in the present economic situation of the world half of its institutions are [politically] manipulated whilst the other half are supposed to be free. The prices of the goods subject to the play of free competition have fallen all over the world.… The other 46
prices have remained fairly rigid. They are manipulated by economic and political coercion, by combines of labor and capital, supported by tariffs and other manipulating legislation.… If selected prices and sheltered wages can be maintained whilst all other prices are declining, a new satisfactory level [of equilibrium] cannot be attained.… The conflict between the free play of economic forces and the manipulation by Governments and monopolies is the main cause of the long continuation of the crisis. It was for this reason that a year later, in 1932, Austrian economist Ludwig von Mises concluded, "The crisis under which the world is presently suffering is the crisis of interventionism and of state and municipal socialism, in short the crisis of anticapitalist policies." In the United States, the crisis of anticapitalist policies arose from the interventions of the Hoover administration. In November 1929, President Herbert Hoover met with leading American business and labor leaders. He said that in this period of crisis, purchasing power had to be maintained to keep the demand for goods and services high. He argued that wage rates should not be cut, that the work week should be shortened to "spread the work" among the labor force, and that governments at all levels should expand public works projects to increase employment. First under the persuasion of the president and then through the power of the trade unions, the money wage rates for many workers were kept artificially high. But this merely created the conditions for more, rather than less, unemployment. In 1930, consumer prices fell by 2.5%, while money wages declined on average by 2%. In 1931, consumer prices fell by 8.8%, while money wages decreased by only 3%. In 1932, consumer prices declined by 10.3%, while money wages decreased by only 7%. In 1933, consumer prices fell by 5.1%, and money wages decreased by 7.9%. While consumer prices fell almost 25% between 1929 and 1933, money wages on average decreased only 15%. Not only were money wages lagging behind the fall in the selling prices of consumer goods through most of these years, labor productivity was also falling — by 8.5% — during this period. As a result, the real cost of hiring labor actually increased by 22.8%. The "high-wage" policy of the Hoover administration and the trade unions, therefore, succeeded only in pricing workers out of the labor market, generating an increasing circle of unemployment. (See, Richard Vedder and Lowell Gallaway, Out of Work: Unemployment and Government in Twentieth-Century America, [1997]) American agriculture was also thrown out of balance by government intervention. During the First World War, the demand for American farm output had increased dramatically. But after 1918, European demand for American agricultural goods decreased. This was due partly to a normal reexpansion of European agricultural production in the new peacetime conditions, but also to the growth in agricultural protectionism in Central and Eastern Europe that closed off part of the European market to American exports. In the 1920s, the U.S. government attempted to prop up American farm production and income through various subsidies and federally sponsored farm cooperative programs. In June 1929, the Hoover administration established the Federal Farm Board (FFB). Once the Depression began, the FFB started to extend cheap loans to the farming community to keep output off the market and prevent prices from falling. First wheat, then cotton and wool, and then dairy products all came within the orbit of government intervention. The artificially high prices merely generated increasingly large unsold surpluses. Then the government attempted to restrict farm output to prevent prices from falling because of the very surpluses the government’s farm price support programs had helped to create. As Austrian economist Murray Rothbard explained in America’s Great Depression (1963): The grandiose stabilization effort of the FFB failed ignominiously. Its loans encouraged greater production, adding to the farm surplus, which overhung the market, driving prices down both on direct and psychological grounds. The FFB thus aggravated the very farm depression that it was 47
supposed to solve. With the FFB generally acknowledged a failure, President Hoover began to pursue the inexorable logic of government intervention to the next step: recommending that productive land be withdrawn from cultivation, that crops be plowed under, and that immature farm animals be slaughtered — all to reduce the very surpluses that government’s prior intervention had brought into being. In a further attempt to protect American agriculture from having to adjust prices and production to the real supply and demand conditions in the world market, the U.S. Congress passed and Herbert Hoover signed the Hawley-Smoot Tariff in June 1930. Benjamin Anderson, in his financial and economic history of the United States, Economics and the Public Welfare (1946), scathingly criticized this act of aggressive protectionism: In a world staggering under a load of international debt which could be carried only if countries under pressure could produce goods and export them to their creditors, we, the greatest creditor nation of the world, with tariffs already far too high, raised our tariffs again. The Hawley-Smoot Tariff Bill of June, 1930, was the crowning financial folly of the whole period from 1920 to 1933.… Once we raised our tariffs, an irresistible movement all over the world to raise tariffs and to erect other trade barriers, including quotas, began. Protectionism ran wild over the world. Markets were cut off. Trade lines were narrowed. Unemployment in the export industries all over the world grew with great rapidity, and prices of export commodities, notably farm commodities in the United States, dropped with ominous rapidity. U.S. farm exports as a percentage of farm income fell from 16.7% in the late 1920s to 11.2% in the early 1930s. U.S. exports of farm commodities fell by 68% between 1929 and 1933. Never was there a clearer case of a government intervention’s consequences being exactly contrary to its stated purpose! After the British government abandoned the gold standard in September 1931, the Abnormal Importation Act was passed, giving the British Board of Trade authority to impose duties up to 100% of the value of imported goods. The very day the act was passed, a 50% import duty was imposed on 23 classes of goods, and all importation of those goods practically ceased. On March 1, 1932, a 10% general tariff increase was established by the British government. And in July 1932, the British government introduced preferential tariffs for countries belonging to the British Empire at the expense of other nations, including the United States. Germany instituted import licensing and bilateral trading arrangements supervised by the government in November 1931. By 1934, with the coming of the Nazis to power in Germany, exchange controls and import licenses were reinforced as part of the new National Socialist system of economic planning. In 1928, the French government lowered the import tariff rate to 15% and lowered it once more to 12% in 1930. But in November 1931, a foreign exchange surcharge of 15% was imposed on British goods. And beginning in mid 1931, the French government established quotas on many imported goods. Indeed, by 1936, 65% of goods imported into France were coming into the country under the quota system. Christian Saint-Etienne, in his book The Great Depression, 1929–1938 (1984), concluded: Tariff restrictions were increasingly complemented by administrative measures, such as prohibitions, quotas, licensing systems, and clearing agreements.… Protectionism only led to a reduction in international trade, affecting all trading nations to a comparable extent, whether they initiated the trade war or merely retaliated.… It is clear that the collapse of international trade in the Depression made international recovery virtually impossible for a decade. 48
But the follies of government interventionism did not end with these disastrous policies. There were still others that made the Great Depression even worse.
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Chapter 12 The Austrian Analysis and Solution for the Great Depression In February 1931, Austrian economist Ludwig von Mises delivered a lecture before a group of German industrialists entitled "The Causes of the Economic Crisis." He explained to his audience that the economic depression through which they were living had its origin in the misguided monetary policies of the 1920s. The leading central banks of the major industrial countries had followed a policy of monetary expansion that had created an artificial boom that finally came to an end in 1929. But after the downturn began, this depression was much more severe and prolonged than many similar business cycles in the past. A unique circumstance was present that prevented the normal process of economic recovery. The unique circumstance was the pervasiveness of government interventionist policies: If everything possible is done to prevent the market from fulfilling its function of bringing supply and demand into balance, it should come as no surprise that a serious disproportionality between supply and demand persists, that commodities remain unsold, factories stand idle, many millions are unemployed, destitution and misery are growing and that finally, in the wake of all these, destructive radicalism is rampant in politics.… With the economic crisis, the breakdown of interventionist policy — the policy being followed today by all governments, irrespective of whether they are responsible to parliaments or rule openly as dictatorships — becomes apparent.… Hampering the functions of the market and the formation of prices does not create order. Instead it leads to chaos, to economic crisis. For the Austrian economists, the Great Depression had been caused in the United States by the attempt to stabilize the price level through monetary expansion. The monetary expansion had artificially lowered interest rates, and that in turn had induced an investment boom in excess of real savings in the economy. Capital, resources, and labor had been misdirected into longer-term investment projects that now, with the end of the monetary inflation, were found to be unprofitable and economically unsustainable to varying degrees. Capital had been malinvested, labor had been misdirected, and the structure of relative prices and wages had been distorted in comparison with the pattern of prices and wages that would have ensured proper balance between the actual supplies and demands for goods and services in the market. Governments in the major industrial countries, including the United States, had responded to the economic crisis by introducing a vast spider’s web of interventionist regulations, controls, and restrictions on both domestic and international trade, as well as numerous public works projects. Rather than alleviating the Depression, the interventionist measures had only made the situation worse. Governmental attempts to maintain prices and wages at levels inconsistent with real market conditions resulted in falling production and rising unemployment as goods went unsold and workers were released from their jobs. The imbalances that began in some markets soon spread to others. The reason for this can be found in the fundamental truth that economists since Jean-Baptiste Say in the early 19th century have called "the law of markets." No one can demand what others have for sale in the market unless he has something to supply in exchange. Each potential demander, therefore, has to offer in trade some good 50
or service that others are interested in buying and at a price they are willing to pay. Supplying a good that others are not interested in buying or pricing it so high that few are willing to purchase it limits the money income that can be earned from sales; and that, in turn, limits the amount of goods and services that can be bought from others. Wrong prices — "disequilibrium prices," in the jargon of the economist — resulted in products’ and workers’ being priced out of the market once the Depression began in 1929. The resulting decreased revenues from the sale of goods and the resulting falling income from loss of employment meant that both businessmen and workers had to cut back their purchases of goods and services that were offered for sale by others. These others, when they were unwilling to sufficiently lower their prices and wages in the face of falling demand, saw, in turn, a decrease in their sales and employment. The failure of prices and wages to adjust downwards in the face of changing market conditions generated a "cumulative contraction" of output and employment, which put further downward pressure on prices and wages in a widening circle of related markets. As the famous English economist Edwin Cannan concisely put it in 1932, "General unemployment is the result of a general asking too much" by people who are offering goods and labor services for sale. In 1933, Ludwig von Mises summarized the nature of the problem: The duration of the present crisis is caused primarily by the fact that wage rates and certain prices have become inflexible, as a result of union wage policy and various [government] price support activities. Thus, the rigid wage rates and prices do not fully participate in the downward movement of most prices, or do so only after a protracted delay.… The continuing mass unemployment is a necessary consequence of the attempts to maintain wage rates above those that would prevail on the unhampered market. Mises explained that now that interventionist policies had resulted in mass unemployment, governments proposed to get around the consequences of their own policies by resorting to a policy of reflation. Governments hoped that if prices were raised through a new monetary expansion, unions would not immediately demand higher money wages to compensate for any lost purchasing power resulting from the increase in the cost of living. If money wages were relatively unchanged while selling prices of goods and services were rising, it would mean that the real wages of workers would be cut, and employers might find it once again profitable to hire the unemployed. But, Mises argued, even if money wages did not immediately increase, the new monetary expansion would be merely setting the stage for another "bust" after a new temporary "boom." The inevitability of this result was explained by the British economist Lionel Robbins (a proponent of Austrian economics) in the pages of Lloyd’s Bank Review in 1932: It is perhaps natural that the wish should arise to meet deflation by a counter inflation: to get around cost rigidities by acting on prices. And no doubt if inflation simply meant the simultaneous and definitive marking up of prices, as by a Government decree, there would be much to be said for this procedure. Unfortunately, inflation does not work this way. It is the essence of inflation that it affects some prices before others, that its final effects are different from its impact effects, and that production is affected differently at different stages of the process. In an inflationary boom, it is this unequal incidence of the inflation which gives rise to the maladjustments, which eventually produce the slump. Entrepreneurs are encouraged by artificially cheap money to embark on enterprises which can only be profitable provided costs do not rise. As the new money works through the system, costs do rise, and their enterprise is thus rendered unprofitable. For the time being, trade seems good but when the full effects of the 51
inflation have manifested themselves there comes a crisis and subsequently depression. What then was the way out of the Great Depression? For the Austrian economists, it required the reversal of the interventionist policies that had only exacerbated the economic crisis and the forgoing of any monetary manipulation as a method for trying to overcome the dilemma of unemployment. On the latter point, Friedrich Hayek, writing in 1932, was clear: To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection — a procedure which can only lead to a much more severe crisis as soon as the credit expansion comes to an end. On the issue of interventionist policies that were preventing the market from normally and competitively functioning to restore economic balance, Lionel Robbins was also clear in 1932: It is impossible to get back to a state of true prosperity until the real underlying causes of the present stagnation are removed — barriers to international trade, in the shape of tariffs, quota systems, exchange restrictions and the like obstacles to internal adjustments in the shape of cost rigidities and bad debts, which should be written off.… But, above all, policy must be directed to restoring the freedom of the market in the widest sense of the term. By this I mean not only the lowering of tariffs and the abolition of trade restrictions but also the removal of all those causes which produce internal rigidity — rigid wages, rigid prices, rigid systems of production. … It is this inflexibility of the economic system at the present day which is at the root of most our troubles. For Austrian economists such as Ludwig von Mises, Friedrich Hayek, and Lionel Robbins, the Great Depression was the fruit of the interventionist state. Beginning with the First World War, throughout the 1920s and into the Depression years of the early 1930s, the classical liberal world of free markets, free trade, and sound money under the gold standard had been undermined, weakened, and finally broken. In its place had arisen government-imposed systems of domestic regulation, nationalistic trade protectionism, price and wage rigidities, production subsidies, and state-sponsored monopolies and cartels. The pre-World War I gold standard, though operated by government central banks, had more or less kept monetary and artificial credit expansions within narrow bounds. By the early and mid 1930s, the monetary systems of most countries were paper money systems or monetary systems nominally still gold-based but manipulated and abused by governments to serve interventionist domestic policies. The Austrian economists attempted to show the dead end to which these policies had led. Unfortunately, their logical arguments and reasoned appeal fell on deaf ears. Instead, the United States and other nations moved further down the interventionist road. By 1933, this road took America to the New Deal, and it took Germany to the National Socialist state.
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Chapter 13 FDR’s New Deal In July 1932, one month after accepting the Democratic Party’s nomination for the office of president of the United States, Franklin Delano Roosevelt delivered a campaign radio address to the nation. He focused on the extravagant spending policies of Herbert Hoover’s administration and the federal budget deficits it had created: "Let us have the courage to stop borrowing to meet continuing deficits," Roosevelt said. "Revenues must cover expenditures by one means or another. Any government, like any family, can, for a year, spend a little more than it earns. But you know and I know that a continuation of that habit means the poorhouse." In 1930, the Hoover administration ran a budget surplus by increasing federal tax revenues by more than 5%, even as the economy was experiencing its first year of the Depression. But in 1931, as revenues fell by 25% in the face of falling business receipts and personal incomes, the federal government ran a budget deficit to cover 13% of its expenditures. In 1932, the deficit spending massively increased even further, representing almost 60% of federal expenditures. Between 1929 and 1932, the accumulated federal debt rose by 15% under Herbert Hoover’s administration. At the Democratic national convention in June 1932, where FDR was nominated for president of the United States, the Democratic Party issued a platform promising a way out of the Great Depression. The party stated: "We believe that a party platform is a covenant with the people to be faithfully kept by the party entrusted with power." Having made that pledge, the Democratic Party offered a program for recovery that promised, among other things: 1. An immediate and drastic reduction of government expenditures by abolishing useless commissions and offices, consolidating departments and bureaus, and eliminating extravagance, to accomplish a saving of not less than twenty-five percent in the cost of federal government. 2. We favor maintenance of the national credit by a federal budget annually balanced on the basis of accurate executive estimates of revenues. 3. We advocate a sound [gold] currency to be preserved at all hazards. 4. The removal of government from all fields of private enterprise except where necessary to develop public works and natural resources in the common interest. 5. We condemn the extravagance of the [federal] Farm Board, its disastrous action which made the government a speculator of farm products, and the unsound policy of restricting agricultural products to the demands of domestic markets. 6. We condemn the Hawley-Smoot Tariff Law, the prohibitive rates of which have resulted in retaliatory action by more than forty countries, created international economic hostility, destroyed international trade, driven our factories into foreign countries, robbed the American farmer of his foreign markets, and increased the cost of production. The Democratic Party platform stated: In conclusion, to accomplish these purposes and to recover economic liberty we pledge the nominees of this convention the best efforts of a great party whose founder [Thomas Jefferson] announced the doctrine which guides us now in the hour of our country’s need: Equal rights for all; special privileges for none. 53
In November 1932, Franklin Roosevelt was elected president of the United States, winning 30% more of the popular vote than Herbert Hoover and 472 of the Electoral College votes to Hoover’s 59. But from the day FDR took the presidential oath of office on March 4, 1933, he moved America in a direction exactly opposite of the promised "covenant with the people to be faithfully kept by the party entrusted with power." In his inaugural address, Roosevelt told the American people: If we are to go forward we must move as a trained and loyal army willing to sacrifice for the good of the common discipline, because, without such discipline, no progress is made, no leadership becomes effective.… I assume unhesitatingly the leadership of this great army of our people, dedicated to a disciplined attack upon our common enemies.… The people of the United States … have registered a mandate that they want direct, vigorous action. They have asked for discipline and direction under leadership. They have made me their present instrument of their wishes. In the spirit of the gift I take it. He hoped that his commandership over the American people would be compatible with the traditional American constitutional order. "But it may be that an unprecedented demand and need for undelayed action may call for temporary departure from the normal balance of public procedure." He would ask Congress for "broad executive power to wage a war against the [economic] emergency as great as the power that would be given me if we were in fact invaded by a foreign foe." But in the event that the Congress refused to give him these special executive powers, he threatened darkly: "I will not evade the clear course of duty that will then confront me." In the same month that he took over the presidential office, Franklin Roosevelt published a book of his speeches that was entitled Looking Forward. The blueprint of all that was to come was clearly laid out. America had grown big and powerful during its first 150 years, but its development had included a great deal of "haphazardness" and "waste" that "could have been prevented by greater foresight and by a larger measure of social planning." Private industry had to give up some of its freedom; agriculture had to be supervised and assisted by the government; public expenditures were needed to increase and reflect modern responsibilities of enlightened political authority, including social security, unemployment insurance, and workers’ compensation; competition, speculation, and banking required increased government regulation; the hours, wages, and conditions of work had to come under greater government control; income and spending power among groups in American society needed to be redistributed; massive public works projects had to be undertaken for the national betterment. Taken all together, FDR said that the "spirit of my program" represented a "new deal" for America, involving "a changed concept of the duty and responsibility of government toward economic life." He said that as part of this, "business must think less of its own profit and more of the national function it performs." And the suppression of private interests to a common interest would "make possible the approach to a national economic policy which will have as its central feature the fitting of production programs to the actual probabilities of consumption" as considered appropriate by the new government planners. During the next four years, Franklin Roosevelt’s New Deal implemented all of these proposals – in spite of the pledge made in the Democratic Party’s political platform of 1932. Instead of "an immediate and drastic reduction of government expenditures … to accomplish a saving of not less than twenty-five percent in the cost of federal government," between 1933 and 1936, government expenditures rose by more than 83%. To cover this massive increase in government spending, Roosevelt’s administration ran huge budget deficits. In 1933, deficit financing covered 56.5% of government expenditures. For 1934, 1935, and 1936, the figures for deficit financing for were, respectively, 54.6%, 43%, and 52.3% of government expenditures. In four years, the federal government’s debt went from $19.5 billion in 1932 54
to $33.8 billion in 1936, representing a 73.3% increase. Instead of ending the "disastrous action which made the government a speculator of farm products and the unsound policy of restricting agricultural products to the demands of domestic markets," the federal government intervened in the affairs of the farming sector to a greater extent than ever before. On May 12, 1933, the Congress passed the Agricultural Adjustment Act (AAA), giving the government wide powers to fix the prices of farm products, purchase agricultural surpluses over an increasing number of crops, and pay farmers to reduce acreage in various lines of production. On May 18, 1933, the Congress passed the Tennessee Valley Act, giving the federal government authorization for the undertaking of a massive public works project for the construction of dams and electrification in the southern states. It was nothing less than socialist planning for land use, conservation, and supplying of energy for a vast subsection of the country. The AAA also gave the Roosevelt administration the authority to reduce the gold content and value of the dollar by up to 50%. Then, in contradiction to the promise that "a sound currency [would be] preserved at all hazards," on June 5, 1933, Congress passed a resolution voiding the gold clause in all government and private contractual obligations, as well as requiring all Americans to turn in their privately held gold for Federal Reserve Notes, under penalty of confiscation and imprisonment. Instead of a "removal of government from all fields of private enterprise," on June 16, 1933, the Congress passed the National Recovery Act (NRA) providing for total federal government control of the industrial sectors of the U.S. economy. Mandatory "codes of fair competition" were established for each sector of the economy, establishing pricing and production regulations for almost every manufactured good in the country. Every retail store in America was encouraged to display the NRA "Blue Eagle" emblem in its store windows to assure people that the stores were "doing their part." On March 29, 1933, the Civilian Conservation Corps was established, putting government in the business of creating work for America’s youth. On May 12, 1933, the Unemployment Relief Act was passed, which later became the Works Progress Administration, which provided direct employment of millions on federal "public works" projects. On July 5, 1935, the National Labor Relations Act was passed, making the federal government arbiter over the private workplace. The Minimum Wage Act was passed on June 25, 1938. The Social Security Act was passed on August 14, 1935, making government responsible for the retirement planning of the American people. And rather than renounce "the prohibitive [tariff] rates" which had "resulted in retaliatory action by more than forty countries, created international economic hostility, [and] destroyed international trade," the Roosevelt administration scuttled the London Economic Conference of June 1933 that could have reestablished stable foreign exchange rates on a gold basis and helped to end the tariff wars between nations. Instead, FDR sent a message to the London conference that the goal of his administration was to manipulate the U.S. dollar’s value for purposes of internal national planning. Franklin Roosevelt changed the face of America. The planned economy was imposed on the United States. Every corner of the market was now under the supervision, control, and regulation of the federal government. An increasing number of Americans became directly and indirectly dependent upon the Washington for their employment and income. The era of big government had arrived in the United States.
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Chapter 14 The New Deal and Its Critics In May 1935, Lewis W. Douglas delivered the annual Godkin Lectures at Harvard University, which were published later that year under the title The Liberal Tradition: A Free People and a Free Economy. Douglas had been appointed by Franklin D. Roosevelt to serve as Director of the Bureau of the Budget when the New Deal began in March 1933. But he resigned a year later, frustrated and disappointed that FDR had failed to implement the program promised in the Democratic National Platform of 1932. Douglas was convinced that the road that Roosevelt’s New Deal was following meant regimentation and ruin for America. Real economic recovery from the Great Depression would come only from freeing the economy from government power and planning. The National Recovery Administration (NRA) and the Agricultural Adjustment Administration (AAA) had denied American industry and agriculture the freedom and flexibility to normally and properly adjust to bring the economy back into balance. The budget deficits and monetary manipulations of the New Deal had threatened financial chaos. The choice America faced, Douglas said, was clear: Will we choose to subject ourselves — this great country — to the despotism of bureaucracy, controlling our every act, destroying what equality we have attained, reducing us eventually to the condition of impoverished slaves of the state? Or will we cling to the liberties for which man has struggled for more than a thousand years? It is important to understand the magnitude of the issue before us.… If we do not elect to have a tyrannical oppressive bureaucracy controlling our lives, destroying progress, depressing the standard of living … then should it not be the function of the Federal government under a democracy to limit its activities to those which a democracy may adequately deal, such for example as national defense, maintaining law and order, protecting life and property, preventing dishonesty, and … guarding the public against … vested special interests? A year earlier William MacDonald published a book equally critical of the New Deal entitled The Menace of Recovery (1934). MacDonald observed: The underlying assumption of the entire recovery program is that social wisdom is the possession of the Federal government, and that neither individuals, nor social groups … can be expected to act wisely and efficiently if left to themselves. Instead, the federal government was controlling and regimenting the American economy: Business is no longer free and such freedom as it retains is being systematically curtailed. Government price-fixing is limiting profits and capital issues must pass elaborate and drastic government tests. Minimum wages, with fixed minimum and maximum periods of labor, will before long be imposed and guaranteed by government for every business and industry, with all differences between employers and employees adjudicated under Federal law administrated by Federal agents. The maximum acreage for staple crops is being fixed by the government, almost every step of the marketing process is being brought under direct government regulation, and farmers are 56
being told what they may do with land which government pressure has withdrawn from cultivation. Banking today is virtually a government function, capital increases that were not needed have been forced and a dangerous scheme of deposit insurance extorted, and the mere possession of gold coin and bullion by the citizen has been made a crime. Direct government competition on grossly unequal terms has been set up through the Tennessee Valley Authority in a large area extending into six States, and the entire social life of the region is to be reconstituted on a government model with government financial aid and government-directed propaganda.… One has only to envisage a few years more of this kind of "recovery" to perceive a nation a large majority of whose people will be living off the government, assured of maintenance because the government cannot let go, and neither expected nor able to show initiative or independence in the face of a government plan and government grants. A similar analysis was given by Ralph Robey in his book Roosevelt versus Recovery (1934), in which he concluded: If we are to prevent such a national disaster, we must turn back to the tenets of liberal capitalism. If we are to prosper as a nation, we must restore the requisites of a sound economic system.… It is a choice between the New Deal and sound prosperity. It is Roosevelt versus Recovery. The same fears were expressed in 1936 by Howard E. Kershner in his volume The Menace of Roosevelt and His Policies. He pointed out that "under the leadership of President Roosevelt America has smoked economic opium," with resulting dreams and delusions of prosperity through planning and paternalism. He concluded his analysis by pointing out: At best, government has always involved a good deal of political racketeering. It was the first and biggest racket ever devised by man, and the fact that it is sometimes carried on by catch words, slogans and the jargon of the so-called economists, instead of swords, guillotines and guns does not make it any less of a racket. How men have struggled, schemed and fought for control of the public purse! How they have used public position and power for private ends!… Mr. Roosevelt … took charge of our government when it was comparatively simple, and for the most part confined to the essential functions of government, and transformed it into a highly complex, bungling agency for throttling business and bedeviling the private lives of free people. It is no exaggeration to say that he took the government when it was a small racket and made a large racket out of it.… In taking the position that the Federal Government in Washington is responsible for the economic condition of the individual, and in putting a vast army of people on federal relief, many of whom now seem to think that government owes them a living, Mr. Roosevelt has sowed to the wind and will reap the whirlwind.… If we are to preserve democracy we must go back to economic freedom. By his persistent advocacy of "socialistic" experiments, his extravagant waste of money, his reckless expansion of public credit, his policy of inflation and tinkering with the currency, his bureaucracy, his catering to class hatreds, his repudiation of promises and loss of faith in government, which his policies have caused — by all this and more, Mr. Roosevelt has endangered our entire heritage of political and economic freedom. Such is the menace of Roosevelt and his policies.
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And in his 1937 book, The Twilight of American Capitalism, A.S.J. Baster pointed out that one of the great merits of a free-market economy was that it neither respected nor protected those who desired special privileges. "Competition is the greater enemy of economic privilege for a group," Baster explained. "It can destroy groups altogether (as those founded on attempted monopolies) and it will maintain others (as those founded on human capacities) only for individuals whose contribution is regularly tested in the market and who are summarily ejected if it is found wanting." In Baster’s view, "The moral is plain." Under the New Deal political order in America, no longer was market competition determining the relative income shares earned by members of the society as a reflection of their success in serving consumer demand. Instead, the political influence of special interests would increasingly determine the amount of income various groups could successfully obtain through governmental redistribution and favors. As a consequence, the very stability of a free democratic order could be threatened as it became the plaything of special interests rather than the protector of individual rights and the competitive order: Lobbies will be maintained by beneficiaries of the State in order to ensure a permanent flow of favors, and by everyone else in order to demand equal treatment; economic decisions will be purchased, or settled by the flimsy oratory of the Chambers; and democracy must ultimately perish when the Government becomes too obviously the sport of all the interests or the mouthpiece of one of them.… The fatal weakness of the New Deal is … the degeneration of democracy resulting from those [economic] plans [and interventions]. The worst features of the New Deal were ended when the U.S. Supreme Court declared the NRA and the AAA unconstitutional in 1935. The federal government’s power to directly dictate prices and production in the American economy was declared outside the bounds of the free society as conceived by the American Founders. But "activist" government was not defeated. Before long, Roosevelt was able to appoint new members to the Supreme Court, who were more open to viewing the Constitution as a malleable "living" document susceptible to changing conceptions of government’s "responsibility" in social and economic affairs. And more to the point, a "new economics" was on the horizon that would offer a sophisticated rationale for a broad range of fiscal and monetary manipulations by the state. Keynesian economics was about to transform the role of government in the market economy.
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Chapter 15 John Maynard Keynes and the "New Liberalism" In 1925, English economist John Maynard Keynes delivered a lecture at Cambridge entitled "Am I a Liberal?" He rejected any thought of considering himself a conservative because conservatism "leads nowhere; it satisfies no ideal; it conforms to no intellectual standard; it is not even safe, or calculated to preserve from spoilers that degree of civilization which we have already attained." Keynes then asked whether he should consider joining the Labour Party. He admitted that "superficially that is more attractive" but rejected it as well. "To begin with, it is a class party, and the class is not my class," Keynes argued. "When it comes to the class struggle as such, my local and personal patriotism, like those of every one else, except certain unpleasant zealous ones, are attached to my own surroundings.… The class war will find me on the side of the educated bourgeoisie." Furthermore, he doubted the intellectual ability of those controlling the Labour Party, believing that it was dominated by "those who do not know at all what they are talking about." This led Keynes to conclude that all things considered, "The Liberal Party is still the best instrument of future progress — if only it has strong leadership and the right programme." But the Liberal Party of Great Britain could serve a positive role in society only if it gave up "old-fashioned individualism and laissez-faire," which he considered "the dead-wood of the past." Instead, what was needed was a "New Liberalism" that would involve "new wisdom for a new age." What this entailed, in Keynes’s view, was "the transition from economic anarchy to a regime which deliberately aims at controlling and directing economic forces in the interests of social justice and social stability." In 1926, Keynes published a lecture entitled "The End of Laissez-Faire," in which he argued, "It is not true that individuals possess a prescriptive ‘natural liberty’ in their economic activities. There is no ‘compact’ conferring perpetual rights on those who Have or on those who Acquire." Nor could it be presumed that private individuals pursuing their enlightened self-interest would always serve the common good. In a period in which industry was becoming concentrated and controlled by handfuls of industrial managers, Keynes proposed "a return, it may be said, towards mediaeval conceptions of separate [corporate] autonomies." But instead of these corporate entities’ being left to their own profit-making purposes, Keynes proposed semi-monopolistic structures that would operate under government approval and with government supervision. In a world of "uncertainty and ignorance" that sometimes resulted in periods of unemployment for members of the work force in society, Keynes suggested "the cure for these things is partly to be sought in the deliberate control of the currency and of credit by a central institution." It also required the government’s centralized collection of statistics and data about "the business situation" so the government could exercise "directive intelligence through some appropriate organ of action over many of the inner intricacies of private business." And he believed that "some coordinated act of intelligent judgement" by the government was required to determine the amount of savings in the society; how much of the nation’s savings should be permitted to be invested in foreign markets; and the relative distribution of that domestic savings among "the most nationally productive channels." Finally, Keynes argued that government had to undertake a "national policy" concerning the most appropriate size of the country’s population, "and having settled this policy, we must take steps to carry it into operation." Furthermore, Keynes proposed serious consideration for adopting a policy of 59
eugenics: "The time may arrive a little later when the community as a whole must pay attention to the innate quality as well as to the mere numbers of its future members." This did not make Keynes a socialist or a communist in any strict sense of these words. Indeed, after a visit to Soviet Russia, he published an essay in 1925 strongly critical of the Bolshevik regime. For me, brought up in a free air undarkened by the horrors of religion, with nothing to be afraid of, Red Russia holds too much which is detestable.… I am not ready for a creed which does not care how much it destroys the liberty and security of daily life, which uses deliberately the weapons of persecution, destruction, and international strife. It is hard for an educated, decent, intelligent son of Western Europe to find his ideals here. But where Soviet Russia had an advantage over the West, Keynes argued, was in its almost religious revolutionary fervor, in its romanticism of the common working man, and its condemnation of money making. Indeed, the Soviet attempt to stamp out the "money-making mentality" was, in Keynes’s mind, "a tremendous innovation." Capitalist society too, in Keynes view, had to find a moral foundation above self-interested "love of money." What Keynes considered Soviet Russia’s superiority over capitalist society, therefore, was its moral high ground in opposition to capitalist individualism. And he also believed that "any piece of useful economic technique" developed in Soviet Russia could easily be grafted onto a Western economy following his model of a New Liberalism "with equal or greater success" compared with that found in the Soviet Union. By the time Keynes wrote these essays in the mid 1920s, he was already one of the most acclaimed economists in the world. His international notoriety had been established in 1919, when he published his criticism of the Treaty of Versailles, The Economic Consequences of the Peace . In 1924, Keynes published A Tract on Monetary Reform, in which he called for an abandonment of the traditional gold standard and the establishment of a government-managed currency. The gold standard meant that the value of a country’s money was determined by international market forces to which each country had to conform in terms of appropriate adjustments in its domestic structure of prices and wages. If trade unions were strong and would not conform their wage demands to market conditions, then adherence to a market-guided gold standard could result in unemployment if the money wages that trade unions insisted upon were above what the global market determined those wages should be. Instead, Keynes advocated abandonment of a fixed exchange rate between gold and the British pound; the foreign exchange value of the British pound should be raised or lowered by the central bank to maintain domestic prices and wages at the politically determined desired level. Or as Keynes expressed it, "When stability of the internal price level and stability of the external exchanges are incompatible, the former is generally preferable." As far as Keynes was concerned, "There is no escape from a ‘managed’ currency, whether we wish it or not. In truth, the gold standard is already a barbaric relic." In 1930, Keynes published a massive two-volume work entitled A Treatise on Money that he hoped would establish his reputation as one of the great economists of the 20th century. But over the next two years, many of the leading economists in Europe and North America wrote reviews of it that demonstrated fundamental flaws in both the assumptions and the logic of his arguments. The most devastating criticisms were made by a young Austrian economist, Friedrich A. Hayek, in a two-part review essay that appeared in 1931–32. Hayek showed that Keynes understood neither the nature of a market economy in general nor the significance and role of the rate of interest in maintaining a proper balance between savings and investment for economic stability. With the coming of the Great Depression, Keynes once again rejected the idea of a free-market solution to overcome the rising unemployment and idled industry that began to intensify following the 60
crash of 1929. His own remedy was outlined in two "open letters" that he addressed to Franklin D. Roosevelt in December 1933 and June 1934 as well as in some addresses and speeches he delivered in England evaluating the possibilities and results of the New Deal. Keynes considered FDR "the trustee for those in every country who seek to mend the evils of our conditions by reasoned experiment within the framework of the existing social system." FDR was the world leader for whom Keynes was "the most sympathetic in the world." In Keynes’s view, the New Deal contained two elements: "recovery and reform." The National Recovery Administration (NRA) represented one of the reform aspects of the New Deal. While considering this a desirable shift in American industrial policy for the long run, Keynes was critical of it as a short-run policy to assist in recovery. First, the forced cartelization of American industry would "upset the confidence of the business world and weaken its existing motives to action before you have had time to put other motives in their place," and it might "overtask your bureaucratic machine." Second, by coercively restricting production and pushing up industrial prices and wages by decree it was decreasing the demand for labor and thus doing nothing to stimulate more employment. Instead, Keynes recommended monetary expansion and federal deficit spending as the avenues for overcoming the mass unemployment of the Great Depression: Public authority must … create additional current incomes through the expenditure of borrowed or printed money.… When more purchasing power is spent, one expects rising output at rising prices. Since there cannot be rising output without rising prices, it is essential to insure that the recovery shall not be held back by the insufficiency of the supply of money to support the increased monetary turnover.… The increased stimulation of output by increased aggregate purchasing power is the right way to get prices up. I put in the forefront, for the reasons given above, a large volume of loan expenditure under government auspices. Preference should be given to those which can be made to mature quickly on a large scale. The object is to get the ball rolling. I put in the second place the maintenance of cheap and abundant credit, in particular the reduction of the long-term rate of interest. In Keynes’s writings of the 1920s and early 1930s, advocating a "New Liberalism" and a deficitspending government to "solve" the Great Depression were all the premises for the Keynesian revolution that would be officially inaugurated with the publication of Keynes’s General Theory of Employment, Interest and Money in 1936. And with those ideas, Keynes produced one of the greatest challenges to a free-market economy in the 20th century.
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Chapter 16 Keynes and Keynesian Economics John Maynard Keynes’s famous treatise, The General Theory of Employment, Interest and Money, was published on February 4, 1936. Its influence on the economics profession following its appearance was astonishing. And its impact on economic theory and policy over the last 80 years has been immense. Paul Samuelson of MIT, the 1970 recipient of the Nobel Prize in economics and one of the most influential expositors of Keynesian economics in the post-World War II period, contributed an essay to a volume entitled The New Economics, edited by Seymour Harris in 1948, two years after Keynes’s death. In an often-quoted passage, Samuelson explained: It is quite impossible for modern students to realize the full effect of what has been advisably called "The Keynesian Revolution" upon those of us brought up in the [pre-Keynesian] orthodox tradition. To have been born as an economist before 1936 was a boon — yes. But not to have been born too long before!… The General Theory caught most economists under the age of 35 with the unexpected virulence of a disease first attacking and decimating an isolated tribe of south seas islanders. Economists beyond fifty turned out to be quite immune to the ailment. With time, most economists in-between began to run the fever, often without knowing or admitting the condition.… This impression was confirmed by the rapidity with which English economists, other than those at Cambridge took up the new Gospel … at Oxford; and still more surprisingly, the young blades at the London School [of Economics] … threw off their Hayekian garments and joined in the swim. In this country [the United States] it was pretty much the same story.… Finally, and perhaps most important from the long-run standpoint, the Keynesian analysis has begun to filter down into the elementary textbooks; and, as everybody knows, once an idea gets into these, however bad it may be, it becomes practically immortal. Even today, when the traditional Keynesian analysis has been challenged and set aside by many economists, the Keynesian framework still haunts most macroeconomic textbooks, demonstrating Samuelson’s point that "however bad it may be," it has become "practically immortal." The essence of Keynes’s theory is to show that a market economy, when left to its own devices, possesses no inherent self-correcting mechanism to return to "full employment" once the economic system has fallen into a depression. At the heart of his approach was the belief that he had demonstrated an error in Say’s Law. Named after the 19th-century French economist Jean-Baptiste Say, the fundamental idea is that individuals produce so they can consume. The classical economist David Ricardo expressed it this way: By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person.… Productions are always bought by productions, or by services; money is only the medium by which the exchange is effected. Keynes argues that there is no certainty that those who have sold goods or their labor services in the market will necessarily turn around and spend the full amount of the income they have earned on the goods and services offered by others. Hence, total expenditures on goods can be less than total income previously earned in the manufacture of those goods. This, in turn, means that the total receipts received by firms selling goods in the market can be less than the expenses incurred in bringing those goods to market. With total sales receipts being less than 62
total business expenses, businessmen have no recourse other than to cut back on output and the number of workers they employ, so as to minimize their losses during this period of "bad business." But, Keynes argues, this merely intensifies the problem of unemployment and falling output. As workers are laid off, their incomes necessarily go down. With less income to spend, the unemployed cut back on their consumption expenditures. That results in an additional falling off of demand for goods and services offered on the market, widening the circle of businesses finding their sales receipts declining relative to their costs of production. And this sets off a new round of cuts in output and employment, setting in motion a cumulative contraction in production and jobs. Why wouldn’t workers accept lower money wages to make themselves once more attractive to employers for rehire in the face of falling demand in the market? Because, Keynes says, workers suffer from "money illusion." If prices for goods and services are decreasing because of a falling off of consumer demand in the market, then workers could accept a lower money wage and still be no worse off in real buying terms if the cut in their money wages was on average no greater than the decrease in the average level of prices. But workers, Keynes argues, generally think only in terms of their money wages, not in terms of their real wages, i.e., what their money income represents in real purchasing power on the market. Thus, workers would often rather accept unemployment than a cut in their money wage. If consumers demand fewer final goods and services on the market, this necessarily means that they are saving more. Why wouldn’t their unconsumed income merely be spent hiring labor and purchasing resources in a different way in the form of greater investment, as savers have more to lend to potential borrowers at a lower rate of interest? Keynes’s response is to insist that the motives of savers and investors are not the same. Incomeearners might very well desire to consume a smaller fraction of their income, save more, and offer it out to borrowers at interest. But there is no certainty, he insists, that businessmen will be willing to borrow that greater savings and use it to hire labor to make goods for sale in the future. Since the future is uncertain and tomorrow can be radically different from what it is today, Keynes states, businessmen easily fall under the spell of unpredictable waves of optimism and pessimism that raises and lowers their interest and willingness to borrow and invest. A decrease in the demand to consume today by income-earners may be motivated by a desire on their part to increase their consumption in the future out of their savings. But businessmen cannot know when those incomeearners will want to increase their consumption out of their savings in the future or what particular goods will be in greater demand when that future day comes. As a result, the decrease in consumer demand for present production merely serves to decrease the businessman’s current incentives for investment activity today as well. If for some reason there were to be a wave of business pessimism resulting in a decrease in the demand for investment borrowing, it should result in a decrease in the rate of interest. Such a decrease in the rate of interest because of a fall in investment demand should make savings less attractive, since less interest-income is now to be earned by lending out a part of one’s income. As a result, consumer spending should rise as savings goes down. Thus, while investment spending may be slackening off, greater consumer spending should make up the difference to ensure a "full employment" demand for the society’s labor and resources. But Keynes doesn’t allow that to happen, because of what he calls the "fundamental psychological law" of the "propensity to consume." As income rises, he says, consumption spending out of income also tends to rise, but less than the increase in income. Over time, therefore, as incomes rise in a society, a larger and larger percentage is saved rather than consumed. In The General Theory, Keynes lists a variety of what he called the "objective" and "subjective" factors that he considers to be the influences on people’s decisions to consume out of income. On the "objective" side: a windfall profit; a change in the rate of interest; a change in expectations about future 63
income. On the "subjective" side: "Enjoyment, Shortsightedness, Generosity, Miscalculation, Ostentation and Extravagance." He merely asserts that the "objective" factors have little influence on decisions as to how much to consume out of a given amount of income — including a change in the rate of interest. And the "subjective" factors are basically invariant, being "habits formed by race, education, convention, religion and current morals … and the established standards of life." Indeed, Keynes reaches the peculiar conclusion that because men’s wants are basically determined and fixed by their social and cultural environment and only change very slowly, "the greater … the consumption for which we have provided for in advance, the more difficult it is to find something further to provide for in advance." In other words, men run out of wants for which they would wish investment to be undertaken; the resources in the society — including labor — are threatening to become greater than the demand for their employment. Keynes, in other words, turns the most fundamental concept in economics on its head. Instead of our wants and desires always tending to exceed the means at our disposal to satisfy them, man is confronting a "post scarcity" world in which the means at our disposal are becoming greater than the ends for which they can be applied. The crisis of society is a crisis of abundance! The richer we become, the less work we have for people to do because, in Keynes’s vision, man’s capacity and desire for imagining new and different ways to improve his life are finite. The economic problem is that we are too well off. As a consequence, unspent income can pile up as unused and uninvested savings; and what investment is undertaken can erratically fluctuate up and down because of what Keynes called the "animal spirits" of businessmen’s irrational psychology concerning an uncertain future. The free-market economy, therefore, is plagued with the constant danger of waves of booms and busts, with prolonged periods of high unemployment and idle factories. Society’s problem stems from the fact that people consume too little and save too much to ensure jobs for all who desire to work at the money wages that have come to prevail in the market and which workers refuse to adjust downwards in the face of any decline in the demand for their services. Only one institution can step in and serve as the stabilizing mechanism to maintain full employment and steady production: the government, through various activist monetary and fiscal policies. This is the essence of Keynesian economics.
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Chapter 17 Keynesian Economic Policy and Its Consequences In a famous lecture entitled "National Self-Sufficiency" delivered in Dublin, Ireland, in April 1933, John Maynard Keynes renounced his previous belief in the benefits of free trade. He declared, "I sympathize … with those who would minimize rather than those who would maximize economic entanglement between nations.… Let goods be homespun whenever it is reasonably and conveniently possible; and above all, let finance be primarily national." He remained loyal to his new allegiance to economic protectionism when he published The General Theory of Employment, Interest and Money in 1936. In one of the concluding chapters, he discovered new value in the 17th- and 18th-century writings of the mercantilists and their rationales for government control over and manipulation of international trade and domestic investment. But Keynes also expressed another sentiment in that 1933 lecture: We each have our own fancy. Not believing we are saved already, we each would like to have a try at working out our salvation. We do not wish, therefore, to be at the mercy of world forces working out, or trying to work out, some uniform equilibrium according to the ideal principles of laissez faire capitalism. Keynes was convinced that left to itself, the market economy could not be trusted to ensure either stable or full employment. Instead, an activist government program of monetary and fiscal intervention was needed for continuing economic prosperity. If this also required a degree of state planning, Keynes was open to that kind of direct social engineering as well. A letter that Keynes wrote to Austrian economist Friedrich A. Hayek in 1944 is often quoted. In it Keynes said that he found himself "in a deeply moved agreement" with Hayek’s arguments in The Road to Serfdom. But less frequently mentioned was what Keynes went on to say in that same letter: I should say that what we want is not no planning, or even less planning, indeed I should say that what we almost certainly want is more. Moderate planning will be safe if those carrying it out are rightly oriented in their own minds and hearts to the moral issue. Dangerous acts can be done safely in a community which thinks and feels rightly, which would be the way to hell if they were executed by those who think and feel wrongly. Of course, the question is, Who determines which members of the society think and feel "rightly" enough to qualify for the power and authority to plan for the rest of us? And how is it to be ensured that such power does not fall into the hands of "those who think and feel wrongly"? Furthermore, on what basis can it be presumed that even those who claim to be "rightly oriented in their own minds and hearts" could ever possess the knowledge and ability to plan some proposed, desirable economic outcome for society? Yet, as a number of commentators have pointed out, Keynes had no doubts about either his "rightness" or competency in claiming such an authority or ability. He belonged to a British elite that viewed itself as superior in practically every way from the other members of the society. As Keynes’s sympathetic biographer Roy Harrod explained, "He was strongly imbued with … the idea that the government of Britain was and could continue to be in the hands of an intellectual aristocracy using the 65
method of persuasion." And as the American Keynesian Arthur Smithies also pointed out, "Keynes hoped for a world where monetary and fiscal policy, carried out by wise men in authority, could ensure conditions of prosperity, equity, freedom, and possibly peace." As we have seen, Keynes argued that the fundamental problem with a laissez-faire market economy was that as incomes went up over time, the saved part of that income would grow proportionally. Individuals were habituated and socialized into having certain types and amounts of consumer wants. When these tended to be satisfied, consumers ran out of things to demand, both in the present and the future. As a result, that would limit the amount of their growing fund of savings for which there would be private investment demand. With a psychological limit on the propensity to consume, and investment demand restrained by limited investment opportunities for future profits, savings in the society would accumulate and go to waste. Since workers were presumed to be unwilling to accept any significant downward adjustments in their money wage demands because of "money illusion," total, aggregate demand for goods and services in the economy would be insufficient to profitably employ all those willing to work at the prevailing, rigid money wages on the market. In Keynes’s mind, the only remedy was for the government to step in and put the unused savings to work through deficit spending to stimulate investment activity. What the government spent those borrowed funds upon did not matter. Even "public works of doubtful utility," Keynes said, were useful, as long as they put people to work. "Pyramid-building, earthquakes, even wars may serve to increase wealth," as long as they create employment. "It would, indeed, be more sensible to build houses and the like," said Keynes, "but if there are political or practical difficulties in the way of this, the above would be better than nothing." Nor could the private sector be trusted to maintain any reasonable level of investment activity to provide employment. The uncertainties of the future, as we saw, created "animal spirits" among businessmen which produced unpredictable waves of optimism and pessimism that generated fluctuations in the level of production and employment. Luckily, government could fill the gap. Furthermore, while businessmen were emotional and short-sighted in their fears and their erratic investment behavior, the state had the ability to calmly calculate the long-run, true value and worth of investment opportunities "on the basis of the general social advantage." Indeed, Keynes expected the government to take on "ever greater responsibility for directly organizing investment." In the future, said Keynes, "I conceive, therefore, that a somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment." As the profitability of private investment dried up over time, society would see "the euthanasia of the rentier" and "the euthanasia of the cumulative oppressive power of the capitalist" to exploit for his own benefit the scarcity of capital. This "assisted suicide" of the interest-earning and capitalist groups would not require any revolutionary upheaval. No, "the necessary measures of socialization can be introduced gradually and without a break in the general traditions of the society." This did not mean that the private sector would be completely done away with. Through its monetary and fiscal policies, the government would determine the aggregate level of spending in the economy, and then private enterprise would be allowed to operate in directing resources for the manufacture of the various individual goods to be sold on the market. The role of fiscal policy was for the government to run deficits and inject a net increase of spending into the economy by borrowing the unused savings that accumulated as idle cash or as unspent hoards of money. The key, in Keynes’s view, was for the government to increase spending enough that prices in general in the economy would rise. "The expectation of a fall in the value of money [a rise in prices] stimulates investment, and hence employment" because it would raise the profitability of prospective investments. Why would rising prices stimulate investment profitability? Because, in Keynes’s view, workers’ 66
"money illusion" worked both ways. Just as workers would not accept cuts in their money wages with a fall in prices, workers would not generally demand an increase in their money wages when there was a rise in prices. "A movement by employers to revise money-wage bargains downward," said Keynes, "will be much more strongly resisted than a gradual and automatic lowering of real wages as a result of rising prices." Thus, the government’s fiscal stimulus would raise prices in general relative to costs of production (especially the money-wage costs of labor), thus increasing profit margins and creating the incentives for private employers and investors to expand output and rehire the unemployed. Matching the fiscal stimulus, government was to introduce any required monetary expansion to keep interest rates low. If the government’s fiscal stimulus did succeed in generating greater investment spending in the private sector, it would tend to increase the private sector’s demand to borrow for the financing of expanding production activities. This increased demand to borrow would tend to push interest rates up and dampen some of the private sector business activity the government would try to stimulate. Thus, the government’s monetary authority was to create enough money to satisfy both the government’s and the private sector’s demand to borrow, while keeping interest rates unchanged (or even lowered). While Keynes was suspicious of attempts to construct statistical models of the economy (indeed, in an article in 1939, he forcefully criticized one of the leading developers of econometric techniques), he clearly believed that it was in the capacity of the government to determine just the right amount of fiscal and monetary stimulus to establish and maintain a fully employed economy. He also argued that government had to regulate and control a country’s imports and exports for purposes of securing a desired level of domestic production and employment. "It will be essential for the maintenance of prosperity that the authorities should pay close attention to the state of the balance of trade.… For a favorable balance, provided it is not too large, will be extremely stimulating," Keynes said. As for the effects this would have on international trade, Keynes stated that "the classical school [of economists] greatly overstressed … [the] advantages of the international division of labor." For Keynes, therefore, no aspect of economic life would remain unaffected by the activist hand of government. After all, Keynes had said, "We each have our fancy," and his purpose was to devise the rationale and tools for government "to have a try working out our salvation."
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Chapter 18 Say’s Law of Markets and Keynesian Economics In the preface to The General Theory of Employment, Interest and Money, John Maynard Keynes stated that "the composition of this book has been for the author a long struggle of escape … a struggle of escape from habitual modes of thought and expression." What Keynes struggled to escape from were the commonsense foundations of economics. From Adam Smith in the 18th century to the Austrian economists of the 21st century, economics has developed and been refined into the study of human action and the logic of human choice. Over 200 years, economists came to more clearly understand that nothing happens in society or in the market that does not first begin with the actions and decisions of individuals. Indeed, the market is nothing more than a summarizing term to express the arena in which multitudes of individuals meet and interact as suppliers and demanders for purposes of mutual gains through trade. Each individual has various goals or ends he would like to achieve. To attain them he must apply various means that may be at hand to bring those desired ends into existence through production. But man finds that, unfortunately, the means at his disposal are often insufficient to satisfy all the uses he has for them. He faces the reality of scarcity. He is confronted with the necessity to choose. He must decide which of the desired ends he prefers more and which he prefers less. And then he must apply the means that he has to achieve the more highly valued ends and leave other, less valued, ends unfulfilled, either for a day or forever. In his state of disappointment, man looks around to see whether there are ways to improve his situation. He discovers that there are others who face the same frustrations of unsatisfied ends, like himself. Sometimes he finds that those others have things that he values more highly than what is in his possession, and they in turn value more highly what he has than what they own. A potential gain from trade arises, in which each can be better off if he trades away what he has for what the other has. But how much of one thing will be exchanged for another? This will be determined through the traders’ bargaining in the market. Finally, they may agree upon terms of trade and establish a price at which they exchange one thing for another: so many apples for so many pears; so many bushels of wheat for so many pounds of meat; so many pairs of shoes for a suit of clothes. Trade becomes a regular event through which men improve their circumstances through the process of buying and selling. Appreciating the value of these trading opportunities, men begin to specialize their productive activities and create a system of division of labor, with each trying to find that niche in the growing arena of exchange in which they have a comparative advantage in production over their trading partners. As the market expands and widens, a growing competition arises among the buyers and sellers, with each trying to get the best deal possible as a producer and a consumer. The prices at which goods are traded come more and more to reflect the contributing and competing bids and offers of many buyers and sellers on both sides of the market. The more complex the network of exchanges, the more difficult becomes the direct barter of goods one for another. Rather than be frustrated and disappointed in not being able to directly find trading partners who want the goods they have for sale, individuals start using some commodity as a medium of exchange. They first trade what they have produced for some particular commodity and then use that commodity to buy the things they desire from others. When that commodity becomes widely accepted and generally used by most, if not all, transactors in the market, it becomes the money-good. It should be clear that even though all transactions are carried out through the medium of money, it is still, ultimately, goods that trade for goods. The cobbler makes shoes and sells them for money to 68
those in the society who desire footwear. The cobbler then uses the money he has earned from selling shoes to buy the food he wants to eat. But he cannot buy that food unless he has first earned a certain sum of money by selling a particular quantity of shoes on the market. In the end, his supply of shoes has been the means for him to demand a certain amount of food. This, in essence, is the meaning of Say’s Law, named after the 19th-century French economist Jean-Baptiste Say. Say called it "the law of markets." Unless we first produce, we cannot consume; unless we first supply, we cannot demand. But how much others are willing to take of our supply is dependent upon the price at which we offer it to them. The higher we price our commodity, other things held equal, the less others will be willing to buy of it. The less we sell, the smaller may be the money income we earn; and the smaller the money income we earn, the smaller our financial means to demand and purchase what others are offering for sale. Thus, if we want to sell all that we choose to produce, we must price it correctly, i.e., at a price sufficiently low that all of it we offer is cleared off the market by potential demanders. Pricing our goods or labor services too high, given other people’s demands for them, will leave part of the supply of the good unsold and part of the labor services offered unhired. On the other hand, lowering the price at which we are willing to sell our commodity or services will, other things held equal, create a greater willingness on the part of others to buy more of our commodity or hire more of our labor services. By selling more, our money income can increase; and by increasing our money income, through correctly pricing our commodity or labor services, we increase our ability to demand what others have for sale. Sometimes, admittedly, even lowering our price may not generate a sufficiently large increase in the quantity demanded by others for our income to go up. Lowering the price may, in fact, result in our revenue or income’s going down. But this, too, is a law of the market: what we choose to supply is worth no more than what consumers are willing to pay for it. This is the market’s way of telling us that the commodity or particular labor skills we are offering for sale are not in very great demand. It is the market’s way of telling us that consumers value more highly other things that they could buy instead. It is the market’s way of telling us that the particular niche we have chosen for ourselves in the division of labor represents one in which our productive abilities or labor services are not worth as much as we had hoped. It is the market’s way of telling us that we need to move our productive activities into other directions, representing lines of production where consumer demand is greater and in which our productive abilities may be valued more highly. Is it possible that consumers might not spend all they have previously earned from selling goods on the market? Is it possible that some of the money earned will be "hoarded," so there will be no greater demand for other goods and hence no alternative line of production in which we might find remunerative employment? Would this not be a case in which "aggregate demand" for goods in general on the market would be insufficient to buy all of the "aggregate supply" of goods and labor services being offered for sale? The answer to this was already suggested in the middle of the 19th century by the English classical economist John Stuart Mill in a restatement and refinement of Say’s law of markets. In an essay entitled "Of the Influence of Consumption on Production" (1844), Mill argued that as long as there are any ends or wants that men desire that have not as yet been satisfied, there is always more work to be done. As long as producers adjust their supplies to reflect the actual demand for the particular goods which consumers wish to purchase, and as long as they price their supplies at prices consumers are willing to pay, there need be no unemployment of resources or labor for all those who are looking for work. Thus, there can never be an excess supply of all things relative to the total demand for all things. But Mill admits that there may be times when individuals, for various reasons, may choose to hoard, or leave unspent in their cash holding, a greater proportion of their money income than is the usual practice. In this case, Mill argued, what is "called a general superabundance" of all goods is in 69
reality "a superabundance of all commodities relative to money." In other words, if we accept that money, too, is a commodity like all other goods on the market for which there is a supply and demand, then there can appear a situation in which the demand to hold money increases relative to the demand for all the other things that money can buy. This means that all other goods are now in relative oversupply in comparison to that greater demand to hold money. To bring all those other goods offered on the market into balance with the lower demands for them (i.e., given that increased demand to hold money and the decreased demand for other things), the prices of many of those other goods may have to decrease. Prices in general, in other words, must go down, until that point at which all the supplies of goods and labor services people wish to sell find buyers willing to purchase them. Sufficient flexibility and adjustability in prices to the actual demands for things on the market always ensures that all those willing to sell and desiring to be employed can find work for themselves. And this, also, is a law of the market. Free-market economists, both before and after Keynes, never denied that the market economy could face a situation in which mass unemployment exists and a sizable portion of the society’s productive capacity is left idle. But if such a situation were to arise, they argued that its cause was to be found in a failure of suppliers to price their goods and labor services to reflect what consumers considered them to be worth, given the demand for various other things, including money. Correct prices always ensure full employment; correct prices always ensure that supplies create a demand for them; correct prices always ensure the harmony of the market. This was the reality of the law of markets from which Keynes struggled so hard to escape.
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Chapter 19 Savings, Investment, and Interest and Keynesian Economics In the 1939 foreword for the French edition of The General Theory of Employment, Interest and Money, John Maynard Keynes said that in writing this book, he had broken out of the prevailing economic orthodoxy "and was reacting strongly against it, that I was breaking its chains and gaining my freedom." The freedom that Keynes wanted to gain was from the laws of economics, the logic of human choice, and the relationships between savings, investment, and interest. For Keynes, spending out of income was determined by his "psychological law" of people’s "propensity to consume" out of any given level of income. This was dependent on various cultural, racial, class, and religious habits of mind that changed only very slowly. One thing that Keynes was certain did not significantly influence people’s willingness to consume was a change in the rate of interest; a rise or a fall in the rate of interest had no significant effect on people’s willingness to save or spend more or less out of income earned. What did the rate of interest influence? According to Keynes: people’s willingness or "propensity" to hoard money. Given the propensity to consume out of income, the amount of income saved could either be invested in interest-earning securities or bonds or be held as an idle cash balance. All that the rate of interest influenced was the relative attractiveness of holding bonds or cash. No matter how low the rate of interest might go, individuals would not consume more; their consumption was determined by the "psychological law." They would merely continue to hold their savings in idle cash. In Keynes’s system, the rate of interest also had no appreciable effect on the willingness to invest. People’s willingness to invest was based on their estimates of the likely future profitability from a possible investment relative to the rate of interest to be paid to borrow the sums needed to undertake the production project. But in Keynes’s view, there is no way to precisely determine what the future holds in store or what the prospective return from an investment is really likely to be. Since we all must try to make some estimate of the probable results from present actions undertaken towards a radically uncertain future, Keynes believed that people fall back on "conventional wisdom." That is, we model our beliefs about the future on the basis of what we think the majority of other people think at any point in time. "Being based on so flimsy a foundation," Keynes argued, "it is subject to sudden and violent changes.… New fears and hopes will, without warning, take charge of human conduct." Being based on nothing but what each thinks the other person believes, investor expectations about investment possibilities and profitabilities are open to dramatic and unpredictable fluctuations that are far more important in influencing investment demand than any changes in the rate of interest, Keynes insisted. The great demon in the Keynesian system, therefore, was the propensity to save some portion of any additional income earned rather than to consume it all. Savings diminished spending in the economy; diminished consumption spending decreased expected revenues from sales; lowered sales expectations made businessmen want to cut back production; lowered production meant fewer jobs; fewer jobs decreased total income earned in the economy; a decline in total income created a further falling off in consumer spending; and this additional falling off in consumer spending set the process of economic contraction in motion once again. If only everything that was earned was consumed, Keynes argued, full employment and high production would be ensured. In explaining the fundamental error in Keynes’s conception of the evils of savings, I can do no better than to quote the insightful response given by the German free-market economist H. Albert Hahn 71
from his 1946 article "Is Saving a Virtue or a Sin?": According to the classical [economic] concept of the problem of savings … the interests of the individual and of the community are in full harmony. He who saves serves his own as well as the nation’s welfare. He improves his own welfare because savings implies the transfer of means of consumption from the present, where his earnings are ample, to the future where his earnings may become scarce through old age and sickness. Furthermore, savings will increase his means through the interest he receives. The nation as a whole, on the other hand, benefits from savings since these savings are paid into a bank or some other reservoir of money from which an employer may borrow for productive purposes, for instance to buy machinery. This means a change in the direction of productive activity. Through saving, production is diverted from goods for immediate consumption to goods which cannot themselves be consumed but with which consumer goods can be produced. Production is diverted, as one puts it, from a direct to a roundabout way of production. The roundabout way of production has the advantage of greater productivity. The high productivity of the more capitalistic production methods has further favorable effects. Because [of this greater productivity] employers can — and by competition are forced to — pay interest on the capital borrowed, to raise wages, and lower costs. The standard of living of the nation rises. This process is renewed over and over again, because increased savings permit primitive direct methods of production requiring small amounts of capital to be replaced by roundabout indirect methods requiring large amounts of capital. But doesn’t the falling off in consumption from the act of savings reduce the demand for goods and thus decrease the profitability from production? Why would businessmen undertake new and timeconsuming investment projects to increase production capacity in the future when demand for consumer goods shows itself to be less in the present? The answer to this Keynesian argument, as we saw, was given by the Austrian economist Eugen von Böhm-Bawerk 35 years before Keynes wrote The General Theory. In a 1901 essay entitled "The Function of Savings," Böhm-Bawerk had pointed out that the error in such an argument arises from the failure to remember that what people do in an act of savings is to defer present consumption, not to plan to forgo consumption permanently. Income-earners shift a portion of their demand for goods from the present to the future, at which point they plan to utilize what they have saved and additionally earned as interest-income for some alternative desired consumption purposes. The savings set aside frees resources and labor to be applied in those different, roundabout productive ways, so there can be produced greater and improved quantities of goods that will be demanded when those times in the future arrive. The task of the entrepreneur is to anticipate the direction and timing of future consumer demand as well as the prices those future consumers might be willing to pay for goods to be offered in certain quantities and qualities. The market rewards those entrepreneurs who more correctly anticipate future market conditions with earned profits and punishes the less competent entrepreneurs with no profits or even losses. The market system of profit and loss through competition for the use of resources and the selling of products assures a greater rationality to investment decision-making than suggested by Keynes’s references to "animal spirits" and "conventional wisdom." In the market economy, control over the investment decision-making process is always tending to be shifted into those entrepreneurial hands that, in the system of division of labor, demonstrate the most competent ability to direct production into the avenues most consistent with the present and future patterns of consumer demand. 72
The market interest rates are meant to bring into balance the individual plans of savers with the individual plans of borrowers and investors. They serve the same function as all other prices in the market: to coordinate the activities of multitudes of people for purposes of mutual benefit through opportunities for gains from trade. Changes in the market rates of interest potentially modify people’s consumption, savings, and investment decisions just as any other change in a price may modify the amount of a good consumers find attractive to buy and sellers find attractive to offer for sale. In a developed market, with numerous consumers and producers, there always tend to be people for whom any change in price will represent their individual threshold point at which they will modify their buying and selling. Each of us has these threshold points; this is what economists call "marginal decision-making." Some incremental change in a price will result in some incremental increase or decrease in the amount of a good some people are willing to purchase or sell. By arguing that some mystical "psychological law" results in people’s consuming a certain amount of their income independent of changes in the rate of interest, Keynes was rejecting the fundamental logic of human action and choice upon which all economic understanding is based. The rate of interest not only influences the attractiveness, at the margin, of investing in bonds and securities versus holding a portion of one’s income as a cash balance. The interest income to be earned from savings is also the cost of not consuming. And as with any other price, if the rate of interest rises or falls, some people will find it less or more attractive to consume. It is the logic of these changes in people’s willingness to consume or save in the face of a change in the rate of interest that ensures that the supplies and demands for consumer goods, savings, and investment projects of particular types and durations are kept in balance. It was this logic of human choice and the rationality of market relationships between savings, investment, and interest that Keynes said he was "reacting strongly against" and from which he wanted to gain his "freedom."
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Chapter 20 Keynesian Economics and the Hubris of the Social Engineer In September 1936, John Maynard Keynes prepared a preface for the German translation of The General Theory of Employment, Interest and Money. Addressing himself to a readership of German economists, Keynes hoped that his theory would "meet with less resistance on the part of German readers than from English" because the German economists had long before rejected the teachings of both the classical economists and the more recent Austrian school of economics. And, said Keynes, "If I can contribute a single morsel to the full meal prepared by German economists, particularly adjusted to German conditions, I will be satisfied." What were the particular "German conditions" to which Keynes referred? For more than three years, Germany had been under the rule of Hitler’s National Socialist regime. And in 1936, the Nazis had instituted their own version of four-year central planning. Towards the end of his preface, Keynes pointed out to his Nazi economist readers: The theory of aggregate production, which is the point of the following book, nevertheless can be much easier adapted to the conditions of a totalitarian state, than … under conditions of free competition and a large degree of laissez-faire. This is one of the reasons that justifies the fact that I call my theory a general theory. Although I have, after all, worked it out with a view to the conditions prevailing in the Anglo-Saxon countries where a large degree of laissez-faire still prevails, nevertheless it remains applicable to situations in which state management is more pronounced. It would be historically inaccurate to accuse Keynes of explicitly being either a Nazi sympathizer or an advocate of Soviet or fascist-type totalitarianism. But Keynes clearly understood that the greater the degree of state control over any economy, the easier it would be for the government to manage the levers of monetary and fiscal policy to manipulate macroeconomic aggregates of "total output," "total employment," and "the general price and wage levels" for purposes of moving the overall economy into directions more to the economic policy analyst’s liking. On what moral or philosophical basis did Keynes believe that policy advocates such as himself had either the right or the ability to manage or direct the economic interactions of multitudes of peoples in the marketplace? Keynes explained his own moral foundations in Two Memoirs, published in 1949, three years after his death. One of them, written in 1938, was on the formation of his "early beliefs" as a young man in his 20s at Cambridge University in the first decade of the 20th century. He and many of the other young intellectuals at Cambridge had been influenced by the writings of philosopher G.E. Moore. Separate from the actual arguments made by Moore, what is of interest are the conclusions reached by Keynes from reading Moore’s work. Keynes said: Indeed, in our opinion, one of the greatest advantages of his [Moore’s] religion was that it made morals unnecessary. Nothing mattered except states of mind, our own and other people’s of course, but chiefly our own. These states of mind were not associated with action or achievement or consequences. They consisted of timeless, passionate states of contemplation and communion, largely unattached to ‘before’ and ‘after.’ 74
In this setting, traditional or established ethical or moral codes of conduct meant nothing. Said Keynes: We entirely repudiated a personal liability on us to obey general rules. We claimed the right to judge every individual case on its own merits, and the wisdom, experience and self-control to do so successfully. This was a very important part of our faith, violently and aggressively held. We repudiated entirely customary morals, conventions and traditional wisdoms. We were, that is to say, in the strict sense of the term immoralists. We recognized no moral obligation upon us, no inner sanction to conform or obey. Before heaven we claimed to be our own judge in our own case. Keynes declared that he and those like him were "left, from now onwards, to their own sensible devices, pure motives and reliable intuitions of the good." Now in his mid 50s, Keynes declared in 1938, "Yet so far as I am concerned, it is too late to change. I remain, and always will remain, an immoralist." As for the social order in which he still claimed the right to act in such unrestrained ways, Keynes said that "civilization was a thin and precarious crust erected by the personality and the will of a very few, and only maintained by rules and conventions skillfully put across and guilely preserved." On matters of social and economic policy, two assumptions guided Keynes, and they also dated from his Cambridge years as a student near the beginning of the century; they are stated clearly in a 1904 paper entitled "The Political Doctrines of Edmund Burke": Our power of prediction is so slight, our knowledge of remote consequences so uncertain that it is seldom wise to sacrifice a present benefit for a doubtful advantage in the future. We can never know enough to make the chance worth taking. What we ought to do is a matter of circumstances.… While the good is changeless and apart, the ought shifts and fades and grows new shapes and forms. Classical liberalism and the economics of the classical economists had been founded on two insights about man and society. First, that there is an invariant quality to human nature that makes him what he is; and if society is to be harmonious, peaceful, and prosperous, men must reform their social institutions in a way that sees to it that the inevitable self-interests of individual men are directed into those avenues of action that benefit not only themselves but others in society as well. They therefore advocated the institutions of private property, voluntary exchange, and open, peaceful competition. Then, as Adam Smith had concisely expressed it, men would live in a system of natural liberty in which each individual would be free to pursue his own ends but would be guided as if by an invisible hand to serve the interests of others in society as the means to his own self-improvement. The second insight was that it is insufficient in any judgment concerning the desirability of a social or economic policy to focus only upon its seemingly short-run benefits. The laws of the market always bring about certain inevitable effects in the long run from any shift in supply and demand or from any intervention by the government in the market order. Thus, as the French economist Frédéric Bastiat had emphasized, it behooves us to always try to determine not merely "what is seen" from a government policy in the short run but also to discern as best we can "what is unseen," i.e., the longer-run consequences from our actions and policies. The reason it is desirable to take the less immediate consequences into consideration is that the longer-run effects may not only not improve the ill the policy was meant to cure but instead make the social situation even worse than if it had been merely left alone. Even though the specific details of the future always remain beyond our knowledge to fully predict, one of the uses of economics is to assist us to at least qualitatively anticipate the likely contours and shape of that future with the aid of an 75
understanding of the laws of the market. Keynes’s assumptions deny the wisdom and the insights of the classical liberals and the classical economists. The biased emphasis is towards the benefits and pleasures of the moment, the short run, with an almost total disregard of the consequences that will only be fully felt tomorrow. It led F.A. Hayek in 1941 to refer to Keynes’s short-run myopia "as a betrayal of the main duty of the economist and a grave menace to our civilization." But if every action and policy decision is to be decided in the context of shifting circumstances, as Keynes insisted, on what basis shall decisions be made and by whom? Such decisions are to be made on the basis of the self-centered "state of mind" of the policymakers, with total disregard for traditions, customs, moral codes, rules, or the long-run laws of the market. Its rightness or wrongness was not bound by any independent standard of "achievement and consequence." Instead it was to be guided by "timeless, passionate states of contemplation and communion, largely unattached to ‘before’ and ‘after.’" The decision-maker’s own "intuitions of the good," for himself and for others, were to serve as his compass. And let no ordinary man claim to criticize such actions or their results. "Before heaven," said Keynes, "we claimed to be our own judge in our own case." Here was an elitist ideology of nihilism. The members of this elite were self-appointed and shown to belong to this elect precisely through mutual self-congratulations of having broken out of the straightjacket of conformity, custom, and law. For Keynes in his 50s, civilization was a thin, precarious crust overlying the animal spirits and irrationality of ordinary men. Its existence, for whatever it was worth, was the product of "the personality and the will of a very few," like himself, naturally, and maintained through "rules and conventions skillfully put across and guilely preserved." Society’s shape and changing form were to be left in the hands of "the chosen" who stood above the passive conventions of the masses. Here was the hubris of the social engineer, the self-selected philosopher-king, who through manipulative skill and guile directed and experimented on society and its multitudes of individual human residents. It is what made Keynes feel comfortable in recommending his "general theory" to a Nazi readership. His conception of a society maintained by "the personality and the will of a very few," after all, had its family resemblance to the Fuehrer principle of the unrestrained "one" who would command the Volk.
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Chapter 21 The Keynesian Revolution and the Early Critics of Keynes American economist Dudley Dillard began his 1948 book, The Economics of John Maynard Keynes, by pointing out, "Within the first dozen years following its publication, John Maynard Keynes’s The General Theory of Employment, Interest and Money (1936) has had more influence upon the thinking of professional economists and public policy makers than any other book in the whole history of economic thought in a comparable number of years." Indeed, by the mid 1940s, especially in England and the United States, Keynes’s General Theory had become practically a "New Testament" for the economics profession. Soon after the Second World War, textbooks began incorporating its teachings for purposes of instructing the young, and nontechnical, readable expositions of Keynes’s ideas were published for purposes of indoctrinating the general public about the wisdom of its policy proposals. One of the most clearly written of these was The Keynesian Revolution by Lawrence R. Klein (who was awarded the Nobel Prize in economics in 1980). Published in 1947, it represents the views of the growing consensus of the time among economists and government policy advocates. The final chapter of Klein’s book outlines what would be expected from government if the Keynesian "insights" were to be fully applied for the "social good." In the brave new world guided by the ideas of Keynes, Americans would have to accept a greater degree of government regimentation than they had been used to in the past. Should they be afraid of this? No, Klein assured his readers. After all, "the regimentation of unemployment and poverty is infinitely more severe than the regimentation of economic planning." He was sure that the American people would "quickly come forth with support" for the regimentation of economic planning. The government economic planners would have to have "complete control over the government fiscal policy so that they can spend when and where spending is needed to stimulate employment and tax when and where taxation is needed to halt upward price movements." The slow and cumbersome congressional budgetary process would have to be put aside. In its place, We must have a planning agency always ready with a backlog of socially useful public works to fill any deflationary gap that may arise [through discretionary government deficit-spending powers]; similarly, we must have a price-control board always ready with directives and enforcement officers to wipe out any inflationary gap that may arise.… Government spending should be very flexible and subject to immediate release or curtailment, in just the precise amount which will maintain full employment, no more and no less. This is the road to the kind of full employment that we need. At the same time, government would have to see to it that the members of society were kept from saving too much and spending too little, since excessive savings would diminish the "aggregate demand" upon which "full employment" was dependent. This would require, Klein argued, an active and conscious policy of redistribution of income: If we redistribute income from the rich, who have a relatively high marginal propensity to save, to the poor [whose marginal propensity to save is generally lower], we will decrease the community’s marginal propensity to save. Such policies of income redistribution can be carried 77
out by taxing the rich and paying a dole or other types of contributions to the poor. Also, the motives for people privately desiring to save would have to be undermined by government’s taking over greater responsibility for such things as retirement planning. Klein argued: Most children are raised on the virtues of thrift, and high spenders are usually considered to be unworthy citizens. It is difficult to change these fundamental habits.… The people acting on individualistic principles do not know their own best interests. They must be taught to look at the system as a whole [in which consumption rather than savings is the ‘socially’ desirable conduct].… We must resort to indirect methods such as social-security programs which wipe out the need for savings. For a book that created such a rapid and mass following among so many economists and public policymakers in such a short period of time, it is worth recalling that when Keynes’s General Theory first appeared, it was greeted by a wide variety of critical reviews in the leading publications of the day. For example, Alvin Hansen, who in the period after the Second World War would become one of the leading proponents of Keynesian economics in the United States, concluded a review in the Journal of Political Economy in October 1936 by pointing out that Keynes’s book "is not a landmark in the sense that it lays a foundation for a ‘new economics’.… The book is more a symptom of economic trends than a foundation upon which a science can be built." Especially critical of The General Theory were many of the leading members of the Chicago school of economics. Henry Simons, for instance, writing in the Christian Century (July 22, 1936) argued that Keynes "gives us a theory of unemployment, interest and money which attains generality by being about nothing at all." His solutions to the problem of economic depressions ran "in terms of a great and curious variety of expedients … intended to demonstrate that wise governmental policy must deal directly with many particular [market] relationships," with little thought as to whether government has the ability to actually master all the problems involved. He concluded that Keynes "may only succeed in becoming the academic idol of our worst cranks and charlatans — not to mention the possibilities of the book as the economic bible of a fascist movement." Jacob Viner, another leading economist at the University of Chicago, in a review in the Quarterly Journal of Economics, vol. 51 (1936), feared that The General Theory’s "display of dialectical skill is so overwhelming that it will have probably more persuasive power than it deserves." Viner was especially critical of Keynes’s opposition to downward adjustments in money-wages as a method for restoring profit margins to firms as part of a market-based return to full employment and balanced investment and production. Viner warned that Keynes’s preference for government-induced increases in aggregate demand, as a method for increasing prices relative to rigid money-wage costs to stimulate full employment, carried the danger of creating the institutional conditions for an inflationary spiral, as labor unions came to demand higher wages to compensate for lost purchasing power due to rising prices: Keynes’s reasoning points obviously to the superiority of inflationary remedies for unemployment over money-wage reductions. In a world organized in accordance with Keynes’s specifications there would be a constant race between the printing press and the business agents of the trade unions, with the problem of unemployment largely solved if the printing press could maintain a constant lead and if only the volume of employment, irrespective of quality, is considered important. Frank H. Knight, also at the University of Chicago, reviewed The General Theory in the Canadian 78
Journal of Economics and Political Science (February 1937). Professor Knight stated that he found the work "quite unsubstantiated." He believed that this was partly the case because of Keynes’s caricature of the ideas of the classical economists, who were "set up as straw men for purposes of attack in controversial writing." And he concluded, "It seems to me reasonable to interpret the entire work as a new system of political economy, built around, and built to support, Mr. Keynes’s conception of inflation as the cure for depression and unemployment." At Harvard University, Joseph A. Schumpeter reviewed Keynes’s book for the Journal of the American Statistical Association (December 1936). He criticized Keynes’s reliance on asserted "psychological propensities," such as the "propensity to consume," as a device for claiming to understand the causes of economic depressions. Rather than being a useful tool for understanding the logic behind human decision-making, "such a ‘propensity’ is again nothing but a deus ex machina, valueless if we do not understand the mechanism of the changing situations, in which consumers’ expenditure alternatively increases or contracts, and redundant if we do." As for Keynes’s inflationary remedies for unemployment, Schumpeter suggested, Let him who accepts the message [in Keynes’s book] rewrite the history of the French ancien regime in some such terms as these: Louis XV was a most enlightened monarch. Feeling the necessity of stimulating expenditure he secured the services of such expert spenders as Madame de Pompadour and Madame du Barry. They went to work with unsurpassable efficiency. Full employment, a maximum of resulting output, and general well-being ought to have been the consequence. It is true that instead we find misery, shame and, at the end of it all, a stream of blood. But that was a chance coincidence. Schumpeter, therefore, suggested: "The less said about the last book [The General Theory] the better."
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Chapter 22 The Chicago School Economists and the Great Depression In 1964, Keynesian economist Robert Lekachman edited a volume of essays entitled Keynes’ General Theory: Reports of Three Decades. Among the contributors was University of Chicago economist Jacob Viner. Added to the reprint of his 1936 review of Keynes’s General Theory was a comment updating his views on Keynes and Keynesian economics. Viner still believed, as he had pointed out almost 30 years earlier, that Keynes had failed to give any "warning about the evil or the danger of inflation." But he also stated, "My appreciation of the quality and originality of [The General Theory’s] analysis as short-run analysis has grown since [1936] rather than shrunk." Viner explained that he had been trained as an "orthodox" economist whose eyes were always on the long run in his economic theorizing. But by 1930 or 1931, he had come to be dissatisfied with orthodox economic theory as a framework for understanding the nature and origins of business cycles. Viner said: A year or two of the Great Depression sufficed to convince me, ‘orthodox’ theorist though I was by training and temperament … that the greater the degree of [the economic] crisis, the greater was the relative importance of the forces whose impact was predominantly short-run in character.… Aside from details … I would have accepted the policy implications of the General Theory in the monetary and fiscal field were they presented as relating to short-run or cyclical fluctuations in employment [only]. Indeed, Viner stated that the Keynesian formula that government should spend more and tax less in depressions and spend less and tax more in economic booms as a policy method to regulate economy-wide fluctuations in employment, output, and prices was one he had advocated in the early 1930s. He quoted from one of his own speeches from August 1931: Tax heavily, spend lightly, redeem debts, are sound Treasury principles during a period of dangerously rapid business expansion; tax lightly, spend heavily, borrow, are equally sound Treasury principles during a period of acute depression.… Really sound Treasury policy … should be a function of the state of business conditions and should be conducted so as to contribute to the smoothing out of business fluctuations. And Viner pointed out, "This formula may have been a discovery of Keynes, but … the idea was then commonplace in my academic surroundings of the time, and I cannot recall that any of my Chicago colleagues would have dissented, or that they needed to learn it from Keynes, or from me." Were the predominantly free-market economists at the University of Chicago in the 1930s advocates of "activist" monetary and fiscal policy by the United States government? In fact many of them were. This is most thoroughly documented in two books, L. Ronnie Davis’s New Economics and the Old Economists (1971) and William J. Barber’s From New Era to New Deal: Herbert Hoover, the Economists, and American Economic Policy, 1921 -1933 (1985). In 1967, Milton Friedman observed that the views of many Chicago economists were very similar to Keynes’s in the early 1930s "as to the causes of the Great Depression, the impotence of monetary 80
policy, and the need to rely extensively on fiscal policy." He referred to a policy statement of Henry Simons, one of the outstanding figures of the Chicago school at that time, who in November 1933 argued for an "increase of expenditures or a reduction of taxes" through deficit spending by the federal government as a policy for an "effective raising of prices" to stimulate demand and employment in the American economy. Friedman pointed out that such views "were in the air at the University of Chicago in the early and mid-1930s" and basically explained why, for the Chicago economists, Keynes’s ideas in The General Theory came as no revelation. In 1932, for example, Frank H. Knight, one of the most respected market-oriented Chicago economists in the United States, supported a proposal of Sen. Robert F. Wagner for federal budget deficits to finance public-works projects. Knight argued that "the government should spend as much and tax as little as possible, at a time such as this, using the expenditure in the way to do the most good in itself and also to point toward relieving the depression." At the end of his review of Keynes’s General Theory in 1937, Knight said that as for "Mr. Keynes’s conception of inflation as the cure for depression and unemployment … I happen to be in sympathy." Also in 1932, 12 University of Chicago economists, including Aaron Director, Harry D. Gideonse, Frank Knight, Lloyd Mints, Henry Simons, and Jacob Viner, issued a memorandum advocating budget deficits as a method for getting out of the Great Depression; the memo also argued for the federal government’s no longer balancing its budget annually but instead over the phases of the business cycle. They admitted that the Depression could be overcome through appropriate adjustments in market prices and wages to reflect the actual underlying conditions of supply and demand in the various sectors of the economy. Given a "deflation of costs and elimination of fixed charges, business will discover opportunities for profitably increasing employment." But they insisted that to follow a market solution would involve "tremendous losses, in wastage of productive capacity, and in acute suffering" because wages and other prices had become downwardly rigid and unresponsive to significant market changes except with a prolonged lag. An economic upturn, instead, should be stimulated through "the form of generous Federal expenditures, financed without resort to taxes on commodities or transactions." These Chicago economists were certain that the budget deficit would take care of itself; as the economy improved under the initial stimulus of government deficit spending, a reflationary rise in prices and production would generate the private-sector revenue out of which higher taxes would move the government’s budget back into balance or even produce a surplus. How should the federal government finance its anti-depression budget deficits? They proposed that the U.S. Treasury could issue new bonds to Federal Reserve Banks, for which the Treasury would receive new Federal Reserve Notes and additional bank deposits on the basis of which the government would increase its spending in the American economy. Thus, the total quantity of currency and bank deposit money in circulation would be increased. What would this increase in currency and bank-deposit money mean for remaining on the gold standard, since the increase in notes and bank deposit claims redeemable on demand for the given available supply of gold could result in a gold drain out of the country, as well as a hoarding of gold at home? The Chicago economists replied: "Once a deliberate reflation is undertaken it must be carried through, whatever that policy may mean for gold." In other words, if a policy of paper-money creation undertaken to pump up domestic demand and prices threatened the retention of the gold standard, then abandonment (at least temporarily) of the gold standard was a sacrifice they were willing to endorse. Furthermore, rather than being fearful that federal deficit spending might go too far, they were more concerned that government spending wouldn’t be high enough. A danger, they argued, was that "measures of fiscal inflation may be too meager and too short lived.… We should be prepared to administer heavy doses of stimulant if necessary, to continue them until recovery is firmly established. … A courageous fiscal policy on the part of the central government" was essential, they insisted. 81
In 1933, the University of Chicago Press published a short monograph entitled Balancing the Budget, signed by several Chicago economists, including Jacob Viner and Henry Simons. The premise of their argument was that the government should balance its budget over several years, running deficits during economic downturns and running surpluses during economic booms: The balancing of budgets should be regarded as a series of long-term operations in which deficits will be incurred and debts increased during years of economic adversity while Treasury surpluses and the rapid retirement of the public debt will be planned for during years of prosperity.… When a series of annual budgets is thus put together, the result is the balancing of the long-term budget with reference to economic cycle periods. The equilibrium between revenue and expenditures is thus intentionally struck over a period of years rather than annually. Thus, in the early 1930s, the leading economists at the University of Chicago, scholars usually considered among the most outspoken defenders of a free-market order, had proposed and strongly defended deficit spending and paper-money inflation as the primary policy techniques for overcoming the unemployment and idle productive capacity of the Great Depression. They knew and had admitted that the cause for the duration and intensity of the Depression was that resource and labor costs were being held artificially above what would be market-clearing prices and wages. But rather than argue for the abolishment of those impediments to the competitive functioning of the market in the United States, they advocated the short-run expedient of inflation and government deficit spending. In other words, many of the Chicago economists had held Keynesian-type policy positions several years before Keynes formalized the rationale for them in the theoretical scheme he developed in The General Theory. What, then, separated the economists of the Chicago school from Keynes and the Keynesians in the 1930s and 1940s? Whereas Keynes had seen the cause of the Depression and its persistence in the instability of private-sector "aggregate demand" for goods and services in the economy, the Chicago economists saw the cause of the Great Depression and its severity in the mismanagement of the monetary system by the Federal Reserve in the early 1930s. But their proposed remedy called not for less government intervention and control over the monetary system. To the contrary, they desired even more and tighter government planning over money and banking in the United States. Theirs, in other words, was the case for an even greater degree of monetary central planning in America.
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Chapter 23 Henry Simons and the "Chicago Plan" for Monetary Reform Henry Simons was one of the guiding intellectual lights at the University of Chicago in the 1930s and 1940s. Noted members of the Chicago school of economics — Milton Friedman and George Stigler, for example — have emphasized the personal and scholarly impact that Simons had on them and an entire generation of graduate students at the University of Chicago during that period. Among the outstanding characteristics of Simons’s writings throughout that period was his outspoken and forthright condemnation and opposition to collectivism, neo-mercantilism, and specialinterest political plundering. He insisted that the choice before America and the world was collectivist planning or competitive free enterprise. If the collectivist road were followed, it would lead to tyranny and corruption. In his famous 1934 monograph, "A Positive Program for Laissez Faire: Some Proposals for a Liberal Economic Policy," Simons argued: The real enemies of liberty in this country are the naive advocates of managed economy or national planning.… With the disappearance of the vestiges of free trade among nations will come intensification of imperialism and increasingly bitter and irreconcilable conflicts of interest internationally. With the disappearance of free trade within national areas will come endless, destructive conflict among organized economic groups — which should suffice, without assistance from international wars, for the destruction of Western civilization and its institutional heritage. Thus, the increasing organization of interest groups (monopoly) and the resurgence of mercantilism ("planning") promise an end of elaborate economic organization (of extensive division of labor nationally and internationally), and an end of political freedom as well. But while forceful in his criticisms of the collectivist trends of his time, his conception of a "positive program" of laissez-faire, paradoxically, was radically interventionist and redistributive! He advocated the nationalization of utility companies and other "noncompetitive" monopolies; he called for the breaking up of large corporations and for legal limitations on their power and size; he proposed using the income tax as a conscious tool for the redistribution of wealth for a greater equality of income; and he believed that there was an important role at every level of government for social welfare programs to reduce the effects of poverty and to raise the cultural character of the population. He also argued that the American money and banking system needed a radical revision. He presented his case for such reform in four publications: in a 1933 memorandum that had a wide circulation but was never published; in his 1934 "Positive Program for Laissez Faire"; and in two pieces published in 1936 entitled "The Requisites of Free Competition" and "Rules versus Authorities in Monetary Policy." Except for the 1933 memorandum, they were reprinted in his 1948 volume, Economic Policy for a Free Society. (The volume appeared posthumously; Simons had died in 1946 at the age of 47, an apparent suicide.) The same proposal was amplified and defended by Simons’s longtime University of Chicago colleague and friend Lloyd Mints in a volume entitled Monetary Policy for a Competitive Society (1950). Simons’s fundamental premise was that a functioning market economy requires fixed and definite "rules of the game" (rule of law; private property; open competition) in the context of which and with 83
the certainty of which individuals in the private sector can more effectively go about their business of production and exchange for mutual improvement of the human condition. He argued that dramatic and repeated fluctuations in production, employment, and the general level of prices had their origin in the fact that the monetary system operated with no such definite rules. The business cycle had its cause in two elements of instability in the monetary order. First, central bank managers were empowered with the discretionary authority to increase or decrease the money supply, guided by their own changing views concerning the quantity of money that should be injected into or withdrawn from the economic system to meet equally changing economic policy goals. This meant a relatively high level of unpredictability for private-sector investment decision-making. Second, the American financial system was constructed upon the principle of fractional-reserve banking. When a bank received a deposit from one of its clients, that deposit then represented a claim for the full amount, payable on demand whenever the depositor wished to either withdraw cash or write a check against his account. But the banks were required to hold only a fraction of the full dollar value of its liabilities to depositors as an actual cash reserve. The rest, above the minimum reserve, was lent out to borrowers as the basis upon which the banks earned interest income. For example, if Smith deposited $100 dollars in his bank account, the bank might hold only $10 (i.e., 10% of the dollar value of the bank’s liability to the depositor) as an actual cash reserve against any withdrawal(s) he might desire to make. It would extend a loan for the remaining $90 to a borrower, Jones, who desired to use that sum for, say, some investment purpose. The bank now would have as outstanding liabilities to pay on demand to both the original depositor (Smith) and the borrower (Jones) a total of $190. If Jones were to withdraw the $90 from the bank for his investment project, and if the original depositor (Smith) were to want to withdraw more than $10 from his account (in the form of either a cash withdrawal or a check that would return to the bank for payment), it is clear the bank would be faced with insolvency. The bank would have created a total of $190 of purchasing power on the basis of a $100 deposit. If Smith were to attempt to withdraw the full $100 on demand, the bank would be required — if it were not to break its promise to pay on demand — to call in the loan of $90 for the full amount (assuming that Jones had the full sum to repay immediately). Bank-created purchasing power in the form of deposits and loans would have to decrease by $190 to fulfill its $100 promise to pay on demand. Thus, the amplitude of fluctuations in bank-created purchasing power is a multiple of the actual amount of deposits made into or withdrawn from commercial banks under a fractional-reserve system. To eliminate, or at least diminish, these two sources of instability in the monetary system, Simons argued for the establishment of a "monetary rule" which those responsible for monetary policy within the government would be required to follow. He suggested several possibilities, but the one he finally proposed as the most practicable one was a monetary rule for the stabilization of the general price level as measured by some price index. In place of fractional-reserve banking, he advocated 100% reserve banking. Banks would be required to hold as a reserve, against their outstanding liabilities to depositors, cash on hand equal to the full dollar value of the deposits left with them. Deposit banking, Simons said, would then become a form of warehousing in which the full sums left on deposit would be not only payable on demand but actually 100% redeemable at all times. For serving as a depository warehouse, banks would receive a fee from depositors for services rendered. Loan banking, in Simons’s plan, would no longer be possible on the basis of payable-on-demand deposits. Instead, he proposed that other banks be allowed, by law, to undertake the lending business only by selling shares in their company and on the basis of the cash raised extend loans to interested borrowers. What would be money in such a system and how would the plan be implemented? Simons called for the permanent abandonment of the gold standard. In its place, there would be a single, uniform 84
national paper currency issued by the federal government. Only the government would have the authority to increase or decrease the quantity of money, with this power delegated to a Monetary Authority and the U.S. Department of the Treasury. They would, therefore, be assigned wide administrative powers to implement the program and to manipulate the quantity of money in circulation to maintain a stable price level. The Monetary Authority would introduce 100% reserve banking by buying government bonds and other securities held by commercial banks and requiring them to use the paper money received as payment for them to enhance their reserve position to a 100% level against outstanding depositor liabilities. (Simons pointed out that this was one way to pay off the federal debt by just printing paper!) Once the new system was in place, the Monetary Authority would be required to use its powers to maintain a stable price level. In a growing economy, with productivity increases and expanding output, there would be a secular trend towards a slowly falling general price level. To counteract this tendency, the Monetary Authority would have to be continually increasing the money supply at some annual rate. The initial buying up of government securities, to fill the banking system with sufficient new national paper currency to put the banks on a 100% reserve basis, would have diminished most of the outstanding federal debt. The Treasury Department, therefore, would have to plan running regular budget deficits to put sufficient government securities in the market for the Monetary Authority to have something to buy up when it wished to increase the quantity of paper money in circulation. The Treasury would also have to have, Simons stated, significant discretionary power to modify both federal expenditures and the tax rate by decree, to ensure the requisite deficit spending for the Monetary Authority to be able to fulfill its "rule" of maintaining a stable price level. In the 1930s and 1940s, this was the Chicago School’s alternative to Keynesian economics: a national paper money managed by a government-established Monetary Authority, working with a U.S. Treasury Department that would have wide discretionary and decree powers to run smaller or larger federal budget deficits so as to manipulate the quantity of money in circulation for the purposes of instituting the rule of a stable price level. Other than the rule or target — price-level stabilization instead of full employment — the monetary and fiscal powers given to the government under the Chicago plan were not much different than those proposed by the Keynesians. Money would be totally nationalized by the government, with no link whatsoever to a marketbased commodity such as gold. A monetary central planning board — the Monetary Authority — would have complete control over the issuance and availability of money within the market society. The executive branch of the government, through the U.S. Treasury, would be free of the constitutional restraints that placed legislative power over taxing and spending in the hands of the Congress. The federal debt and all future deficits would be taken off the books through the monetary miracle of the printing press. And the banking industry would be under strict regulations specifying how and in what form they could undertake the business of financial intermediation. This was the Chicago School’s version of a "New Economics."
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Chapter 24 Milton Friedman’s Framework for Economic Stability In the post-World War II period in the United States, there have been few voices as important for the defense of the free market as that of Milton Friedman. In his 1962 book Capitalism and Freedom, he forcefully challenged the trend towards increasing government control over economic life. Friedman eloquently argued that economic liberty was vital for the preservation of both personal and political freedom. And he recommended market-oriented solutions to various social problems in place of "big government." Friedman reformulated and popularized this theme for a global audience in his television series and book, Free to Choose (1980). Equally important, Milton Friedman has been a voice of reason and scholarly rigor in opposition to many of the dominant Keynesian ideas. He demonstrated that many of the most cherished Keynesian assumptions were based on faulty economic theorizing and an erroneous understanding of the historical facts. It is not an exaggeration to say that Friedman was a prime mover in significantly changing the focus of postwar macroeconomic theory from the direction given to it by Keynes in the 1930s. In doing so, Friedman has been a true disciple and defender of the Chicago tradition. From his teachers at the University of Chicago in the 1930s, he learned the superiority of the market order over the regulated economy and the planned society. But he also adopted their views on monetary and banking reform. His 1960 volume, A Program for Monetary Stability, contains a defense of Henry Simons’s proposal for 100% reserve banking under a fiat-money system managed by the government. Probably Simons’s greatest influence on Milton Friedman concerned the desirability of government’s following articulated, long-run policy "rules" in place of discretionary monetary and fiscal powers in pursuit of short-run policy goals. In a 1951 essay, "The Effects of a Full-Employment Policy on Economic Stability," Friedman showed that short-run, activist Keynesian policies were likely to generate more, rather than less, economywide instability. He pointed out that there were inescapable "time lags" between "undesired" changes in the level of general economic activity and government policy responses to counteract them. The Keynesian presumption had been that any observed deviations in macroeconomic employment and output from a targeted level of full employment should immediately bring a response through increases or decreases in taxes and government spending to move the economy back to its appropriate full-employment level. Constant adjustments in government taxing and spending could prevent both inflation and depression. Friedman pointed out that three time lags were likely to prevent the smooth success of such Keynesian policies. First, there existed a lag between an actual change in the macroeconomy and the collection of the statistical data on the basis of which it would become known to the policymaker that there was a problem needing correction. Second, there was a lag between the recognition that there was a problem and the decision leading to the actual implementation of a change in fiscal or monetary policy. And, third, there was the lag between the undertaking of the policy action and its working through the economy and affecting the general level of employment and output. He argued that from the time the data had been collected, interpreted, and acted upon to the time a change in policy had begun to have its full effects, the economy would not have stood still. The economy would have been following its own "natural" path. As a result, by the time the policy change actually had its effect, the need for that particular policy may have passed. Even worse, the new 86
policy’s effects might not only be too late to solve the problem, they could help to create a new problem that needed fixing. For example, suppose that the statistical data at the policymaker’s disposal suggested the macroeconomy was heading into a downturn. The policymaker might conclude that what was needed was increased government deficit spending to stimulate "aggregate demand." But by the time the government’s additional deficit spending started to have its effects, the economy might have "moved on" and naturally begun to recover from any recessionary tendencies. The new government spending would then be added to a normal market-induced recovery, possibly threatening to push up aggregate demand too much, resulting in government-created inflationary problems. But the policymaker might not know his "anti-depression" policies were generating an inflationary problem until it was too late, once again because of those time lags. The inevitable informational ignorance on the part of the policymaker and the inescapable delay before any policy change had its full effects on the economy meant that discretionary government policy always ran the risk of doing the supposedly right thing too late and making any new situation worse than if the government had merely left the market alone. Did that mean, therefore, that Friedman believed government should leave the market economy alone? No, it did not. Three years earlier, in 1948, he had published an article entitled "A Monetary and Fiscal Framework for Economic Stability." First, the monetary framework should be one like that advocated by Henry Simons: 100% reserve banking with a government-managed fiat money. Second, the level of government spending in the society should be based on a long-run political consensus concerning the government programs and services for which the public was willing to pay through taxes. Third, there should be a progressive income tax, primarily relying on a personal income tax. And, fourth, the government should not run annual balanced budgets. Instead, government budget deficits and surpluses would be used as the primary policy tool to maintain a targeted level of national income in the economy. Suppose the economy were to go into a downturn. Aggregate demand for goods and services would decline, and employment would fall off with a resulting decrease in total income earned in the society. A decline in national income would result in a decrease in government tax revenues. But instead of government’s adjusting its spending to the lower level of tax receipts to maintain a balanced budget, the government would maintain the same level of expenditures that would have been fully funded by taxes if the economy had continued to operate at full employment. A budget deficit would "automatically" result, which the government would service either by issuing non-interest-earning securities or merely by printing money. The amount of government deficit-spending on goods and services or in the form of unemployment insurance payments would more or less maintain aggregate demand in the economy at the level that would have prevailed if there had not been a market-generated lapse from full employment. If the economy, instead, were to be "overheating," with national income rising above a fullemployment level, inflationary forces would now be at work. Again, government would maintain its own level of targeted expenditures, with a budget surplus "automatically" coming about as tax revenues began to exceed the amount of government spending because of rising incomes. The additional dollars siphoned off the market through higher tax revenues would be taken out of circulation, tending to slow down and bring the inflation to a halt. The government’s budget surpluses would prevent aggregate demand from rising above a level of national income consistent with full employment. Friedman advocated a progressive income tax because he wanted it to be used as a macroeconomic policy tool. As incomes fell during an economic downturn, individuals would fall into lower tax brackets, meaning that individuals would be retaining a larger after-tax percentage of whatever income they earned. In an inflationary environment, incomes would be rising, resulting in people’s retaining a smaller after-tax percentage of their income as they were pushed up into higher tax brackets. Thus, a progressive income tax would serve as an instrument for government to manipulate the amount of 87
private-sector spending out of different levels of national income. Governments, under Friedman’s plan, would no longer have the discretion to change taxing and spending to try to maintain a targeted level of full employment. Instead, the "rule" would be: maintain the desired level of government expenditure that would be fully covered by taxes if the economy were operating at full employment. If the economy started to fall into recession or overheat into inflation, government budget deficits or surpluses, respectively, would "automatically" result. Maintaining the targeted level of government spending would compensate for any fluctuations in private-sector aggregate demand that would threaten to create either unemployment or inflation. Given the dominance of Keynesianism in the late 1940s and early 1950s, it is easy to see that the thinking behind Friedman’s arguments was to demonstrate two things: first, to show that a discretionary policy of "demand management," as advocated by the Keynesians, could in fact be counterproductive because of the time lags between deciding that a policy should be changed and the full effects from any change in policy; and, second, to suggest that the Keynesian goal of maintaining a full employment level of aggregate demand could be attained by simply following the rule of maintaining a desired fullemployment level of government spending and allowing government budget deficits and surpluses to "automatically" bring about the necessary corrections in total spending in the economy. Nonetheless, Friedman’s arguments served to reinforce the fundamental assumptions underlying the entire Keynesian framework: First, and most important, that a market economy could not be "left alone" because it contained the potential for a lapse from full employment that needed and required fiscal and monetary correction through government action. Second, that taxes were not an unfortunate "necessary evil" that should be kept at the minimum, consistent with the performance of those limited "essential functions" of protection of life, liberty, and property, which (whether one agrees with it or not) was the view of the older classical liberals who were always suspicious of any government taking of people’s private income and wealth. Instead, a progressive income tax was to be a conscious macroeconomic tool for demand-management policy by government. And, third, that government monopoly control over the supply of money was desirable and essential for government manipulation of private-sector activity in the market, regardless of whether the target was a stable price level, full employment, or a certain level of national income. Whether it was his intention or not, Friedman’s proposed "monetary and fiscal framework for economic stability" legitimated the Keynesian arguments for government intervention in the market economy. By accepting the Keynesian "terms of the debate," the only issues remaining in dispute concerned how government should try to demand-manage the market economy, not whether it was needed or whether government should.
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Chapter 25 Milton Friedman and the Demand for Money In 1951, economist Howard S. Ellis happily pointed out, "Money is currently in the process of being rediscovered.… During the late thirties and the war years, it became fashionable with certain theoretical economists [the Keynesians] to stamp any especial concern with the supply of money and credit with the stigma of a hopelessly naive quantity theory. This tendency in economic theory was reflected and increased by government policies. Fiscal policy preempted the field during the [great] depression of the thirties, and direct controls during the [second world] war.… Both monetary theory and monetary practice were consigned to limbo." Keynes and the Keynesians had argued that economywide instability in output and employment was due to the erratic "animal spirits" of private-sector investors whose unpredictable changes in optimism and pessimism generated fluctuations in investment spending. However, when investors’ demand to borrow decreased and interest rates declined, savers did not decrease their savings and increase their consumption even though the interest income earned from lending a portion of their wealth had now gone down. Instead, they increased their holding of idle cash balances because spending out of income was determined independently of relative prices and the rate of interest by what Keynes called the "psychological law" of the propensity to consume. Therefore, as a result of a decline in private-sector investment, total money spending in the economy would decrease. And since workers were unwilling to decrease their money-wage demands for being employed because of "money illusion," total employment would decline as well, leaving the economy in a potential state of high unemployment. Money, in the Keynesian framework, was relegated to a place of secondary importance in the policy toolkit of activist government. Increasing the money supply to try to stimulate the economy, in the Keynesian view, was pointless. Any such increases would merely be absorbed for the most part into unspent cash hoards, leaving total spending in the economy unchanged. Instead, government needed to run a budget deficit and either borrow the private sector’s idle cash savings to put it into circulation or directly spend any increases in the money supply upon various public-works projects to stimulate employment and private-sector investment. The quotation from Howard Ellis suggests that there had been growing criticisms of the Keynesian theory of the demand for money. The most thoroughgoing criticism of this Keynesian conception in the decade after the Second World War was made by Milton Friedman. In 1956, Friedman edited a collection of essays entitled Studies in the Quantity Theory of Money , for which he wrote the introductory essay, entitled "The Quantity Theory of Money – A Restatement." Friedman argued that the Keynesian view of the demand for money was too narrow. Suppose that an individual had an income of $100. And further suppose that the Keynesian "psychological propensity to consume" at that level of income was for this individual to spend $50. That would leave the individual with $50 to allocate between investment (in the form of bonds) and idle cash. And also suppose that at a rate of interest of 6%, this individual would invest $25 of his unspent income in bonds. That would leave him with $25 as a cash balance, or 25% of his income. If the rate of interest were to decrease to, say, 5%, because of a decline in investment demand caused by those "animal spirits" becoming more pessimistic, according to the Keynesians this individual would decrease his investment in bonds by, say, $10, since the return on this form of investment would have declined. But he would not increase his consumption spending by $10 as the alternative to saving in the form of investing in bonds. Instead, the individual would shift that $10 into 89
his cash balance holdings. As a result, the percentage of his income held as idle cash would have increased to 35% ($35 out of his $100 income). In this Keynesian view, the demand for money was considered "unstable." That is, the desire to hold cash balances as a percentage of income could fluctuate in a wide range. Total spending in the economy would no longer be $75 ($50 on consumption spending and $25 by those issuing bonds to others who had savings to lend). It would now be $65 (initially the same $50 on consumption spending by income earners and only $15 by those still issuing bonds to facilitate investment spending now that those "animal spirits" had made businessmen more pessimistic). And average unspent cash balances would have changed from $25 to $35. Friedman argued that holding money has both costs and benefits, just like holding any other asset in which an individual might invest his wealth. The prospective benefit from holding a certain sum of one’s wealth in the form of a cash balance is that it provides the individual with a readily available purchasing power over goods in the marketplace. The real value of holding any given quantity of money as a cash balance is based on the general purchasing power, or exchange value, of money as expressed in the average price level of goods in the market. But the benefit of holding a sum of money as a cash balance can also be influenced by any expected change in the general price level of goods. If prices are expected to rise by a certain percentage over a year, the benefit from holding that cash balance will be reduced, since with each passing day the real buying power of each unit of money will be falling as prices rise. Conversely, if prices are expected to fall by a certain percentage during that year, the benefit from holding that cash balance will increase, since with each passing day the real buying power of each unit of money will be rising as prices decline. In the case of expected price inflation, the demand for money will decrease while the demand for real goods and other assets expected to increase in market value as prices rise will increase; in the case of expected price deflation, the demand for money will increase and the demand for real goods and other assets expected to decrease in market value as prices go down will decrease. Competing against money as ways in which an individual can invest and hold his wealth are, Friedman argued: (1) real consumer goods that provide the individual with valued services from their use or consumption; (2) bonds offering an interest return from lending money to an enterprise wishing to borrow; (3) equities, or ownership shares, in a enterprise offering an expected return from net revenues resulting from the selling of a product or service on the market; (4) human capital, or investment in acquiring improved skills through more education or professional training that will increase the market value of one’s future labor services on the market. An individual divides his wealth among these competing uses until he has a preferred combination at which the expected return from any one of them is tending to equal the expected return from all the others. That is, the last dollar invested in holding bonds gives the same expected return as the last dollar invested in buying an equity share in a company, and gives the same expected return as the last dollar invested in improving one’s labor skills, and gives the same expected return as the last dollar spent on goods and services for consumer satisfaction, and gives the same expected return as the last dollar chosen to be held in a cash balance for facilitating future buying opportunities. And any change in the price or expected return from any one of these ways of holding one’s wealth will modify the combination of them that will be considered most attractive to have. If the choices open to the individual are widened to include more than just a tradeoff between bonds and cash holdings, then the demand for money is far more "stable" than the Keynesians had argued. Think of the example given earlier of the situation in which the rate of interest decreased from 6% to 5% because of a decrease in the investors’ demand to borrow. But now assume that the individual has a variety of different directions into which he can shift that portion of his savings previously invested in bonds, as Friedman suggested. The individual now takes that $10 no longer invested in bonds and, say, puts $2.50 into buying more consumer goods, $2.50 into purchasing equity 90
shares in some enterprises, $2.50 into investing in improving his future labor skills through additional education or professional training, and an additional $2.50 into his cash balance holdings. The percentage of his $100 income held as an average cash balance would have increased from 25 to 27.5 percent, a change in his demand for money far smaller than that suggested in the Keynesian example. That change would represent a much smaller decrease in total money spending in the economy than the Keynesians believed and, therefore, a much smaller required decrease in the general level of prices and wages to bring aggregate supply in the economy into balance with the lower aggregate demand for goods and services. In the Keynesian case, the decrease in total spending from $75 to $65 represented a 13.3% decrease in aggregate demand in the economy. In the example using Friedman’s assumptions, the decrease in total spending from $75 to $72.50 represented only a 3.3% decrease in aggregate demand in the economy. Friedman’s conclusion, therefore, was that if the demand for money was far more stable than the Keynesians had assumed, then significant short-run fluctuations in economywide output and employment, as well as price inflations and deflations, had to have their source in changes in the supply of money. And it is what led Friedman to argue: The central fact is that inflation is always and everywhere a monetary phenomenon. Historically, substantial changes in prices have always occurred together with substantial changes in the quantity of money relative to output. I know of no exception to this generalization, no occasion in the United States or elsewhere when prices have risen substantially without a substantial rise in the quantity of money relative to output or when the quantity of money has risen substantially relative to output without a substantial rise in prices.
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Chapter 26 Milton Friedman and the Monetary "Rule" for Economic Stability In 1967, Milton Friedman delivered the presidential address at the American Economic Association in Washington, D.C. His theme was "The Role of Monetary Policy." He argued that there was "wide agreement about the major goals of economic policy: high employment, stable prices, and rapid growth." What separated economists, he said, were their views on the most appropriate methods to bring these desired things about. Friedman emphasized what he believed an active monetary policy could not succeed in permanently doing. First, monetary policy could not permanently lower interest rates below the level that the market forces of supply and demand would tend to establish. It was true that increasing the money supply could temporarily increase the supply of lendable funds in the banking system and bring about a decrease in the rate of interest. But in the longer run, the increase in the money supply would result in a general rise in prices. Higher prices would bring about an increased demand to borrow funds for investment and other purposes because borrowers would need a larger sum of money to facilitate the same real activities. At the same time, lenders would be less willing to lend at that lower rate of interest because the rise in prices would require them to hold a larger proportion of their money income as a cash balance to facilitate any desired purchases at those higher prices. Both of these factors would tend to push interest rates back to their previous market-determined levels. Furthermore, if the monetary expansion were to continue for a long period of time and individuals came to expect a continuing general rise in prices in the future, lenders would begin to tag an "inflation premium" onto the rate of interest at which they were willing to lend because of the loss in purchasing power caused by the price inflation during the period of the loan. For example, suppose that in a situation of zero price inflation, the market would have set the rate of interest at 5%. Now suppose that price inflation was raising prices in general, at an average annual rate of 3%. If lenders came to know this or believe it, they would begin to demand a rate of interest of 8% — 5% representing the "real" return on lending funds and 3% as compensation for the higher cost of buying goods at the end of the loan’s term. Indeed, inflationary expectations of this type could push interest rates far above what they had been before the monetary expansion had begun. Second, Friedman argued, monetary policy could not permanently push unemployment below a market-determined "natural rate." Over any period of time, there is always a certain amount of unemployment owing to several factors. For example, normal changes in supply and demand throughout an economy are always resulting in a certain amount of shifting of the labor force among various sectors of the economy and thus there are always some people between jobs. Also, there are various institutional rigidities that result in a certain amount of unemployment: minimum-wage laws, trade-union restrictions that limit employment opportunities in occupations, regulatory controls that impose various production costs and restrictions that limit job offerings, and welfare programs that create incentives for people to choose not to work. While institutional reforms that reduced or eliminated these barriers to a more competitive market could reduce unemployment, an activist monetary policy could not. Suppose that the monetary authority, however, did attempt to reduce the level of unemployment through an increase in the money supply (or an increase in the rate of monetary expansion). The 92
monetary expansion would, indeed, increase the demand for goods and services in general in the economy, which would begin to put upward pressure on the prices of finished goods. If resource prices and labor costs did not immediately rise to reflect the now-higher prices of those finished goods, profit margins would increase. The greater profits to be earned would act as an incentive for employers to try to expand production and increase their sales. But over time, resource prices and wages would go up as well. With employers throughout the economy all attempting to expand their respective productions, the demand for resources and labor would increase, bringing about a rise in resource prices and wages as those employers bid against each other. At the same time, the higher prices for goods and services in general would be decreasing the real value of the money incomes earned by resource owners and workers. They would now demand higher prices and money wages to compensate for the purchasing power lost because of the price inflation. These two factors would, over time, result in the elimination of the greater profit margins that had served as the initial stimulus for employers to try to expand output and increase their work forces. In the long run, Friedman insisted, any monetary expansion would fail to reduce unemployment below its "natural rate." Any "positive" employment effects would only be transitory. What, then, could monetary policy do? The first and most important lesson that history teaches about what monetary policy can do — and it is a lesson of the most profound importance — is that monetary policy can prevent money itself from being a major source of economic disturbance. A second thing monetary policy can do is provide a stable background for the economy.… Our economic system will work best when producers and consumers, employers and employees can proceed with full confidence that the average level of prices will behave in a known way in the future — preferably that it will be highly stable. Finally, monetary policy can contribute to offsetting major disturbances in the economic system arising from other sources. By the latter, Friedman stated he meant an active monetary policy to counteract inflationary or recessionary forces that might be at work from nonmonetary sources, such as government budget deficits or a transition from a wartime to a peacetime economy. Friedman concluded his presidential address by stating that the central monetary authority, therefore, should adopt a public policy of "a steady rate of growth" in the money supply. I myself have argued for a rate that would on the average achieve rough stability in the level of prices of final products, which I have estimated would call for something like a 3 to 5 percent per year rate of growth in currency plus all commercial bank deposits. By making that course one of steady but moderate growth in the quantity of money, [the monetary authority] would make a major contribution to avoidance of either inflation or deflation of prices. That is the most that we can ask from monetary policy at our present stage of knowledge. But why have a central monetary authority at all? Why not leave money to the market, as would be the case under a completely market-based and market-determined gold standard, for example? Why not have the forces of market supply and demand determine both what shall be used as money and the quantity that it is found most profitable to provide for monetary purposes? Friedman’s clearest defense of a purely fiat or paper money standard was developed in his book A Program for Monetary Stability (1960). His basic answer is that the mining and supplying of a commodity money, such as gold, takes away resources that could be used for other purposes, and that this is an unnecessary cost to society.
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The maintenance of a commodity standard requires the use of real resources to produce additional amounts of the monetary commodity — of men and other resources to dig gold or silver or copper out of the ground or to produce whatever other commodities constitute the standard.… The use of … resources for this purpose establishes a strong social incentive in a growing economy to find cheaper ways to provide a medium of exchange. A paper money, he argued, clearly was that cheaper alternative. The problem, in his view, was that the provision of a fiat or paper money standard could not be left to the private market. First, there was the matter of fraud; a paper money was open to counterfeiting or other failures to meet contractual obligations by any private banks issuing that paper money. Second, private issuers of paper money might create them in such quantities that a serious inflation might be threatened, and when any such inflationary episode finally came to an end it might result in a collapse of the banking system as a whole. And, third, the potential instability from privately issued paper money would fail to provide the necessary institutional framework for general economic stability. Friedman concluded: Something like a moderately stable monetary framework seems an essential prerequisite for the effective operation of a private market economy. It is dubious that the market can by itself provide such a framework. Hence, the function of providing one is an essential governmental function on a par with the provision of a stable legal framework. Like his teacher, Henry Simons, Friedman advocated a system of 100% reserve banking. The monetary authority would raise bank minimum reserve requirements gradually over a period of time, with the monetary authority supplying all required increases in paper money to meet these new higher reserve requirements until they reached 100%. And the monetary authority, Friedman said, would then follow the "rule" that the stock of money be increased at a fixed rate year-in and year-out without any variation in the rate of increase to meet cyclical needs. This rule could be adopted by the [Federal] Reserve System itself. Alternatively, Congress could instruct the Reserve System to follow it.… The rate of increase should be chosen so that on the average it could be expected to correspond with a roughly stable long-run level of final product prices. To judge from [the historical] evidence, a rate of increase of 3 to 5 percent might be expected to correspond with a roughly stable price level. But was this, in fact, a monetary system that could provide the necessary framework for general economic stability? Could a central monetary authority be trusted to follow such a "rule" and forgo the temptations of discretionary manipulation of the money supply? Was a paper money standard really less costly than a commodity standard like gold? Even Milton Friedman began to have second thoughts in later years.
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Chapter 27 Milton Friedman’s Second Thoughts on the Costs of Paper Money In July 1985, Milton Friedman delivered the presidential address at the Western Economic Association on the topic "Economists and Economic Policy," which was published in the January 1986 issue of Economic Inquiry. He stated that his many years in advocating a monetary "rule," under which the central monetary authority would increase the money supply at a constant annual rate regardless of changing economic conditions, had been a waste of time. The reason, he said, is that there is no basis for thinking it would ever be in the interest of those who managed the government monetary system to follow such a rule: Most of my own work dealing with public policy has had the same character of proceeding as if I were addressing governmental officials selflessly dedicated to the public interest. I have attempted to persuade the Federal Reserve System that it was doing the wrong thing and it ought to adopt a different policy. This time was ill-spent because the public-interest characterization of government is basically flawed.… We do not regard a businessman as selflessly devoted to the public interest. We think of a businessman as in business to improve his own welfare, to serve his own interest.… Why should we regard government officials differently? They too aim to serve their own interest, and in government as in business we must try to set up institutions under which individuals who intend only their own gain are led by an invisible hand to serve the public interest. The Federal Reserve System puts a great deal of power in the hands of a few people and it is so constructed that it has been in their self-interest to pursue a policy which, I believe, has been very harmful for the public rather than helpful.… Clearly, it was not in the self-interest of the Federal Reserve hierarchy to follow the hypothetical policy [of a monetary rule]. It was therefore a waste of time to try to persuade them to do so. But if government officials, including central monetary authorities, cannot be trusted to serve some rightly understood conception of the "public interest" instead of various political agendas that further their personal and ideological interests, what kind of monetary order can ensure that this does not occur or that its likelihood is minimized? Milton Friedman, as we have seen, had advocated a fiat or paper money standard guided by a monetary rule of an annual expansion of the money supply at a fixed rate because he believed that it was less costly than a gold standard, less open to inflationary excess, and more likely to provide the monetary framework for general economic stability. But by the mid 1980s, Friedman had second thoughts about whether government could be trusted ever to follow the necessary restraint to provide this supposedly superior paper money system. He began to regularly quote a sentence from Irving Fisher’s 1911 book, The Purchasing Power of Money : "Irredeemable paper money has almost invariably proved a curse to the country employing it." In June 1986, Friedman published a short article in the Journal of Political Economy entitled "The Resource Cost of Irredeemable Paper Money." He said: In earlier discussions, other monetary economists and I took it for granted that the real resource cost of producing irredeemable paper money was negligible, consisting only of the cost of paper and printing. Experience under a universal irredeemable paper money standard makes it crystal 95
clear that such an assumption, while it may be correct with respect to the direct cost to the government of issuing fiat money, is false for the society as a whole. The costs of a paper money standard to the society as a whole, Friedman argued, arose precisely from the uncertainty of future monetary policy under government monetary discretion and the inflationary bias that always tended to persist under government control of paper money. During inflationary times, people often tied up real resources that otherwise could have been applied for productive activities in the accumulation of gold and silver hoards as a hedge against rising prices. It led individuals to absorb greater costs in searching out investment strategies that would earn interest incomes believed likely to stay ahead of paper money’s depreciation over time. It also created incentives for the development of futures markets in commodities and currencies that would efficiently help protect individuals from the greater uncertainty concerning price and foreign exchange-rate fluctuations during periods of monetary instability but which might never have needed to come into existence if not for paper money mismanagement by governments. Friedman concluded that "the direct resource cost of the gold and silver accumulated in private hoards [in the 1970s and 1980s] may have been as great as or greater than it would have been under an effective gold standard." And while such commodity and currency futures markets serve a useful function by enabling economic agents to hedge against uncertainty and undertake long-term commitments … nevertheless … they would not have arisen if the new [paper] monetary regime had not led to greatly increased uncertainty about interest rates and inflation. Also in 1986, Friedman coauthored an article with Anna Schwartz in the Journal of Monetary Economics that asked the question, "Has Government Any Role in Money?" They concluded that in principle it did not need to have one and historically sometimes had none. They argued: The apparently great value to the economy of having a single unit of account linked with an (ultimate) medium of exchange does not mean that government must play any role, or that there need be a single producer of the medium of exchange. And indeed, historically, governments have entered the picture after the event, after the community had settled on a unit of account and private producers had produced media of exchange.… Historically, producers of money have established confidence by promising convertibility into some dominant money, generally specie [e.g., gold or silver]. Many examples can be cited of fairly long-continued and successful producers of private moneys convertible into specie. We do not know, however, of any example of the private production of purely inconvertible fiduciary moneys. They stated: "Our own conclusion … is that leaving monetary and banking arrangements to the market would have produced a more satisfactory outcome than was actually achieved through government involvement." However, they did not argue for a return to a gold standard. In his article on irredeemable paper money, Friedman made this point very clear: Let me emphasize that this note is not a plea for a return to a gold standard.… I regard a return to a gold standard as neither desirable nor feasible — with the one exception that it might become feasible if the doomsday predictions of hyperinflation under our present system should prove correct. Why wouldn’t a market-based gold standard be feasible or desirable under present circumstances? Friedman explained his reasoning in an April 1976 lecture entitled "Has Gold Lost Its Monetary Role?" that was delivered in Johannesburg, South Africa. Simply put, governments are no longer willing to be 96
restrained by a gold standard. They want control over money for various macroeconomic manipulative purposes. However, Friedman said that if you could re-establish a world in which government’s budget accounted for 10 percent of the national income, in which laissez-faire reigned, in which governments did not interfere with economic activities and in which full employment policies had been relegated to the dustbin, in such a world you might be able to restore a real gold standard. A real honest-to-God gold standard is not feasible because there is essentially no government in the world that is willing to surrender control over its domestic monetary policy. But if a "real honest-to-God" market-based gold standard were to be reestablished, how might it be brought about? Milton Friedman offered his own suggestion in a 1961 paper entitled "Real and Pseudo Gold Standards," which was reprinted in his collection of essays Dollars and Deficits (1968). Individuals should, once more, be free to use money as gold, should they so choose, with the prices of goods and services expressed in units of gold, he said. Friedman explained: Under such a real gold standard, private persons or government might go into the business of offering storage facilities, and warehouse receipts might be found more convenient than the gold itself for transactions. If individuals find warehouse certificates for gold more useful than literal gold, private enterprise can certainly provide the service of storing the gold. Why should gold storage and the issuance of warehouse certificates be a nationalized industry? Finally, private persons or governments might issue promises to pay gold either on demand or after a specific time interval which were not warehouse receipts but nevertheless were widely acceptable because of confidence that the promises would be redeemed. Such promises to pay would still not alter the basic character of the gold standard so long as the obligors were not retroactively relieved from fulfilling their promises, and this would be true even if such promises were not fulfilled on time, just as the default of dollar bond issues does not alter the monetary standard. But, of course, promises to pay that were in default or that were expected to be defaulted would not sell at face value, just as bonds in default trade at a discount.… Such a system might, and I believe would, raise grave social problems and foster pressure for government prohibition of or control over the issue of promises to pay gold on demand. But that is beside my present point, which is that it would be a real gold standard. And Friedman also emphasized his political-philosophic view of such a gold-based monetary system: "A real gold standard is thoroughly consistent with [classical] liberal principles and I, for one, am entirely in favor of measures promoting its development."
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Chapter 28 The Chicago and Austrian Economists on Money, Inflation, and the Great Depression In the post-World War II period, the two leading schools of free-market thinking have been the Austrian school, led by Ludwig von Mises and Friedrich A. Hayek, and the Chicago school, led by Milton Friedman and George Stigler. Together they have rigorously and lucidly analyzed and criticized the errors and dangers in socialist, Keynesian, and interventionist policies. Though their methods of analysis have often been different, both groups have reached a similar conclusion: only the free-market economy can ensure both freedom and prosperity. Both the Austrians and Chicagoans, as we have seen, rejected Keynes’s argument that the market economy was fundamentally unstable and likely to generate extended periods of unemployment and idle resources. They both also argued that when inflations and depressions occurred, they were the result of monetary mismanagement and government interventions that reduced market flexibility in the face of changing circumstances. And both schools of thought were suspicious of discretionary monetary and fiscal policies, particularly of the Keynesian type, believing that they would only make for less stability, not more. But the Austrian economists and the members of the Chicago school have differed on a number of crucial issues in the field of monetary theory, history, and policy. Central to those issues are their different interpretations of the causes and cures for the Great Depression of the early 1930s. Their different interpretations of that period arise from their differing conceptions of how money influences the market economy. And those differences come from their different views of how economic processes should be studied. Friedman and most other monetary theorists in the Chicago tradition accepted the Keynesian idea of a macroeconomic or aggregative analysis. For example, in a reply to some of his critics published in 1974, in a volume entitled Milton Friedman’s Monetary Framework: A Debate with His Critics, Friedman said: Rereading the General Theory has … reminded me what a great economist Keynes was and how much more I sympathize with his approach and aims than with those of many of his followers.… I believe that Keynes’s theory is the right kind of theory in its simplicity, its concentration on a few key magnitudes, its potential fruitfulness. I have been led to reject it, not on these grounds, but because I believe that it has been contradicted by evidence: its predictions have not been confirmed by experience. The incompleteness in Keynes’s theory, according to Friedman, was in its narrow definition of people’s choices when deciding to hold money or spend it in some way. When the choices among which individuals may choose are widened, the demand for money appears more stable than Keynes thought, Friedman concluded. While claiming to construct his framework from the decisions of individuals to hold various sums of money relative to their desires to spend that money on various goods and services, Friedman soon shifts to statistical aggregates and averages that summarize away the real individual choices and decisions that make up the activities and outcomes of the actual market process. And like Keynes, Friedman focuses on these macroeconomic aggregates: total demand for money relative to the total 98
supply of money; the effect on total spending arising from an increase in the total supply of money; and the resulting impact on aggregate output in the short run and on the general price level in the long run. The Austrian economists have taken a different view. They have argued that it is important not to forget that statistical averages of total output and the general price or wage levels do not exist in reality. They are the creation of the economic statistician summing and arithmetically averaging in various ways the individual prices, wages, and outputs of the multitudes of individual goods and services that are bought and sold on the market. Or as Friedrich Hayek expressed it: In fact, neither aggregates nor averages do act upon each other, and it will never be possible to establish necessary connections of cause and effect between them as we can between individual phenomena, individual prices, etc.… Yet we are doing nothing less than this if we try to establish direct causal connections between the total quantity of money, the general level of prices and, perhaps, also the total amount of output. For none of these magnitudes as such ever exerts an influence on the decisions of individuals. Focusing on general aggregate effects of changes in the quantity of money on output and prices, Friedman argues that to the extent that an increase or a change in the rate of increase in the money supply influences production and employment in the economy, the effect is "transitory" and limited in its effect. In the longer run, as wages and prices adjust to the changed amount of money in the economy, the only lasting effect will be the creation of a higher general level of prices and wages with no permanent change in the aggregate amounts of employment and production. Any effects on relative prices, the allocation of resources, or the distribution of income during a period of monetary inflation will be mostly temporary and of secondary importance, Friedman argues. They are simply "first-round" effects that will be of little significance from the longer-run perspective. Or as Friedman expressed it in that same reply to his critics, "One way to characterize the quantitytheory [of money] approach is to say that it gives almost no importance to first-round effects." Friedman reaches his conclusion by analyzing changes in the money supply in the following way: Imagine that a helicopter randomly drops money down on a population; the people of the society pick up the money and proceed to spend it until prices have risen to a level high enough to once again balance the demand for money with the increased supply. On the other hand, the Austrians have argued that while it is true that in the long run, increases in the money supply do result, other things held unchanged, in a rise in prices in general, it is necessary to analyze the process by which changes in the money supply enter the economy and the particular ways they influence individual demands and supplies and individual prices and production plans. Or as Austrian economist Oskar Morgenstern put it: If no account is given where this additional money originates from, where it is injected, with what different magnitudes and how it penetrates (through which paths and channels, and with what speed), into the body economic, very little information is given. The same total addition will have very different consequences if it is injected via consumers’ loans, or via producers’ borrowings, via the Defense Department, or via unemployment subsidies, etc. Depending on the existing condition of the economy, each point of injection will produce different consequences for the same aggregate amount of money, so that the monetary analysis will have to be combined with an equally detailed analysis of changing flows of commodities and services. The Austrians have considered this more detailed analysis of the inevitable non-neutral influence of money as essential to any complete understanding of inflation’s full effects on the market economy. Given their different perspectives on how best to analyze money and inflationary processes in the 99
market economy, it is not surprising they have viewed the causes and cures for the Great Depression differently, as well. Friedman, for example, looks at the 1920s and concludes that Federal Reserve policy at that time was not inflationary at all, with the general wholesale price level fairly stable during that decade. If there are criticisms of Fed policy to be made, Friedman argues, it should be that in the early 1930s, the American central bank did not do more to increase the money supply, after it had contracted by about one-third, to lift the U.S. economy out of the Depression. The Austrians, looking beneath the stable price level of the 1920s, have argued that if not for the expansion of the money supply during that decade, prices would have slowly fallen to reflect the significant increase in productivity and output due to technological innovations and capital formation. Instead, Fed monetary expansion kept prices higher than otherwise would have been the case, which created the illusion of economic stability through a stable price level and brought about an unsustainable misdirection of capital investment as well as labor and resource misallocation. The imbalances Fed policy produced finally became visible after 1929. When the Depression began, the solution should have been a writing down of malinvested capital and a lowering of wages and prices to reflect the downturn in economic activity and the decrease in the money supply caused by bank failures due to bad loans and depositors’ wanting to withdraw money from their accounts. Instead, first the Hoover administration and then Roosevelt’s New Deal did everything possible to prevent the necessary and healthy market corrections. That was the real reason for the depth and the duration of the Great Depression. Yet, at the end of the day, both the Austrians and the Chicagoans reach one essential, common conclusion: monetary central planning has created more instability during the last one hundred years than there would have been if money and the banking system had been left outside of government control.
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Chapter 29 The Gold Standard in the 19th Century The history of paper money is an account of abuse, mismanagement, and financial disaster. Generally, the classical economists of the 19th century understood that and warned of the dangers of paper money. In France, the lesson had been learned during the French Revolution, when a flood of paper money, known as the assignats, resulted in economic catastrophe. In Great Britain, the lesson had been learned as a result of the British government’s financing of the war against Napoleon. The Bank of England, a private corporation, had been born in 1694 out of the British government’s need for cheap loans to finance its expenses. Three years later, the bank was given extensive monopoly rights covering banking and note-issuing activities within England, with its monopoly power reinforced by an act of Parliament in 1742. Once the war with France began in the 1790s, the British government saw its military expenses rise dramatically. The government had what would be called today a "line of credit" that enabled it to pay its expenses with bills that the Bank of England was expected to redeem on demand in gold. But by 1797, the bank was faced with such heavy demands for gold redemption from claimants, both domestic and foreign, that its gold reserves were reaching dangerously low levels. The British government passed the Bank Restriction Act, which freed the Bank of England from having to redeem its bank notes and other financial claims in gold. When the Restriction Act was passed, the Bank’s notes in circulation had a face value of £9.7 million on gold reserves of £1.1 million. When the war was approaching its end in 1814, bank notes outstanding had a face value of £28.4 million on gold reserves of £2.2 million. Between 1797 and 1814, commodity prices in general in Britain had about doubled and the value of the British paper pound had depreciated by about 30 percent on the Hamburg foreign-exchange market. In 1809, David Ricardo, one of the leading figures of British classical economics, published a monograph entitled The High Price of Bullion. He argued that the depreciation of the British pound was due solely to the excessive expansion of the Bank of England’s notes that had been made possible by the removal of redemption on demand in gold by the Restriction Act. Ricardo reasoned that the close connection between the Bank of England and the British government, due to the latter’s heavy borrowing and the former’s large amount of lending irredeemable paper money to the government, had resulted in the Bank’s losing any independence it had in its money-creation powers. It had become a financial arm of the government. Only one thing could return Britain to a stable currency: gold redemption on demand. Said Ricardo: It is said … that the Bank of England is independent of Government.… But it may be questioned whether a bank lending many millions more to government than its capital and savings, can be called independent of that Government.… It was then owing to the too intimate connection between the Bank and the Government, that the restriction [act] became necessary; it is to that cause, too, that we owe its continuance. To prevent the evil consequences which may attend perseverance of this system, we must keep our eyes steadily fixed on the repeal of the restriction bill. The only legitimate security which the public can possess against the indiscretion of the Bank is to oblige them to pay their notes on demand in specie [i.e., in gold or silver]. In 1810, the House of Commons appointed a Select Committee on the High Price of Gold Bullion. Its report reached the same conclusions as Ricardo and argued for a return to gold redemption at the earliest possible time. Between 1814 and 1821, Bank of England notes in circulation were reduced by 101
almost one-third, while gold reserves were increased tenfold. Finally in 1823, the Bank of England was required to begin redeeming on demand its notes for gold. Except for some brief bank panic periods later in the 19th century, Bank of England notes and bank-deposit accounts were redeemable on demand for gold until 1914, when Britain suspended gold payments during World War I. Throughout the 19th century, the mark of a sound economist and policymaker was an appreciation of the need to prevent governments from directly or indirectly manipulating the monetary system for political or economic reasons. John Stuart Mill, in his 1848 Principles of Political Economy, expressed the widely shared view that if no check was placed on the power of issuers of paper money, the issuers may add to it indefinitely, lowering its value and raising prices in proportion; they may, in other words depreciate the currency without limit. Such a power, in whomsoever vested, is an intolerable evil.… To be able to pay off the national debt, defray the expenses of government without taxation, and in fine, to make the fortunes of the entire community, is a brilliant prospect, when once a man is capable of believing that printing a few characters on bits of paper will do it.… There is therefore a preponderance of reasons in favor of a convertible, in preference to even the best regulated inconvertible currency. The temptation to over-issue, in certain financial emergencies is so strong, that nothing is admissible which can tend, in however slight a degree, to weaken the barriers that restrain it. By the 1890s, practically every major Western industrial country had put its monetary system on the gold standard. What did being on the gold standard mean? T.G. Gregory explained it concisely in his book The Gold Standard and Its Future (1935): If bank deposits are convertible into Bank of England notes and Bank of England notes are effectively convertible into gold [at a fixed rate of exchange], the mass of British purchasing power in Great Britain is linked to gold and Great Britain is upon the gold standard. By the fact that such a large number of countries had each linked their respective currencies to gold at some fixed rate of redemption in this manner, there emerged an international gold standard. A person in any one of those countries could enter any number of established, authorized banks and trade in a certain quantity of bank notes for a stipulated sum of gold, in the form of either coin or bullion. He could transport that sum of gold to any of the other gold-based countries and readily convert it at a fixed rate of exchange into the currency of the country to which he had traveled. As Murray Rothbard expressed it in What Has Government Done to Our Money? that meant, The world was on a gold standard, which meant that each national currency (the dollar, pound, franc, etc.) was merely a name for a certain definite weight of gold. The ‘dollar,’ for example, was defined as 1/20 of a gold ounce, the pound sterling as slightly less than 1/4 of a gold ounce. … This meant that the ‘exchange rates’ between various national currencies were fixed, not because they were arbitrarily controlled by government, but in the same way that one pound of weight is defined as being equal to sixteen ounces. Why did governments recognize and (with occasional exceptions) follow the rules of the gold standard through most of the 19th century? Because the gold standard was considered an integral element in the reigning political philosophy of the time, classical liberalism. As the German free-market economist Wilhelm Roepke explained in International Order and Economic Integration: The international "open society" of the 19th century was the creation of the "liberal spirit" in the widest sense, [guided by] the liberal principle that economic affairs should be free from political 102
direction, the principle of a thorough separation between the spheres of government and of economy.… The economic process was thereby removed from the sphere of officialdom, of public and penal law, in short from the sphere of the ‘state’ to that of the ‘market,’ of private law, of property, in short to the sphere of "society." At the same time, said Roepke, This [liberal] principle also solved an extremely important special problem of international integration … i.e., the problem of an international monetary system … in the form of a gold standard.… It was a monetary system which rested upon the structural similarity of the national systems, and which made currency dependent, not upon political decisions of national governments and their direction, but upon the objective economic laws, which applied once a national currency was linked to gold.… But it was at the same time a phenomenon with a moral foundation.… The obligations, namely, which a conscientious conformity with the rules of the gold standard imposed upon all participating countries formed at the same time a part of that system of written and unwritten standards which … comprised the [international] liberal order. In the 19th century, the ruling idea had been liberty. The wealth of nations was seen as arising from individual freedom in a social order respecting private property in the means of production. The relationships among men, it was believed, should be based on voluntary exchange for mutual benefit. Just as there were no inherent antagonisms among men in a free market within the same nation, there were no inherent antagonisms among men living in different nations. The mutual gains from trade could be expanded by extending the principle of division of labor to a global scale. If men were to benefit from those possibilities, a stable, sound, and trustworthy monetary order had to assist in the internationalization of trade. Gold was considered the commodity most proven through the ages to serve that function. And preservation of the gold standard, therefore, was given a prominent place among the limited duties assigned to the classical-liberal state of the 19th century. There was only one fundamental problem and inconsistency in this conception of and role for the gold standard in the free society. It left control over the value and supply of money in government hands. In an age that believed in the superiority of free markets and private enterprise, it practiced the theory of monetary central planning. The gold standard, after all, was a government-managed monetary system.
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Chapter 30 The Gold Standard as Government-Managed Money In his 1942 book, This Age of Fable, German free-market economist Gustav Stolper pointed out: Hardly ever do the advocates of free capitalism realize how utterly their ideal was frustrated at the moment the state assumed control of the monetary system.… A "free" capitalism with government responsibility for money and credit has lost its innocence. From that point on it is no longer a matter of principle but one of expediency how far one wishes or permits governmental interference to go. Money control is the supreme and most comprehensive of all government controls short of expropriation. Even in the high-water mark of classical liberalism in the 19th century, practically all advocates of the free market and free trade believed that money was the one exception to the principle of private enterprise. The international monetary order of the 19th century, of which Wilhelm Roepke spoke in such glowing terms, was nonetheless the creation of a planning mentality. The decision to "go on" the gold standard in each of the major Western nations was a matter of state policy. A central-banking structure for the management and control of a gold-backed currency was established in each country by its respective government, either by giving a private bank the monopoly control over gold reserves and issuing banknotes or by establishing a state institution assigned the task of managing the monetary system within the borders of a nation. The United States was the last of the major Western nations to establish a central bank, but it finally did so in 1913. That even the gold standard was a government-managed monetary system was succinctly explained by economist Michael A. Heilperin in his book Aspects of the Pathology of Money (1968): Wherever gold was chosen as a monetary standard, the gold content of the national monetary unit was defined by law, and the central bank was entrusted with the maintenance of that gold parity. The means to that end was convertibility on the one hand and purchase of gold by the central bank in unlimited quantities at a fixed price, on the other. In other words, under a gold standard the price of gold in terms of national currency was stabilized and the central bank operated as a sort of "gold pool." As the bank had to sell gold on demand, it had to keep a certain stock of gold and the relation of the gold to the note issue was also defined by law. Whenever the bank lost gold it had to restrict the note issue … and this was done by raising the rate of interest and restricting the discounts of bills of trade.… The reverse would happen when the central bank obtained gold.… To what extent and at what moment the appropriate central bank policy would be carried out, was largely a matter of judgment. It is true that the range of discretionary powers enjoyed by central banks were limited and that the principles of administrating the monetary system were very clear and simple, but the fact remains that the system was rather managed than automatic. Melchior Palyi, in his book The Twilight of Gold, 1914—1936 (1972), highlighted this aspect of government-managed gold standards before the First World War: A new approach developed under the leadership of the Bank of England in the late 1860s and 104
early 1870s.… The practice of central banking had now evolved to the use of discretionary measures — that is, as far as "control" over short-term fluctuations in the balance of payments and in domestic credit conditions were concerned. Managerial discretion was essential to decide, for example, when and how to intervene in a panic by granting liberal credit at high interest rates in order to forestall forced liquidation of otherwise sound assets. Yet, the basic objective of discretionary policy was to try to prevent panic and dangerous gold drains and to be able to counteract them if they occurred.… When an active policy line was chosen, it became mandatory to induce the financial community, the commercial banks in particular, to coordinate their credit practices with those of the central bank.… Central bankers had to learn their profession; not only the quasi-mechanical rules of the game, but also the techniques of adapting them to immediate control objects. In the 19th century there was a greater humility among those who constructed and implemented various government economic policies. There was a general agreement with Adam Smith’s observation that "the statesman, who should attempt to direct private people in what manner they ought to employ their capitals, would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate, and which would nowhere be so dangerous as in the hands of a man who had the folly and presumption enough to fancy himself fit to exercise it." The classical liberals were deeply suspicious of government abuse of the printing press. They believed that only a monetary system under which all bank-issued notes and other claims were redeemable on demand for gold could act as a sufficient check against the abuse and debasement of a currency. Or as the English classical economist Nassau Senior summarized it: "The power to issue inconvertible paper [money] has never been granted or assumed without it sooner or later abused." But central-banking authorities were nonetheless given the authority and responsibility to manage the gold reserves at their disposal and the quantity of notes and other bank deposit claims outstanding to maintain the soundness of the monetary system and to counteract various short-term fluctuations in the national currency’s foreign-exchange rate, the balance of payments, and the quantity of financial credit available in the country’s economy. Their policy "tools," as Heilperin and Palyi pointed out, included manipulation of short-term interest rates and the buying and selling of private-sector bills of trade and securities. The central bankers needed to "learn their profession" concerning "matters of judgment" about when to raise or lower interest rates and tighten or loosen available credit and how to "induce" private financial institutions to "coordinate" their own credit-issuing practices with those of the central bank, within "the range of discretionary powers enjoyed by central bankers." While the goals for monetary policy may have been considered modest and limited in the eyes of the classical liberals of the 19th century, it remained a fact that the monetary system was a subject for national government policy. In an era of relatively unrestricted free-market capitalism, money and the monetary system were a "nationalized industry." And as such, even most of the advocates of economic liberty argued for monetary socialism and monetary central planning. They failed to call for and defend the privatization of the most important commodity in a market economy – the medium of exchange. As a result, when economic collectivism, socialism, and interventionism gained popularity and power in the early decades of the 20th century, money was the one area in which the central-planning ideal was already triumphant. For a hundred years, it had been taken for granted that the state should have either direct or indirect monopoly control over the supply of money in the market. Or as Vera Smith explained in The Rationale of Central Banking (1936), "It is notable that when laissez faire theories and policies were at their height so far as other industries were concerned, banking was already regarded as in another category. Even the most doctrinaire free-traders … were unwilling to apply their principles to the business of banking. It was widely contended that banking must be the subject of some 105
special regulations." In the decades after the First World War, the goals assigned to monetary central planning changed, but the instrument for their application remained the same – central bank management of the money supply. As we have seen, Yale University economist Irving Fisher advocated the stabilization of the price level. As Fisher stated in The Money Illusion (1928), To stabilize the buying power of the monetary units has long been the dream of economists.… And since the volume of circulating credit is controllable and controlled [through the Federal Reserve central bank], we have already a managed currency in spite of ourselves. If we insure scientific management in place of hit-and-miss management we shall thereby attain stabilization. John Maynard Keynes argued in his Tract on Monetary Reform (1923), "The war has affected a great change. Gold itself has become a ‘managed’ currency.… All of us from the Governor of the Bank of England downwards are now primarily interested in preserving the stability of business, prices and employment." The goal of monetary central planning, in Keynes’s view, as he articulated it in the 1930s, was for monetary policy to support and facilitate government "aggregate demand management" for manipulating the economywide levels of employment and output. The Chicago school economists in the 1930s had argued for a fiat paper-money system directly controlled by the government, with the responsibility to manipulate the quantity of money for stabilization of the price level. And later, Milton Friedman, as a leader of the Chicago School, also long advocated a paper-money system managed with a similar goal in mind. In his Age of Fables, Gustav Stolper pointed out in 1942 that "there is today only one prominent [classical] liberal theorist consistent enough to advocate free, uncontrolled competition among the banks in the creation of money. [Ludwig von] Mises, whose intellectual influence on modern neoliberalism was very strong, has hardly made one proselyte for that extreme conclusion." But over the last several decades, however, there has emerged a new generation of free-market critics of monetary central planning who are in favor of market money and private, free banking. Ludwig von Mises and Friedrich A. Hayek have been the inspiration for this new school of advocates for a free market in money.
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Chapter 31 Ludwig von Mises on the Case for Gold and a Free Banking System Throughout most of the 20th century, one of the leading proponents of the gold standard was the Austrian economist Ludwig von Mises. Why gold? Mises explained this many times, but did so, perhaps, most concisely in a 1965 essay entitled "The Gold Problem": Why have a monetary system based on gold? Because, as conditions are today, and for the time that can be foreseen today, the gold standard alone makes the determination of money’s purchasing power independent of the ambitions and machinations of governments, of dictators, of political parties, and of pressure groups. The gold standard alone is what the 19th-century freedom-loving leaders (who championed representative government, civil liberties, and prosperity for all) called "sound money." The eminence and usefulness of the gold standard consists in the fact that it makes the supply of money depend on the profitability of mining gold, and thus checks large-scale inflationary ventures on the part of governments. But, at the same time, Mises was conscious of the fact that even a gold standard established and controlled by the political authority was still a managed monetary system. Thus, in Monetary Stabilization and Cyclical Policy (1928), he emphasized: However, it should certainly not be forgotten that under the "pure" gold standard governmental measures may also have a significant influence on the formation of the value of gold. In the first place, governmental actions determine whether to adopt the gold standard, abandon it, or return to it. Every political act … insofar as it affects the demand for, and the quantity of, gold as money, represents a "manipulation" of the gold standard and affects all countries adhering to the gold standard.… In this sense, all monetary standards may be "manipulated" under today’s economic conditions. The importance of a monetary system based on gold, therefore, in Mises’s view, was that it limited the range of discretion open to governments to manipulate the quantity and value of money. The fundamental rule that the supply of money in the economy is anchored to the profitability of gold production as determined by market forces depoliticized the monetary system to a significant degree. Given an established redemption ratio between bank notes and a quantity of gold on deposit in banks; given fixed reserve requirements on checking and other forms of bank deposits; given an established rule of the right of free import and export of gold between one’s own country and the rest of the world; and assuming that the political authority with responsibility over the country’s monetary system does not interfere with these conditions and rules, then political influences on the value and quantity of money would be minimized. But since such a gold-based monetary system would still be established by the political authority and managed and supervised by the political authority or its designated institutional agent, even a gold standard was open to state intervention and manipulation. And having this authority, Mises argued, those political agencies assigned the task of managing a country’s monetary system increasingly manipulated the gold standard in the last decades of the 19th century and early decades of the 20th 107
century, reflecting the growing socialist, interventionist-welfare statist and Keynesian ideas that had come to dominate during that period. The protective safeguards against inflation and monetary mismanagement that even a gold standard had offered were eaten away. As Mises expressed it in The Theory of Money and Credit in 1924: The safeguards erected by the [classical] liberal legislation of the nineteenth century to protect the bank-of-issue [i.e., the central bank] system against abuse by the State have proved inadequate. Nothing has been easier than to treat with contempt all the legislative provisions for the protection of the monetary standard. All governments, even the weakest and most incapable, have managed it without difficulty. Their banking policies have enabled them to bring about the state of affairs that the gold standard was designed to prevent: subjection of the value of money to the influence of political forces. This led Mises to the conclusion that whatever shortcomings or problems that might have been seen in the idea of an unregulated, free banking system, all such criticisms paled into insignificance in comparison with the politically created monetary chaos during the First World War and ever since then. The destruction of the German mark during the great German inflation of the early 1920s was merely the starkest example, in his view. The only monetary and banking system that would have the potential capability of minimizing, if not preventing, monetary abuses on the part of governments would be a free banking system. In Human Action (1949), Mises summarized the case for a free banking system: What is needed to prevent any further [monetary abuse] is to place the banking business under the general rule of commercial and civil laws compelling every individual and firm to fulfill all obligations in full compliance with the terms of contract.… Free banking is the only method available for the prevention of the dangers inherent in credit expansion.… Under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular — one is tempted to say normal — feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions. How a free banking system would create incentives on the part of those owning and managing unregulated private banks to restrain their issuance of what Mises called "fiduciary media" (bank notes and bank deposit accounts not 100 percent fully covered by gold and other specie reserves in their banks) was concisely explained by him in Monetary Stabilization and Cyclical Policy : Even if governments had never concerned themselves with the issue of fiduciary media, there would still be [private] banks of issue and fiduciary media in the form of notes as well as checking accounts. There would then be no legal limitation on the issue of fiduciary media. Free banking would prevail. However, banks would have to be especially cautious because of the sensitivity to loss of reputation of their fiduciary media, which no one would be forced to accept. In the course of time, the inhabitants of capitalistic countries would learn to differentiate between good and bad banks. No government would exert pressure on the banks to discount [loans] on easier terms than the banks themselves could justify. However, the managers of solvent and highly respected banks, the only banks whose fiduciary media would enjoy the general confidence essential for money-substitute quality, would have learned from past experiences. Even if they scarcely detected the deeper correlations, they would nevertheless know how far they might go without precipitating the danger of a breakdown.
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The cautious policy of restraint on the part of respected and well-established banks would compel the more irresponsible managers of other banks to follow suit, however much they might want to discount [loans] more generously. If several [private] banks of issue, each enjoying equal rights, existed side by side, and if some of them sought to expand the volume of circulation credit [i.e., notes and deposits not backed 100 percent by gold] while the others did not alter their conduct, then at every bank clearing [i.e., the settling of accounts among the banks], demand balances would regularly appear in favor of the conservative institutions. As a result of presentation of notes for redemption and withdrawal of their cash balances, the expanding banks would very quickly be compelled once more to limit the scale of their emissions. Would the establishment of a truly free banking system make a country’s monetary system impervious to state control, manipulation, and destruction? Mises admitted that it might not, because ultimately a sound monetary and banking system could be maintained only against the background of an ideology consistent with the classical-liberal ideals of individual freedom, a free-market economy, and free trade. When he asked in 1924 whether a free banking system could have survived state encroachments in 1914, when World War I began and governments became hungry for revenue and wealth for the expansion of giant war machines, Mises admitted that the answer would probably have been "No." The permanent securing of a monetary system from political abuse and control could come only from a change in the ideologies that had come to dominate men’s minds in the 20th century. In a monograph entitled Stabilization of the Monetary Unit — From the Viewpoint of Theory, published in 1923 as the great German inflation was reaching its climax of destruction, Mises argued: Inflationism, however, is not an isolated phenomenon. It is only one piece in the total framework of politico-economic and socio-philosophical ideas of our time. Just as the sound money policy of gold standard advocates went hand in hand with [classical] liberalism, free trade, capitalism and peace, so is inflationism part and parcel of imperialism, militarism, protectionism, statism and socialism.… The belief that a sound money system can once again be attained without making substantial changes in economic policy is a serious error. What is needed first and foremost is to renounce all inflationist fallacies. This renunciation cannot last, however, if it is not firmly grounded on a full and complete divorce of ideology from all imperialist, militarist, protectionist, statist, and socialist ideas. But through the decades after Mises wrote these words in the early 1920s, governments around the world only moved further in the statist and socialist directions about which he expressed such deep concern. However, beginning in the 1980s and 1990s, as market-oriented ideas once again became a growing force in political debates, the idea of the denationalization of money has been raised as the alternative to central banking for the first time in more than a century. And the opening of this modern debate was begun by Mises’s Austrian-school colleague, Friedrich A. Hayek, in the 1970s.
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Chapter 32 Friedrich A. Hayek and the Case for the Denationalization of Money Shortly after the publication of his now-famous book, The Road to Serfdom, in 1944, Austrian economist Friedrich A. Hayek was in the United States on a lecture tour. In April 1945, he appeared on an NBC radio broadcast during which, in response to a question about whether the American Federal Reserve System was consistent with a free society, he stated, "That the monetary system must be under central control has never, to my mind, been denied by any sensible person. It is part of that [government] framework within which competition can work." And when asked whether the Federal Reserve was "socialistic in character," Hayek replied, "Do not make me responsible for all the nonsense which has ever been talked by anybody." Fifteen years later, in his treatise The Constitution of Liberty (1960), Hayek argued, "The experience of the last fifty years has taught most people the importance of a stable monetary system.… The inflationary bias of our day is largely the result of the prevalence of the short-term view" fostered and popularized by Keynes through the "fundamentally antiliberal aphorism, ‘In the long run we are all dead.’" Hayek stated that discretionary monetary policies to maintain "full employment" had produced nothing but dangerous inflationary tendencies throughout the Western world. It was understandable, therefore, that many now looked back wistfully to the earlier era of monetary stability under the gold standard and advocated its return. But, he declared, "It is important to be clear at the outset that this is not only politically impracticable today but would probably be undesirable if it were possible." Instead, Hayek proposed a government monetary authority that would pursue "the reasonable goal of a high and stable level of employment" through "aiming at the stability of some comprehensive price level" by means of adjusting the quantity of money in the economy to any changes in the general demand for money by transactors in the market. Thus, Hayek advocated both a general monetary "rule" — stability of a "price level" — and a monetary central-planning authority possessing the discretion to modify the supply of money to reflect changes in the demand for money. Another 15 years later, however, Hayek’s views on money and monetary policy radically changed. About a year after being awarded the Nobel Prize in economics in 1974, he delivered a lecture on "International Money" in September 1975 at a conference in Switzerland. In early 1976, it was published in London as a monograph under the title Choice in Currency: A Way to Stop Inflation. He explained that under the influence of Keynes and Keynesian domination of monetary and macroeconomic policy, governments were invariably guided by short-run goals in the service of various special-interest groups. The consequence was the constant abuse of the printing press and a resulting price inflation to feed the seemingly insatiable demands of privileged and politically influential groups. Hayek now concluded that some method had to be found to free the ordinary citizen from the government’s monopoly control of the medium of exchange. The answer, he suggested, was allowing individuals the freedom to use whatever money they chose, instead of their being captives of the increasingly depreciated monetary unit imposed on the market by the government: There could be no more effective check against the abuse of money by the government than if people were free to refuse any money they distrusted and to prefer money in which they had confidence. Nor could there be a stronger inducement to governments to ensure the stability of 110
their money than the knowledge that, so long as they kept the supply below the demand for it, that demand would tend to grow. Therefore, let us deprive governments (or their monetary authorities) of all power to protect their money against competition: if they can no longer conceal that their money is becoming bad, they will have to restrict the issue. Make it merely legal and people will be very quick indeed to refuse to use the national currency once it depreciates noticeably, and they will make their dealings in a currency they trust. The upshot would probably be that the currencies of those countries trusted to pursue a responsible monetary policy would tend to displace gradually those of a less reliable character. The reputation of financial righteousness would become a jealously guarded asset of all issuers of money, since they would know that even the slightest deviation from the path of honesty would reduce the demand for their product. Hayek’s proposal was for people to have the option to competitively select among the various currencies issued by governments. Later that year, however, Hayek published a short volume, Denationalisation of Money: An Analysis of the Theory and Practise of Concurrent Currencies (1976; revised, expanded edition, 1978), in which he proposed an even more radical idea. He said, "When one studies the history of money one cannot help wondering why people have put up for so long with governments exercising an exclusive power over 2,000 years that was regularly used to exploit and defraud them." Hayek outlined a system of free, competitive private banking, outside the control of government, that would supply the money used in the market society. By "private competitive currencies," however, Hayek did not mean a system of private and independent banks accepting deposits in, say, gold or silver, and issuing coins or paper notes representing fixed quantities of gold and silver, redeemable on demand. Instead, he suggested a system of alternative currencies in which each issuing bank would promise and attempt to keep the value of its private money constant through an expansion or contraction of its currency in circulation. The criterion for what type of action would be called for in any particular situation would be an index of commodity prices representing a market basket of "widely traded products such as raw materials, agricultural foodstuffs and certain standardized semi-finished products." When the index began to rise, it would be a signal for that bank to withdraw its currency from circulation, and when the index began to fall, to increase the quantity of its currency outstanding. Why would a currency of "stable value" be desired by the public? Because, Hayek argued, the requirements of economic calculation and the desire for less uncertainty involving contracts for deferred payments would probably make this the most preferred type of medium of exchange. The possible utilization of alternative competing monies available on the market would act as a restraint on reckless monetary expansion on the part of any bank. The expansionist bank would soon find its money depreciated in relation to other market currencies. Either the bank would have to return to a more conservative loan-making and money-issuing policy or face repudiation on the part of the public. "This is the process by which the unreliable currencies would gradually all be eliminated," Hayek reasoned. How would these alternative private monies come into circulation in the first place? Hayek argued that if he were in charge of a bank, I would announce the issue of non-interest bearing certificates or notes, and the readiness to open current checking accounts, in terms of a unit with a distinct registered trade name such as a "ducat." The only legal obligation I would assume would be to redeem these notes and deposits on demand with, at the option of the holder, either 5 Swiss francs or 5 D-marks or 2 dollars per ducat. This redemption value would however be intended only as a floor below which the value 111
of the unit could not fall because I would announce at the same time my intention to regulate the quantity of the ducats so as to keep their … purchasing power as nearly as possible constant. Hayek seemed to believe that new, private competing currencies would have the ability to be accepted as money because they would be, at least initially, redeemable in stipulated quantities of already-existing government monies, such as the franc, the mark, or the dollar. But if market participants were interested in moving into an alternative private currency of choice it would be because they were searching for a medium of exchange whose market value was not depreciating, or at least not expected to depreciate as rapidly or over as prolonged a period, as had the government money they had been previously obliged to use. Hayek’s proposal was open to the following question: Would people be interested in accepting and willing to accept a new money whose present value was represented only by a promised intention to keep its future value stable according to a designated index number and whose initial redeemability was in fixed quantities of a money (or monies) from which people were trying to escape? In other words, was this a procedure and a promise attractive enough for market actors to be willing to accept such a new private money to begin with? Could such a network of private monies ever get off the ground? And why would such private paper currencies be more attractive than private competitive banks operating on the basis of deposits of commodities historically used as money, such as gold or silver? Another weakness in Hayek’s proposal was his notion of private bank’s manipulating the quantity of their respective currencies to "stabilize" their values as measured by some statistically constructed price index. What Hayek seemed to want private issuers of money to do was what he warned against almost 50 years earlier when the Federal Reserve System had attempted to stabilize the general price level in the 1920s, a policy which he argued had been the central cause of the economic downturn of 1929. Hayek had argued in the late 1920s and the 1930s that such a monetary manipulation in the name of price-level stabilization would distort interest rates, potentially induce investment activities in excess of available savings in the economy to sustain them in the long run, and create the conditions for an eventual economic downturn in production and employment. If a single monetary authority within a national area can create such serious distortions and imbalances, a multitude of private banks each increasing or decreasing their currencies as guided by various price indices could intensify the number of faulty price signals by which investors might be influenced in making their production decisions. But in spite of such possible criticisms, the crucial role of Hayek’s proposal for the denationalization of money was that it opened a new, serious discussion concerning the possibility for a market-based monetary order free and separate from government management and control. He heralded a new campaign in the fight for freedom: What we need is a Free Money Movement comparable to the Free Trade Movement of the 19th century. If we want free enterprise and a market economy to survive … we have no choice but to replace the governmental currency monopoly and national currency systems by free competition between private banks of issue.… The recognition of this truth makes it … a crucial issue which may decide the fate of free civilisation.
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Chapter 33 Murray N. Rothbard and the Case for a 100 Percent Gold Dollar In 1962 there appeared a collection of essays edited by Leland B. Yeager entitled In Search of a Monetary Constitution. It contained contributions by such leading members of the Chicago school of economics as Milton Friedman and Jacob Viner and the originator of public-choice theory, James Buchanan. They each advocated a central monetary authority that would be assigned the task of managing the monetary system, with limited discretion to maintain a desired level of price stability. The volume also included a contribution by a young Austrian school economist, Murray N. Rothbard, whose essay was entitled "The Case for a 100 Percent Gold Dollar." That same year — 1962 — Murray Rothbard published Man, Economy, and State, a two-volume treatise representing the most systematic presentation of economic principles from within the Austrian tradition since Ludwig von Mises’s major work, Human Action, in 1949. The following year — 1963 — Rothbard published America’s Great Depression, in which he presented a detailed Austrian interpretation of how Federal Reserve monetary policy in the 1920s created the economic imbalances that resulted in the economic downturn that started in 1929 and of how the misguided interventionist policies of the Hoover Administration in the early 1930s prevented a normal recovery and instead turned it into the worst economic contraction of the 20th century. The theme of Rothbard’s 1962 essay was the question, What type of monetary system would eliminate the possibility for government manipulation of the money supply, reduce the likelihood of the business cycles of inflations followed by depressions, and be most consistent with the principles of a free society grounded in the market relationships of voluntary exchange and the fulfillment of contractual promises? Rothbard emphasized: We should keep in mind that money, in any market economy advanced beyond the stage of primitive barter, is the nerve center of the economic system. If, therefore, the state is able to gain unquestioned control over the unit of all accounts, the state will then be in a position to dominate the entire economic system, and the whole society. In the processes of private market exchange, money is acquired by supplying desired goods and services and by offering them for sale to others in the society who are willing to pay a money price for them. Then with the money earned by supplying and selling demanded commodities, the income earner proceeds to offer money in exchange for what those others, in turn, are presenting to the market for purchase. The circle of exchange is closed, with goods ultimately trading for goods and each participant in the market arena able to acquire what he wants from others only by providing them with things that they are willing to buy. The only exceptions to this process are the producers of the money-good itself. Following Carl Menger and Ludwig von Mises, Rothbard argued that money originates out of the market process, in which some commodity emerges as the most widely used and generally accepted good to overcome the inconveniences of direct barter transactions. Thus, those who manufacture this commodity began as the suppliers of some good desired originally as a consumer or producer good, which now has an additional use and value as a medium of exchange. 113
In the market, the producers of the money-good, say, the miners and minters of gold and silver coins and bullion, are supplying something that has actual market value to demanders, for which they are willing to pay a price in the form of other goods offered in exchange. And on the private market, the amount of the money-good mined and supplied is determined and limited by the profitability of extracting that commodity from the ground, given that the resources and labor to do so have alternative uses in the economy for which input prices must be paid. The inconvenience to people of carrying and storing actual quantities of gold and silver coins and bullion resulted in the development of warehousing, in which the money-commodity was placed, for a fee, on deposit for safekeeping. The depositor would receive a receipt or "claim check" recognizing his right to redeem his money-commodity fully or partly on demand. After a time, as such warehousing establishments developed reputations for reliability within communities, market transactors began to transfer the receipts in market transactions in place of actually withdrawing some quantity of gold or silver before every exchange. The warehouse claims to the money-commodity on deposit began to be used as money substitutes viewed by the market participants as being "as good as gold." The problem, Rothbard explained in his 1962 article, as well as in other writings, including his monographs What Has Government Done to Our Money? (1963, reprinted 1990) and The Case against the Fed (1994), is that the owners of the warehousing facilities often also operated as lenders of their own funds to potential borrowers in the market. That is, they began to function as bankers also. But these emerging bankers soon came to realize that they could extend additional loans to borrowers in the form of "notes" that looked exactly like the warehouse receipts issued to their gold and silver depositors. And that the look-alike notes were accepted in trade on the market, since they too were viewed by sellers of goods as money substitutes that in principle could be turned in for redemption for gold and silver at any time at the warehousing-bank establishment. This, Rothbard argued, was the beginning of "fractional-reserve banking." The gold and silver on actual deposit with a bank represented the "reserves" against which the receipts and notes issued by that bank could be redeemed "on demand." But that also meant that the total face value of notes and receipts in circulation now exceeded by some multiple the amount of gold and silver against which they represented a claim. Why? Because there were the receipt-notes issued to those who actually deposited some quantities of gold and silver with the warehouse-banker, and there were the additional receipt-notes issued by the bank to borrowers, who used them to buy various goods. If enough actual depositors and holders of a bank’s receipts and notes all were to demand payment in the form of gold or silver withdrawals in the same short period of time, the gold and silver available would be found to be only a fraction of the claims being turned in for redemption. The bank would then be faced with at least insolvency and possibly even bankruptcy. Rothbard condemned fractional reserve banking as a violation of contract: In my view, issuing promises to pay on demand in excess of the amount of the goods on hand is simply fraud, and should be so considered by the legal system. For this means that a bank issues "fake" warehouse receipts — warehouse receipts, for example, for ounces of gold that do not actually exist in the vaults. This is legalized counterfeiting; this is the creation of money without the necessity of production, to compete for resources against those who have produced. In short, I believe that fractional-reserve banking is disastrous both for the morality and for the fundamental bases and institutions of the market economy.… In sum, I am advocating that the law be changed to treat bank notes and deposits as what they are in economic and social fact: claims, warehouse receipts to standard [gold or silver] money — in short, that the note- and deposit-holders be recognized as owners-in-law of the gold … in the bank’s vaults. 114
The money and banking system of the free society therefore, Rothbard argued, should be based on a system of 100 percent gold reserves. He also argued that this would eliminate the "business cycle." Banking would have two divisions: one would be pure warehousing, in which the depositor paid a fee to store his actual gold or silver and for which the actual amount deposited would always be in the vault for 100 percent redemption on demand. The other division of the banking establishment would be for saving and lending, in which sums would be deposited for a stipulated period of time during which depositors could not make a withdrawal (except under specifically prearranged terms and penalties). These saved sums would then be available for lending purposes for contracted periods of a loan. Only that amount of money income actually saved by members of a community would be available for investment purposes by those desiring to borrow from the banks. Thus, savings and investment would be kept in balance, with limited potential for the type of savings-investment imbalances that usually occur in the business cycle. Setting aside the problem of the business cycle, Rothbard’s central argument against fractionalreserve banking was that it represented fraud — an issuing of bank notes and a publicly stated promise to pay on demand that could not be fulfilled if enough depositors were to want redemption within the same period of time. This argument, however, has been questioned by a number of free-market advocates. For example, Mark Skousen, in his thorough study, Economics of a Pure Gold Standard (1996), asked whether the fraud charge would be true if customers were told up front that some banks operated on a fractional-reserve basis and that they could make their deposits at a 100-percent-reserve banking institution for which they paid a fee or at one that offered them interest on their deposit but which could not guarantee continuous 100 percent redemption under certain circumstances, such as a heavy demand for withdrawals by some of these clients. "What fraud is committed if a customer voluntarily agrees to lend his banker his funds with the contractual agreement that the customer can withdraw his loaned funds on demand? This is surely a strong possibility under market conditions and is free from force or fraud," Skousen argued. "And, yet, by permitting such contractual arrangements, a fractional reserve system is sure to develop on a broad scale." Furthermore, if a bank’s notes and checks clearly state that it operates on a fractional reserve basis, then no potential recipient of such a note or check could claim fraud if he were to accept it as a money substitute in a market transaction. And, indeed, the case for a private, free banking system, probably with fractional-reserve banking, has been the primary focus of the opponents of monetary central planning for the past quarter of a century.
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Chapter 34 Free Banking and the Political Case against Central Banking When Ludwig von Mises made the case for free banking in his monograph Monetary Stabilization and Cyclical Policy in 1928, he argued that the inflations and depressions that the major industrial countries had experienced in the 19th and early 20th centuries might not have occurred "if there had been no deviation from the principle of complete freedom in banking and if the issue of fiduciary media [bank notes in circulation not fully covered by specie reserves held by the banks that had issued them] had been in no way exempted from the rules of commercial law." The booms and busts of the business cycle could finally be reduced or eliminated only "through the establishment of completely free banking." But Mises admitted that "the time is not yet ripe – not now and not in the immediate future" for the free banking alternative, given the ideological and interventionist trends through which the 20th century was passing. But in the wake of the disasters and disappointments with Keynesian economic policies in the 1970s, the intellectual climate became conducive for rethinking the "unthinkable," and, beginning in the 1980s, there emerged a new monetary literature that challenged the assumptions of and justifications for central banking. This new generation of monetary economists were most often influenced by the earlier writings of the Austrians – Mises, Friedrich Hayek, and Murray Rothbard. Among the leading members of the new free banking school are: Lawrence H. White, who has written Free Banking in Britain: Theory, Experience, and Debate, 1800 -1845 (1984), Competition and Currency: Essays on Free Banking and Money (1989), and The Theory of Monetary Institutions (1999); George A. Selgin, who published The Theory of Free Banking: Money Supply under Competitive Note Issue (1988) and Bank Deregulation and Monetary Order (1996); Kevin Dowd, who authored Private Money: The Path to Monetary Stability (1988), The State and the Monetary System (1989), and LaissezFaire Banking (1993); and Steven Horwitz, who wrote Monetary Evolution, Free Banking & Economic Order (1992). Kevin Dowd also edited a collection of essays by a group of free-market monetary theorists under the title The Experience of Free Banking (1992). They mounted a forceful attack against the rationale for a central banking system, arguing that economic instability and monetary imbalance were more likely under monetary central planning than the free banking alternative. Lawrence White insisted that a central banking system necessarily ran an inescapable danger from political abuse. First, governments and central banks were always tempted to capture the profits from "seigniorage." Seigniorage represents the difference between what it costs the monetary authority to produce a unit of money and the value of that monetary unit in terms of its purchasing power over goods and services in the market. For example, if printing a one-dollar bill costs 25 cents, the government is then able to acquire on the market, by being the first to spend that new dollar, 75 cents of goods and services over the costs of manufacturing that unit of money. The government can tax the public 25 cents to buy the raw materials to run a dollar off the printing press and then siphon off an additional 75 cents of the private sector’s production of goods and services when it spends that paper dollar in the marketplace. Inflationary profits are there to be made by the government and its central bank as long as the cost of manufacturing a unit of money is less than what that unit can buy in the market. In the case of the U.S. Federal Reserve System, which is required to return all profits from its activities as a "gift" to the U.S. Treasury, this creates an incentive for the central bank to pad its 116
operating costs in the form of larger staffs, higher salaries, more expensive facilities, and more frequent and more costly travel and other business expenses. Its seigniorage profits are partly hidden "on the books" in the form of increased expenditures to manage the monetary and banking system of the United States. White also emphasized the temptation of using a "politicized money supply regime" to try to initiate a "political business cycle" that runs "the danger of destabilization of real output and employment in pursuit of reelection." Since the monetary central planners are politically appointed to the management of the central bank, they are open to pressure and bias to assist those in political power by attempting to create "good times" as an election is approaching. Monetary central planners, like any other type of central planner, of course, lack the perfect knowledge to manipulate the money supply with the "scientific precision" necessary to stimulate the desired amount of production and employment when it would be most optimal in an electoral cycle. And market participants always have incentives to try to correctly anticipate future monetary policy to adjust their production and pricing decisions so as not to be negatively affected by manipulations of the money supply. But, paradoxically, precisely because neither the monetary central planners nor the private actors in the market possess the knowledge to estimate perfectly and to anticipate how, when, and to what degree an increase (or a change in the rate of increase) in the money supply will have its full impact on prices, productions, and employment, the central bank authority can introduce a degree of "surprise" into the market economy. This surprise element can make agents in the private sector confuse a monetary manipulation for real, profit-creating opportunities in the market that induce investment and production activities that only much later will be discovered to be the false stimuli of the artificial boom. Because politics can influence the monetary policy decisions of the central bank, the case has often been made that the best answer to this dilemma is to make the central bank as independent as possible. If the executive or legislative branches of government cannot directly pressure the monetary central planners, they will be able to deliberate on the best monetary policy for the long-run good of the nation. White responded to this argument by pointing out: Being answerable to no one is certainly a comfortable situation. For this reason the officials of any central bank are themselves likely to be found in the forefront of those advocating independence for the agency. An independent central bank’s private constituency – presumably the large commercial banks – will generally have a private agenda which is not identical with the preferences of the common holders of money [the ordinary private citizens in the market].… In any event, the prospect of a central bank beholden to the commercial banks is not much cheerier than that of a central bank beholden to Congress. Furthermore, he argued the degree to which a central bank can ever actually be independent of the executive and legislative branches of government is very limited. "Congress created the Federal Reserve System, and can rewrite its mandate at any time as it has in the past," White pointed out. "Knowing this, the Federal Reserve’s management cannot afford to be unresponsive to congressional pressures. The same is undoubtedly true of any other legislatively created central bank." British free banking advocate Kevin Dowd has both echoed and extended the political argument against central banking. Controlling the money supply offers the political authorities immense power over the distribution of the wealth and income of the citizenry of a country and the productive uses to which those citizens can be induced to apply the resources, capital, and labor at their disposal. As a result, changes in various political coalitions in the halls of power constantly create new motives and incentives to try to change the way wealth and income are distributed in the society and the types of 117
production and employment activities various special interest groups desire to have stimulated. Nor should periods of relatively low price inflation be taken as an indication that fears about political manipulation of the monetary system are misplaced or exaggerated. Said Dowd: Changes in the value of the [monetary] standard reflect changes in the balance of political power between those groups which benefit from inflation and those which lose from it. Among other things, this implies that the current relatively low rate of inflation merely reflects the strength of the present anti-inflation coalition – itself the consequence of the fright that most people experienced during the last bout of high inflation – and there is every reason to expect inflation to rise again as that coalition begins to lose its grip. Unless something is done to change the monetary regime, people’s memories of high inflation are likely to recede over time, and with this their fear of inflation. The way would then be open for policies that would lead to a new bout of high inflation. Even if the current ruling group were fully aware of the dangers of price instability, and totally committed to stable prices, it generally lacks the power to pre-commit future governments to maintain price stability. However much the private sector may believe in the "good intentions" of the present British government, the latter can make no guarantees binding its successors, or even its own future actions. The only way this can be avoided is to remove the power to meddle with the [monetary] standard, and that in turn requires that the [monetary] standard be effectively depoliticized. But even if it were possible to completely remove politics from the central banking system and its decision-making process, making the monetary central planners free from both governmental and private-sector pressures and biases in setting and implementing monetary policy, the advocates of free banking have argued that those monetary central planners would still be unable to successfully manage the monetary system in a manner equal to or better than a fully market-based private, free banking system.
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Chapter 35 Free Banking and the Economic Case against Central Banking A fundamental insight of the classical economists beginning with Adam Smith was the possibility for social order without political design. Adam Smith’s metaphor, of men pursuing their individual interests being guided as if by an invisible hand to serve a purpose that was no part of their respective intentions, demonstrated that human society did not need governmental controls and commands and indeed would be greatly harmed if government attempted to direct men in their market pursuits. Yet there was one area in which the classical economists believed a role for government was essential: the control of the money supply. Even the gold standard of the 19th century was a government-managed monetary system. And in the 20th and 21st centuries, governments have centrally planned the national monetary systems all around the world through the issuance of fiat, or paper, currencies. Yet monetary central planning has many of the same problems and limitations as all other forms of central planning. Bringing out the parallels between central planning in general and monetary central planning has been an important theme taken up by both Lawrence H. White and George Selgin. In his study of Free Banking in Great Britain (1984), White drew attention to the fact that in the 19th century, advocates of free banking emphasized the problem of the "overissuing" of currency under central banking. Even under the gold standard, if there is a single issuer of a currency within a country, there is limited feedback to inform that bank that it is "excessively" increasing the money supply. Imagine that there are several private banks that issue bank notes and checking accounts to their depositors for gold originally deposited with them. But assume that the gold holdings are centralized and held in the vault of the central bank; that is, any gold received by one of the private banks is redeposited by it with the central bank. At the same time, each of the private banks therefore acquires a right to demand currency notes issued by the central bank with a face value equal to its gold deposit. And it is these central bank currency notes that the private banks issue to private citizens who have been the original gold depositors. Any checking accounts opened with them by private citizens on the basis of gold deposits can be "cashed" for the central bank currency notes as well. Suppose that a depositor with private bank A writes a check for $100 for some commodity he has purchased in the market, and that the seller of this good deposits the check in his private bank B. Bank B now credits his account in the amount of an additional $100, against which the depositor may demand central bank currency notes or writes checks himself. Bank B will send the deposited check back to bank A for payment. The central bank will deduct $100 worth of gold from bank A ‘s account with the central bank and will credit the account of bank B with an equivalent amount. The total money supply, represented by the amount of central bank currency notes in circulation and checking account money against which central bank currency notes can be demanded, will not have changed. And all the gold will have remained in the vault of the central bank, with the title to $100 of that gold merely having been changed on the central bank’s ledger book. Now suppose that the central bank decides to expand the money supply to finance a government budget deficit (perhaps owing to a war crisis). The government issues a $1,000 bond that is bought by one of the private banks. Against the bond, the private bank extends a $1,000 loan to the government in the form of a checking account that the government can now use to purchase various goods in the 119
market. To this point there is nothing inherently inflationary in the process. With available but limited gold funds on deposit with the central bank, the private bank has merely extended a loan to the government at the expense of some potential borrower in the private sector who can’t match the interest payment offered by the government. But now the central bank offers to buy the government bond from that private bank and credit that private bank’s account with the central bank for the amount of $1,000. That means that the private bank will have an additional $1,000 available to extend additional loans to others in the market in the form of additional central bank currency notes or a checking account that can be "cashed" for $1,000 in currency notes. No additional or new gold has been deposited into the banking system, yet there is now an extra $1,000 of central bank currency or checking account money in the economy. There is now $2,000 worth of central bank money in circulation on the basis of $1,000 of gold in the vault of the central bank. Currency and checking deposit claims to that gold now exceed the amount of gold available to meet those claims. An inflationary "overissuance" of the money supply has occurred that, under a gold standard, eventually will have to be reversed. But the critics of central banking argued that such an excessive increase in the money supply could continue for some time before the central bank would be forced to bring it to an end. As the additional $1,000 of new central bank money comes into the economy in the form of additional loans from private banks, the extra $1,000 will be competing against the previously existing money supply for available goods and services offered on the market. Over time the prices of those goods and services within country A will start to rise owing to the increased number of dollars bidding for them. The rising cost of domestically manufactured goods will make less-expensive foreign goods appear more attractive to buyers in country A. But since the national central bank currency of country A is normally not usable for buying goods in other countries, the private citizens of country A will begin to redeem their bank notes and checking accounts for gold, which they will then want to export as payment for the less-expensive foreign goods available in countries B and C. The private banks in country A will turn in central bank currency notes for gold to pay out to their depositors. Only now, after an "overissuance" of the money supply and an inflationary process may have continued for some time, will the central bank be faced with significant and increasing demands for quantities of gold from its vault for export. And the greater has been the currency creation and price inflation, the heavier will become the redemption demand for gold. Indeed, precisely because increases in the money supply do not immediately and simultaneously raise all prices in the market, the monetary expansion can continue for some time before a wide-enough circle of goods will have risen sufficiently in price that the central bank finally faces an emerging and growing "gold drain" that may threaten to reach "dangerous" proportions. The loss of gold and threatened additional losses of gold will eventually force the central bank to stop and reverse its monetary expansion, if it is not to run the risk of a panic and the danger of not being able to maintain its adherence to the gold standard. However, the "negative feedback" of significant gold losses may take so long to materialize and for anyone to respond to it under a central banking system that that country’s market economy can face a high degree of inflationary instability followed by a price deflation and depression when the central bank reverses the monetary expansion with a monetary contraction to stay on its government centralized gold standard. How is this problem of monetary management under central banking – even under a gold standard – similar to the problem of central planning in general? This theme was highlighted by Selgin in his 1988 volume, The Theory of Free Banking. The function of a price system in a competitive free market is to serve as a method of communication. Any system of division of labor naturally creates with it a vast network of consumers and specialized producers who must somehow be able to inform each other 120
about their changing patterns of demand and willingness and abilities to supply for purposes of mutual coordination of multitudes of millions of individual plans. Free-market prices are delicate and sensitive signal switches that record any and every change in the patterns and intensities of supply and demand. Those changing prices create the profit opportunities and loss penalties that serve as the incentives for individuals to modify what and how much they demand and supply of the various goods desired on the market and brought to it. In principle the monetary and banking system should be open to the same free-market competitive pricing system and operate under it to inform the demanders and suppliers of money and the managers of a private banking system about the changing desires and abilities to demand and supply various forms and quantities of money and money-substituting media of exchange. The free-market competitive pricing system should also see to it that the banking system successfully brings together borrowers and lenders to properly coordinate the plans of savers and investors for a fairly smooth meshing of consumption and production activities throughout the economy. But under central banking, as was explained, an "excessive" expansion of the money supply lacks a sensitive and fairly rapid feedback mechanism to inform the central monetary managers that the system is threatened with instability. Instead, it can be open to abrupt, significant, and prolonged disruptions of inflationary periods followed by deflationary downturns. In other words, a centralized monetary system can be open to monetary changes and fluctuations introduced by the central monetary authority that do not reflect changes in market supply and demand conditions. Once introduced, the result can be extended periods of inflation and deflation, even under a gold standard managed by a central bank. Could the free market do better? Yes, say the proponents of free banking, and they have tried to explain how.
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Chapter 36 Free Banking and the Competitive Limits to Monetary Expansion It was in 1754 that the Scottish philosopher David Hume published his Political Discourses, containing his famous essay "Of the Balance of Trade," in which he refuted the mercantilist argument that unless the government regulated the international commerce of a country, that country might lose its supply of the precious metals — gold and silver — owing to an unfavorable balance of trade. The mercantilists feared that in importing attractively cheap goods from foreign nations in excess of its own exportable goods, the home country would have to pay for these net purchases through the export of gold and silver in order to settle its international accounts for buying those goods, which would result in a decrease in the amount of its "treasure" of specie money. Hume responded by formulating what has become known as the "specie-flow mechanism." If the government in the home country were to increase its supply of paper currency, over time prices in the home country would begin to rise. That would make it attractive for people in the home country to buy less-expensive foreign substitute goods in place of the now more-costly ones at home. It would make goods manufactured at home less attractive for foreigners to buy as well. Imports into the home country would increase and exports out of the home country would decrease, resulting in an "unfavorable" balance of trade. If the paper currency was redeemable in gold or silver, residents in the home country would redeem their paper currency for the precious metals and export them to pay for the net purchase of desired imports, and the home country would have a net loss of its specie money. But Hume argued that this was only the first step in a sequence of reactions in the market set in motion because of the domestic paper-money inflation. Unless the home government were to run the risk of losing its entire supply of gold and silver reserves, it would have to reverse its expansion of paper money, bringing about a monetary contraction and a decline in prices in the home country. At the same time, the foreign nations experiencing a net inflow of gold and silver by selling more goods to the home country would see a rise in their own domestic prices due to the influx of additional sums of gold money into their economies. The fall in prices in the home country and the rise in prices in the foreign countries would bring about a reverse movement in gold and silver as residents in the home country now purchased more less-expensive domestically produced goods and residents in foreign nations increased their demand for exportable goods from the home country, since their own manufactured goods would have become more expensive. Gold and silver would flow out of foreign nations and back to the home country until prices had once more risen in the home country and fallen back in the foreign nations, bringing about a balance of trade between the different countries of the world. Market-based changes in prices and international buying and selling would ensure a "natural" distribution of the precious metals among countries without government interference or regulation of foreign trade. The lesson the classical economists of the 19th century drew from Hume’s specie-flow mechanism was that the only "good" that governments could do was to restrain their own temptations for "excess" issues of paper currencies by adhering to a gold standard with paper currency redeemable on demand and by keeping international trade free from regulation and control. Gold-backed, redeemable money and free trade were the two institutions to ensure a sound and stable monetary order in the classical-liberal world of the 19th and early 20th centuries. As long as 122
these were the "rules of the game" followed by governments and central banks, the classical economists and liberals were certain this was the best arrangement to be hoped for in an imperfect world. But, as the advocates of free banking pointed out, even this institutional regime still had a looseness that permitted a potentially long lag between an abuse of the printing press and the resulting full effects on prices and trade that would generate a "brake" on the inflationary process. Or as Kevin Dowd summarized the problem in The State and the Monetary System (1989): With a monopoly bank there will therefore be a greater, and more persistent, over-issue before demands for redemption bring it into line. This, in turn, seems to imply that the over-issue will be that much more disruptive, and that interest rates, prices and output will move further out of line before being checked by the bank’s measures to counter its loss of reserves.… Eventually, of course, the pressure of direct redemption would suffice to stop them, but the process of checking the over-issue would obviously take longer. The reason, which Dowd and other free-banking proponents have pointed out, was that with gold reserves concentrated in the hands of the central bank, any apparent "overissuance" by one of the commercial banks would result merely in a redistribution of titles to gold among the commercial banks belonging to the central banking system when the banks "cleared" their accounts with each other. The actual gold held in the vaults of the central bank might remain uncalled-upon for a long period of time before the paper-money expansion had sufficiently raised prices in general that it finally resulted in a demand for gold withdrawals by depositors who wanted to finance increased imports of less-expensive goods. However, the free bankers have argued, the situation would be significantly different in a monetary system without a central bank and a centralized concentration of gold reserves. Each private bank would offer its facilities as a depository for customer gold and any other precious metals that the market had chosen as useful media of exchange. The bank would issue its own notes to depositors as claims to those deposits or credit depositors’ checking accounts against which they could write checks issued by that bank. The depositors would then proceed over time to use those notes and checks to purchase goods and services, to the extent that sellers were willing to accept the notes and checks as a result of that bank’s brand-name recognition and trustworthiness among transactors in the market. Sellers would deposit the notes and checks they had accepted in trade in their own accounts in other banks. The private banks would periodically have "clearing" procedures in which they settled their accounts with each other (which historically developed long before government central banking ever appeared on the scene). Any bank that found itself owing net amounts to other banks, over and above what the other banks owed them, would have to settle through an actual transfer of gold or whatever other precious metals were used as the ultimate market-based money. That bank’s gold reserves would immediately and precisely be reduced by the actual amount it had to transfer to those banks with which it had an "adverse" balance. And at the same time, the gold reserve position of other banks would increase precisely to the extent that they received net transfers. The gold positions of these private banks would be a continuously close mirror image of the spending and receipt patterns of their respective depositors. The banks would be mere repositories serving the needs of their depositors who found it convenient to house their commodity money with them for safety and ease of use through the market-accepted substitutes of private bank notes and checks. Changes in the net income and net gold-owning positions of the banking customers would be quickly reflected in net transfers of gold among the private banks in the clearing process. Now suppose that one of these private banks decided to issue a quantity of notes or checks in excess of depositors’ gold in their vaults in the form of loans to potential borrowers to earn additional interest-income from the transaction. The borrowers would use the notes or checks to purchase the 123
goods and services for which they wanted loans to begin with. Those notes and checks would be deposited by market sellers in their own banks, and those banks would present them for redemption at the next interbank clearing session. The bank that had undertaken the overissue of notes and checks would be faced with a net obligation to pay a sum of gold out of its reserves to other banks, and within a relatively short period after having issued the excess supply of its notes and checks. The loss of gold would be an immediate and direct signal, a rapid negative feedback, that it had undertaken a "monetary policy" that might threaten its financial solvency, its customer confidence, and its market reputation if it persisted in its private "monetary expansion." If this private bank were to persist in its "easy-money" policy, it would risk losing its gold reserves at each bank clearing session, arouse concerns among depositors that might result in their transferring their deposits to other, financially sounder banks, and a growing hesitancy on the part of sellers in the market to accept its notes and checks in trade at their face value. As George Selgin explained in The Theory of Free Banking (1988): It means that a solitary bank in a free banking system cannot pursue an independent loan policy. A "cheap-money" policy in particular would only cause it to lose reserves to rival banks. Also, no bank would be able, by overissuing, to influence the level of prices or nominal income to any significant degree, since the clearing mechanism rapidly absorbs issues in excess of [market] demand, punishing the responsible bank. Could a private bank in a free banking system attempt to expand its notes and checks on the market in excess of its depositors’ demand for them? Yes. Could it long persist in that practice? It is highly unlikely precisely because that bank, within a short period of time, would feel the consequences of its actions. Nor could it force other banks to follow the same course of action, and thus it could not by itself have a significant effect either on the general level of prices or on the market structure of relative prices because of its singular monetary and lending policy. Thus, the lag between an overissuance of private bank notes and the resulting negative feedback on that bank’s gold reserves would be much shorter and much more localized in its effects than under a central banking system.
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Chapter 37 Free Banking and the Market Demand for Money One of the primary benefits of economic freedom is that it decentralizes the negative effects that may arise from ordinary human error. Every one of us makes decisions that we hope will produce outcomes we desire. Yet the actual outcomes from our actions often fail to match up to the hopes that motivated them. A businessman who misreads market trends in planning his private company’s production and marketing strategies may experience losses that require him to cut back his activities, resulting in some of his employees’ losing their jobs and in resource suppliers’ experiencing fewer sales because the losssuffering businessman reduces his orders for what they have for sale. But the negative ripple effects from his entrepreneurial mistakes are localized within one corner of the overall market. Other sectors of the market will not be directly penalized or subject to the unfortunate effects of his poor judgment. Profit-making enterprises can freely go about their business hiring, producing, and then selling the goods which they have more correctly anticipated the consuming public actually desires to buy. Under central planning, however, errors committed by the central planners are more likely to have an impact on the economy as a whole. Every sector of the economy is directly interlocked within the centrally planned blueprint for the allocation of resources, the quantities of different goods and services to be produced, and the distribution of the output to the consuming public. Centralized failures in resource use or production decisions more directly affect every sector of the economy, since nothing can happen in any of the government-run industries independently of how the central planners try to fix their mistakes. Everyone more directly feels the consequences of the central planners’ errors and must wait for those planners to devise a revised central plan to correct the problem. Monetary central planning suffers from the same sort of defect. Changes in the money supply emanate from one central source and are determined by the monetary central planners’ conceptions of the "optimal" or desired quantity of money that should be available in the economy. Their central decision can indirectly influence the pattern of interest rates (at least in the short run) and the market structure of relative prices and inevitably bring about changes in the general value, or purchasing power, of the monetary unit. The monetary central planners’ policies work their way through the entire economy, possibly bringing about a cycle of an inflationary boom followed by general economic downturn or even depression. Halting the inflation and bringing an unsustainable boom to an end depends upon the monetary central planners’ discovery that things "may have gone too far" and a decision by them to reverse the course of monetary policy. Many, if not most, sectors of the market will then have to modify and correct investment, production, and employment decisions that had been made under the false, inflationary price signals the central planners’ monetary policy has artificially created. Capital, wealth, and income spending patterns in the market will have been misdirected and partly wasted because of the errors committed by the monetary central planners. The opponents of central banking have argued that the occurrence of such errors would be less frequent and discovered more quickly under competitive free banking. Any private bank that "overissued" its currency would soon discover its mistake through the feedback of a loss of gold reserves through the interbank clearing process. The bank would realize the necessity of reversing 125
course to ensure that its gold-reserve position was not seriously threatened and of avoiding the risk of losing the confidence of its own customers because of heavy withdrawals by depositors. Moreover, the effect of such a private bank’s following a "loose" and "easy" monetary policy would be localized by the fact that only its banknotes and check money would be increasing in supply because of the additional spending of those to whom that bank had extended additional loans. It could neither force an economywide monetary expansion throughout the entire banking system nor create an economywide price-inflationary effect. Any negative consequences, while being unfortunate, would be limited to a relatively narrow arena of market decisions and transactions. The free-banking advocates have also argued that a system of competitive free banking would more smoothly adjust the supply of money to changes in the demand for money, while at the same time ensuring a continuing coordination of savings choices and investment decisions throughout the economy by means of localized adjustments in private bank-lending policies. The demand for money takes two forms in the decisions of market participants. The distinction between the two has been usefully explained by Murray N. Rothbard in his treatise, Man, Economy, and State (1962). There is first of all a "pre-income demand for money." This represents the amount of money individuals desire to acquire for all purposes – consumption, investment, and cash balance holdings. Each person decides what quantity of his goods, labor services, resources, and other factors of production he wants to offer to the market as the means of earning money income. Each of us makes this choice in the context of the value to us of all the things that a sum of money earned can buy on the market in comparison with the opportunity cost of all the other non-money-earning ways we might use our labor, time, and resources. There is also a "postincome demand for money." Having chosen to earn a certain money income, we must then decide how much of it to spend immediately on various consumption and investment purposes and how much of it to hold as a cash balance over a period of time to facilitate or take advantage of future desired or possible spending opportunities. Each of us decides, in other words, how much of our earned money income we wish to hold as an average cash balance over the period of time between receiving one paycheck and receiving the next. We not only save when we directly invest a portion of our income or wealth in a business enterprise or when we lend a portion of our income or wealth to someone else (either directly or indirectly by depositing a sum of our income in a "savings account" with a financial institution). We defer consumption, i.e., we do not immediately demand goods and services against which our money income could make purchases in the market, when we choose to hold an average cash balance rather than spend it. Our demand for money as a postincome demand to hold an average cash balance is therefore also a decision to save. Thus, our willingness to supply goods, services, labor, and resources to the market reflects our preincome demand for money. And our preference to hold an average cash balance and spend our previously earned income at a certain rate over a period of time on consumption and investment opportunities reflects our postincome demand for money. And any choice to increase or decrease our average cash-balance holding represents our decision to decrease or increase the rate at which we spend our earned income on consumption or investment activities during an income period. Expressed differently, an increase or decrease in our average cash-balance holding during a period of time reflects our decision to change our average rate of saving out of income during that same period of time. In a market-based free-banking system, depositors could choose to hold their desired average cash balances either in the actual commodity money (gold, perhaps) or in banknotes or checking-account balances representing the amount of commodity money they had deposited with a financial institution, or in a combination of the two. In a developed monetary and banking system, it probably would be the case that most people would, for convenience’ sake, deposit their commodity money in a financial 126
institution. They would use bank-notes or checking accounts issued to them by private banks as the claims against their gold deposits as money-substitutes in most transactions (to the extent to which each of these private banks had a market reputation that their banknotes and checks were "as good as gold," meaning they were trusted as being redeemable on demand at face value). Suppose that some depositors banking with the "Adam Smith Bank" desired to maintain the same average cash balance but to hold a larger percent of their cash balance in the form of actual gold coins or bullion. They would turn in banknotes or cash checks equal to the amount of gold they wished to redeem. And an equivalent sum of these money-substitutes would then be withdrawn from circulation by the Adam Smith Bank. But the average rate of spending as reflected in the demand for consumer goods and direct investment purchases would not have changed, though a larger percentage of transactions might now occur in the form of gold coins or bullion. The reverse would happen if depositors desired to hold a larger portion of their unchanged average cash balance in the form of banknotes or checking accounts; they would deposit a chosen amount of their gold coins or bullion with the private bank of their choice. And there would be a larger sum of Adam Smith banknotes and checks in circulation and possibly used in transactions on the market. However, suppose that some persons wished to increase their average cash-balance holding. This would mean that during the income period they desired to decrease their rate of spending on consumer goods and direct investment purchases. They could do so by redeeming a portion of their banknotes and checking-account balances for gold and holding a larger portion of their now higher average cash balance in the form of actual commodity money; or they could merely decrease their rate of spending in the form of banknotes and checks written and as a result hold "on hand" a larger portion of their earned money income in the form of Adam Smith banknotes and checking-account balances during the income period. That would also mean that these depositors were increasing their savings, i.e., deferring the amount of their more immediate demand for consumer goods their earned income would enable them to purchase on the market. The increased preference for savings would be reflected in the market in: a fall in the rate of interest; the freeing of labor and resources employed in the consumer goods sectors (since the demand for consumer goods would have decreased owing to the desire to spend less and save more in the form of cash balance holdings); an increase in borrowing stimulated by the decline in the rate of interest; and a redirection of labor and resources to more longer-term investment projects that would bring forth more, better, and less-expensive consumer goods in the future. How precisely would this market adjustment and reallocational process work itself out under a system of free banking?
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Chapter 38 Free Banking and the Coordination of Savings and Investment In any extended social system of division of labor, the crucial economic problem is how the vast network of interdependent market participants will successfully communicate with each other about their diverse and changing demands for goods and the ability to supply them. In the competitive free market, this problem is solved by a functioning price system. The prices for finished consumer goods and the factors of production smoothly and rapidly register every change in any corner of the market concerning a desire in demand and a willingness and ability to supply. The price system of the market economy serves as what Friedrich A. Hayek has called an extended telecommunications device to inform everyone about changes that may be relevant to his own individual plans. Changes in prices assist in dispersing information about the need for persons to adjust their own activities to better coordinate their own actions with those with whom they may trade for mutual benefit. Interest rates are meant to serve the same function in coordinating the intertemporal choices of the participants of the market. The decision of some participants to save requires a process of coordination with the decisions of others who wish to invest for purposes of increasing the quantity and quality of goods that can be available at various times in the future. A decision not to spend and instead to defer the possibility to consume can take two forms. First, an individual can choose to allocate a portion of the income he has earned and lend it to another who wants to have financial access to more goods and services in the market for investment purposes than his own income and savings would permit him to purchase or hire. This person can either directly lend to a prospective borrower or do so indirectly by placing his savings in a financial institution that serves as an intermediary in selecting the prospectively most profitable enterprises to which to lend the savings placed in its care. Second, a person can choose to save more and consume less by decreasing the rate of spending out of his income during a given income period. In other words, he chooses to increase the average cash balance he holds during that income period. This, too, represents a decline in the person’s potential demand for the amount of consumer goods his money income would permit him to purchase in the market. Suppose, for example, that at the previously prevailing prices in the market, this person had purchased four boxes of breakfast cereal, two quarts of milk, and three loaves of bread during the period between receiving his paychecks. And now, instead, he chooses to purchase during that income period three boxes of breakfast cereal, one quart of milk, and two loaves of bread. His demand for these consumer goods will have decreased, and at the end of the income period he would find himself holding a positive cash balance of a certain amount that represented his deferred consumption. By holding on to this portion of his earned income in the form of cash, he has increased his savings. And the resources and labor that had been devoted to the manufacture of the consumer goods he no longer demands are free to be used in different ways. How would a change in a person’s preferences for consumption and savings be conveyed through the market under a system of competitive, free banking? A person could reduce his consumption and shift a greater portion of his income into a time deposit with his private bank, which promises a rate of interest with the understanding that the depositor will not withdraw that sum of money for a stipulated period of time, say a year. 128
That sum of money will then be available for the bank to extend as a one-year loan to a borrower, who agrees to pay back the loan, with interest, at the end of the year. With the loan, the borrower will enter the market and increase his demand for the resources and labor services that have been freed from their former employment in the production of more direct consumption goods for new uses in more "roundabout" investment activities. On the other hand, as we have seen, a person could increase his savings by decreasing his rate of consumption spending and adding to his average cash-balance holding. How would information about this form of additional savings be conveyed to the private bank with which he holds gold deposits and bank notes or possesses a checking account representing a sum equal to the gold to which he held title? An explanation has been concisely offered by George Selgin in his Theory of Free Banking (1988): A general increase in the demand for … money [to hold as a larger average cash balance] is equivalent to a general decline in the rate of turnover of [bank-note and checking-account] money. Bank notes change hands less frequently, and the holders of demand deposits write fewer (or perhaps smaller) checks. As a result, bank liabilities pass less frequently into the hands of persons or rival issuers who return them to their points of origin for redemption. The reduction in turnover of liabilities leads directly to a fall in the volume of bank clearings. When this happens banks find they have excess reserves relative to the existing level of their liabilities, and so they are able to increase their holdings of interest-earning assets, which they do by expanding the supply of [bank-note and checking-account] money [in the form of additional loans to prospective borrowers]. Doesn’t this mean that private, competitive free banks would be operating on the basis of fractional reserves, i.e., issuing bank notes and extending checking accounts to borrowers in excess of the amount of gold reserves necessary to continuously meet in full the potential redemption demands of their depositors for their own original gold deposits? Yes, it does. Doesn’t this mean that such private banks, by promising to redeem all notes and checking accounts on demand for gold deposited with them, would be promising something that could not be fulfilled if a sufficient number of bank-note and checking-account holders all were to demand their gold all at once? Yes, in principle, that is true too. Is this a system of sound and truthful banking? It depends. If such banks declaratively specify that they are fractional-reserve institutions on the face of their notes and checks, promising to pay normally on demand but not being always able to meet all obligations at once under certain circumstances, there is no apparent reason for claiming that such private, fractional-reserve banks are operating on a fraudulent basis. Furthermore, as free-banking advocate Kevin Dowd has suggested, private, fractional-reserve banks might find it advantageous to offer depositors "option clauses." A bank would contractually promise that if, for whatever reason, it failed to redeem notes and checking accounts on demand for a specified period of time, the bank would pay a compensating penalty fee for its failure to immediately meet its obligation to its depositors or note holders. Part of the entrepreneurial art of private, competitive free banking would be for the managers of such banks to anticipate correctly the average amount of gold-reserve withdrawal demands from depositors and from other banking institutions when bank representatives regularly meet to settle their respective note and check claims against one another. And, as we have seen, any over-issuance of bank notes or checking accounts by means of the lending process would soon provide negative feedback to the bank managers as a heavier-than-expected withdrawal of gold reserves signaled the need to begin following a more cautious and conservative lending policy. In fact, this point suggests the market mechanism through which each private bank would discover 129
whether any of its respective depositors and note holders were choosing to increase their savings preferences through a decrease in their rate of spending by holding a larger portion of their income in the form of an enlarged average cash balance. Because customers had decreased their rate of spending and held larger average bank balances, fewer of that bank’s notes and checks would be passing into the hands of sellers of goods or to other banking institutions, and thus fewer of them would be presented to the issuing bank for redemption. Suppose that the managers of a bank had made the calculation that, on average, only 10 percent of outstanding note and checking-account liabilities tended to be presented for redemption by depositors or through the clearing process. On the basis of, say, $100 of gold reserves, that bank could have in circulation $1,000 worth of notes and checking accounts and have just enough gold on hand to meet the regular amount of redemption claims made against it during a period of time. Now suppose that because of an increase in savings in the form of larger cash-balance holdings, only $90 worth of notes and checks begin to be returned to the bank for redemption during the pertinent period of time. The bank could then lower its rate of interest to attract additional borrowers and increase its lending by $100. Total notes and checking accounts issued by this bank would then be $1,100 on the basis of that same $100 of gold reserves. The bank would have decreased the ratio of notes and checking accounts to gold reserves to something closer to 9 percent instead of 10 percent. But the increased notes and checks outstanding in the form of loans are in fact tending to just compensate for and reflect the greater amount of savings in the form of larger average cash-balance holdings. The issuing bank therefore responds to the note holders’ decision to increase their cash-balance form of savings by increasing its investment loans by an amount that more or less just reflects the change in the savings preference of income earners. The rate of gold-reserve withdrawals by depositors and note holders as a percentage of outstanding bank-note and checking-account liabilities acts as one of the sources of information to the bank that decisions by income earners to save more and consume less should have its balancing response in a decrease in interest rates, more lending, and greater investment spending. Each private, competitive bank would increase or decrease its respective outstanding note issue and checking-account liabilities to smoothly and effectively see that its lending policies properly reflected the savings preferences of its depositors and note holders. The free-banking system would have its own internal market-response process to ensure the tendency for a coordination of the savings and investment decisions of the multitude of market participants.
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Chapter 39 Free Banking and the Benefits of Market Competition One of the strongest arguments that advocates of the free market have made over the last 200 years has been to point out the benefits of competition and the harmfulness of government-supported monopoly. In a competitive market, individuals are at liberty to creatively transform the existing patterns of producing and consuming in ways they think will make life better and less expensive for themselves and other members of society as a whole. Wherever legalized monopoly exists, the privileged producer is protected from potential rivals who would enter his corner of the market and supply an alternative product or service to those consumers who might prefer it to the one marketed by the monopolist. Innovation and opportunity are either prevented or delayed from developing in this politically guarded sector of the economy. Production methods remain unchanged or are modified only with great delay. Product improvements are slow in being developed and introduced. Incentives for cost efficiencies are less pressing and, when utilized, are often only sluggishly passed on to consumers in the form of lower sale prices. Those who have the vision and daring to enter the market and successfully innovate and create newer or better products than the existing suppliers are offering are stymied or blocked from doing so in the protected sectors of the economy. They are forced to apply their entrepreneurial drive in lessprofitable directions or are dissuaded by the political restrictions from even attempting to do so. The product improvements they would have supplied to the consuming public remain invisible "might-havebeens" lost to society. Furthermore, as Friedrich A. Hayek especially emphasized, market competition is the great discovery procedure through which it is determined who can produce the better product with the most desired features and qualities and at the lowest possible price at any given time. It is the peaceful market method through which each participant in the social system of division of labor finds his most highly valued use as judged by the relative pattern and intensity of consumer demand for the various goods supplied. Competition’s dynamic quality is that it is a never-ending process. In the arena of exchange, every day offers new opportunities and allows entrepreneurs and innovators to create new opportunities that they are free to test on the market in terms of possible profitability. Every political restriction or barrier placed in the way of competition, therefore, closes the door on some potential creativity, risk-taking, and entrepreneurial discovery of more efficient and rational uses of men, materials, and money in the interdependent and mutually beneficial relationships of market specialization and cooperation. The choice is always between market freedom and political constraint, between the competitive process and governmentally created monopoly. This general argument in favor of market competition and against politically provided monopoly is no less valid in the arena of money and banking. Money may be chosen by the participants in the market, or government can impose the use of a medium of exchange on society and monopolize control over its supply and value. The benefit from market-chosen money is that it reflects the preferences and uses of the exchange participants themselves. Participants in the market process will sort out which commodities offer those qualities and characteristics most useful and convenient in a medium of exchange. As the Austrian economists persuasively demonstrated, while money is one of those social institutions that are "the results of human action but not of human design," it nonetheless remains the spontaneous composite outcome of multitudes of individual choices freely made by buying and selling 131
in the marketplace. The alternative is what the American economist Francis A. Walker referred to in 1887 as "political money." Political money is one that the government determines shall be used as money and whose supply "is made to depend upon law or the will of the ruler." He warned that under the best of circumstances the successful management of a government-controlled money would "depend upon an exercise of prudence, virtue and self-control, beyond what is reasonably and fairly to be expected of men in masses, and of rulers and legislators as we find them." Governments would, in the long run, always be tempted to abuse the printing press for various political reasons. But besides the dangers of political mischief, the fact is that the government monetary monopoly prevents the market from easily discovering whether, over time, market participants would find it more advantageous to use some particular commodity or several alternative commodities as different types of media of exchange to serve changing and differing purposes. The "optimal" supply of money becomes an arbitrary decision by the central monetary monopoly authority rather than the more natural market result of the interactions between market demanders desiring to use money for various purposes and market suppliers supplying the amount of commodity money that reflects the profitability of mining various metals and minting them into money-usable forms. But commodity money, as history has shown, has its inconveniences in everyday transactions in the market. There are benefits from financial depositories for purposes of safety and lowering the costs of facilitating transactions. But what type of financial and banking institutions would market participants find most useful and desirable under a regime of money and banking freedom? The answer is that we don’t know at this time precisely because government has monopolized the supplying of money; and it imposes, through various state and federal regulations, an institutional straitjacket that prevents the discovery of the actual and full array of preferences and possibilities that a free market in monetary institutions might be able to provide and develop over time. The increasing globalization of commerce, trade, and financial intermediation during the past decades has certainly demonstrated that there is a far greater range of possibilities that market suppliers of these services could provide and for which there are clear and profitable market demands than traditionally thought 25 or 30 years ago. But even in this more vibrant global competitive environment, it remains the case that whatever options have begun to emerge have done so in a restrictive climate of national and international governmental regulations, agreements, and constraints. Suppose that monetary and banking freedom were established. What type of banking system would then come into existence? Some advocates of monetary freedom have insisted that a free banking system should be based on a 100 percent commodity money reserve. Others have argued that a free banking system would be based on a form of fractional-reserve banking, with the competitive nature of the banking structure serving as the check and balance on any excessive note issue by individual banks. Until monetary and banking freedom is established, we have no way of knowing which of the two alternatives would be the most preferred. This is for the simple reason that under the present government-managed and government-planned monetary and banking system, market competition is not allowed to demonstrate which options suppliers of financial intermediation might find it profitable to offer and which options users of money and financial institutions would decide are the ones best fitting their needs and preferences. Given the diversity in people’s tastes and preferences, the differing degrees of risk people are willing to bear for a promised interest return on their money, and the variety of market situations in which different types of monetary and financial instruments might be most useful for certain domestic and international transactions, it probably would be the case that a spectrum of financial institutions would come into existence side by side. At one end of this spectrum would be 100 percent reserve banks that guaranteed complete and immediate redemption of all commodity money deposits, even if every depositor were to appear at that bank within a very short period of time. 132
Along the rest of the spectrum would be various fractional-reserve banks at which lower or no fees would be charged for serving as a warehousing facility for deposited commodity money. Their checking accounts might offer different interest payments depending on the fractional-reserve basis on which they were issued and on the degree of risk or uncertainty concerning the banks’ ability to redeem all deposits immediately under exceptional circumstances. Some banks might offer both types: they might issue some bank notes and checking accounts that were guaranteed to be 100 percent redeemable on the basis of commodity money deposited against them; and they might issue other bank notes and checking accounts that, under exceptional circumstances, were not 100 percent redeemable. And these banks might offer "option clauses" stipulating that if any designated notes or checking accounts were not redeemed on demand for some limited period of time, the note and account holder would receive a compensating rate of interest for the inconvenience and cost to himself. Whether most banks would be closer to the 100 percent reserve end of this spectrum or farther from it is not – and cannot be – known until the monetary and banking system is set free from government regulation, planning, and control. As long as the government remains as the monetary monopolist, there is just no way to know all the possibilities that the market could or would generate. Indeed, for all we know, the market might devise and evolve a monetary and banking system different from that conceived even by the most imaginative free-banking advocates. Competition is thwarted by government monopoly money, and the creative possibilities that only free competition can discover remain invisible "might- have-beens." How then can the existing system be moved towards a regime of monetary and banking freedom?
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Chapter 40 Towards a System of Monetary and Banking Freedom The great tragedy of the 20th century was the arrogant and futile belief that man can master, control, and plan society. Man has found it difficult to accept that his mind is too finite to know enough to organize and direct his overall social surroundings according to an overarching design. The nature of this problem was neatly explained by Walter Lippmann in his 1937 book, An Inquiry into the Principles of the Good Society: The thinker, as he sits in his study drawing his plans for the direction of society, will do no thinking if his breakfast has not been produced for him by a social process which is beyond his detailed comprehension. He knows that his breakfast depends upon workers on the coffee plantations of Brazil, the citrus groves of Florida, the sugar fields of Cuba, the wheat farms of the Dakotas, the dairies of New York; that it has been assembled by ships, railroads, and trucks, has been cooked with coal from Pennsylvania in utensils made of aluminum, china, steel, and glass. But the intricacy of one breakfast, if every process that brought it to the table had deliberately to be planned, would be beyond the understanding of any mind. Only because he can count upon an infinitely complex system of working routines can a man eat his breakfast and then think about a new social order. The things he can think about are few compared with those which he must presuppose.… Of the little he has learned, he can, moreover, at any one time comprehend only a part, and of that part he can attend only to a fragment. The essential limitation, therefore, of all policy, of all government, is that the human mind must take a partial and simplified view of existence. The ocean of experience cannot be poured into the bottles of his intelligence.… Men deceive themselves when they imagine that they can take charge of the social order. They can never do more than break in at some point and cause a diversion. Money is one of those institutions that owes its origin and early development to social processes beyond what individual minds could have fully anticipated or comprehended. But money’s evolution has been constantly "diverted" from what would have been its market-determined course by governments and political authorities that saw in its control an ability to plunder the wealth of entire populations. Debasement and depreciation of media of exchange through monetary manipulation has been the hallmark of recorded history. In the middle of the 19th century, British classical economist John R. McCulloch pointed out, The history of this and all other countries, shows that the power of making unrestricted issues of paper money has never been entrusted to any man, or set of men, without being abused; that is, without its being issued in inordinate quantities. And in the 1880s, American economist Francis A. Walker warned: The danger of overissue is one which never ceases to threaten an Inconvertible Paper Money. The path winds even along the verge of the precipice. Vigilance must never be relaxed. The prudence and self-restraint of years count for nothing, or count for very little, against any new 134
onset of popular passion, or in the face of a sudden exigency of the government. From this danger a people receiving into circulation an Inconvertible Paper Money can never escape. A single weak or reckless administration, one day of commercial panic, a mere rumor of invasion, may hurl trade and production down the abyss.… Not only does the danger of overissue never cease to menace a community having such [paper] money in circulation, but the moment an overissue in fact occurs the impulse to excess acquires violence by indulgence. To prevent such abuses and their deleterious effects, advocates of freedom supported the gold standard to impose an external check on monetary expansion. Paper money was to be "convertible," redeemable on demand to bank-note and checking-account holders at a fixed ratio of redemption. "The distinctive quality of good paper money is that it can be converted into gold or silver at any time," said American economist J. Laurence Laughlin, also in the 1880s. "No paper money is good unless the promise to pay means what it says, and unless the convertibility is constantly tested." But even this limit on government-managed money was eliminated in the 20th century by the hubris of the central-planning mentality, under which money, too, was to be completely under the control of the monetary central planners as part of the vision of designing and directing the economic affairs of society. Said John Maynard Keynes, "The gold standard, with its dependence on pure chance, its faith in ‘automatic adjustments,’ and its general regardlessness of social detail" was just "part of the apparatus of conservatism." It was better to set it aside so wise and intelligent experts such as he could use government to guide an economy to prosperity and full employment. In the wake of Keynesianism’s failures and contradictions, the proposals were then made, for example by Milton Friedman, for implementing monetary "rules" for the management of the central monetary system. However, as Canadian economist David Laidler observed, such monetary rules are a figment of the economic theorist’s imagination: Devices that seem satisfactory in the artificial safety of an economic model will not withstand the onslaught of politics in the real world. Monetary policy is an inherently political matter, and we will have a better chance of getting it right if we recognize that from the outset. Laidler’s assumption is that money as a political tool should be accepted, and the opponent of monetary abuse should, as he puts it, "get back into the trenches" to use government avenues to nudge monetary policy in the direction he prefers. But as Kevin Dowd points out in reply, The key point … is the free bankers’ claim that the only solution to the monetary policy problem is to abolish monetary policy entirely. This would eliminate the current need to appeal to the state to get monetary policy right. Monetary central planning is one of the last vestiges of generally accepted out-and-out socialist central planning in the world. The fact is that even if monetary policy could somehow be shielded from the pressures and pulls of ideological and special-interest politics, there is no way to successfully centrally manage the monetary system. Government can no more correctly plan for the "optimal" quantity of money or the properly "stabilized" general scale of prices than it can properly plan for the optimal supply and pricing of shoes, cigars, soap, or scissors. The best monetary policy, therefore, is no monetary policy at all. The advocate of the free market believes that the need for foreign trade policies would be eliminated by ending all trade restrictions or 135
barriers and permitting free trade. He also believes that the need for domestic regulatory policies would be eliminated by abolishing the regulatory agencies and repealing the antitrust laws and simply permitting market-guided competition and exchange. Logically the need for monetary policy would be eliminated by abolishing government monopoly control and regulation over the monetary and banking system. As Austrian economist Hans Sennholz once concisely expressed it, We seek no reform law, no restoration law, no conversion or parity, no government cooperation: merely freedom.… In freedom, the money and banking industry can create sound and honest currencies, just as other free industries can provide efficient and reliable products. Freedom of money and freedom of banking, these are the principles that must guide our steps. What should these steps be? At a minimum, they should include the following: 1. The repeal of the Federal Reserve Act of 1913, and all complementary and related legislation giving the federal government authority and control over the monetary and banking system. 2. The repeal of legal-tender laws, that give government power to specify the medium through which all debts and other financial obligations, public and private, may be settled. As Lord Farrer pointed out in his Studies in Currency (1898), "The ordinary law of contract does all that is necessary without any law giving special functions to particular forms of currency." Individuals, in their domestic and foreign transactions, would determine through contract the form of payment they mutually found most satisfactory for fulfilling all financial obligations and responsibilities into which they entered. 3. Repeal all restrictions and regulations on the free entry into the banking business and in the practice of interstate banking. 4. Repeal all restrictions on the right of private banks to issue their own bank notes and to open accounts denominated in foreign currencies or in weights of gold and silver. 5. Repeal of all federal and state government rules, laws, and regulations concerning bank-reserve requirements, interest rates, and capital requirements. 6. Abolish the Federal Deposit Insurance Corporation. Any deposit insurance arrangements and agreements between banks and their customers and between associations of banks would be private, voluntary, and market-based. In the 1920s, free-market economist Thomas Nixon Carver once observed, In the absence of force, peace and liberty simply exist; they do not have to be created or supported. Capitalism has its beginning in a condition under which no man can be dispossessed of what he has produced or discovered except with his own consent. In the absence of force, capitalism automatically exists in the same sense that peace and liberty automatically exist. In the absence of government regulation and monopoly control, a free monetary and banking system would exist; it would not have to be created, designed, or supported. A market-based system would naturally emerge, take form, and develop out of the prior system of monetary central planning. What would be its shape and structure over time? What innovations and variety of services would a network of free, private banks offer to the public over time? What set of market-determined commodities might be selected as the most convenient and useful media of exchange? What types of money substitutes would be supplied and demanded in a free-market world of commerce and finance? Would many or most banks operate on the basis of fractional or 100% reserves? There are no definite answers to these questions, nor can there be. It is deceptive to believe, as 136
Walter Lippmann explained, that we can comprehend and anticipate all the outcomes that will arise from all the market interactions and discovered opportunities that the complex processes of the free society would generate. It is why liberty is so important. It allows for the possibilities that can only emerge if freedom prevails. It’s why monetary freedom, too, must be on the agenda for economic liberty in the 21st century.
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About the Author
Dr. Richard M. Ebeling is the recently appointed BB&T Distinguished Professor of Ethics and Free Enterprise Leadership at The Citadel. He was formerly professor of Economics at Northwood University, president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003). Dr. Ebeling is also the author of Austrian Economics and the Political Economy of Freedom (Edward Elgar, 2003) and Political Economy, Public Policy and Monetary Economics: Ludwig von Mises and the Austrian Tradition (Routledge, 2010), and is the editor of the three-volume Selected Writings of Ludwig von Mises (Liberty Fund). He is also the co-editor and co-author of the five-volume, In Defense of Capitalism (2009–2014), and the co-editor of When We are Free (2014).
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The Future of Freedom Foundation Founded in 1989 and based in Fairfax, Virginia, The Future of Freedom Foundation is a nonprofit educational foundation. Its mission is to advance liberty by presenting an uncompromising moral, philosophical, and economic case for individual freedom, private property, and a constitutional republic. FFF aims to influence the course of thinking away from the philosophy of socialism, the welfare state, the managed economy, and the national-security state and toward the philosophy of individual liberty, free markets, and limited government. FFF neither solicits nor accepts governmental funds. Our operations are funded by subscriptions, donations, and bequests from our supporters. To send FFF a donation, or to provide for FFF in your planned giving, please visit the support section of our website — www.fff.org. FFF’s uncompromising tradition is carried forward in its books. Three are by Sheldon Richman: Your Money or Your Life: Why We Must Abolish the Income Tax; Tethered Citizens: Why We Must Abolish the Welfare State; and the award-winning Separating School & State: How to Liberate America’s Families. Five are collections edited by Jacob G. Hornberger and Richard M. Ebeling: The Dangers of Socialized Medicine; The Case for Free Trade and Open Immigration; The Failure of America’s Foreign Wars; The Tyranny of Gun Control; and Liberty and Security: Opposing the War on Terrorism. And one is a booklet by Jacob G. Hornberger: Economic Liberty and the Constitution. FFF has also published three books relating to the assassination of President John F. Kennedy: The Kennedy Autopsy by Jacob G. Hornberger, JFK’s War with the National Security Establishment: Why Kennedy Was Assassinated by Douglas P. Horne, and Regime Change: The JFK Assassination by Jacob G. Hornberger. In the summer 2015, FFF announced a new campaign to publish ebooks that can spread its uncompromising perspective on liberty far and wide. The first three of these are Freedom and Security: The Second Amendment and the Right to Keep and Bear Arms by Scott McPherson; and Monetary Central Planning and the State by Richard Ebeling; and The Evil of the National-Security State by Jacob G. Hornberger. To become a supporter of this ongoing campaign, you can donate here. All of these titles are available for purchase in our store. The Foundation also shares its ideas on liberty through lectures, speeches, seminars, conferences, radio appearances, and Jacob Hornberger’s weekly Internet show "The Libertarian Angle." FFF’s journal, Future of Freedom (previously called Freedom Daily), is a monthly publication of libertarian essays, book reviews, and quotations from freedom’s greatest champions. FFF also publishes FFF Daily, a free daily Internet newsletter that consists of original FFF articles plus likeminded articles from other online publications. Make a donation to FFF, subscribe to Future of Freedom, sign up for FFF Daily, or visit us at www.fff.org to read our library of articles and view our library of videos. We hope you join us in this important work.
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