David Wessel revisited this question in his “Capital” column in the February 24, 2011, Wall Street Journal. He correctly stated that the Federal Reserve under Chairman Ben Bernanke takes the position that the course of inflation depends on expectations: Inflation will stay low if people expect it to stay low. Wessel quotes Bernanke: “The state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability.”

The Fed chairman has the causation precisely backwards. Fed policy systematically shapes inflation expectations. His statement focuses on the short-run and ephemeral over the long-run and permanent. In so doing, Bernanke follows in a long line of central bankers.

In A History of the Federal Reserve (volume 1: 1913-51), Carnegie-Mellon University Professor Allan Meltzer summarizes the central-bank mindset. To the degree there is theory behind the policies of central bankers, it derived from the nineteenth-century banking school thinkers. Chief among them was Thomas Tooke, who “denied that money, credit, or base money bore any consistent relation to prices. Most Federal Reserve officials remained in this tradition in the 1920s. They denied that their actions affected prices” (57–58).

Unfortunately for defenders of current Fed policy, inflation is accelerating around the world. Singapore’s economy has benefited from revived global trade, but consumer price inflation is now running at an annual rate of 5.5 percent. In Vietnam, an emerging economy of note, consumer price inflation is running at 12 percent. Food riots plague India. Even American consumers are starting to feel the lash of inflation, as anyone who goes to the grocery store can attest. It is not a question of whether inflation is on the horizon. Inflation is here.

In a February 23 Wall Street Journal op-ed, retired Journal editorial writer George Melloan explained how economics has contributed to the turmoil in the Middle East. Consumer price inflation in Egypt rose to 18 percent annually in 2009 from 5 percent in 2006. In Iran inflation rose to 25 percent in 2009 from an already high 13 percent rate in 2006. Inflation surges hit family budgets hard, especially for the many in these countries living at the margin. Desperate people take to the street. As Melloan wryly observes, “About the only one failing to acknowledge a problem seems to be the man most responsible, Federal Reserve Chairman Ben Bernanke.”

Monetary policy is not the sole culprit in the rise of food prices. There have been a number of negative supply shocks affecting the supply of various foodstuffs, and these shocks have certainly contributed to higher prices. Central bankers often point the finger at these to deflect accusations that monetary policy is at fault.

Two points must be made. First, global food production and prices have been rising. Rising prices and output reflect rising demand relative to supply. Second, nearly all commodities, not just agricultural commodities, have been caught in a monetary updraft. Along with food prices we have seen rising prices of oil (even before the Middle East turmoil), gold, silver, copper, and a whole range of other commodities used in production. One noteworthy laggard is natural gas, whose price has been kept down by positive supply shocks of new discoveries. This, contrary to the narrative of central bankers, is the supply story.

Commodities, along with most globally traded goods, are priced in dollars. The Fed creates “base money”: bank reserves plus currency. Banks then expand on base money by lending out reserves. The more base money and bank money produced, the higher the dollar prices of commodities and other goods. It is the old story of too much money chasing too few goods and driving up their prices. That is inflation conventionally defined.

The inflation story this time has been complicated by a weak U.S. economy, whose growth is still dampened by the consequences of the housing boom and bust. The bank expansion of the money supply through lending has occurred not in the U.S. economy but in emerging economies, particularly in Asia and Latin America. Bernanke promised his easy-money policy would create jobs, and it has—but not in the United States. Of course, to the degree that prosperity in these countries has depended on the Fed’s easy-money policy, it has been a false prosperity. The citizens of these countries are paying for it now in the form of inflation.

The Fed has been paying a low interest rate on reserves, which to some extent has restrained lending by banks. With loan demand weak or of poor quality, banks have chosen to keep money on deposit at their local Federal Reserve bank and earn a safe return. As loan demand picks up, however, banks will likely begin lending out their reserves. That appears to be happening as this is being written.

Here are some details of the linkage between Fed policy and global inflation. The currencies of many countries are pegged to the dollar. Their exchange rates are either a constant or change only slowly. The Hong Kong dollar is an example of the former, the Chinese yuan of the latter. Even so-called floating currencies are not really floating. Central banks intervene to prevent their value from rising rapidly against a flagging U.S. dollar. The only important central bank that seems to be letting its currency float freely against the U.S. dollar is the Swiss, and the Swiss franc is appreciating against the dollar fairly steadily.

Thus, as a practical matter, when the Fed creates dollars it results in an increased money supply in other countries. It is not necessarily one for one, but it is proportional. The Fed’s low-interest policy has fueled not only a commodities boom but a real-estate bubble in Asian countries and elsewhere. Some countries have imposed capital controls to counteract Fed policy, but these are seldom fully effective.

The Fed chairman argues that foreign central banks can offset Fed policy. Doing so confronts them with a Hobson’s choice. Foreign central banks pegged to the dollar can break the peg and let their currencies appreciate and domestic interest rates increase. If they act effectively they risk sending their own economies into the tank. Based on experience, it is equally likely that higher interest rates in those countries would attract more speculative capital, fueling asset bubbles, commodity prices, and eventually consumer price inflation. The last is what has in fact been happening. Small, open economies in practice are unable to offset a tsunami of dollars.

Bernanke is being disingenuous about the options foreign central banks and governments have to counteract the Fed’s easy-money policy, which threatens a global outbreak of inflation similar to the 1970s.

David Wessel revisited this question in his “Capital” column in the February 24 Wall Street Journal. He correctly states that the Federal Reserve under Chairman Ben Bernanke takes the position that the course of inflation depends on expectations: Inflation will stay low if people expect it to stay low. Wessel quotes Bernanke: “The state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability.”

The Fed chairman has the causation precisely backwards.  Fed policy systematically shapes inflation expectations. His statement focuses on the short-run and ephemeral over the long-run and permanent. In so doing, Bernanke follows in a long line of central bankers.

Central-Bank Mindset

In A History of the Federal Reserve (volume 1: 1913-51), Carnegie-Mellon University Professor Allan Meltzer summarizes the central-bank mindset. To the degree there is theory behind the policies of central bankers, it derived from the nineteenth-century banking school thinkers. Chief among them was Thomas Tooke, who “denied that money, credit, or base money bore any consistent relation to prices. Most Federal Reserve officials remained in this tradition in the 1920s. They denied that their actions affected prices” (57-58).

Unfortunately for defenders of current Fed policy, inflation is accelerating around the world.  Singapore’s economy has benefited from revived global trade, but consumer price inflation is now running at an annual rate of 5.5 percent. In Vietnam, an emerging economy of note, consumer price inflation is running at 12 percent. Food riots plague India. It is not a question of whether inflation is on the horizon. Inflation is here.

In a February 23 op-ed in the Wall Street Journal, retired Journal editorial writer George Melloan explained how economics has contributed to the turmoil in the Middle East. Consumer price inflation in Egypt rose to 18 percent annually in 2009 from 5 percent in 2006. In Iran inflation rose to 25 percent in 2009 from an already high 13 percent rate in 2006. Inflation surges hit family budgets hard, especially for the many in these countries living at the margin. Desperate people take to the street.  As Melloan wryly observes, “About the only one failing to acknowledge a problem seems to be the man most responsible, Federal Reserve Chairman Ben Bernanke.”

Monetary policy is not the sole culprit in the rise of food prices. There have been a number of negative supply shocks affecting the supply of various food stuffs, and these shocks have certainly contributed to higher prices. Central bankers often point fingers at them to counter accusations that monetary policy is at fault.

Money Updraft

Two points must be made. First, global food production and prices have been rising. Rising prices and output reflect rising demand relative to supply. Second, nearly all commodities, not just agricultural commodities, have been caught in a monetary updraft. Along with food prices, we have seen rising prices of oil (even before the Middle East turmoil), gold, silver, copper, and a whole range of other commodities used in production. One noteworthy laggard is natural gas, whose price has been kept down by positive supply shocks of new discoveries. Natural gas is the genuine supply story, and runs counter to the narrative of central bankers.

Commodities, along with most traded goods globally, are priced in dollars. The Fed creates “base money”: bank reserves plus currency. Banks then expand on base money by lending out reserves.  The more base money and bank money produced, the higher the dollar prices of commodities and other goods. It is the old story of too much money chasing too few goods and driving up their prices. That is inflation conventionally defined.

The inflation story this time has been complicated by a weak U.S. economy, whose growth is still dampened by the consequences of the housing boom and bust. The bank expansion of the money supply through lending has occurred not in the U.S. economy but in emerging economies, particularly in Asia and Latin America. Bernanke promised his easy-money policy would create jobs, and it has – but not in the United States. Of course, to the degree that prosperity in these countries has depended on the Fed’s easy-money policy, it has been a false prosperity. The citizens of these countries are paying for it now in the form of inflation. American consumers are even now beginning to feel the lash of inflation, as any homemaker who goes to the grocery store can attest.

The Fed has been paying a low interest rate on reserves, which to some extent has restrained lending by banks. With loan demand weak or of poor quality, banks have chosen to keep money on deposit at their local Federal Reserve bank and earn a safe return. As loan demand picks up, however, banks will likely begin lending out their reserves. That appears to be happening as this is being written.

Pegged to the Dollar

Here are some details of the linkage between Fed policy and global inflation. The currencies of many countries are pegged to the dollar. Their exchange rates are either a constant or change only slowly. The Hong Kong dollar is an example of the former, the Chinese yuan, of the latter. Even so-called floating currencies are not really floating. Central banks intervene to prevent their value from rising rapidly against a flagging U.S. dollar. The only important central bank that seems to be letting its currency float freely against the U.S. dollar is the Swiss, and the Swiss franc is appreciating against the dollar fairly steadily.

Thus, as a practical matter, when the Fed creates dollars it results in an increased money supply in other countries. It is not necessarily one for one, but it is proportional. The Fed’s low-interest policy has fueled not only a commodities boom, but a real-estate bubble in Asian countries and elsewhere. Some countries have imposed capital controls to counteract Fed policy, but these are seldom fully effective.

The Fed chairman argues that foreign central banks can offset Fed policy. Doing so confronts them with a Hobson’s choice. If they act effectively to offset Fed policy by raising their interest rates and exchange rates, they risk sending their own economies into the tank.  Based on experience, it is equally likely that higher interest rates in those countries would attract more speculative capital, fueling asset bubbles, commodity prices, and eventually consumer price inflation. The last is what has in fact been happening.

Bernanke is being disingenuous about the options foreign central banks and governments have to counteract the Fed’s easy-money policy, which threatens a global outbreak of inflation similar to the 1970s.

(This article expands on a post at ThinkMarkets.)

Melloan recently retired from a 54-year career with the Wall Street Journal. He is a superb wordsmith, able to turn the dry details of finance into highly readable prose. He has a story to tell and tells it very well.

Bad economic policy and troubled times often stimulate good economic ideas. That was true of the 1970s and stagflation: the simultaneous appearance of recession and inflation. It was a crisis for Keynesian economics and a crucible for revisionist economic thinking. It led to Reaganomics and a renewal of the American spirit.

For Melloan the core principles of supply-side thinking and the Reagan revolution (“a repeat of the American Revolution”) were cutting marginal tax rates and restoring sound money: “Sound currency is essential to the health of an economy.” He correctly characterizes supply-side economics as “a revival of classical economic theory.” The classical view is that production not consumption is the engine of economic growth. The supply-siders focused on government policies that would stimulate production. They wanted to extricate the U.S. economy from the inflationary and recessionary abyss of the 1970s.

Supply-side thinking triumphed and justified Reagan’s tax cuts and Paul Volcker’s assault on inflation. The ensuing prosperity lasted through the 1990s.

So what happened? It’s now a familiar story and begins in June 2003. After a series of rate cuts, the Fed decided to do one more and bring the fed funds rate down to 1 percent. “It was a bridge too far,” in Melloan’s words.

The rate cuts ignited the great money binge. “Everyone joined in the fun”: banks, mortgage brokers, the Republican Congress, and state legislators. Spending of all kinds exploded. Add an ill-conceived policy to promote homeownership, institutionalized in Fannie Mae and Freddie Mac, and you understand why the money binge channeled through housing finance and home building.

Melloan criticizes the Fed for its policy blunders. He observes that the Federal Reserve System was founded in 1913 to stabilize the banking system. Only 17 years later, the new central bank presided over the Great Depression. One could add that numerous recessions followed, accompanied by an inflationary bias in monetary policy only temporarily interrupted under Volcker. Melloan has a realistic view of the Fed’s role today: “Claims that it operates independently of political influence have little basis in fact, but give politicians deniability when it errs, as it often does.”

Melloan strongly criticizes President Obama’s policies, especially his spending. He described Obama’s 2010 budget as “more like a revolution than a mere change.”

Maybe.

There was perhaps a fiscal revolution, but it began under the second President Bush. Melloan lets Bush off with little more than an observation of his fiscal “permissiveness.” Bush comes off sounding like an indulgent grandfather to Congress, rather than the author of a great spending binge.

The saga of the Bush administration reveals a fatal flaw in supply-side thinking, if not as originated, then as practiced. In preaching the magic of tax cutting, supply-siders took their eye off the spending side of the budget. Tax cuts and sound money foster entrepreneurship and economic growth. But the process is not unbounded.

Government spending measures the real resources appropriated by the government and constitutes the true burden on the private sector. Spending can be financed by current tax collections or borrowing. Borrowing must be paid by future taxes. The Fed can inflate away some of the real value of government debt, but that substitutes an inflation tax (loss of wealth) for a conventional one.

Culminating in the Crash of 2008, Bush’s spending binge paved the way for Obama’s victory. Rather than bringing “change,” however, Obama has ushered in the third Bush term.

In his final chapter Melloan outlines a multistep program for an American renewal. To be effective, however, a multistep program must begin with recognition of the problem. The economic problem did not begin with Obama but with the easy-spending policies of the Bush administration and the easy-money policies of the Fed. Both fiscal and monetary profligacy must be recognized and reversed.

Notwithstanding this criticism, I heartily recommend The Great Money Binge for a highly readable account of the Crash of 2008 and the largely misbegotten response.

Economists are prone to write turgid prose and employ a jargon-filled style. Not these two gems. Each author is a deservedly well-regarded economist, eminent in his field, but their books are written for the layman. Both draw on detailed academic research, but neither requires the reader to wade through thickets of citations.

Taylor poses these questions: “What caused the financial crisis? What prolonged it? What worsened it dramatically more than a year after it began?” His answer in each case is first and foremost “specific government actions and interventions.” The heart of his argument is a criticism of Fed monetary policy under Alan Greenspan in the aftermath of the collapse of the dot-com bubble. The Fed cut interest rates and continued cutting aggressively, taking the short-term interest rate under its control (the federal funds rate) down to 1 percent. The rate stayed at 1 percent for a year. Other market interest rates fell as well. The artificially low cost of borrowing fueled the housing boom.

Taylor uses a figure to compare housing starts as they actually occurred in the boom with a counterfactual simulation—as they would have occurred had the Fed adhered to policies that began in the early 1980s and continued into the 1990s. The result: “No Boom, No Bust” in housing. Not everyone agrees that monetary policy was so benign throughout the period dubbed the “Great Moderation.” But the Fed’s cheap money policy after 2000–01 brought back volatility in housing and the economy last seen in the 1970s.

Taylor explains how the Fed exported its easy money to other countries (especially the European Union), drawing them into the crisis. He also examines the many other complications, including such issues as the actions of Fannie Mae and Freddie Mac, and the role of securitization. His analysis of the many policy missteps in response to the crisis is masterful. These policy errors prolonged the crisis.

While Taylor covers a broad array of issues, focusing particularly on monetary policy, Sowell focuses
on the housing market itself, chronicling the “skyrocketing rise” in home prices. From 2000 to 2005 the median sales price of a single-family home rose 53 percent, from $143,600 to $219,600. In the priciest markets, like New York City, Los Angeles, and San Diego, prices escalated at an even more rapid rate (79, 110, and 127 percent, respectively). How could home prices have increased so much in such a short period, then fallen so fast?

Sowell also asks the commonsense questions. “When it comes to the home mortgage boom and bust, who was to blame? The borrowers? The lenders? The government? The financial markets?” He answers yes to all the above and notes that “economics cannot explain such things.” Politics drove the housing boom, and he turns to the politics.

First, there is the wonderfully misnamed policy of “affordable housing.” Never precisely defined, it is
a complex combination of misguided policies. They include policies to lower borrowing costs, down payments, lending standards, and, generally, costs of homeownership. Instead they have together combined to increase housing costs. As Sowell observes, it is precisely where government intervention in housing is the greatest that housing costs are highest.

Government housing policies have been at war with themselves. Sowell cites the case of housing in coastal California, now one of the highest-priced markets in the country. As late as 1969, however, home prices there were affordable by a number of measures and in line with home prices in the rest of the nation. In the 1970s California began introducing land-use restrictions that drove up costs for lots and their development. He examines alternative explanations for the rapid escalation in prices and concludes it was the land-use policies that were responsible for astronomical housing costs in coastal California.

California’s land and housing policies were extreme, but not unique. So we have longstanding policies restricting the supply of land and homes meeting policies to stimulate demand. When demand is stimulated and supply restricted, prices will necessarily increase. Land-use restrictions, affordable housing, and easy credit caused the housing boom and bust.

For the full story, I recommend these two estimable books to Freeman readers.

Ill-conceived policies to encourage homeownership channeled cheap credit into housing markets. Land-use and zoning policies restricted the supply of housing in key desirable markets. In The Housing Boom and Bust, Thomas Sowell of the Hoover Institution has shown how these policies brought about a crisis in housing and finance.

Others have told the story from a number of perspectives and with varying emphasis on different factors. My purpose here is to focus on the policy responses to the crisis and ask whether they have been helpful or harmful.

TARP

On October 3, 2008, Congress enacted the law creating TARP (the Troubled Asset Relief Program), which was authorized to spend up to $700 billion to purchase troubled assets from financial institutions. A little more than a month later, then-Treasury Secretary Henry Paulson announced that rather than buying troubled assets, the Treasury would use the money for capital injections into banks in return for preferred shares.

Regardless of one’s attitude toward bailouts generally, Paulson’s original plan was a recipe for disaster. To help the banks he would have needed to overpay for the assets to the detriment of the taxpayers. If he had paid then-current prices, accounting rules would have forced all firms holding such assets to write them down (not just those selling the assets). Financial institutions holding dubious mortgage-backed assets were desperately trying not to write them down because that might have threatened their depleted capital base. It is fair to say that Paulson failed to grasp the underlying problems at these institutions when he first proposed the program.

TARP became a capital-relief plan. It harkened back to the Reconstruction Finance Corporation (RFC) of the Great Depression. Under Jesse Jones and in conjunction with Franklin Roosevelt’s Bank Holiday, all the nation’s banks were examined and divided into the good, the bad, and the ugly. Call it his version of a “stress test.” Those deemed beyond hope were never reopened. Those troubled but salvageable were eligible for RFC capital injections. Jones also extracted resignation letters from senior management of institutions being bailed out. If he deemed existing management best suited to run the bank, it could stay. If not, it was replaced.

In comparison, Paulson’s strategy was “ready, shoot, aim.” Banks received government injections of money to replace depleted capital, with nothing explicit extracted in return. There were vague promises that banks would resume lending but there was nothing enforceable. The banks were stress-tested only after having received government funds. There were second and even third rounds of bailouts for some banks, indicating they had been weaker than thought. We know that at least one—CIT, a financial institution that received $2.3 billion in TARP money—should have been allowed to close. Instead it eventually filed for bankruptcy, and the taxpayer funds were lost.

Moreover, in what has become a national disgrace, existing management at bailed-out banks remained in place. The Bush administration failed to impose even the level of control exercised under FDR.

On the one-year anniversary of the announcement of Paulson’s reversal on TARP, I was asked by Newsweek for my assessment. “It hasn’t done what [Paulson] said it would,” I said. “Yes, it saved some banks from going under, but did it restore the health of the banking system? Absolutely not.” I stand by that assessment today.

What Does Government Stimulate?

The fiscal response to the crisis of the Bush/Obama administrations has been to spend their way out of the recession. In the process the nation’s debt has skyrocketed. There are deficits and debt as far as the eye can see, and our children’s future has been mortgaged. The 2009 fiscal deficit was double that of 2008. It is running at 10 percent of GDP, and former Fed governor and Bush adviser Larry Lindsey estimates deficits will run at 7 percent of GDP for a decade.

Because of the work of Milton Friedman and his monetarist followers, countercyclical fiscal policy fell under a cloud. First, they argued that recessions are difficult to forecast and we only typically know we have entered one after the fact. The monetarists also argued that fiscal policy was subject to the cumbersome legislative process and thus could not be quickly implemented. Once spending began, its effects were only felt slowly. All this wisdom was forgotten in the panic of the Bush administration and then more so in the Obama administration.

The Economic Stimulus Act of 2008, passed in February of that year, mainly sent $100 billion in checks to households in early summer to stimulate consumption and jump-start the economy. As Stanford economist John Taylor, author of Getting Off Track, has shown, the money did nothing and the economy slid into recession later that year. Any economist worth his salt knows that temporary government cash infusions will likely be saved and at best have transitory effects on spending.

Undaunted by that failure, the Obama administration decided to up the ante on the theory that there had just not been enough fiscal stimulus. It replaced billions in spending with trillions in spending: the stimulus package added on to TARP. In the next section I also discuss Fed spending masquerading as monetary policy.

What is the record? It appears that the recession may have ended in the third quarter of 2009. That would make it less than one year in duration–not atypical in that sense. Most of the Obama stimulus money has yet to be spent. (Recall Friedman’s arguments on fiscal policy.) It may be good electoral politics to claim credit for a still-nascent recovery. But it is poor economics. More likely, the self-adjusting forces of the market have been at work.

Clearly, nothing the government has done has been able to lower the unemployment rate. GDP is an abstraction; being out of work is a reality. In October the unemployment rate exceeded 10 percent. (It fell back to 10 later.) A broader measure of unemployment exceeded 17 percent. These numbers put the flesh on the skeleton of policy debates. More ominously, we now are seeing indications that wage rates are falling. As the Wall Street Journal reported, Professor Kenneth Couch of the University of Connecticut estimates that displaced workers returning to work will on average take a 40 percent pay cut.

Double-digit unemployment rates and double-digit wage cuts are depression statistics. In what way is government spending “stimulating”? In an editorial the Wall Street Journal concluded that “no matter how hard or imaginatively the Administration spins, the reality is that the stimulus has been the economic bust that critics predicted it would be.”

Indeed, the labor story helps us to see the dark side of stimulus spending. A good chunk of it has gone to state governments to support bloated budgets in the face of collapsing revenues. Those fiscal transfers are being done, at least in part, to placate public-sector unions, which want to protect the incomes and pensions of their members.

Fiscal stimulus has failed. What about the monetary variant?

Monetary Stimulus

The Fed’s response to the crisis has drawn mixed reviews among free-market economists. Some approve of the Fed’s easing in 2008–09 as a response to an increased demand for money (falling velocity). Nearly all market-oriented economists are disquieted by the explosion of the Fed’s balance sheet as it takes on more and more assets of dubious quality. It will be extremely difficult for the central bank to dispose of such assets when it inevitably comes time for it to tighten. The Fed will likely suffer losses, and such losses impact the taxpayer. (The Fed’s surplus is paid to the Treasury.)

Many economists have been critical of the Fed for its targeted-credit policies, which amount to credit allocation. They favor one sector at the expense of others, and constitute fiscal policy rather than monetary policy. The Fed’s leadership is dismayed at its loss of approval by the general public and fears calls for greater political oversight. But the backlash is of the Fed’s own making.

In the end its fortunes are tied to the economy’s. Most Americans do not know the technicalities of monetary policy. But Fed Chairman Ben Bernanke has taken an active and public role in defending the policy response to the crisis (under both Bush and Obama). Under Bernanke the Fed has promised much and delivered little.

Just as Americans fear the spending and budget deficits, many understand that easy money helped get us into the crisis. Now Dr. Bernanke has prescribed the strongest dose of cheap money ever administered. How can the elixir that caused the boom cure the bust?

The Bernanke Fed is engaged in a policy of reflating (re-inflating) the economy: stimulating money demand to restart economic growth. It justifies the policy on the basis of Professor Bernanke’s own research that shows the evils of deflation. But what prices is he trying to prop up? All prices? Even in hyperinflations, some prices fall. Is he trying to prevent downward adjustment in wages? As suggested above, wage rates in hard-hit sectors may be falling at double-digit rates. Is he preparing for double-digit price inflation? If so, gold is underpriced at $1,000 an ounce.

Astute observers increasingly fear that what is being reflated is another asset bubble. At present, the asset bubble is concentrated in commodities (such as gold, copper, and oil) and Asian real estate. In what is known as a carry trade, global investors are borrowing dollars at low interest rates to invest in property in cities like Hong Kong and Singapore. Instead of bringing prosperity to Americans, the Fed’s policy is fueling speculation. Instead of production in the United States, the Fed’s easy money is creating paper wealth for Asian property owners.

The rise in commodity prices is perhaps most ominous. The U.S. economy remains weak and unemployment elevated. Yet Americans are already paying higher prices for gasoline. They are facing the prospect of renewed inflation and economic weakness: stagflation. That would be an updated version of the economy of the 1970s. The Fed is thereby impoverishing Americans. Is it any wonder many are calling for a reconsideration of its role?

Ill-conceived policies to encourage home ownership channeled cheap credit into housing markets.  Land-use and zoning policies restricted the supply of housing in key desirable markets.  In The Housing Boom and Bust, Thomas Sowell of the Hoover Institution has shown how these policies brought about a crisis in housing and finance.

Others have told the story from a number of perspectives and with varying emphasis on different factors.  My purpose here is to focus on the policy responses to the crisis and ask whether they have been helpful or harmful.

TARP

On October 3, 2008, Congress enacted the law creating the TARP (the Troubled Asset Relief Program).  That law authorized the expenditure of up to $700 billion to purchase troubled assets from financial institutions. A little more than a month later, then-Treasury Secretary Paulson announced a shift in the use for TARP money.  Rather than buying troubled assets, the Treasury would use the funds for capital injections into banks in return for preferred shares.

Regardless of one’s attitude toward bailouts generally, Paulson’s original plan was a recipe for disaster. To help the banks he would have needed to overpay for them to the detriment of the taxpayers.  If he had paid then-current prices, accounting rules would have forced all firms holding such assets to write them down (not just those selling the assets).  Financial institutions holding dubious mortgage-backed assets were desperately trying not to write them down because that might have threatened their depleted capital base.  It is fair to say that Paulson failed to grasp the underlying problems at these institutions when he first proposed TARP.

TARP became a capital-relief plan.  It harkened back to the Reconstruction Finance Corporation (RFC) of the Great Depression. Under Jesse Jones and in conjunction with Roosevelt’s Bank Holiday, all the nation’s banks were examined and divided into the good, the bad, and the ugly.  Call it his version of a “stress test.”  Those deemed beyond hope were never reopened.  Those troubled but salvageable were eligible for RFC capital injections.  Jones also extracted resignation letters from senior management of institutions being bailed out.  If he deemed existing management best suited to run the bank, they could stay.  If not, they were replaced.

In comparison, Paulson’s strategy was “ready-shoot-aim.”  Banks received government injections of money to replace depleted capital, with nothing explicit extracted in return.  There were vague promises that banks would resume lending, but nothing enforceable.  The banks were stress-tested only after having received government funds.  There were second and even third rounds of bailout for some banks, indicating they had been weaker than thought.  We know that, in at least one case, CIT, a financial institution that received $2.3 billion in TARP money should have been allowed to close. Instead it eventually filed for bankruptcy and the taxpayer funds were lost.

Moreover, in what has become a national disgrace, existing management at bailed-out banks was permitted to remain in place.  The Bush administration failed to impose even the level of control exercised under FDR.

On the one-year anniversary of the announcement of Paulson’s reversal on TARP, I was asked by Newsweek for my assessment.  As reported, I said that “it hasn’t done what [Paulson] said it would. Yes, it saved some banks from going under, but did it restore the health of the banking system? Absolutely not.”   I stand by that assessment today.

What Does Government Stimulate?

The fiscal response to the crisis of the Bush/Obama administrations has been to spend their way out of the recession.  In the process the nation’s debt has skyrocketed. There are deficits and debt as far as the eye can see, and our children’s future has been mortgaged. The 2009 fiscal deficit was double that of 2008.  It is running at 10 percent of GDP, and former Fed governor and Bush adviser Larry Lindsey estimates they will run at 7 percent of GDP for a decade.

Because of the work of Milton Friedman and his monetarist followers, countercyclical fiscal policy fell under a cloud. First, they argued that recessions are difficult to forecast and we only typically know we have entered one after the fact.  The monetarists also argued that fiscal policy was subject to the cumbersome legislative process and thus could not be quickly implemented.   Once spending began, its effects were only felt slowly.  All of this wisdom was forgotten in the panic of the Bush administration and then more so in the Obama administration.

The Economic Stimulus Act of 2008, passed in February of that year, mainly sent $100 billion in checks to households in early summer to stimulate consumption and jumpstart the economy.  As Taylor has shown, the money did nothing and the economy slid into recession later that year. Any economist worth his salt knows that temporary government cash infusions will likely be saved and at best have transitory effects on spending.

Undaunted by that failure, the Obama administration decided to up the ante on the theory that there had just not been enough fiscal stimulus.  They replaced billions in spending with trillions in spending: the stimulus package added on to the TARP.  In the next section I also discuss spending by the Fed that is masquerading as monetary policy.

What is the record?  It appears that the recession may have ended in the third quarter of 2009.  That would make it less than one year in duration–not atypical in that sense.  Most of the Obama stimulus money has yet to be spent.  (Recall Friedman’s arguments on fiscal policy.)  It may be good electoral politics to claim credit for a still-nascent recovery.  But it is poor economics.  More likely, the self-adjusting forces of the market have been at work.

Clearly nothing the government has done has been able to halt the upward march in the unemployment rate.  GDP is an abstraction; being out of work is a reality.  In October the unemployment rate exceeded 10 percent.  A broader measure of unemployment exceeded 17 percent.  These numbers put the flesh on the skeleton of policy debates.  More ominously we now are seeing indications that wage rates are falling.  As the Wall Street Journal reported, Professor Kenneth Couch of the University of Connecticut estimates that displaced workers returning to work will on average take a 40 percent pay cut.

Double-digit unemployment rates and double-digit wage cuts are depression statistics.  In what way is government spending “stimulating”?  In a recent editorial the Wall Street Journal concluded that “no matter how hard  or imaginatively the Administration spins, the reality is that the stimulus has been the economic bust that critics predicted it would be.”

Indeed, the labor story helps us to see the dark side of stimulus spending. A good chunk of it has gone to state governments to support bloated budgets in the face of collapsing revenues.  Those fiscal transfers are being done, at least in part, to placate public-sector unions, which want to protect the incomes and pensions of their members.

To the degree that unionized government workers can resist cuts in wages and benefits, the needed adjustments are born by others.  New hires, contract workers, and outside vendors suffer.  Non-unionized workers in the private sector generally bear a disproportionate share of the adjustment costs in the form of lower wages and unemployment.

Fiscal stimulus has failed.  What about the monetary variant?

Monetary Stimulus

The Fed’s response to the crisis has drawn mixed reviews among free-market economists.  Some approve of the Fed’s easing in 2008-09 as a response to an increased demand for money (falling velocity). Nearly all market-oriented economists are disquieted by the explosion of the Fed’s balance sheet as it takes on more and more assets of dubious quality.  It will be extremely difficult for the central bank to dispose of such assets when it inevitably comes time for it to tighten.  The Fed will likely suffer losses, and such losses impact the taxpayer.  (The Fed’s surplus is paid to the Treasury.)

Many economists have been critical of the Fed for its targeted-credit policies, which amount to credit allocation.  They favor one sector at the expense of others, and constitute fiscal policy rather than monetary policy.  The Fed’s leadership is dismayed in the turnaround of its approval by the general public, and they fear calls for greater political oversight.  But the backlash against the Fed is of its own making.

In the end the Fed’s fortunes are tied to the economy’s.  Most Americans do not know the technicalities of monetary policy.  But Fed Chairman Ben Bernanke has taken an active and public role in defending the policy response to the crisis (under both Bush and Obama).  Under Chairman Bernanke the Fed has promised much and delivered little.

Just as Americans fear the spending and budget deficits, many understand that easy money helped get us into the crisis. Now Dr. Bernanke has prescribed the strongest dose of cheap money ever administered.  How can the elixir that caused the boom cure the bust?

The Bernanke Fed is engaged in a policy of reflating (re-inflating) the economy: stimulating money demand to restart economic growth.  It justifies the policy on the basis of Professor Bernanke’s own research that shows the evils of deflation.  But what prices is he trying to prop up? All prices?  Even in hyperinflations, some prices fall.  Is he trying to prevent downward adjustment in wages?  As suggested above, wage rates in hard-hit sectors may be falling at double-digit rates.  Is he preparing for double-digit price inflation? If so, gold is underpriced at $1,000 an ounce.

Astute observers increasingly fear that what is being reflated is another asset bubble. At present, the asset bubble is concentrated in commodities (such as gold, copper, and oil) and Asian real estate. In what is known as a carry trade, global investors are borrowing dollars at low interest rates to invest in property in cities like Hong Kong and Singapore. Instead of bringing prosperity to Americans, the Fed’s policy is fueling speculation. Instead of production in the United States, the Fed’s easy money is creating paper wealth for Asian property owners.

The rise in commodity prices is perhaps most ominous.  The U.S. economy remains weak and unemployment elevated.  Yet Americans are already paying higher prices for gasoline.  They are facing the prospect of renewed inflation and economic weakness: stagflation.  That would be an updated version of the economy of the 1970s.  The Fed is thereby impoverishing Americans.  Is it any wonder many are calling for a reconsideration of its role?

In little more than two years, Greenspan’s legacy has been reevaluated. At hearings of the House Oversight Committee, he tried to save as much of his original reputation as possible. Chairman Henry Waxman set the tone by observing that the entire economy was paying the price for Greenspan’s inattention to the risks in the subprime mortgage market.

Greenspan’s defense reminded me of a famous scene in the movie Casablanca. The flawed but ultimately heroic Captain Renault (played by Claude Rains) announces that Rick’s was being shuttered until further notice. Asked why, Captain Renault stated (as he accepted his nightly winnings) that he was “shocked” to discover that gambling was going on. In a similar vein, Greenspan expressed to the House committee his “shocked disbelief” that risky lending had been going on during his tenure.

As Fed chairman, Greenspan was the architect—the “maestro”—of a low-interest policy that flooded the economy with cheap credit after the collapse of the dot-com bubble in 2000-01. Real (inflation-adjusted) short-term interest rates were negative for several years. Risk premiums were driven down to historic lows—indeed, they all but disappeared. These elements made for a classic asset bubble. As economic historian Gary Gorton recently noted (in his paper, “The Panic of 2007”), the whole subprime house of cards would have tumbled down if housing prices had simply stopped rising, much less begun falling. They stopped rising and then began falling in 2007 and into 2008.

We’re Forever Blowing Bubbles

Economists have been observing and analyzing asset bubbles for centuries. Adam Smith talked about the South Sea company (and its bubble) in The Wealth of Nations. The effects of credit policy—first of ease then restriction—were well-analyzed by nineteenth-century economists. In the twentieth century, booms and busts were the central focus of business-cycle theorists. These included such figures as the British economist J. M. Keynes and the Austrian economists Ludwig von Mises and Friedrich A. Hayek. Mises and Hayek in particular linked the development of asset bubbles to easy-credit policies of central banks. Later, entire schools of economics—Keynesian, Monetarist, etc.—wrote on the topic.

The elements of a classic bubble should not have eluded the Fed chairman. The Fed sets the Fed funds rate, the rate at which banks lend to each other. That rate greatly influences other short-term lending rates. For three years, the Fed funds rate was at or below 2 percent. For one year in that period, the rate was 1 percent. That cheap-money policy fostered the leveraged borrowing and risk-taking that characterized the subprime mortgage market. Elsewhere I have called this “casino capitalism.” (See my “Subprime Monetary Policy,” The Freeman, November 2007)

In an October 18 interview with the Wall Street Journal, Anna Schwartz, the eminent economic historian (and coauthor with Milton Friedman of A Monetary History of the United States), observed that asset bubbles—“manias,” as she calls them—always have the same cause. “If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset.” In the dot-com bubble it was equity shares of high-tech start-up companies. In recent years it has been residential real estate. The asset may change, but not the cause—monetary policy.

Grant Me Fiscal Discipline, but Not Yet

Why do central bankers repeat the same mistakes over and over again? Dr. Schwartz has the answer: “In general, it’s easier for a central bank to be accommodative, to be loose, to be promoting conditions that make everybody feel that things are going well.” I guess we could call this “feel-good” monetary policy.

How did Greenspan answer the question of why he had been so accommodative, so loose? He told us he was merely following orders, complying with the will of Congress. He had done “what I was supposed to do, not what I’d like to do.” This is followership, not leadership. It’s also just not so.

Under Article I, Section 8, of the U.S. Constitution, Congress has the power “to coin money, regulate the Value thereof, and of foreign coin, and fix the Standard of Weights and Measures.” Though at times controversial, courts have endorsed Congress’s power under that clause to create a central bank and delegate to it the conduct of monetary policy. The Fed was designed and structured to have operational independence. While the seven governors are political appointments, the presidents of the 12 reserve banks are not. The Fed has always been self-financing and needed no appropriation from Congress. That design has maintained its operational independence.

The House hearing should have focused not on Greenspan’s personal failings but rather on institutional failure. The Fed was created in 1913 to save the country from recurring financial panics. It was a bankers’ bank that would provide liquidity to ordinary banks, so that credit squeezes would no longer bring economic activity to a halt. By the 1920s, economists like Irving Fisher were arguing that central banks could manage money and keep its value more stable than did the gold standard. So the promise of central banking was stable prices and the end of panics and credit squeezes.

The Fed got off to a rocky start. After World War I, the economy was hit by the panic of 1920-21. By some measures, it was the sharpest panic in U.S. history. The Great Depression followed, beginning in 1929 (full recovery did not occur until after World War II). Monetary policy was thought to have improved after the war. But then came the inflation of the late 1960s, 1970s, and into the 1980s. Some economists believed they detected a “Great Moderation,” first in residential construction in the 1980s and later in real growth (GDP) and inflation. Every time observers thought central bankers had got it right, there was another mania, another panic, another recession.

Today, nearly 100 years after the founding of the Fed, we are in the midst of financial panic, experiencing a credit squeeze, and caught between inflationary and deflationary forces.

At some point even the most ardent supporters of central banks must question whether there is an institutional flaw in them. Some critics think the restoration of the gold standard would be the cure. Some think central banks themselves must be abolished. More of the same is unthinkable. Financial instability is, unjustly, undermining the case for free markets.

Show trials of principals like that of Alan Greenspan appeal to a sense of schadenfreude, but they are no substitute for some serious rethinking of our monetary institutions.

Government programs and policies often serve to insulate individuals from the full consequences of their actions. For instance, subsidized federal flood insurance leads individuals to build more homes in flood plains than would otherwise be the case. The public naturally feels sympathy for homeowners who are the victims of flooding, and supports more assistance for those caught up in these dreadful situations. The “help” often exacerbates the problem, however, by removing incentives for homeowners to rebuild on higher and drier land. The general public wonders why the catastrophes appear more frequently. Pundits ascribe them to global warming, and nature is blamed for the effects of manmade policy.

Since the 1930s the federal government has insured bank deposits. That scheme inherently reduced the vigilance of bank depositors toward their banks, removing constraints on risk-taking by the insured depository institutions. The situation became acute in the 1980s and 1990s, when unconstrained risk-taking by banks and thrift institutions led to a series of banking and financial crises. Eventually the deposit-insurance system was reformed and banking put on a sounder basis. Now we are in need of a reform of monetary policy.

Crisis in the Mortgage Market

Last February the popular press discovered subprime mortgage loans (see box) when two major originators of such loans, HSBC Holdings PLC and New Century Financial, disclosed increased loan loss provisions. HSBC is a globally diversified financial company. While it was a large lender in the market, the aggregate amount of its subprime loans was not a significant portion of its total portfolio.

New Century Financial fared much less well because of the concentration of its lending in this risky category. Its stock price collapsed after problems surfaced the previous February, and the company eventually declared bankruptcy.

Other lenders in the subprime market experienced difficulties. Fears of a housing collapse and even an economic recession grew as investors gauged the size and extent of the problem in the mortgage market.

The crisis was foreseen by many. For more than a year before the bust, bankers, analysts, and even regulators knew they had a mess in the making. As John Makin of the American Enterprise Institute observed, the lending practices in the subprime market were “shoddy and absurd.”

Lewis Ranieri, former chairman of Salomon Brothers, echoed those comments: “We’re not really sure what the guy’s income is and . . . we’re not sure what the house is worth. So you can understand why some of us become a little nervous.” Ranieri helped pioneer the bundling of mortgages into marketable securities (“securitization”), so he should know!

The collapse of the subprime mortgage market is the latest in a series of financial bubbles whose existence reflects, at least in part, moral hazard in financial markets. Moral hazard is the outcome of explicit or implicit guarantees to investors. At one time, deposit insurance was a major culprit. Today, monetary policy is fostering moral hazard.

Moral hazard occurs when some action or policy alters the behavior of individuals in a counterproductive way. Specifically, a policy intending to mitigate risk causes individuals instead to assume more risk. For example, a poorly designed policy insuring against fire could lead individuals to diminish resources devoted to fire prevention. In that case, the insurance would increase the probability of the insured risk occurring. (Of course, well-designed insurance policies should reduce risk. And in competitive markets, that is what normally happens.)

Earlier financial crises were the effects of deposit insurance and bank-closure policies that effectively insulated depositors and even other bank creditors from risk in the event of the failure of depository institutions. In an October 2002 speech to economists in New York, then-Fed Governor Ben Bernanke described the savings-and-loan crisis of the 1980s as “a situation . . . in which institutions can directly or indirectly take speculative positions using funds protected by the deposit insurance safety net—the classic ‘heads I win, tails you lose’ situation.” After an intellectual and political battle of more than a decade, the deposit-insurance loophole was sealed.

To better understand moral hazard, consider the case of a gambler going to a casino. If he bears the losses, his bets will be constrained by that risk. If someone were to guarantee him against loss, but allow him to keep the profits, the gambler would have an incentive to make the riskiest possible bets. He gains all the profits but bears none of the losses. One might designate such a system as “casino capitalism.” Current Fed policy has encouraged casino capitalism in the housing market.

Monetary policy can generate moral hazard if it is conducted so as to bail investors out of risky and otherwise ill-advised financial commitments. If investors come to expect that the policy will persist, they will deliberately take on additional risk without demanding commensurately higher returns. In effect, they will lend at the risk-free interest rate on risky projects, or at least at a lower rate than would otherwise be the case. Too much risky lending and investment will take place, and capital will be misallocated.

Money and Prices

To simplify a complex theoretical issue, an ideal monetary policy is one that facilitates and does not distort economic decision-making by individuals. Market prices play a critical role in that process by signaling to everyone the relative scarcity of goods and urgency of ends.

Austrian economist and Nobel laureate in economics F. A. Hayek characterized the price system as a communications mechanism for transmitting information about economic values. By communicating that valuable information, the price system helps coordinate economic activities. In its simplest formulation, prices tend to bring about equality between supply and demand in each market.

As with any communication system, it is desirable to filter out “noise,” extraneous signals that interfere with communication. Money is indispensable to price formation, but money can generate noise along with information. The ideal monetary policy is one in which there is no noise, only valid price signals. The best possible monetary policy would maximize the signal-to-noise ratio.

Monetary noise comes about when policy changes the value of money. In economies on gold or silver standards, the discovery of new sources of the precious metal can set in motion forces leading to an expansion of the money supply and the depreciation in the value of money. In modern times, money is created by printing it, or through expansion of bank liabilities. In nearly all developed countries, the rate of that expansion is (or can be) controlled by central banks.

Changes in the value of money create monetary noise because investors and ordinary individuals mistake changes in money prices for changes in relative prices. For instance, during inflation prices will rise just to reflect the increase in money and not necessarily because there has been a shift in preferences.

Current monetary policy is much improved from the record of the late 1960s, 1970s, and early 1980s. That was the era of double-digit inflation and sky-high interest rates. In a December 2002 speech to the Economic Club of New York, then-Fed Chairman Alan Greenspan put monetary policy in historical context:

Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent overissuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess.

Some scholars have suggested that money influences not only the prices of consumer goods and wages, but also asset prices. They argue that money can work its mischief without showing up in consumer goods inflation. Widely used price indices, such as the consumer price index (CPI), do not include asset prices. A stable price index of consumer goods would thus not be a good measure of the value of money. Professor Charles Goodhart pointed to the two-decade experience of Japan, in which consumer prices were stable while asset prices fluctuated wildly. He asked rhetorically what the meaning of “inflation” is in such a context.

Goodhart argued that at least one category of assets figures so large in consumer purchases that it cannot be ignored: housing. Rental prices and housing prices do not always move in tandem. Home prices are affected by monetary policy in a number of ways, most notably through interest rates.

If asset prices are not incorporated into measures of inflation, their movements will not be action-forcing events for policymakers. Fed chairmen will wring their hands about “irrational exuberance,” but will be powerless to do anything until the effects of asset-price changes are manifested in undesirable changes in current prices and output.

The Greenspan Doctrine

The new moral hazard in financial markets has its source in what can be best described as the Greenspan Doctrine. It was clearly enunciated by Greenspan in his December 19, 2002, speech, in which he made an asymmetric argument leading to an asymmetric monetary policy. He argued that asset bubbles cannot be detected and monetary policy ought not in any case to be used to offset them. The collapse of bubbles can be detected, however, and monetary policy ought to be used to offset the fallout.

Two months earlier Ben Bernanke had made a similar argument. He endorsed the Greenspan Doctrine, arguing against the use of monetary policy to prevent asset bubbles: “First, the Fed cannot reliably identify bubbles in asset prices. Second, even if it could identify bubbles, monetary policy is far too blunt a tool for effective use against them.” Since Bernanke is now Fed chairman, it is reasonable for market participants to assume that the Greenspan Doctrine still governs current Fed policy.

Wrong Question

The two men were surely asking and answering the wrong question. They were implicitly treating bubbles as solely the consequences of real shocks or disturbances. (An example of a real shock is a technological innovation leading to productivity gains and higher future expected profits in a sector.) They asked whether monetary policy should be used to offset the effects of real shocks and concluded that it should not. The latter is the correct answer to the question they each posed.

A different question would be whether monetary policy should be conducted so as to create or exacerbate asset bubbles, which would not have occurred or would have been milder absent the assumed monetary policy. The answer to that question is surely no. Consider Bernanke’s apt characterization of moral hazard in the context of the deposit-insurance crisis: “When this moral hazard is present, credit flows rapidly into inelastically supplied assets, such as real estate. Rapid appreciation is the result, until the inevitable albeit belated regulatory crackdown stops the flow of credit and leads to an asset-price crash.”

Bernanke could have been talking about the subprime-mortgage market. That bubble and collapse cannot, however, be blamed on deposit insurance. First, deposit insurance is no longer systematically mispriced and banking supervision has improved. Second, the majority of mortgages are no longer made by insured depository institutions. Yet something generated the moral hazard that enabled shoddy underwriting of subprime mortgages to persist for years.

The Greenspan Doctrine helped create moral hazard in housing finance. The Fed announced that it will take no action against bubbles, but will act aggressively to offset the consequences of their collapse. In effect the central bank is promising at least a partial bailout of bad investments. The logic of the old deposit-insurance system is at work: policymakers should protect investors against losses, no matter their folly. Or, in Greenspan’s own words: monetary policy should “mitigate the fallout [of an asset bubble] when it occurs and, hopefully, ease the transition to the next expansion.”

In the present context, the “next expansion” could also be rendered as “the next asset bubble.” If the Fed promises to “mitigate the fallout” from “irrational exuberance,” then it is rational for investors to be exuberant. Investors may be at risk for some loss, as with a deductible on a conventional insurance policy, but losses are still being mitigated.

Rate Cut in 2000

The Fed cut the Fed Funds rate sharply after the bursting of the stock market bubble in March 2000. In the eyes of many, the Fed cut rates too far and held them down too long, fueling not only a vigorous economic expansion but also the housing bubble. In his December 2002 speech, Greenspan was at pains to deflect any argument that the Fed was inflating a housing bubble. “To be sure,” he acknowledged, mortgage debt was high relative to household income [remember the date] by historical norms. But “low interest rates” were keeping the servicing requirements of the mortgage debt manageable (emphasis added). “Moreover, owing to continued large gains in residential real estate values, equity in homes has continued to rise despite very large debt-financed extractions.”

How wrong the Fed chairman was! If Greenspan was not worried about interest rates resetting, why should mortgage bankers and homeowners worry? It would have been reasonable to read into the chairman’s musings an implicit guarantee of continued low rates. A homeowner is certainly entitled to bet his home on the come if he wants. Should the central bank encourage such behavior?

Monetary Policy for a Free Economy

In his 2002 speech to the Economic Club of New York, Greenspan spoke disapprovingly of a policy that permits prices to nearly double in two decades. At current CPI inflation rates, however, prices will double in less than three decades. If inflation were to rise to 3 percent and remain there, prices would double in 24 years. That is not much progress against inflation, and surely we can expect better.

In a vibrant market economy with technological innovation and ever-new profit opportunities, the monetary policy that maintains true price stability in consumer goods requires substantial monetary stimulus. That stimulus will have a number of real consequences, including asset bubbles. These asset bubbles have real costs and involve misallocations of capital. For example, by the peak of the tech and telecom boom in March 2000, too much capital had been invested in high-tech companies and too little in “old-economy firms.” Too much fiber-optic cable was laid and too few miles of railroad track were laid.

By 2002 the Fed was worried about the possibility of price deflation and introduced a strong anti-deflationary bias. A tilt to stimulus was understandable at the time. A continued bias against deflation at any cost, however, will produce a continued bias upward in price inflation. The inflation rate begins at the positive number. With the bursting of each asset bubble and the fear of deflationary pressure, Fed policy must ease. The Greenspan Doctrine prescribes a stimulative overkill that begins the cycle anew. The Greenspan-era gains against inflation will then prove to be only temporary. His doctrine will be the death of his legacy, a legacy that already includes a housing bubble and its aftermath.

There is a long tradition in law, economics, and politics focusing on critical institutions as the source of development. Notable among these institutions are private property, the rule of law, and a stable monetary system. Together they undergird a market economy. In recent years, abundant empirical evidence has accumulated supporting the case for the free market as the path to development.

While supporters of a market economy have largely won the war of ideas, they have been less successful in winning the battle over public policy. Even in developed countries, which owe their material success to economic freedom, the market is under constant political attack. In the many undeveloped economies, the situation is far worse.

What are the incentives for political leaders to adopt good economic policies? And why has that occurred in only a few countries? To answer these questions, one must look at what motivates political leaders.

All political leaders need legitimacy to continue to govern. In democracies, that legitimacy is subject to periodic tests called elections. Between the political cataclysms of elections, politicians daily seek out support to advance their political agenda. Legitimacy is tested in a government’s every political battle.

When leaders of democratic governments lose legitimacy, those governments fall. Witness Argentina. Twice in recent history, an Argentine president has left office before his term expired because he had lost political legitimacy. Recall the experience of President Nixon, who resigned his office when he lost political legitimacy.

By contrast, a leader can do unpopular things if his legitimacy is accepted. Prime Minister Tony Blair led his country into an unpopular war. His Spanish counterpart, José María Aznar, did the same against even greater opposition. Aznar’s party eventually lost power, but only after a miscalculation by Aznar over the identity of the perpetrators of a horrific terrorist act on March 11, 2004. As the examples illustrate, it matters little whether the form of democratic government is parliamentary or presidential. Loss of political legitimacy is a democratic government’s downfall.

Authoritarian governments lack the many sources of political feedback that are a hallmark of democracy. Thus systemically bad economic policies can endure in such countries. North Korea is a prime example. As authoritarian and totalitarian as that regime may be, however, it must keep its legitimacy to govern. There are signs that its legitimacy has been undermined and the political leadership is changing its economic policy as a consequence.²

Even the most cynical observer must accept that political leaders take account of the most important desires of the citizens. One need not ascribe benevolence to politicians, only a desire to stay in office. Citizens of all countries not only want to avoid starvation; they want to enjoy a higher standard of living for themselves and their children. In short, they want to prosper.

Whether governments care about economic freedom depends on how widespread is an understanding of the connection between that freedom and prosperity. The evidence is that empirical measures of economic freedom have broadened and deepened that understanding among leaders and ordinary people alike.

Economic and Political Freedom

Milton Friedman’s analysis of the relationship between economic and political freedom, his book Capitalism and Freedom, was the inspiration for the empirical measures of economic freedom. He debunked the myth that the two freedoms are disconnected; that, Chinese menu-style, one can choose freely from political systems and then pair that choice with an economic system. He went so far as to say that “a society which is socialist cannot also be democratic, in the sense of guaranteeing individual freedom.”

Friedman reversed the priority customarily accorded to political freedom, describing economic freedom as “an indispensable means toward the achievement of political freedom.” He argued that societies could be economically free but not politically free. There is at least the appearance of a contradiction in Friedman’s argument. On the one hand, he asserts that you cannot pick and choose among freedoms. On the other hand, he suggests that you may be able to do so to a limited extent. Societies can possess economic freedom without political freedom (but not the other way around). Yet in the end, economic freedom will lead to political freedom, although political freedom will not necessarily lead to economic freedom.

Controversial when made, the argument became more so when economic reforms in Chile were introduced under the authoritarian government of General Pinochet. Today we have other examples of economic freedom advancing more quickly than political freedom, China being the most notable case.

When Friedman wrote Capitalism and Freedom, “economic freedom” was a scarcely used phrase, much less understood. It needed definition. And it needed to be measured if there were to be widespread acceptance of its importance for economic development. Hence, two indexes of economic freedom were born, from the Heritage Foundation/Wall Street Journal and Fraser Institute.³

Economic freedom is “the absence of government coercion or constraint on the production, distribution, or consumption of goods and services beyond the extent necessary for citizens to protect and maintain liberty itself.”⁴ The definition is inherently Lockean in conception. Accordingly, it echoes the truth set down in the most important American political document, the Declaration of Independence: “that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty, and the Pursuit of Happiness—That to secure these Rights, Governments are instituted among Men, deriving their just Powers from the Consent of the Governed.”

Economic freedom cannot be directly measured. But its institutional determinants are susceptible to measurement. These are the institutions that guarantee “personal choice, voluntary exchange, freedom to compete, and protection of person and property.”⁵ Foremost among these is private property.

The great English jurist William Blackstone defined property as “that despotic dominion that one man claims and exercises over the external things of the world, in total exclusion of the right of any other individual in the universe.”⁶ That stark formulation emphasized an important element of property ownership—the ability to exclude other users and uses.

Only with a protected domain of choice can a property owner appropriate all the benefits and incur all the costs of his decisions to allocate his property to different uses. That weighing of costs and benefits ensures that maximum value accrues from the use of property. It is only through the protected domain of private property and the calculus of decision-making that claims can be sustained about the efficiency of a market economy.

Along with Ronald Coase and Harold Demsetz, Armen Alchian is the founder of the modern property rights school of economics. He formulated the scope of property rights as follows:

By a system of property rights I mean a method of assigning to particular individuals the “authority” to select, for specific goods, any use from a nonprohibited class of uses. . . . [T]he concepts of “authority” and “nonprohibited” rely on some concept of enforcement or inducement to respect the assignment and scope of prohibited choice. A property right for me means some protection against other people’s choosing against my will one of the uses of resources said to be “mine.”⁷

Enforcement and Transferability

In addition to exclusivity, there must be enforcement and transferability of property rights. Without protection and enforcement of private property rights, the right would be nugatory. Transferability enables an owner to produce and exchange on the market, and to capture the full value of his property.

These elements enable individuals to choose and act, and to engage in voluntary exchange. It is out of that human choice and human action that competition arises. “Competition” is a term of art in economics. A competitive system is one in which producers strive to satisfy consumers at the lowest cost. It is a system in which anonymous individuals cooperate through the market, each to achieve his own goals.

The stronger the protection of private property, the more will individual choice guide economic decisions. These choices will respond to market prices; it is prices that guide decision-making. They communicate information to producers about the intensity of consumer preferences and the relative scarcity of resources needed to satisfy those wants.

Private property ensures that producers can appropriate the returns from efficient use of resources to satisfy consumers. That expectation provides the incentive for individuals to invest their assets productively in the service of consumers they may never know. The stronger the protection of private property, the more effective an economy will be in creating wealth.

Richard Pipes, the distinguished historian of Russia, argues in Property and Freedom that property is the source of liberty: “While property in some form is possible without liberty, the contrary is inconceivable.” Property is the source of the legal and political institutions guaranteeing liberty. As such, property is the bedrock of a free society.

Pipes’s view reverses the normal analysis in which the rule of law and political liberty are the preconditions for the emergence of private property. His view, however, better explains the history of liberty. Property took the form of possession long before there was legal recognition of such claims, much less formal legal title. “Prolonged tenure” was the source of such claims, which “custom” recognized.

A system of law recognizing property in land, titling it, and governing its transfer comes only after possession and prolonged use. For Pipes, the fact of inherited property is the source of a law of inheritance, not the other way around.

Pipes’s historical treatment is consistent with de Soto’s analysis of possession as the basis for titling land. De Soto has identified the absence of a system of legal titling of property as the source of undevelopment. He contends that “the only way to find the extralegal social contract on property in a particular area is by contacting those who live and work by it.”

Pipes’s position is somewhat different from Friedman’s. In Capitalism and Freedom, Friedman acknowledged that the relationship between economic and political freedom “is complex and by no means unilateral.” He supports the priority of economic freedom, however.

By contrast, Pipes argues that property rights are the source of both economic and political freedom.

I am not suggesting a great chasm on the issue. Pipes’s view focuses our attention, however, on one key institution as the source of both economic and political liberty: property rights. If he is correct, then the debate over economic and political freedom has been misguided. Neither is prior to the other. Instead, each is a consequence of a third factor, private property. Property is the source of all liberty.

The Scope of Private Property

While there are multiple factors, or variables, used in both the Heritage and Fraser indexes, a number of them are really measuring aspects of property rights. For instance, when government regulates economic activity it attenuates property rights. It does so by putting conditions on the use of property over and above those imposed by the abstract rules of the law of property.

Economists have long understood how economic regulation can hobble market activity. That insight has been confirmed on a global scale by a surprising source: the World Bank. In its second annual report on regulation, Doing Business in 2005, it measures the regulatory burden in 145 countries. Using seven measures of the ease with which a business can be started, gain credit, expand and hire labor, and contract and discharge labor, the Bank finds that the regulatory burden is negatively associated with prosperity in individual countries.

Inflation erodes the value of private property and effects nonmarket transfers of wealth among creditors and debtors. Inflation also interferes with market pricing by distorting relative prices and resource allocation. Consequently, inflation undermines the system of property rights.

Restrictions on trade and capital flows interfere with the rights of property owners. What is called “foreign” trade and investment are just transactions between contracting individuals. They are not transactions between nations. When governments inhibit these transactions, they attenuate private property rights of their own citizens.

Measures of the degree of black-market activity and corruption—the two being highly correlated—actually measure the consequences of other market interventions. If individuals are prohibited from engaging in mutually beneficial exchange, they will seek to circumvent the prohibitions. That may lead to extralegal market transactions and payments to officials to overlook the prohibited activity. Yet corruption introduces its own problems, in addition to those resulting directly from the interference with property rights.

Corruption is an effect of interference with property rights. But it attenuates property rights further by making them insecure. In corrupt societies the rule of men is substituted for the rule of law. The ability to conduct business is governed not by rules, but bureaucratic whim.

Of course, eliminating the attenuation of property rights would go a long way to rooting corruption out of a society. As a practical matter, that is easier said than done. The conceptual point, however, is that even when there appear to be other determinants of liberty, they are either aspects of, or intertwined with, property rights.

Economic Freedom: The Record

Economic freedom has increased every year since the first Heritage Index was published in 1995. The Fraser report goes back to 1970. According to that measure, economic freedom declined in the 1970s, reached its nadir in 1980, and has been increasing ever since.

Economic freedom improved despite any number of regional economic crises and upheavals in individual countries. There was the Mexican peso crisis of 1994–95, the Asian financial crisis of 1997–98, the Russian debt debacle of 1998, and more recently, the return of left populism in Latin America.

There are two striking features of the most highly rated countries. All have strong protection of private property. And nearly all are seafaring nations with a long history of international trade.

Trade is important because it opens countries up not only to goods, but also ideas, including political ideas, and institutions, including the rule of law. As countries become more commercially driven and outwardly oriented, they evolve strong commercial codes. Sometimes the legal codes are imported, as when Dutch-Roman law became the basis for Scottish law.

There are two notable groupings of such highly rated countries with a common history. First are Great Britain and its former colonies. Britain and five of its former colonies occupied six of the top ten positions in the Heritage 2004 Index. The former colonies are Hong Kong, Singapore, New Zealand, Ireland, and the United States. And Australia fell next at number 11. (In the 2005 Index the United States dropped to number 12.)

The second grouping consists of the Nordic countries: Estonia, Denmark, Sweden, and Iceland. (Estonia is typically listed as a Baltic country, which it clearly is. But in temperament, history, culture, and language, it is also a Nordic country. Ask an Estonian.) The Netherlands also fits the overall theme of strong property rights and a history of openness to trade. The Nordic countries also share a common history of alliance with the Hanseatic League.

The good showing of many member states of the European Union puts the lie to the contention that Europe is a monolith. Brussels’s bureaucrats may very well wish that every policy were centralized. But their pleadings for tax harmonization and centralization only prove that economic policies remain diverse within the Union.

Some governments use Brussels as an excuse to implement bad policies. Others, such as Ireland and Denmark, persist in asserting their sovereignty against diktats from Brussels. Ireland is a low-tax country for business; Luxembourg remains a tax haven for financial capital; and Britain, Denmark, and Sweden retain their monetary sovereignty. (Europe’s political leaders are generally rhetorically anti-Thatcherite, but often practically Thatcherite in their policies.⁸)

One can go on with the theme of trade and property. Bahrain is a bright spot in the Middle East. It has a seafaring history and strongly protects property rights. Chile, the freest economy in Latin America, is a trading nation that has strong protection of private property. And Chile pioneered the privatization of social security.

There are no counterexamples to this theme until the Bahamas. A former British colony that still strongly protects property rights, the Bahamas is highly protectionist. As with a number of Caribbean nations, it finances government spending with tariffs.

Needless to say, countries at the bottom of the rankings have weak property-rights systems and are protectionist. While Asia has four of the freest economies in the world, it also has the largest number—six—of repressed economies: Tajikistan, Uzbekistan, Turkmenistan, Burma (Myanmar), and North Korea.

With this overview in mind, I now turn to the central question of the article. Do governments care about economic freedom and have the economic indexes had an impact?

How Governments Respond

The difference between poverty and prosperity is freedom. How well do governments understand that connection? Surely, the answer is that it varies. That variation helps explain why some governments put in place policies promoting prosperity, while others promote penury.

Understanding is not enough. Politics play a role. Frequently, leaders understand that free markets and open economies underpin economic growth. But they face political hurdles erected by rent-seeking beneficiaries of an interventionist system.

The political leaders of Estonia grasped the connection and overcame the political opposition.⁹ That country and its economy suffered under 50 years of Soviet occupation, and the economy was a “shambles,” according to Mart Laar, the prime minister who led a successful government of reform. The reformers understood the importance of the rule of law: “There can be no market economy and democracy without law, clear property rights, and a functioning justice system.”

The Estonian reformers stuck with their plan even when the going got tough:
All tariffs were abolished, forcing domestic producers to compete on the world market. 
All subsidies to enterprises were ended. 
A flat personal income tax was introduced. The tax on corporate income was abolished for re-invested profits.

The term “shock therapy” has been used to describe the transition in some countries. If Poland employed shock therapy, then Estonia employed electrocution for the old economic regime. The reformers introduced so many changes so fast that their opponents had no time to regroup. There is a lesson there for other reformers. Gradualism can become a death sentence for economic reform.

In western Europe, Ireland is a standout for its economic reforms. In the 1970s it was an economic basket case. Human capital was a major export—people emigrated. Ireland underwent a series of reforms, including tax reform and deregulation. The “Celtic Tiger” has experienced a return of its diaspora, and now imports labor from all over the EU and the rest of Europe.

When he became prime minister of Great Britain, Tony Blair made a decision not to undo the main features of Thatcherism but to tinker at the edges. It is unlikely, however, that Britain’s freedom rankings played a role in that calculus. Nonetheless, at some level the Blair government understands that free markets deliver the goods to its constituents.

The most notable successes chronicled in both indexes have been Hong Kong and Singapore, ranking in the top two positions. They are two open economies, virtual free ports. Each has strong protection of property rights and takes a light regulatory touch with business. Neither is a Western-style democracy, though elections are held in each city-state.

There has been intense rivalry between Hong Kong and Singapore for top position not only in the Heritage and Fraser rankings, but also in other measures of economic success. The Hong Kong government has always been jealous of its rankings. Both governments vigorously defend policies when criticized.

Hong Kong in particular has shown a willingness, however, to moderate or even reverse policy if its preeminent position as a free economy is threatened. The most notable example of this flexibility involved the company shares purchased by the government on the open market in August 1998 to support the Hong Kong dollar. In June 1999, under intense criticism from the Heritage Foundation and others, the government announced it would place the shares in a “Tracker Fund” and sell most of them off.

Receptive to Criticism

For many years, Singapore dismissed outside criticism of its policies. In recent years, however, the government has become more receptive to criticism and even solicits it. Whether in response to that criticism or for its own domestic reasons, the government is lowering marginal tax rates. The cuts will be phased in over three years. Whether by accident or design, the cut in the first year was just sufficient to improve its freedom score in the Heritage rankings.

The Hong Kong and Singapore stories show the difficulty of identifying whether there is a feedback loop from freedom ranking to policy. Domestic political forces can push in the same direction as advice from U.S. think tanks. In the case of Hong Kong, outside criticism—especially from the Heritage Foundation, which has a Hong Kong presence—gets magnified in the local press and is soon echoed in local criticism.

Throughout east Asia, excluding Japan, the freedom rankings receive great attention in the local press. Governments must respond to what then becomes domestic opposition to policies. That is true even in a developed country like Australia. (I was in Australia for a release of the 2001 Heritage Index. There was a raucous debate in the Senate over whether the Liberal government or the Labor opposition deserved the most credit for the nearly 20 years of successful economic reform in the country. We were as warmly received by the Laborites as by the Liberals. In reality, both political parties deserve credit, as each recognized in private.)

New Zealand, one of the most open economies in the world, is an interesting case study. Free trade is supported strongly by the Labor party. Mike Moore, formerly the head of the World Trade Organization, is an old Labor Party politician. A firebrand, he can talk of manning the barricades in defense of free trade against the antiglobalists. “Free trade is the best hope of the worst off,” he says.¹⁰

The Kiwis were proud of their 2004 third-place ranking in the Heritage Index. In New Zealand’s case, however, no outside criticism is needed to keep the country on its free-trade path. Were it not for its large government sector and tax burden, along with intrusive environmental regulations, it could be the freest economy in the world.

In recent years, some governments produced elaborate reports to try to influence their rankings in the Heritage Index. One country even graded itself using the Heritage methods and format. It was accurate and quite a good job. Heritage staff did its own assessment, however.

In Asia, especially, a good case can be made that the freedom rankings have influenced public policy. That influence varies by country and is not significant in Japan.

Latin America

The Heritage Index has been taken note of in parts of Latin America since it began its Spanish-language edition in 2001. In late 2000 we visited with Chile’s vice president, a member of the social democratic ruling party, who greeted us warmly. He clearly had read that year’s report on Chile and absorbed it, including its critical elements. He repeated our argument about not slackening in the reform process. Later that week he gave a speech to a business group repeating that message. The Index certainly reinforced his better instincts on economic issues.

In Latin American countries the message of economic freedom is conveyed to the local population through the press and public events. It is not received equally well in every country. In a country like Chile the message can be accepted as reinforcing what is long-standing public policy. Surprisingly, some of the largest turnouts and most favorable receptions have been in Venezuela. The people of that country hunger for freedom.

Finally, if it need be said, countries not doing well in the rankings frequently complain. Those countries are typically more interested in improving their rankings than their policies. That they complain suggests that outside criticism matters to them. This category includes the government of one country on the State Department’s list of state sponsors of terrorism.

The freedom rankings of both Heritage and Fraser can play a useful role in reinforcing good policies in countries committed to them. And they can occasionally help turn back bad policies. Not much can be done in a country with a political culture inimical to freedom. Even then, as with Venezuela, ordinary people can be reached by the message. There is no way to tell in the long run how that influence might be felt. We have witnessed the long-run influence of liberal ideas in countries in central and eastern Europe living under communist-party rule.

Governments care because they need to be re-elected and, ultimately, require legitimacy. At every stage, a government wishing to promote economic freedom will face opposition from entrenched interests. That some governments are able to overcome such opposition confirms that leadership matters in public policy.

The connection between government policy and a ranking in the freedom reports can become fairly indirect. Even in the case of North Korea, the most closed economy in the world, leaders must eventually respond when bad policies produce repeated catastrophes.

The Heritage and Fraser efforts can best be viewed as spotlights casting their beams on the dark corners of policy, bringing transparency and political accountability where they are lacking. And they brilliantly illuminate the policy successes in the world. That seems to be impact enough.

Notes

1. For more comparisons and sources, see Gerald P. O’Driscoll, Jr., and Lee Hoskins, “Property Rights: Key to Economic Development,” Cato Institute Policy Analysis No. 482, August 7, 2003, pp. 2–3.
2. Gordon Fairclough, “North Korea Allows Markets to Grow, Eases Central Control,” Wall Street Journal, June 20, 2003.
3. James Gwartney and Robert Lawson, Economic Freedom of the World: 2004 Annual Report (Vancouver, B.C.: Fraser Institute, 2004); and Marc A. Miles, Edwin J. Feulner, and Mary Anastasia O’Grady, 2004 Index of Economic Freedom (Washington, D.C.: Heritage Foundation and Dow Jones & Company, Inc., 2004).
4. Miles et al., p. 50. Italics in the original.
5. Gwartney and Lawson, p. 5.
6. William Blackstone in Ehrlich’s Blackstone, ed. J. W. Ehrlich (San Carlos, Calif.: Nourse Publishing Co., 1959), p. 113.
7. Armen A. Alchian, Economic Forces at Work (Indianapolis: Liberty Press, 1977), p. 130.
8. See Gerald P. O’Driscoll, Jr., and Sara J. Fitzgerald, “Thatcherism Triumphant? The New Business Climate in Europe,” In the National Interest, February 26, 2003, www.inthe
nationalinterest.com/Articles/Vol2Issue8/vol2issue8Odriscollfitzgerald.html.
9. Mart Laar, “How Estonia Did It,” in Gerald P. O’Driscoll, Jr., Edwin J. Feulner, and Mary Anastasia O’Grady, 2003 Index of Economic Freedom (Washington, D.C. Heritage Foundation and Dow Jones & Company, Inc., 2003), pp. 35–37.
10. Quoted in “Moore’s Code,” New Zealand Herald, August 31, 2002.