In response to questions by U.S. Senator Jack Reed (D-RI), Bernanke joined in the chorus of those predicting skyrocketing interest rates in the United States and abroad if the federal government defaulted on its debt obligations because Congress did not raise the debt ceiling. It was not a given that the federal government would have defaulted if the ceiling had not been raised. But ignoring that fact, Bernanke argued that the “loss of investor confidence [following default] could potentially raise interest rates quite significantly. . . . But if interest rates rise, that’s clearly going to reduce investment, uncertainty will rise, that will reduce the abilityness [sic] of firms to hire and invest. . . . So I can only conclude that this would be very bad for—for jobs.”

Did the person supposedly in charge of determining interest rates in the United States through Federal Reserve credit creation really say that? What was the rationale for QE1 and QE2 (quantitative easing) if not to lower interest rates and promote economic prosperity? And who inspired that mistaken thinking? John Maynard Keynes, of course.

Keynes argued in the General Theory (1936) that interest rates are determined by the supply and demand for central-bank money (cash) and not by the supply and demand for savings (or lendable capital), as his predecessors from David Hume and Adam Smith on down to Alfred Marshall had explained. Therefore, in Keynes’s view, it is the responsibility of a central bank to increase its supply of money enough to depress interest rates to such a low level as to result in the “euthanasia of the rentier, of the functionless investor,” who relies on “the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital” to demand interest payments. That is, money should become so plentiful that no one would be obliged to pay interest to borrow it. (Of course, Keynes here confuses money with savings or wealth.)

The money (cash) supply-and-demand theory of interest rates was the predominant view among Mercantilist thinkers from the sixteenth to eighteenth centuries. It was to correct that mistaken view that Hume, in his essay “Of Interest,” explained that although interest rates may be influenced temporarily by the abundance or scarcity of money, they are permanently determined by the flow of savings relative to their demand:

High interest arises from three circumstances: A great demand for borrowing; little riches to supply that demand; and great profits arising from commerce [hence the desirability of demanding more loans]: And these circumstances are a clear proof of the small advance of commerce and industry, not of the scarcity of gold and silver [money]. Low interest, on the other hand, proceeds from the opposite circumstances: A small demand for borrowing; great riches to supply that demand; and small profits arising from commerce: And these circumstances are all connected together, and proceed from the increase of industry and commerce, not of gold and silver.

Hume’s elaboration on that point was the basis of subsequent classical writers’ explanation of interest-rate determination by the supply and demand for savings. Keynes, on the other hand, denied all such explanation and declared in his 1939 preface to the French edition of the General Theory that, in arguing that interest rates rather are determined by “the demand and the supply of money, that is to say [by] the demand for liquidity and the means of satisfying this demand [he is] returning to the doctrine of the older, pre-nineteenth century economists. Montesquieu, for example, saw this truth with considerable clarity—Montesquieu who was the real French equivalent of Adam Smith, the greatest of your [French] economists, head and shoulders above the Physiocrats in penetration, clear-headedness and good sense (which are the qualities an economist should have).”

Has Bernanke now abandoned his adherence to Keynes’s money, or liquidity supply-and-demand, theory of interest rates, or was he merely participating in the debt-default scare to further the federal government’s agenda of raising the debt ceiling to accommodate its profligate spending?

After all, Bernanke also acknowledged to Senator Reed that besides the Chinese, the Fed is “the largest holder of our Treasury debt.” Why wouldn’t the Fed simply cancel the Treasury’s debt and purchase some more to save the federal government from its predicted default? To support the political-posturing view of Bernanke’s statements, one could legitimately cite his similar proclamations in fall 2008 that without the Troubled Asset Relief Program (TARP), giving the Treasury secretary $700 billion to purchase “toxic assets” mainly from investment banks, businesses could not meet their payrolls. The claim wasn’t true. Businesses borrow from commercial banks, not investment banks, to meet payroll. And commercial banks rely mainly on the public’s deposits to lend to businesses. The public would not have stopped making deposits with banks had TARP not passed. Besides, then-Treasury Secretary Hank Paulson didn’t initially use the money for the bill’s stated purposes. But the scare worked to push Congress to vote for the legislation.

More likely Bernanke simply employed the common-sense view of interest-rate determination through the supply and demand for financial assets (interest rates thus being inversely related to the price of financial assets), which is the classical economics view, in contradiction to Keynes, but without consciously intending to be anti-Keynes. Buyers of such assets (IOUs) are the savers while sellers of financial assets are the borrowers. Clearly, many U.S. Treasury bond holders would be inclined to sell them should a default occur. Such selling would reduce their price and thus raise their yield (interest). Therein lies the contradiction of Keynes and the affirmation of the classical principle he denied—namely, that the supply and demand for savings are the principal or permanent determinants of interest rates. Bernanke couldn’t deny the obvious, even as he exaggerated the consequences of a government default.

So what if the U.S. defaulted on its debt obligations and the yield on its debt rose? Must all interest rates rise as a result of the nonzero default risk on Treasuries? Not necessarily. There would simply be a narrowing of the risk premium between U.S. government bonds and other private-sector securities. Treasury securities would lose their default-risk advantage over other securities but retain their liquidity-risk advantage, given the Federal Reserve’s readiness, hence commercial banks’ readiness, to redeem Treasury securities on sight. There is no reason that the default risk of the bonds and stocks of such corporations as Apple, Microsoft, Google, or Walmart should rise just because that of the U.S. government has risen. Thus the yield on private securities may decline (as investors flee Treasuries) while that on U.S. government securities rises, leaving the average unchanged.

Savers are constantly looking for instruments (financial assets) through which they can earn returns on their savings. There may be some diversion of savings into gold, driving up its price further. But investors in gold also know that, like all other commodities, the bubble created by current fears about Treasuries will also burst in due course. Thus the predicted skyrocketing of worldwide interest rates from a possible U.S. government debt default was an exaggeration. If interest rates rise it will be the result of a contraction in the rate of savings worldwide.

Besides, high interest rates, as Hume explained in his 1752 essay, are not necessarily injurious to a high rate of economic growth. It is high interest rates resulting from a contraction in savings that reduce economic growth. One easily can verify this from the level of interest rates in the United States during the economic boom from 2003 to the fall of 2008. The yield on a one-month Treasury rose steadily from 0.91 percent in May 2004 to 5.16 percent in June 2006 while the unemployment rate declined from 5.6 to 4.6 percent. On the other hand, the one-month rate stood at 0.02 percent in June 2011 because of the Fed’s massive injection of credit while the economy has continued to be mired in anemic growth and the unemployment rate has risen to over 9 percent.

Raising taxes to balance the federal budget would not necessarily lower interest rates. Rather, higher taxes would reduce disposable income and thus the flow of savings. The high level of government spending—financed either by debt or high taxes—would put pressure on interest rates to rise. It also would divert more savings from private-sector investments that would otherwise promote sustained employment and economic growth. These are the insights of classical macroeconomics that Keynes failed to appreciate and his modern followers continue to miss.

Current low U.S. interest rates are unsustainable. They are going to rise with or without an increase in the federal government’s debt ceiling. Savers will not forever endure the current negative real interest rates. Cutting federal spending is the surer path to resumption in robust economic growth and reduction in the rate of unemployment. As David Ricardo acutely observed in his 1810 pamphlet, “The High Price of Bullion”:

To suppose that any increased issues of the Bank [of England] can have the effect of permanently lowering the rate of interest, and satisfying the demands of all borrowers, so that there will be none to apply for new loans, . . . is to attribute a power to the circulating medium [money] which it can never possess. Banks would, if this were possible, become powerful engines indeed. By creating paper money, and lending it at three or two per cent. under the present market rate of interest, the Bank would reduce the profits on trade in the same proportion; and if they were sufficiently patriotic to lend their notes at an interest no higher than necessary to pay the expences of their establishment, profits would be still further reduced; no nation, but by similar means, could enter into competition with us, we should engross the trade of the world. To what absurdities would not such a theory lead us! Profits can only be lowered by a competition of capitals not consisting of circulating medium. As the increase of Bank-notes does not add to this species of capital, as it neither increases our exportable commodities, our machinery, or our raw materials, it cannot add to our profits nor lower interest [permanently].

Experience around the world repeatedly has confirmed Ricardo’s warning against the belief in a central bank’s money creation as the engine of economic growth instead of the pursuit of policies that encourage increased private savings.

In response to questions by U.S. Senator Jack Reed (D-RI), Bernanke joined in the chorus of those predicting skyrocketing interest rates in the United States and abroad if the federal government defaulted on its debt obligations because Congress did not to raise the debt ceiling.  It is not a given that the federal government would default if the ceiling were not raised.  But ignoring that fact, Bernanke argued that the “loss of investor confidence [following debt default] could potentially raise interest rates quite significantly.… But if interest rates rise, that’s clearly going to reduce investment, uncertainty will rise, that will reduce the abilityness [sic] of firms to hire and invest.… So I can only conclude that this would be very bad for  — for jobs.”

Did the person supposedly in charge of determining interest rates in the United States through Federal Reserve credit creation really say that?  What was the rationale for QE1 and QE2 (quantitative easing) if not to lower interest rates and promote economic prosperity?  And who inspired that mistaken thinking?  John Maynard Keynes, of course.

What Keynes Argued

Keynes argued in the General Theory (1936) that interest rates are determined by the supply and demand for central-bank money (cash) and not by the supply and demand for savings (or loanable capital), as his predecessors from David Hume and Adam Smith on down to Alfred Marshall  explained.  Therefore, in Keynes’s view, it is the responsibility of a central bank to so increase its supply of money as to depress interest rates to such a low level as to result in the “euthanasia of the rentier, of the functionless investor,” who relies on “the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital” to demand interest payments.  That is, money should become so plentiful that no one would be obliged to pay interest to borrow it.  (Of course, Keynes here confuses money with savings or wealth.)

Indeed, the money (cash) supply-and-demand theory of interest rates was the predominant view among the sixteenth-eighteenth-century Mercantilist thinkers.  It was to correct that mistaken view that Hume, in his essay “Of Interest,” explained that although interest rates may be influenced temporarily by the abundance or scarcity of money, they are permanently determined by the flow of savings relative to their demand:

High interest arises from three circumstances: A great demand for borrowing; little riches to supply that demand; and great profits arising from commerce [hence the desirability of demanding more loans]; And these circumstances are a clear proof of the small advance of commerce and industry, not of the scarcity of gold and silver [money].  Low interest, on the other hand, proceeds from the opposite circumstances: A small demand for borrowing; great riches to supply that demand; and small profits arising from commerce: And these circumstances are all connected together, and proceed from the increase of industry and commerce, not of gold and silver.

Keynes’s Denial

Hume’s elaboration on that point was the basis of subsequent classical writers’ explanation of interest-rate determination by the supply and demand for savings.  Keynes, on the other hand, denied all such explanation and declared in his 1939 Preface to the French edition of the General Theory that, in arguing that interest rates rather are determined by

the demand and the supply of money, that is to say [by] the demand for liquidity and the means of satisfying this demand [he is] returning to the doctrine of the older, pre-nineteenth century economists.  Montesquieu, for example, saw this truth with considerable clarity, — Montesquieu who was the real French equivalent of Adam Smith, the greatest of your [French] economists, head and shoulders above the Physiocrats in penetration, clear-headedness and good sense (which are the qualities an economist should have).

Has Bernanke now abandoned his adherence to Keynes’s money or liquidity supply-and-demand theory of interest rates, or was he merely participating in the debt-default scare to further the federal government’s agenda of raising the debt ceiling to accommodate its profligate spending?

After all, Bernanke also acknowledged to Senator Reed that besides the Chinese, the Fed is “the largest holder of our Treasury debt.”  Why wouldn’t the Fed simply cancel the Treasury’s debt and purchase some more to save the federal government from its predicted default?  To support the political-posturing view of Bernanke’s statements, one could legitimately cite his similar proclamations in fall 2008 that without Congress’s passage of TARP (Troubled Assets Recovery Program), giving the Treasury secretary $700 billion to purchase “toxic assets” mainly from investment banks, businesses couldn’t meet their payrolls.  The claim wasn’t true.  Businesses borrow from commercial banks, not investment banks, to meet payroll.  And commercial banks rely mainly on the public’s deposits to lend to businesses.  The public would not have stopped making deposits with banks had TARP not passed.  Besides, the Treasury secretary, Hank Paulson, did not use the funds immediately for the purpose the bill was passed.  But the scare worked to push Congress to vote for the legislation.

Common Sense

More likely, Bernanke simply employed the common-sense view of interest-rate determination through the supply and demand for financial assets (interest rates thus being inversely related to the price of financial assets), which is the classical economics view, in contradiction to Keynes but without consciously intending to be anti-Keynes.  Buyers of financial assets (IOUs) are the savers while sellers of financial assets are the borrowers.  Clearly, many U.S. Treasury bond holders would be inclined to sell them should a default occur.  Such selling would reduce their price and thus raise their yield (interest).  Therein lies the contradiction of Keynes and the affirmation of the classical principle he denied, namely, that the supply and demand for savings are the principal or permanent determinants of interest rates.  Bernanke couldn’t deny the obvious, even as he exaggerated the consequences of a government default.

So what if the U.S. defaulted on its debt obligations and the yield on its debt rose?  Must all interest rates rise as a result of the nonzero default risk on Treasuries?  Not necessarily.  There would simply be a narrowing of the risk premium between U.S. government bonds and other private sector securities.  Treasury securities would lose their default-risk advantage over other securities but retain their liquidity-risk advantage, given the Federal Reserve’s readiness, hence commercial banks’ readiness, to redeem Treasury securities on sight.  There is no reason why the default risk of the bonds and stocks of such corporations as Apple, Microsoft, Google, or Walmart should rise just because that of the U.S. government has risen.  Thus the yield on private securities may decline (as investors flee Treasuries) while that on U.S. government securities rises, leaving the average unchanged.

Savers are constantly looking for instruments (financial assets) through which they can earn returns on their savings.  There may be some diversion of savings into gold, driving up its price further.  But investors in gold also know that, like all other commodities, the bubble created by current fears about Treasuries would also burst in due course.  Thus the predicted skyrocketing of worldwide interest rates from a possible U.S. government debt default is an exaggeration.  If interest rates rise, it would be the result of a contraction in the rate of savings worldwide.

High Interest Rates and Economic Growth

Besides, high interest rates, as Hume explained in his 1752 essay, are not necessarily injurious to a high rate of economic growth.  It is high interest rates resulting from a contraction in savings that reduce economic growth.  One easily can verify this from the level of interest rates in the United States during the economic boom from 2003 to the fall of 2008.  The yield on a one-month Treasury rose steadily from 0.91 percent in May 2004 to 5.16 percent in June 2006 while the unemployment rate declined from 5.6 to 4.6 percent.  On the other hand, the one-month rate stood at 0.02 percent in June 2011 because of the Fed’s massive injection of credit while the economy has continued to be mired in anemic growth and the unemployment rate has risen to 9.2 percent.

Raising taxes to balance the federal budget would not necessarily lower interest rates.  Rather, higher taxes would reduce disposal income and thus the flow of savings.  The high level of government spending — financed either by debt or high taxes — rather would put pressure on interest rates to rise.  It also would divert more savings from private-sector investments that would otherwise promote sustained employment and economic growth.  These are the insights of classical macroeconomics that Keynes failed to appreciate and his modern followers continue to miss.

Current low U.S. interest rates are unsustainable.  They are going to rise with or without an increase in the federal government’s debt ceiling.  Savers will not forever endure the current negative real interest rates.  Cutting federal spending is the surer path to resumption in robust economic growth and reduction in the rate of unemployment. As David Ricardo in his 1810 pamphlet, “The High Price of Bullion,” acutely observed:

To suppose that any increased issues of the Bank [of England] can have the effect of permanently lowering the rate of interest, and satisfying the demands of all borrowers, so that there will be none to apply for new loans, … is to attribute a power to the circulating medium [money] which it can never possess.  Banks would, if this were possible, become powerful engines indeed.  By creating paper money, and lending it at three or two per cent. under the present market rate of interest, the Bank would reduce the profits on trade in the same proportion; and if they were sufficiently patriotic to lend their notes at an interest no higher than necessary to pay the expences of their establishment, profits would be still further reduced; no nation, but by similar means, could enter into competition with us, we should engross the trade of the world.  To what absurdities would not such a theory lead us!  Profits can only be lowered by a competition of capitals not consisting of circulating medium.  As the increase of Bank-notes does not add to this species of capital, as it neither increases our exportable commodities, our machinery, or our raw materials, it cannot add to our profits nor lower interest [permanently].

Experience around the world repeatedly has confirmed Ricardo’s warning against the belief in a central bank’s money creation as the engine of economic growth instead of the pursuit of policies that encourage increased private savings.

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.

That was then. Today, according to a federal prosecutor, a “terrorist” can be someone who privately creates and circulates a silver coin adorned with the dollar sign and denominated in dollar amounts but has a metallic value far above its face value. In fact, the coin in question was similar to the silver dollars that once circulated regularly in this country but have since disappeared. The prosecutor, Anne Tompkins, declared:

Attempts to undermine the legitimate currency of this country are simply a unique form of domestic terrorism. While these forms of anti-government activities do not involve violence, they are every bit as insidious and represent a clear and present danger to the economic stability of this country. We are determined to meet these threats through infiltration, disruption, and dismantling of organizations which seek to challenge the legitimacy of our democratic form of government.

This dastardly act of “terrorism” was committed by 67-year-old Bernard von NotHaus, who recently was convicted in federal court in North Carolina by a jury that deliberated for under two hours. He faces the rest of his life in prison for minting and circulating the Liberty Dollar. The Asheville Citizen notes: “The government also is seeking the forfeiture of about 16,000 pounds of Liberty Dollar coins and precious metals valued at nearly $7 million.”

It is sheer nonsense that von NotHaus engaged in behavior that is a “clear and present danger to the economic stability of this country.” But that’s a good description of Ben Bernanke, chairman of the Federal Reserve.

As one who remembers when the Johnson administration announced in 1965 that it no longer would make silver dimes, quarters, half-dollars, and dollars (replacing them with the infamous “sandwich” coins), I can say the charge that creating a silver coin undermines the U.S. economy is a howler. From QE1 and QE2 (quantitative easing) to the Fed’s inflation targets, if anyone has broken the very spirit of the act that will send Bernard von NotHaus to prison, it is Bernanke.

If von NotHaus did anything, he exposed the sorry fact that the U.S. government’s currency is hopelessly debased. If that is terrorism, then anyone who openly criticizes the monetary system is a terrorist. One wonders if prosecutors like Tompkins think the next level of terrorism prosecution is to go after those critics.

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.)

Yet some data and sound theory, which take into account more than simple macroeconomic aggregates—higher GDP good, lower GDP bad—indicate that the U.S. economy has not fully recovered. The official unemployment rate is still over 9 percent, private long-term investment remains at low levels, and even GDP growth has been weak, in spite of the great increase in government spending for final goods and services (which adds directly to GDP, defined as consumption plus investment plus government spending plus net exports).

The weak recovery is clearly recognized by policy-makers, who have advocated and implemented additional fiscal and monetary stimulus by the Obama administration and perhaps the Federal Reserve. They seem to take for granted that an unexpectedly slow recovery requires even more expansionary government policies to keep the economy on track.

The slow recovery from the recession presents an analytical challenge, provoking debate among macroeconomists and pundits. As usual, there are many diverse explanations, some complementary, some contradictory. To an important extent these divergences reflect different conceptions of the business cycle. I will describe and briefly analyze four of the most common explanations.

The Keynesian Story

Let us start with the Keynesian story, filtered through the writings of Paul Krugman. (There are much more nuanced versions of Keynesianism than Krugman’s.) In his weekly column and popular blog at the New York Times, Krugman declares that the slow recovery and the persistence of high unemployment arise from a “lack of aggregate demand,” which is the main cause of the poor sales by private businesses and hence of the high unemployment rate.

In his characteristic self-confident argumentative style, Krugman asserts, “Businesses aren’t hiring because of poor sales, period, end of story.” This sentence is followed by a graph showing a substantial increase since late 2008 in the percentage of small businesses that named “poor sales” as their “single most important problem.” The remedy for this malaise is, of course, more public spending: “[T]he best thing government could do to help business would be to spend more, increasing demand.”

However, as many economists have written in recent years, Krugman’s focus on aggregate demand is simplistic, to say the least. First, one needs to ask, why is the growth of aggregate demand so weak? It may very well be that spending less and saving more is a healthy reaction to the previous unsustainable boom. Thus weak demand might be an inevitable consequence, not the deep cause, of the current bust.

Furthermore, what particular parts of the economy—which markets or industries—suffer most from low sales? As Austrian economists argue, we need to disaggregate the macroeconomic picture to understand what is going on. Nevertheless, such disaggregated analysis does not seem to be important for some Keynesians, such as Krugman and Brad DeLong. In November 2009, DeLong wrote, “At this point, anything that boosts the government’s deficit over the next two years passes the benefit-cost test—anything at all.”

The Monetarist Story

The monetarist story of Milton Friedman’s followers is usually presented as the free-market alternative to the Keynesian interpretation. However, these explanations have important though subtle points in common.

In simple terms the monetarist thesis focuses mainly on sudden bank credit contraction. Monetarists argue that the accumulation of vast amounts of excess reserves by banks—which basically means that instead of lending money to the private sector, they are keeping it to themselves—has negative effects for the whole economy. Given that credit is usually considered the economic equivalent to the human body’s blood circulation, a credit contraction is seen as invariably dangerous. If a person suffers a sudden loss of blood, the cure would be to inject blood into him. The same cure applies to credit, the monetarists claim.

Economists from this perspective usually refer to how the velocity of money—the average frequency with which a unit of money is spent in a specific period—collapsed in the second half of 2008. To compensate for this reduction, monetarists recommend an expansionary monetary policy by the central bank.

Although one might think that Fed Chairman Ben Bernanke’s strategy has been to respond precisely in this way, some economists, such as Scott Sumner, argue otherwise. Sumner claims the Fed’s monetary policy since the end of 2008 has actually been contractionary relative to what the economy needed at that time. Bernanke should have been more aggressive, Sumner argues, to avoid the contraction of nominal GDP that finally occurred.

This explanation suffers from several problems, similar to the shortcomings of the Keynesian story: (1) excessive aggregation of key concepts—making extensive use of GDP as the key indicator of the cycle does not allow the monetarists to explain the crux of the matter, which is the real microeconomic distortions in the productive structure of the economy that had been created during the boom; (2) the analysis of the crisis and the sharp credit contraction as exogenous shocks, rather than consequences of the previous unsustainable credit expansion. From Sumner’s point of view, it seems that the fall in nominal GDP was something to be avoided.

The Austrian Story: The Adjustment Problem

For economists drawing on the Austrian story, GDP contraction was a symptom of the bust, the inevitable hangover after a credit spree that led to bad decisions—malinvestments and excessive leverage. As the Austrian business cycle theory emphasizes, the economy has to go through a process of adjustment that cleanses the massive errors resulting from economic decisions taken in the past. This restructuring involves not only reallocating factors of production (capital and labor), but also reducing debt a significant amount (deleveraging), which has contractionary effects on demand and aggregate economic activity.

This consideration leads to the first element of the best explanation for the prolongation of the recession: the fact that the necessary adjustment process has not been completed. As a recent report by the Bank for International Settlements (BIS) concludes, the debt reduction of private economic agents still has a long way to go. But as the Spanish economist J. R. Rallo argues, keeping interest rates extremely low for a prolonged period, as the Federal Reserve has, creates incentives for people not to reduce debt and adjust to the new circumstances. Moreover, government “stimulus” policies may have made things worse by massively increasing federal government debt.

Furthermore, the necessary reallocation of the factors of production—both intersectoral (from sectors overexpanded during the bubble to sectors that will yield higher profits in the future) and intrasectoral (among different products and services in the same sector) may take a long time, especially in the labor markets. Apart from the fact that the adjustment in relative prices and wages may take longer than desirable because of rigidities, there are additional issues worth considering.

Research on markets with search frictions—which won Peter Diamond, Dale Mortensen, and Christopher Pissarides the 2010 Nobel prize in economics—may fit in this context. For several decades mainstream neoclassical economists have depicted the market as a mechanism that perfectly and instantaneously coordinates supply and demand. The Nobel laureates, however, have emphasized that economic agents often have to spend time and resources in making that adjustment (search frictions). Moreover, finding satisfactory employment for people who have just lost jobs may require the acquisition of substantially different skills and capabilities. The features of this process depend on the degree of specificity and complexity of the economy’s capital structure. Thus not only physical capital but also human capital has to go through an adjustment process. All this takes time.

Regime Uncertainty

The second main piece of the puzzle of the recession’s duration is the “regime uncertainty” argument formulated by Robert Higgs. He first elaborated this concept to explain why the Great Depression lasted so long, finding that the Roosevelt administration, with its constant attacks (in rhetoric and in policies) on the free-enterprise system and its threats to private property, was largely responsible for the failure of long-term private investment to recover fully until World War II ended.

Not surprisingly, in a series of commentaries since 2008, Higgs has found parallels in the Obama administration’s actions and in the stagnant private investment that help to explain why sustained economic recovery has not yet taken place.

Higgs points to several particular causes: the surge in the federal deficit and debt; the likely introduction of new taxes to finance the recent massive public spending, or changes in existing tax rules; the potential burdens on businesses brought about by environmental and energy regulations; and the still uncertain real effects of Obamacare and the new financial regulatory framework.

Problems related to the adjustment process, along with the existence of regime uncertainty, might form a relatively complete explanation of why the U.S. economy is still suffering from the Great Recession, complementing the analysis expressed in the Mises/Hayek business cycle theory.

The importance of this debate, and how current economic events are interpreted, can hardly be exaggerated. As economist Mario Rizzo has noted, the resolution of this puzzle “will affect economics and public perceptions for a long time to come,” just as the debate between Hayek and Keynes in the 1930s had profound (and unfortunate) consequences for the future of the economics discipline. Let us hope that the outcome will be different this time.

Krugman and many other economists believe that the government is much too stingy and that what it needs to do is not cut back on spending and borrowing but rather throw the spending levers full forward. I present their views (as fairly as possible) and then look at them from another perspective.

The Keynesians – including Krugman – hold that the key to recovery is spending, increasing “aggregate demand” to move our economy out of an alleged “liquidity trap.” (A “liquidity trap” is a special situation, according to Keynesians, in which interest rates are near zero and people are holding money and not spending it. The way to bust out, say Keynesians, is for governments to borrow and spend in order to give the economy “traction.”)

Furthermore, with Ben Bernanke at the Federal Reserve System claiming that the Fed needs to find creative ways to ratchet up the rate of inflation to at least match “target” rate of 2 percent, we have the supposed experts claiming that inflation is the magic carpet to prosperity and full employment.

The thinking behind such policy prescriptions is this: Inflation will lead individuals and businesses to spend now, which supposedly will clear the inventories and convince producers to make more goods to put on the shelves. Further inflation will encourage people to continue spending, and the process will go on indefinitely. According to Krugman and others, this will give the economy traction, and from there the spend-produce-spend machine will grind along.

No Perpetual Motion

Excuse me if I differ with this assessment. First and most important, a surge of new money, while encouraging people to spend now, will not result in the economic perpetual motion that inflation advocates predict. What is more likely is that producers will gladly sell their current inventories, but they also would recognize the rush of spending as temporary at best.

The problem is that the new money injected into the system will not encourage longer-term capital investment, and why should it? Unlike the producers in economists’ mathematical models, which assume that firms automatically invest in new capital when spending increases, people in the real world are living, breathing, and thinking entities who actually observe economic conditions.

Second, with the hostile rhetoric against businesses coming from the Usual Suspects in Washington and in the media, the climate amenable to long-term investment simply is near nonexistent. Economist Robert Higgs writes that the current political environment is fraught with “regime uncertainty”: Entrepreneurs and capitalists are unwilling to commit resources long-term if the government is likely to confiscate them or create an economic climate so hostile that profitability is impossible.

As Henry Hazlitt wrote, with inflation the “good effects” come first and the bad effects follow. In the beginning people have more money in their pockets, and they purchase things at prices that existed before the surge of new money. It looks as though prosperity has returned.

However, as more and more money is pumped into the economy, not only do prices go up but so do inflationary expectations. Long-term capital investment is jettisoned for assets that will increase in value relative to money during inflation, and in the end the economy is mired in both higher prices and higher unemployment.

Hazlitt likened inflation to the “Dead Sea Fruit,” which “turns to ashes” in one’s mouth. Unfortunately, the most “brilliant” minds are demanding we harvest and eat this fruit, and when it turns to ashes they will blame businesses and free markets. They always do.

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?

Posner describes well-known events—the failure of investment banks Bear Stearns and Lehman Brothers, the series of bailouts by the Treasury and the Federal Reserve, the stimulus package passed by Congress—then tries to explicate the causes of the crisis. His account, unfortunately, merely hews to current conventional wisdom.

Here’s a capsule version: Deregulation of banks combined with cheap and easy credit to cause interlinked debt and real estate bubbles. “Free market ideology” left banks and other financial firms free to take huge risky bets on mortgages, which they did. In 2007–08 the twin bubbles collapsed, resulting in a steep downturn in economic activity. The government had to shore up the system with extraordinary measures. The long-term solution is more government action to restrain and supervise financial institutions, although Posner would wait until the dust settles before reregulating.

It’s true that some household borrowing was channeled to risky instruments like adjustable-rate mortgages and much of the lending by banks was turned into complex securities backed by debt. When property prices declined and foreclosures spread, the values of these securities also declined, decimating bank balance sheets. But all that is a consequence not a cause of the trouble.

At the heart of the story is the ready availability of credit that fueled excessive borrowing and lending. Posner describes how the Fed flooded the economy with money in the early 2000s in response to the collapse of the previous bubble in stocks. However, he claims that even without the Fed’s loose monetary policy, an alleged global capital surplus brought in enough money from abroad to keep interest rates low.

That claim is dubious. Yes, Asians saved a lot, but other people, notably Americans, saved relatively little. In the world as a whole there was no surge in saving to drive down interest rates. It was the Fed’s easy money that pushed markets into a credit binge.

Posner’s line is that “Laissez-faire capitalism failed us, but government allowed the preconditions of depression to develop and wreak havoc with the economy.” He discusses the Federal Reserve’s culpability for the crisis, granting that it “would be a powerful argument against re-regulation,” but places more blame on that hobgoblin, “free market ideology.” The “free market” canard requires one to ignore that the United States hasn’t had anything close to a free financial market in a century.

Major mistakes by experts pose a challenge for Posner’s way of looking at behavior. For example, he describes Fed Chairman Ben Bernanke’s neglect of the warning signs of an impending crash as “extremely puzzling.” As a proponent of neoclassical economics, Posner assumes that people act rationally in the sense of making the best choices in view of all available information. And the Fed must be even more rational than the rest of us.

Another academic tribe, behavioral economists, attributes the crisis to human quirks like herding or imitation. Posner rejects those explanations on the ground that such behavior is not really irrational. On regulatory issues, however, he does not differ from behavioral economists who assume that government experts are trustworthy because they’re better informed than the general population.

Long before the currently fashionable behavioral school emerged, F. A. Hayek criticized the neoclassical rationality premise but came to a different conclusion from today’s proregulation behavioral economists. He found that government agents possess less wisdom than the market, which pools the knowledge of many individuals. The “fatal conceit” (as Hayek put it) that government knows better has resulted in economic disasters ranging from the Soviet Union to the Federal Reserve’s destabilizing policies.

Now the Fed is to become an even more powerful regulator of vaguely defined “systemic risk.” Posner grasps that “The successive Federal Reserve chairmanships of Greenspan and Bernanke must be reckoned prime causes of the financial crisis,” but even so agrees with President Obama that more government intervention is needed.

As a reform, Posner advocates the consolidation of agencies like the Securities and Exchange Commission into one top regulator along the lines of Britain’s Financial Services Authority. He appears oblivious to the fact that this authority with its overarching powers did not save Britain from financial crisis.

This highlights the book’s great flaw: Posner clings to the myth of benign government rationalism.

To be sure, financial firms leveraged up—that is, they did a lot of business with borrowed money. That juiced up revenues and bonuses in the boom—and exacerbated losses in the downturn. Selling notes based on questionable mortgages as collateral was one method for tapping into the money sloshing around.

Without abundant credit, it would not have been possible to borrow so much and in so many different ways. Banks create credit but are subject to myriad controls by the Federal Reserve System. Money was plentiful because of Fed policy.

Politicians, pundits, and the Obama administration want to impose new regulation on the financial system, giving wider powers to government agencies. Depending on how and to what extent they implement that agenda, the Federal Reserve—alongside other agencies like the Securities and Exchange Commission—stands to gain greater authority. Hence the Fed’s track record is a timely and pertinent subject.

Although the institution now commands unquestioning acceptance, its inception was controversial. Richard Timberlake, in his history of monetary policy in the United States, quotes a congressman shortly after the 1913 passage of the law that created the Federal Reserve System: “This act establishes the most gigantic trust on earth, such as the Sherman Antitrust Act would dissolve if Congress did not by this Act expressly create what by that Act it prohibited.”

That gigantic trust has correspondingly gigantic effects on the economy, through multiple roles and powers. As overseer of ordinary banks the Fed makes sure they play by the rules. As lender of last resort it can keep banks going through cash-flow problems. Beyond its supervision of individual banks the Fed pursues economy-wide goals.

It operates various levers that reduce or expand the supply of money and credit. In what is generically called monetary policy, the Fed uses the levers to boost a drooping economy—as is happening at present—or cool down an overheated one. In theory those efforts benefit society at large.

In reality—well, let’s take a look at the 1930s and our own time to understand the Fed’s role in the two most dramatic financial crises of living memory.

Stability Found and Lost

Two seminal insights emerged from the path-breaking A Monetary History of the United States, 1867–1960 (1963) by Milton Friedman and Anna Schwartz. They argued that the Federal Reserve worsened the banking collapse of the 1930s and probably killed off a potential recovery by tightening money. In reaction to a drain on U.S. gold reserves, the Fed clamped down on an already shrinking money supply, thereby turning an ordinary recession into what came to be known as the Great Depression.

Current Fed Chairman Ben Bernanke agrees with that conclusion and is certainly not repeating the mistake. He has eased money in every way it can be eased.

But Friedman and Schwartz offered a broader lesson as well. They showed that the stock of money became subject to greater fluctuations after the Fed took over the control of money from the gold standard system. “The blind, un-designed, and quasi-automatic working of the gold standard turned out to produce a greater measure of predictability and regularity—perhaps because its discipline was impersonal and inescapable—than did deliberate and conscious control exercised within institutional arrangements intended to promote monetary stability,” Friedman and Schwartz wrote.

By the late twentieth century it looked as though central bankers had taken this criticism to heart. They had reason to congratulate themselves on what was called the Great Moderation. Since the mid-1980s both prices and output growth had been reassuringly stable. In a 2004 speech Bernanke argued that this was primarily due to improved monetary policy, although economic change and plain old luck also may have played a role, too.

At that time Bernanke was not yet Fed chairman, but he was a member of the board of governors, a position he held from 2002 to 2005. Current Treasury Secretary Tim Geithner was president of the New York Federal Reserve Bank from 2003 until this year. These facts are worth recalling because there is a tendency to concentrate the blame on former chairman Alan Greenspan. But whatever one thinks of Greenspan, the officials who currently make policy were there with him as the Fed sowed the seeds of financial crisis.

In retrospect those seeds were already discernible in the late 1990s. The steep rise in housing prices had started, encouraged by a stock bubble that created the illusion of wealth. In 1998 the Fed eased interest rates several times in response to panic after Russia defaulted on its bonds and the related near-failure of a large hedge fund, Long-Term Capital Management. This policy reassured investors, who subsequently bid up share prices to the stratosphere in 1999 even as the Fed reversed course.

The stock bubble burst in early 2000, and the economy stalled. Interest-rate cuts are prescribed and expected in a recession, so it is no surprise that the Fed took that course. But even after the economy recovered, rates stayed exceptionally low in comparison to what they would have been by the standard of the Great Moderation.

Stanford University economist John Taylor has used a measure known as the Taylor Rule to demonstrate that monetary excess lasted several years, into 2006. The title of Taylor’s new book says it all: Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis.

Not everybody agrees that monetary policy was loose during the Greenspan era. David Henderson and Jeffrey Rogers Hummel argued in the March issue of The Freeman that monetary policy was not expansionist from 2001 to 2006 as measured by the declining growth of monetary aggregates. The Taylor Rule, however, allows the comparison of two periods—and the federal funds rate was lower in the 2000s than in the 1980s.

Another explanation of the monetary excess, endorsed by Bernanke and Greenspan, is that there was a global glut of savings. But Taylor shows that worldwide there was no such glut because the surplus savings in Asia and the Middle East were offset by a savings gap in other countries, in particular the United States.

It is fair to say that most of us partook of the Fed’s generous punch, whether by running up credit-card debt, buying houses beyond our means, trading with borrowed money, or making 30 percent on exotic debt instruments. Monetary excess meant that borrowing was easy; mortgages were to be had for a song. Housing prices rose at amazing rates year after year. With the hazard of price declines out of sight and out of mind, homeowners, developers, and banks overextended themselves.

It was an extraordinary boom; hence the following bust was also extraordinary. In effect, the stability of the 1980s Great Moderation was over by the time Bernanke credited monetary policy for fostering that stability.

What Failed

The bubble-and-collapse sequence is now attributed to a failure of capitalism, to use the title of a new book by Richard Posner, a judge and prolific author. According to a widely held view, the private financial system is intrinsically unstable, with leverage a central element in its penchant for self-destruction. Had the system been properly regulated and restrained, it would not have gone haywire. Hence whatever is not sufficiently regulated should be nailed down to avoid similar disasters in the future. Much of the media reflects that view.

And yet the Fed and the Securities and Exchange Commission (SEC) between them already have massive regulatory powers over banks and broker-dealers, including investment banks. What is more, they and other agencies were part of the President’s Working Group on Financial Markets, set up after the crisis of 1998 to deal with systemic risk—the kind of danger that came up so frequently in 2007–2008.

Despite all the regulatory powers, a crisis broke out. Posner may represent current conventional wisdom when he writes that the government’s myopia, passivity, and blunders played a critical role in allowing the recession to balloon, but there would have been a crisis anyway regardless of those shortcomings.

The alternative view, represented by Taylor (following in the footsteps of Ms. Schwartz and the late Mr. Friedman), is that monetary policy turned what might have been mild cyclical fluctuations into a big bubble, inevitably leading to a big collapse. No easy money, no crisis.

Regarding the central bank’s multiple functions, its stance in the supervision of individual banks appears to have been of a piece with its broader policy. The Fed as overseer of banks could have demanded that they reduce their use of leverage, but the Fed as maker of monetary policy was providing the wherewithal for that leverage.

Hence the let-them-leverage regulatory stance was not accidental or myopic; it was consistent with deliberate monetary policy. If policymakers were concerned about the galloping credit expansion, they should not have let money go loose in 2003–2006. Lacking such concern, the Fed had no reason to get banks to reduce their risk. The whole institution took this track, not just Alan Greenspan.

Controlling or Creating Risk?

There’s no question private action results in economic cycles, largely because human beings have mental biases that keep them focused on the near term. The key point, though, is that even the largest private actor does not have the impact of the gigantic banking trust. Monetary policy is system-wide; policy mistakes have ramifications across the economy.

So the Fed by itself can create systemic risk, even as people call for expanding its powers to control the systemic risk posed by market participants like banks and hedge funds.

The Fed actively implemented measures that destabilized the system in the 1930s and again in the 2000s, albeit in different ways. The mistake was different—back then the Fed tightened in a downturn; this time it kept money too loose in an upturn. But there was the same fundamental consequence of financial and economic instability.

Timberlake thus summarized the Federal Reserve’s track record: “It comes across as a prototypical governmental institution operating under the rule of men rather than the rule of law.” To prevent misguided monetary interventions, the discretion of the people who run the institution should be limited.

Friedman argued for rule-based monetary policy, specifically that the Fed should follow a rule to keep the money supply growing steadily at a fixed rate of 3 to 5 percent a year. This turned out to be difficult to implement, given that the money supply and its relation to the economy are complicated.

This is where the Taylor rule, which describes actual policy during the Great Moderation, comes in. Taking that policy as a template, the Fed can set the short-term interest rate in accordance with a constant formula based on inflation and output.

Compared to Friedman’s fixed rate, the formula is more flexible.  But it keeps interest-rate policy predictable and transparent. If followed consistently, rule-bound monetary policy, combined with proper enforcement of existing regulations for banks and broker-dealers, would prevent the excesses seen in recent years.

Government Intelligence and the Nirvana Fallacy

Instead, what’s being advocated is broader activity by policymakers. Posner, for instance, draws the conclusion that “we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails.” It is interesting that he sees a need not just for more-active government but more intelligent government. If government action has not been intelligent in the past, why expect it to be intelligent in the future?

We’re talking about institutions with overarching powers that have caused a variety of harms, from deliberate Fed policies that created instability to the SEC’s inability to detect fraud even after being told about it, misleading investors into believing that all was well with Bernard Madoff. (See my May Freeman article on the Madoff case) If there is more government activity of this sort, there will be even worse disasters.

One way to prevent another round of government-made debacles would be to replace the central bank with market-based money, thereby imposing an impersonal discipline—to use the words of Friedman and Schwartz. But following the Taylor Rule is a more likely solution, since it serves the goal Fed officials themselves say they want to pursue, namely, more predictable and transparent policy.

Those calling for greater interventionism tend not to engage the issue of what the government does in reality. There is a presumption that regulation is the cure-all, even as we live through the effects of a systemic policy failure. Economist Robert Solow, in a review of Posner’s book, writes that Panglossian ideas about “free markets” encouraged lax or no regulation of a potentially unstable financial apparatus.

When you consider the actual role of the Federal Reserve in crises, it is the notion of government activism as the solution to financial uncertainty and fluctuations that comes across as Panglossian.