This summer marked the 40th anniversary of President Richard M. Nixon’s decision to sever the U.S. dollar’s official link to gold. On August 15, 1971, Nixon took to the airwaves in a national address from the Oval Office to declare that the U.S. Treasury would no longer honor foreigners’ demands to redeem dollars for gold. Because the United States was then the last country in the world with a currency defined by gold, it represented a complete and historic decoupling of the globe’s currencies—literally the money of the entire world—from the yellow metal.

For the first time in at least 2,700 years, dating to the Lydian coinage in what is now Turkey, gold was used as official money nowhere in the world. And for the first time ever the world’s monetary affairs were defined by a system of politically managed fiat currencies—that is, paper money run by governments or their central banks. The story behind Nixon’s catastrophic mistake, and the lessons it contains for today, suggest a framework for monetary policy and reforms that will induce strong and sustainable economic growth in the future.

It is important to understand what many current central bankers seem to have forgotten: the seminal importance of sound money—dependably valued, honest money whose value is not intentionally manipulated—as an institution in a modern exchange economy. Economies grow, and material wealth and welfare advance, through three interconnected phenomena, all of which are crucially supported by a well-functioning monetary unit: 1) efficient use of scarce resources via a system of prices and profit-and-loss, both of which encourage optimizing behavior on the part of all; 2) saving and the accumulation of capital for investment; and 3) the division of labor, specialization, and trade.

Regarding the last phenomenon, we would all be poor, and indeed most of us dead due to starvation, if we had to make and produce all our own food, housing, clothing, and other necessities and modern luxuries. As Adam Smith explained in his famous examination of a pin factory, dividing up the metal-straightening, wire-cutting, grinding, pin-head fashioning, and fastening and bundling operations into 18 separate steps increased the productivity of labor in the factory by at least 240-fold. (This of course dramatically increased productive output and raised workers’ real incomes.) And of course for society at large this specialization was not confined to single factories but spread across industries and agriculture: The baker, the butcher, the brewer, and the cobbler could all focus on their productive specialties and produce for a market wherein they could exchange with other specialists for desired goods.

Via economies of scale and scope, then, specialized production and exchange help to create a material horn of plenty for all in a society that’s felicitously based on peaceful, harmonious social cooperation. And here’s the key: None of this would be possible without a dependable monetary unit that serves as a medium for this exchange. Absent sound money, in fact, a division of labor, with all its specialized knowledge and skills, could hardly be exploited, because barter would mean that, say, a neurosurgeon would have to find a grocer who coincidentally needed brain surgery every time he wanted to obtain food. A barter society is by definition a primitive and poor one.

Similarly, the explosion in human progress in the last three centuries was propelled by the accumulation of capital, the tools, machinery, and other assets that increase per capita output and dramatically increase living standards. And here again, a well-functioning monetary unit facilitates the saving that allows for capital accumulation: Income need not be consumed immediately but can be transferred to others to invest productively in return for future payment streams. Sound money, in short, greatly enhances wealth-creating exchange and transfer of resources between present and future, and in doing so often assists in the development of higher output capacity in the future.

There is a third crucial way in which sound money serves to advance civilized human progress: By providing a common denominator for the expression of all exchange prices between goods, money greatly facilitates trade among all parties, thus extending the breadth of markets as far as money’s use itself, which in turn intensifies the division of labor that increases productive output and per capita incomes. Think about it: Without a monetary unit of account there would be an infinite array of prices for one good against all other goods; for example, the bread-price of shoes, the book-price of apples, and so on. In turn, calculation of profit and loss, on which effective use of scarce resources so critically depends, would be impossible.

In sum the institutional development and use of money has been an immense human achievement, every bit as important as language, property rights, the rule of law, and entrepreneurship in the advancement of human civilization. And it is important to note that while several commodities were tried as monetary exchange media over the centuries, from fish to cigarettes, the precious metals and especially gold were seen to be most effective, as they are valuable, highly divisible, durable, uniform in composition, easily assayable, transportable, and bear high value-to-bulk, along with being relatively stable in annual supply. In short, in an ever-changing world of imperfection, gold has been found to be a near-perfect, and certainly dependably valued, form of money.

Money, International Trade, and Economic Growth

To understand much about our current economic challenges and what to do to meet them, it is important to understand why gold, after several centuries of trial and error, came to be seen as sound money versus paper, other commodities, and even silver. The term sound money is especially important to grasp: It is meant to describe a reliable, dependably valued medium of exchange and account, not subject easily to manipulation, which can therefore effectively perform the three functions of money described above, all of which lead to prosperity and an advancing economy. This is critical for a civilized society whose economy is based on monetary exchange, because money is literally one-half of every transaction. So when the value of the monetary unit is volatile—when money becomes more or less unsound—it changes the intended terms of trade between parties, especially when that transaction involves exchange between present and future, as in capital investment. This in turn can cause such exchanges to break down or lead to distortions in trade that bring malinvestment of assets and waste of scarce resources.

No better illustration of this can be seen than in the German hyperinflation of 1923. German war reparations mandated by Versailles had so burdened the German economy that the German government took literally to printing the currency known as the papiermark in massive quantities. This rapidly depreciated the value of the currency until in the fall of 1923 workers were paid in wheelbarrows of cash twice daily. The velocity of spending skyrocketed, as workers immediately rushed to trade the quickly worthless paper money for anything of tangible value, buying commodities they often did not need. Saving and investment were stunted, price inflation soared out of control, and civil society lurched toward a complete breakdown by the end of 1923, when $1, which had bought 5.21 marks in 1918, now bought 4.2 trillion of them.

Seen another way, the German hyperinflation is an example of a “virus” infecting the economy, distorting prices in every transaction, every entrepreneurial investment decision, and the value of every bank account. Every calculation of profit and loss was changed in real terms as well, thus causing resources to be inefficiently used or traded—that is, wasted. While the harm caused by unsound money is usually less than what occurred in 1923 in Germany, it was no less real in a 1970s-style inflation, a 1930s-style deflation, or a 2000s-style housing bubble fueled by falsified interest rates thanks to the Fed’s over-creation of money.

Conversely it was sound money, based on the international gold standard, that greatly impelled the fantastic rise in living standards across the nineteenth century in many parts of the globe. Gold as a common medium facilitated dramatic increases in trade and the international division of labor. With a dependably valued international medium of exchange and unit of account, long-term investment could be undertaken, and ever-increasing volumes of mutually profitable trading developed between nations, increasing jobs, output, and living standards dramatically. The century up to 1914 was a golden age of prosperity and harmony among nations, and while not devoid of all war, recessions, or panics, it was comparatively more peaceful and productive than any other period in human history.

The Rise of Central Banking

While the Bank of England was created in 1694, the United States did not get a central bank until the creation of the Federal Reserve System in 1913; by 1935, with the creation of the Bank of Canada, all modern nations had central banks. In theory a central bank, through monopoly banknote issue and effective control of a nation’s money supply, serves as a stabilizing influence in an economy by acting as a banker’s bank, a lender of last resort providing liquidity in panics, and a regulator of commercial banks and thus governor of their excesses. (However, in a recent exhaustive study, economists George Selgin and William Lastrapes of the University of Georgia and Lawrence White of George Mason University show that recessions were shorter and less severe, inflation and unemployment lower, and economic growth stronger and more durable in the century before 1913 than since the Fed’s creation). At the least, the central bank’s mandate included—and seemed to assure—maintenance of the value of the currency.

Beginning with World War I, and continuing through the Great Depression and World War II, the links to gold were for the most part effectively severed from most nations’ currencies, including the U.S. dollar. In the summer of 1944 economists (led by John Maynard Keynes and Harry Dexter White) met at Bretton Woods, New Hampshire, to design a postwar monetary system conducive to international trade. The resulting mechanism, known as the gold-exchange standard, tried to resurrect the beneficial aspects of the nineteenth century’s classical gold standard and lasted until Nixon scrapped it in 1971. In short the Bretton Woods agreement charged the U.S. government with defining the dollar in gold ($35 per ounce) and maintaining convertibility at this rate only with foreign governments and central banks. (Pointedly, there was no similar obligation to U.S. banks or citizens; gold had disappeared from circulation in the United States after Franklin Roosevelt’s 1933 decree.) In turn all foreign nations were to peg their currencies to the dollar, thereby preserving a regime (however illusory) of fixed exchange rates so as to promote certainty in international exchange and encourage cross-border trade and investment.

By the 1960s this system was beginning to break down on all sides. Foreign governments announced periodic devaluations against the gold-linked dollar to promote exports and allow for domestic government spending, and the United States ramped up “guns-and-butter” federal spending on both the Great Society and the Vietnam War. Inflation slowly crept into the U.S. economy, and gold-redemption requests spiked by the late 1960s at the U.S. Treasury’s gold window.

Nixon thus made his fateful decision in the summer of 1971, freeing the government from any redemption obligations. This had two immediate effects: It amounted to an automatic, if stealthy, repudiation of U.S. debt in real terms because it devalued all dollar-denominated assets and currency at once. It also allowed the U.S. government, in concert with a technically independent Federal Reserve, to manage the U.S. money supply for its own political ends indefinitely.

The Predictable Aftermath of 1971

In developing his theory of money and credit a century ago, the great economist Ludwig von Mises explained why a system of fiat currencies was bound to break down: The politicians’ urge to inflate the money supply in order to commandeer the resources of the real economy via expanded government spending would prove too great. Further, because the dollar was the de facto reserve currency of the globe post-Nixon (replacing gold itself), any U.S. inflation would encourage other nations’ monetary expansions and competitive devaluations in tandem. And indeed, an era of predictable instability has been the result: A trenchant stagflation in the 1970s was followed by banking and S&L crises in the 1980s; Russian, Asian, and Latin American banking crises in the 1980s–90s; overleveraged financial institutions and moral hazard-based bailouts of too-big-to-fail institutions in the 1990s–2000s; and in the last decade or so two Fed-induced bubbles and subsequent crashes. The second of those, based in the housing sector, “went viral” across the world thanks to the huge nominal amount of funds plus leverage of U.S.-based mortgage debt, coupled with the expectation on the part of investors that the U.S. government would guarantee any mortgage-bond losses.

This instability has starkly proven another tenet of Mises’s seminal work: Fiat currencies managed by central banks with a monopoly on note issue, rather than being a source of macro stability, are themselves the causal agents of repeated boom-and-bust business cycles. By increasing the money supply at zero effective cost, central banks encourage government spending and cause interest rates to fall below their natural rate, which induces private investment and a temporary boom. But this boom, usually in capital-equipment sectors or long-term durables, is not based on real individual and institutional savings. That is, the accumulation of capital is not “backed” by the real resources of society. By definition such a boom is inherently unsustainable and unstable, and must end in a bust and painful retrenchment. The greater and longer the creation of fiat money by the central bank, the harder and longer will be the ensuing recession.

A Path to Reform

The best solution to the myriad problems caused by the Fed’s post-Nixon fiat currency management is to return to sound money generated by private markets and intermediated by freely competing banks issuing their own notes. These notes could be backed by any commodity but most likely would involve a return to gold. Banks would compete for customer deposits and loan business on the basis of the soundness of their balance sheets and thus could not over-issue—or else they’d face redemption of their outstanding notes and a potential collapse from a bank-run. Such a system is far more stable than a monopoly central bank without constraints, subject to the inexorable pull of political designs (that is, malfeasance).

But there are many challenges to developing and implementing such a free-banking system with commodity money; this is the subject of work to be published in the future. Meanwhile a second-best solution would be for the Federal Reserve to cease and desist with any further fiat money creation—in essence, freeze the monetary base where it is, permanently. The Fed could then announce an intent to return to full gold convertibility, and any new notes it issued (and used by Fed member banks) would be 100 percent backed by gold. Any maturing securities held as assets on the Fed’s balance sheet would be used to purchase gold to build the Fed’s reserves. The permanent price of gold would be set over a period of months after the announcement of the new regime, as gold itself and competing currencies traded at new (lower) levels based on the U.S. government’s new commitment to dollar stability.

The results of this reform program would be electric and dramatic. Capital investment would soar in the United States, as America became a haven for high-productivity ventures once again. The entire U.S. economy would in effect be recapitalized. While an end to activist Fed monetary policy would raise the short end of the yield curve, over time real interest rates would revert to historic low levels due to dollar stability. Such monetary reform implies pro-growth fiscal reforms as well; the U.S. government’s profligacy would have to end because fiscal laxity would no longer be supported by an accommodating Fed. A new, sound dollar and a passive Fed would also engender other pro-growth reforms in banking, such as a reduction in or end to deposit insurance and a lower burden of regulations that stunt growth. The banking sector would at once be more competitive, better capitalized, less brittle, and on sounder footing itself.

To bring this about monetary policy must again become a big political issue—the dominating political issue—in a way it has not been since the presidential election of 1896, when William Jennings Bryan railed against a “cross of gold.” Indeed this can happen if people come to understand that the main culprit of U.S. booms and busts since 1971, and indeed the primary progenitor of the global disaster of 2008—from which we have yet to recover—is the political management of money by the Federal Reserve. Sound money, honest money, besides being a necessary cause of sustainable economic growth itself, is the antidote to the tragically unnecessary torpor of our modern world.

It is as though the Fed were riding on the back of a double-headed monster. It cannot hang on forever, but it cannot dismount the beast without being devoured. As it is, the U.S. Treasury depends on ZIRP to fund America’s ballooning debt. When investors flee an enfeebled dollar the Fed is likely to be the “buyer of first resort” so that the price of Treasurys does not fall, pushing up interest rates. (So far Treasurys with low yields are still in high demand.) So with the Fed insisting that short-term interest rates will remain near zero “for an extended period,” a phrase used for the past two years, a new round of QE is almost inevitable.

For its part, QE involves flooding financial institutions with excess liquidity to try to flatten out the yield curve and depress long-term interest rates in hopes of sparking a recovery. But QE has created a massive overhang of excess reserves in the banking system that constitute repressed price inflation. And the sums involved are truly staggering: The Fed has injected at least $2.3 trillion into the financial system since Lehman Brothers collapsed in September 2008.

From late 2008 through March 2010 the Fed bought longer-term securities worth $1.7 trillion (QE1). This included purchases of $500 billion in mortgage securities and $100 billion in agency debentures with a target of $1.25 trillion for mortgage debt. Purchasing mortgage-backed securities and bailing out AIG and Bear Stearns, as well as buying other securities, led to a 140 percent increase in the monetary base.

In November 2010 the Fed began QE2 by buying an additional $600 billion in longer-term Treasury securities, a program that officially expired at the end of June. Yet the Fed has indicated it will continue buying Treasurys using proceeds from maturing debt it already owns.

Stealth Easing

With over $112 billion of the Fed’s government bond holdings maturing over the coming 12 months, replacement alone would involve purchasing over $9 billion of Treasurys each month. It also has more than $914 billion of mortgage-backed debt and $118 billion of debentures issued by government-sponsored enterprises (Fannie Mae and Freddie Mac). As such this is a “stealth” continuation of QE with only a limited, if any, decrease in the money-creation process.

For all the fanfare about QE, it must be said that it constitutes a last-gasp step and admission of the failure of other monetary policy tools. Consider the case of Japan. Its central bank, the Bank of Japan (BoJ), began asset purchases under QE to offset deflation and stimulate its ailing economy in early 2001. After nearly a decade of setting interest rates near zero the BoJ realized it had been unable to conjure up an economic recovery. Then after five years of gradually expanding its bond purchases, the BoJ exercised an exit strategy from QE in 2006, only to begin again.

Last March the BoJ increased its QE program from ¥5 trillion to ¥10 trillion (about $130 billion) scheduled until the end of 2012. Recently it announced another expansion to ¥15 trillion ($183 billion).

Incentives vs. Growth

A child untutored in economics might think it makes no sense to continue massive increases of liquidity into the economy that have been ineffective for so long. But most central bankers and many economists argue that previous amounts were too little and more is needed.

The incentives that QE and ZIRP create for commercial banks make it easy to see why these policies cannot promote economic growth. On the one hand, low interest rates reduce the cost of borrowing, which should encourage more investment spending. But on the other, commercial banks pay almost nothing to borrow yet receive interest payments from the Fed to hold excess reserves, making them unlikely to extend new loans.

A sufficiently high interest rate paid on bank reserves will induce banks to choose a risk-free interest-bearing asset rather than lending to private-sector borrowers. And so it is that commercial banks are earning record profits while making very few new loans.

Exit Strategy?

The question of whether the Fed or the BoJ has an effective “exit strategy” from monetary expansion using near-zero interest rates and quantitative easing remains open. One possibility for the Fed is to engage in repurchase agreements (repos) to remove some of the excess liquidity that it pumped into the financial system.

These repos involve selling securities to commercial banks with the Fed agreeing to buy them back at a higher price at a later date. But once again commercial banks will find holding risk-free interest-bearing assets a much better bet than issuing new commercial loans.

In the end both QE and ZIRP have been ineffective in restoring economic vitality while also creating a massive overhang of repressed inflation. Most economists view business startups, especially small and medium-sized enterprises, as the key to economic recovery and growth. Yet QE and associated central-bank policies are diverting credit away from newly forming firms.

The Fed has now announced it will continue the “exceptionally” low short-term interest rates until the middle of 2013. This indicates that U.S. central bankers are unconvinced of the errors of their ways in their policy choices. That they are unwilling or unable to change course means the U.S. and Japanese economies are doomed to painfully slow economic growth for the foreseeable future.

Nowhere is this more true than in government, which means we have to watch it closely. Unfortunately preconceived notions can make us impervious to events right in front of us and lead us to colossal misperceptions.

Take the Federal Reserve System. (All together now: Please!) Since the central bank controls the money supply, advocates of free markets and market-based money are understandably wary of its power to generate inflation. It’s inflated in the past and has the capacity to do so in the future. So attention naturally goes in that direction.

The problem is that while we’re watching for inflation, we might be missing the Fed’s real mischief elsewhere. In stage magic this is called misdirection.

Jeffrey Rogers Hummel, a macroeconomist at San Jose State University and a Freeman contributor (not to mention an old friend), says that’s exactly what has been happening. While inflation hawks have been busy looking for any sign, or even any word, of monetary expansion, Hummel writes, “[Fed chairman Ben] Bernanke has so expanded the Fed’s discretionary actions beyond merely controlling the money stock that it has become a gigantic, financial central planner.”

In other words, “Bernanke’s targeted and sterilized bailouts have altered the fundamental nature of the Federal Reserve. . . . [T]he Fed that emerged from the [housing and financial] crisis is no longer the same as the Fed before the crisis. . . . Most economists appear not to appreciate fully how drastic the changes are that Bernanke has wrought.”

Note the word “sterilized.” That means the Fed’s huge bailout program has been carried on largely without creating net new money. And that makes the Fed a menace to markets even when it’s not generating inflation! Hummel says that what we should be concerned about today with respect to the Fed is not inflation but central, nonmarket control of the allocation of scarce capital. In our obsession with inflation, we are missing an ominous leap further into corporate statism.

Hummel spells this all out with admirable clarity and detail in “Ben Bernanke versus Milton Friedman: The Federal Reserve’s Emergence as the U.S. Economy’s Central Planner,” published in Freeman columnist Robert Higgs’s great quarterly journal, The Independent Review, Spring 2011.

Bernanke’s efforts to channel capital to particular firms and sectors, including insolvent financial institutions, are breathtaking in scope. Previous Fed chairmen, notably Alan Greenspan, poured new money into the economy in response to anticipated crises, but they did not attempt to direct the money to chosen destinations. That was left to the market (however distorted). Things are different now. Bernanke directs the flow of credit—and has been doing it generally without creating new money.

How so? By selling assets to or borrowing money from banks and other institutions. Follow the money: When the Fed sells assets (T-bills, mortgage-backed securities, whatever) or borrows, it takes money out of the economy. If it turns around and lends the money to a bank, the impact on the money stock is a wash. However, the Fed has acted like a central planner of the capital market. Hummel leaves no doubt that this is what the Fed was up to before September 2008.

After that the Fed appeared to create huge amounts of new money through what has been called “quantitative easing” (QE1 and then QE2). But since 2008 it has also paid banks interest on reserves kept in their Fed accounts. “Bernanke in effect created money and then borrowed it back from the banks by paying them interest. . . . [T]he payment of interest on reserves was tantamount to borrowing back from depositories the full $800 billion increase in reserves and more. No wonder the impact of the base explosion on the broader monetary measures (except for M1) was so muted,” Hummel writes.

Summing up, Hummel says, “Helicopter Ben talks a good line about being ready to unleash quantitative easing, but this talk only imparts an aura of justification for the Fed’s incredibly expanded role in allocating the country’s scarce supply of savings. If anything, his policies were closer to a quantitative tightening. A better moniker would therefore be ‘Bailout Ben.’”

* * *

The Progressive Era’s infatuation with regulation of labor markets is typically portrayed as a humanitarian impulse. But could darker motives have been at work? Art Carden and Steven Horwitz have evidence to support that suspicion.

During last summer’s debt-ceiling controversy Fed Chairman Ben Bernanke made a remarkably anti-Keynesian concession that undercut his own monetary policies. James C. W. Ahiakpor has the scoop.

The government now will pay people—possibly a lot—to blow the whistle on the companies they work for. One need not believe that business is faultless to see the dangers in this government-created incentive. Warren Gibson spells it out.

Arthur Koestler’s classic novel about the horrors of the Soviet Union, Darkness at Noon, was published 70 years ago this year. Edward Bruce Walker has a tribute to Koestler and his unique book.

Classical liberals like Arthur A. Ekirch, Jr., and George C. Roche III, as well as Progressives, were critics of the Gilded Age. Joseph Stromberg thinks they were onto something.

One of the most influential journalists of the twentieth century was Walter Lippmann, an establishment figure who mostly took wrong positions on economic policy. But for a brief period he was struck with free-market insights about the impossibility of central planning. Harold B. Jones, Jr., has the details.

Bureaucratic central decision-making is notoriously bad because it ignores what F. A. Hayek called “the knowledge of the particular circumstances of time and place.” Paul Schwennesen applies this principle to two seemingly dissimilar cases.

Here’s what our ever-curious columnists have cooked up this issue: Lawrence Reed pays attention to the sadly neglected Samuel Smiles. Robert Higgs takes a scalpel to Lyndon Johnson’s War on Poverty. Thomas Szsaz focuses on a degraded and disfavored class of Americans. John Stossel exposes the scam of college. Charles Baird traces crony unionism in the government sector. And Arthur Foulkes, reading that claim that America can be great only through big government, responds, “It Just Ain’t So!”

Books coming under our reviewers’ microscopes cover so-called great leaders, the Mont Pelerin Society, state nullification of federal law, and the relationship between science and liberal democracy.

Or not. These are all half-truths and distortions, all too easy to find on the Internet. Bloggers like to begin with the discovery that commercial banks hold shares of Fed stock and those shares pay an annual dividend. A further discovery that the Fed makes big profits is all it takes to send some of them off on a conspiracy tangent. Because shareholders in a profit-seeking corporation are its owners, so it must be with the Fed, they think. Profiteering, world-government schemes, and who knows what else, must surely follow. As I will show, these half-baked ideas are distractions from the serious issues that surround the Federal Reserve System.

Yes, commercial banks hold shares of stock in their local Federal Reserve branch, but these shares do not confer ownership in any meaningful sense. Ownership is defined as the legal and moral right to use and dispose of some asset. Ownership can be conditional or temporary, as when you lease an apartment and acquire the right to occupy it for a limited time, but not to run a business in it or do major renovations. Your purchase of shares of stock in a public corporation gives you rights to vote in shareholder elections, receive any dividends declared, and sell your shares—but that’s about all. You may not walk into the corporate offices and start giving orders; on the other hand, you may not be held liable for any misdeeds of corporate officers or employees. If you acquire shares in a nonpublic company like Facebook, you accept additional restrictions on when and to whom you may sell your shares.

Member banks receive a fixed 6 percent annual dividend on their Fed stock and enjoy limited voting rights. But there the resemblance to ordinary shares ends. The banks are obliged to acquire shares when they become members of the Fed, and they may not sell their shares or pledge them as collateral. An initial issue of stock was seen as a good way to capitalize the Fed when it began, but there has been no need for additional capital and those shares are no longer significant.

Each branch has a board of directors with six members elected by local member banks and three appointed by the central board of governors. However, board members are not all bankers. Moreover, under a rule recently enacted by Congress, only nonbankers may serve on committees that select Fed bank presidents. This new rule is one way in which the ground has been shifting under the Fed recently; more about this below.

In the beginning the Fed was quite decentralized. A dollar bill in my wallet is imprinted “Federal Reserve Bank of San Francisco,” a remnant of the formerly dispersed power. The headquarters operation was initially a modest one, operating out of an office in the Treasury Department, but it now has its own imposing building, greatly expanded powers, and a correspondingly larger staff. With so much power now centralized, the branches engage mainly in monitoring local conditions and passing recommendations up to the board of governors. They have also become known for differing interests and points of view. The St. Louis Fed, for example, has an excellent collection of data available to the public. The Cleveland Fed is known for innovative research.

The Fed is a nonprofit institution, but that designation means only that profits are not its primary mission. The Red Cross is also a nonprofit, and like the Fed, it does earn a profit during any year in which gross income exceeds expenses. From an accounting point of view, such profits are essentially the same as those earned by firms in competitive markets, but not from an economic point of view. Competitive profits serve the vital function of directing scarce capital resources to the most urgent unmet demands of consumers. The Fed’s profits serve no such function.

Its income consists primarily of interest earned on its securities portfolio. Until recently the portfolio was made up almost entirely of Treasury securities. It has expanded greatly since 2008 to include mortgage-backed securities, loans to such pillars of the financial system as Harley-Davidson, and other assets including direct real-estate holdings. It incurs operating expenses of the usual sort: salaries, buildings, supplies, and more.

Remember that $79.3 billion profit? The 2010 figure, far higher than the $47.4 billion recorded for 2009, did not benefit the Fed’s managers or member bank shareholders because the money was remitted to the Treasury. That’s the law. It happens every year. If any private firm earned that much in a year it would be headline news and a boon to stockholders. For the Fed this is just an interesting statistic.

Who Calls the Tune?

The answer to the question “Who owns the Fed?” is that it’s the wrong question. Instead, we should ask: Who calls the Fed’s tune? That’s not such an easy question, yet it’s the only way to reach an understanding of why the Fed acts as it does and why it has done so much economic damage.

First and foremost, the Fed was created by Congress and can be modified or abolished by Congress. Clearly Congress is the Fed’s most important constituent.

The U.S. president also holds substantial sway over the Fed. He appoints the seven-member board of governors subject to Senate confirmation. The powerful Open Market Committee, which makes monetary policy decisions, consists of those seven plus the president of the New York Fed and four seats that are rotated among the 11 regional presidents.

But even though it exercises ultimate control, Congress has given the Fed a degree of independence that no other federal agency enjoys. Although its profits are swept back to the Treasury, the Fed enjoys a sweet deal that is unavailable to ordinary Federal agencies, which must plead with Congress for an annual appropriation. The Fed spends whatever it wants on operations, constrained only by the necessity to keep up appearances—not to look like fat-cat bankers. Its profit is whatever remains after all expenses have been paid, and, in contrast to ordinary corporate accounting, after dividends have been paid.

The Fed’s vaunted independence is a good thing, the thinking goes, because we don’t want the stewards of our money to be caught up in the swirl of day-to-day politics. But independence trades off against accountability. After all, in a democracy the bureaucracies are supposed to be accountable to Congress. The purse strings are the primary means of accountability among the other agencies, but there are no such strings tying Congress to the Fed.

Such control as commercial banks exert is not so much a function of their nominal stockholdings as it is of their connections through the network of good ol’ boys that weaves through government and “private” financial institutions. The Fed surely looks out for the interests of major private institutions, especially big banks, insurance companies, and securities firms. It does not want big-bank failures or a stock-market crash. It must be cognizant of foreigners who hold $3 trillion in U.S. Treasury debt and are keenly aware of the Fed’s actions and pronouncements.

These incentives have little to do with the Fed’s official dual mandate: stable prices and high employment. That mandate was established by the Employment Act of 1946 and the Humphrey-Hawkins act of 1978. These were times when no one questioned the Keynesian idea that inflation and unemployment always trade off against each other (the Phillips curve) and that monetary and fiscal policy must steer a course between two extremes. If the proponents of the mandate could see the relatively stable prices of recent years coupled with high unemployment, they would call for major Fed “easing.” If they then found out how much easing we have already had and the consequent monstrous increases in debt, they would surely be speechless.

Swift Changes

Some congressmen are calling for reassessing the dual mandate. This is just one way in which things are changing fast for the Fed. This once-staid institution is under increasing attack and is finding it necessary to defend itself, as when Chairman Ben Bernanke came out of his cloister to appear on 60 Minutes, a decision he may regret given the reaction to his astonishing claim that further “quantitative easing” will not increase the money supply.

New rooms are being added to the Fed mansion even as the sand shifts under it. Congress has given it extensive new powers unrelated to monetary policy, most notably a new consumer protection agency. The idea is that the Fed’s independence will ward off regulatory capture, something that always seems to happen to ordinary regulatory agencies. We shall see.

Rep. Ron Paul is the Fed’s most prominent critic. Last year his bill to require an audit of the Fed garnered a great many cosigners in the House. He reintroduced it at the start of the 2011 session, this time with his son Rand Paul on hand in the Senate to file the same bill there.

But in some ways the Fed is already quite transparent. Its website has extensive reports, updated regularly and more detailed than any releases from commercial banks or private corporations. And while deliberations of the powerful Open Market Committee are secret, detailed minutes are now made available shortly after each meeting.

In other ways it is quite secretive. For example, the Fed refused to disclose the names of banks that got loans during April and May 2008, denying Freedom of Information Act (FOIA) requests filed by Bloomberg and Fox News. Responding to lawsuits, the Fed did not claim it was a private institution and therefore exempt. Instead it cited potential harm to the banks that had borrowed, but the court sensibly ruled against a “test that permits an agency to deny disclosure because the agency thinks it best to do so. . . .” The information was released.

“End the Fed” has become a rallying cry for Ron Paul and his supporters. His little book by that name will not earn any academic awards, but as a mass-market polemic it does a good job of making his case without conspiracy theories or private-ownership sideshows. There is, however, room for honest debate about fractional-reserve banking, which he opposes.

About the Fed, though, Ron Paul is right. Whatever good intentions its managers may have, the Fed, like all central banks, exists ultimately as an enabler of ever bigger government. My colleague Jeffrey Rogers Hummel may be right when he says the Fed is becoming the central planner of the U.S. economy. But when we argue for replacing the Fed with market institutions, we must take the time and effort to get our facts straight and to expose the complex network of special interests that supports the Fed. Wrongheaded and simplistic arguments only hinder the cause.

Free banking is better than central banking because only in a free market can the optimal prices and quantities of goods be determined. Those goods include the money supply, and prices include the rate of interest.

There is no scientific way to know in advance the right price of goods. With ever-changing populations, technology, and preferences, markets are turbulent, and fluctuating human desires and costs cannot be accurately predicted.

The quantity of money in the economy is like that of other goods. The optimal amount can only be discovered by the dynamics of supply and demand. The impact of money on prices depends not just on the amount of money but also on its velocity—that is, how fast the money turns over. The Fed cannot control this since it cannot control the amount people want to hold, or the demand. Also, even if the Fed could determine the best amount of money for today, the impact of its moves takes months to play out, so the central bankers would need to be able to accurately predict the state of the economy months into the future.

The Fed also fails because of political pressure. Although the Fed is supposed to be independent, in practice, when the economy is depressed, there is strong political pressure to “do something,” specifically to “stimulate” by expanding the money supply. Since Congress created the Fed and can alter it, it is impossible for the Fed to be purely independent of politics.

The Federal Reserve was set up to provide price stability, yet the United States suffered high inflation during the 1970s and continuous inflation since World War II. The Fed was also supposed to provide economic stability, but since World War II there have been severe recessions in 1973, 1980, 1990, and 2007–2009. The Fed was supposed to ensure stability in the financial system, but it failed to prevent the Crash of 2008 and the Great Recession that followed. But the challenge is to explain why free banking would be better.

Suppose gold once again became a global currency. It would be the real money, and the U.S. dollar would be defined as a particular weight of gold. A $20 gold coin had about an ounce of gold before 1933.

Under free banking most transactions would not occur with gold, but rather with more convenient money substitutes. Banks would issue paper bank notes inscribed with their bank names. Anyone holding bank notes could exchange them for gold. For example, if $1,000 was equivalent to an ounce of gold, then anyone could go to a bank and convert $1,000 in paper bills to one ounce of gold coins. Likewise one could withdraw $1,000 of deposits in gold coins.

Competition among banks, as well as convertibility into gold, would result in price stability, since the banks would only be able to issue as many bank notes as the public was willing to hold. If there were more bank notes than that, they would come back to the bank to be exchanged for gold. But the money supply would also be flexible, since if there were a greater demand to hold money, the amount of bank notes or bank deposits would increase.

The Structure of Capital Goods

Free banking mitigates the boom-bust cycle. There is a structure to capital goods similar to a stack of pancakes. At the bottom of the stack are rapidly circulating capital goods such as inventory close to the consumer-goods level. As we go up the stack, the capital goods turn over more slowly. At the top are long-duration investments such as real-estate development. Goods become more sensitive to interest rates as you move up the stack. Lower interest rates make the stack steeper, as there is more investment in long-term investments.

In a free market the “natural rate” of interest depends on the preference for goods sooner rather than later, or “time preference.” Interest is the premium paid to shift purchases from the future, for which one would have to save enough to pay cash, to the present day by borrowing.

The Fed lowers the rate of interest by creating fiat money out of nothing. As a result, businesspeople borrow more for capital goods high on the stack, such as real estate. Prices rise fastest and soonest where the money is being injected into the economy with loans. Thus real-estate prices escalate, creating a bubble like those that occurred before 1973, 1980, 1990, and 2007; indeed a similar bubble occurred during the 1920s before the Great Depression.

Every boom preceding a bust has been fueled by artificially cheap credit. With free banking the interest rate would not be manipulated down. The natural rate of interest would raise the carrying cost of borrowed funds, reducing if not preventing the financial fever.

Further Reforms

Free banking is not a panacea: There need to be other reforms to achieve sustainable economic growth. Punitive taxes, subsidies, and arbitrary restrictions all distort the economy, stifle enterprise, and create turbulence. But even without such other reforms, the case for replacing central banking with free banking is strong, resting on three facts:

1. The optimal money supply and interest rates are unknowable in advance, and can only be discovered by market dynamics.

2. Political pressure makes the Fed expand the money supply and reduce interest rates when the economy is depressed, and this fuels an unsustainable boom that results in the next bust.

3. Government insurance, guarantees, the expectation of bailouts, and other subsidies induce excessive risk-taking, making financial crashes worse.

Cowen states that if the Fed were to shut down, the new base money would be Treasury bills. (Base money currently consists of money in circulation, bank vault cash, and commercial bank reserves on account at the Fed.) But folks don’t buy groceries with Treasury bills. The best transition base money would be the current amount of Federal Reserve notes, whose supply would be frozen, as suggested by Professor George Selgin. Then new-money expansion would be the money substitutes issued by the banks, convertible into base money. Eventually, with the abolition of legal-tender laws, world financial markets would converge on a common global currency, gold.

The case for free banking is similar to the case for healthy living. It is better to prevent economic illness than to have to treat it.

The report card comes in the form of a working paper from the Cato Institute: “Has the Fed Been a Failure?” by George A. Selgin, William D. Lastrapes, and Lawrence H. White. (White, of course, is a Freeman contributing editor and regular lecturer at FEE’s Advanced Austrian Economics Seminar. Click here for a C-SPAN video of White summarizing the paper [at 46 minutes in], and click here for a podcast of an interview with Selgin.)

The authors state in their abstract:

As the one-hundredth anniversary of the 1913 Federal Reserve Act approaches, we assess whether the nation’s experiment with the Federal Reserve has been a success or a failure. Drawing on a wide range of recent empirical research, we find the following: (1) The Fed’s full history (1914 to present) has been characterized by more rather than fewer symptoms of monetary and macroeconomic instability than the decades leading to the Fed’s establishment. (2) While the Fed’s performance has undoubtedly improved since World War II, even its postwar performance has not clearly surpassed that of its undoubtedly flawed predecessor, the National Banking system, before World War I. (3) Some proposed alternative arrangements might plausibly do better than the Fed as presently constituted. We conclude that the need for a systematic exploration of alternatives to the established monetary system is as pressing today as it was a century ago.

In light of the Fed’s defined mission — monetary support for economic growth, stable prices, maximum employment — the authors use the following criteria to assess its record: “the relative extent of pre- and post-Federal Reserve Act price level changes, pre- and post-Federal Reserve Act output fluctuations and business recessions, and pre-and post-Federal Reserve Act financial crises.” The Fed has done poorly on every count. No one familiar with the Mises-Hayek critique of central planning will be surprised. Central banking is not equivalent to comprehensive planning of the economy, but money is the most pervasive good and monetary engineers suffer the same insurmountable ignorance as any central planner.

I can only hit the paper’s highlights here.

Inflation

Selgin et al. pronounce the Fed a dismal failure in controlling inflation. “[F]ar from achieving long-run price stability, it has allowed the purchasing power of the U.S. dollar, which was hardly different on the eve of the Fed‘s creation from what it had been at the time of the dollar‘s establishment as the official U.S. monetary unit, to fall dramatically.”

This is truly astounding. The value of the dollar was essentially stable from the late eighteenth century to the second decade of the twentieth century! “A consumer basket selling for $100 in 1790,” they write, “cost only slightly more, at $108, than its (admittedly very rough) equivalent in 1913.” (Of course that extra $8 bought far better products.)

And since that time? “[T]hereafter the price soared, reaching $2422 in 2008…. [M]ost of the decline in the dollar‘s purchasing power has taken place since 1970, when the gold standard no longer placed any limits on the Fed’s powers of monetary control.”

The dollar has lost 95 percent of its value since the Fed came into existence.

Deflation

The authors say that since the Great Depression the Fed has rid the economy of deflation (defined as falling prices), which was a feature of the late nineteenth-century economic landscape. Economists, including Fed chairman Ben Bernanke, generally deem deflation as something to be avoided at almost all costs, so they would give the Fed kudos in this respect. But Selgin et al. point out (as have others, such as Steven Horwitz) that what matters is not deflation per se but the kind of deflation.

Harmful deflation — the sort that goes hand-in-hand with depression — results from a contraction in overall spending or aggregate demand for goods in a world of sticky prices. As people try to rebuild their money balances they spend less of their income on goods. Slack demand gives rise to unsold inventories, discouraging production as it depresses equilibrium prices. Benign deflation, by contrast, is driven by improvements in aggregate supply — that is, by general reductions in unit production costs — which allow more goods to be produced from any given quantity of factor and which are therefore much more likely to be quickly and fully reflected in corresponding adjustments to actual (and not just equilibrium) prices.

Historically, benign deflation has been the far more common type.

During roughly the last quarter of the nineteenth century, prices in the United States declined 37 percent – 1.2 percent a year on average. That’s what the Fed has saved us from, thank you very much.

Frequency and Duration of Recessions

Again, the pre-Fed record is better than the Fed’s performance. Drawing on the latest research the authors conclude:

[A]lthough contractions were indeed somewhat more frequent before the Fed‘s establishment than after World War II (though not, it bears noting, more frequent than in the full Federal Reserve sample period), they were also almost three months shorter on average, and no more severe. Recoveries were also faster, with an average time from trough to previous peak of 7.7 months, as compared to 10.6 months. Allowing for the recent, 18-month-long contraction further strengthens these conclusions.

So the central bank has given us longer recessions and slower recoveries. Nice.

This provocative paper also addresses the Fed’s record regarding volatility in output and employment, banking panics, the “Great Moderation” of the Greenspan years, and its role as “lender of last resort.” This last topic is especially interesting. Under the classical doctrine, the lender of last resort was to make loans only to solvent (though illiquid) banks at higher-than-market interest rates. The Fed has trashed that doctrine by bailing out insolvent institutions and accepting toxic “assets” as collateral.

Selgin et al. reject the “too big to fail” doctrine, arguing that the fear-mongering about “systemic risk” is unsubstantiated. Bailing out the creditors of insolvent institutions, as the Fed did during the current financial crisis, has increased the future exposure of the public by reinforcing moral hazard — encouraging excessively risky behavior by creating the expectation of government rescue. In the process the Fed has gone from lender of last resort to allocator of capital – an ominous move toward central planning.

The authors do not endorse the pre-Fed system, which (as discussed last week) was heavily regulated by the national and state governments. Indeed, for most of American history interstate and intrastate branch banking was illegal, producing an industry of uncompetitive and undiversified banks.

Nor do they explore the free-banking alternative, though Selgin and White are well-known advocates of it. Instead they confine their analysis to various rules that would take away the Fed’s discretionary power over the money supply. These would be improvements but a far distant second to free banking.

The authors leave no doubt that “the Fed‘s poor record calls for seriously contemplating a genuine change of regime.”

I don’t want to rehearse the whole debate in this column, but I do want to address a claim made by opponents of FRB.  They often say something like: “If I deposit $1,000 in my bank and it has to hold only 10 percent reserves, it can create $10,000 in new money.”  This claim is ambiguous at best and downright wrong at worst. As stated it betrays a lack of understanding how fractional reserve banks (whether under free or central banking) actually work.

First of all, this claim is ambiguous about where the deposit comes from and what it consists of.  For example, if I deposit a $1,000 check in my bank that you’ve written on your bank, what happens?  It’s true that my bank gets $1,000 in new reserves, but it cannot create $10,000 in new loans with the money.  Why not?  Imagine it credited $10,000 to the borrowers’ accounts.  What would they then do?  They would spend it because that’s why people borrow money!  And what happens when it’s spent?  The banks in which the funds are eventually deposited ask the original bank for $10,000 in reserves.

The problem is that if the bank was at its 10 percent requirement before the $1,000 deposit came in, it cannot lose $10,000 in reserves without falling below its minimum requirement (or its desired level, in a free-banking system with no such requirement, which would be unacceptably risky without deposit insurance).  What can the original bank afford to lose?  Well, it has my new deposit of $1,000 against which it has to keep 10 percent, or $100.  Therefore it has $900 to loan out.  And that’s all.  Banking rule #1: No individual bank can lend more than its excess reserves, in this case $900.

Now you say, “Yes, but that $900 will be spent and deposited at another bank, which will keep $90 and lend out $810, and so on.”  And you are quite right, which indicates banking rule #2:  The banking system can expand by a multiple of those original excess reserves.  Assuming 1) all banks face a 10 percent requirement, 2) no one takes out cash, and 3) no banks hold excess reserves, the system will create $10,000 based on that original $1,000 deposit.  So perhaps the problem with the original statement is that it focused on one bank only rather than the banking system as a whole.

What’s Unseen

But that’s not it — and we need the help of Monsieur Bastiat to see the unseen.  If the $1,000 I deposited came from your bank, it loses the $1,000 in reserves transferred to my bank.  That forces your bank to call in loans to make up the lost reserves, which leads to reserves being lost by other banks, which then have to do the same thing.  The result is that the $10,000 created by my bank’s gain in reserves is canceled by the $10,000 destroyed by your bank losing those reserves.  When you write a check to me and I deposit it, there is no bank multiplier on net (assuming the three conditions above hold). Thus we see the reverse of rule #2, as the system simultaneously contracts by a multiplied amount of the original deposit/withdrawal.

So how does new money ever get created and multiplied on net?  By injections of new reserves.  Only one entity can create new reserves in a fiat money system with a central bank:  the central bank.  When the Fed conducts open-market operations it adds new net reserves to the system, which enables the money-multiplier process with no offsetting loss in reserves elsewhere.  The central bank and only the central bank can do this.

A clever fellow might now say, “Well, what if I deposit currency into my bank?  There’s no offset then, right?”  That is indeed true.  But where did the currency come from?  At some point, you or someone else had to withdraw it from the banking system, which caused a multiplied contraction in the total money supply because currency counts as reserves.  The two halves of the process are separated in time, unlike with the deposits, but the net effect in the long run is still zero.

New currency can cause the money multiplier, but guess what is the only thing that can create new currency in a system with a monopoly central bank?  You got it:  the central bank. If you want to know whom to blame for setting off the money-multiplier process, you need only look there.

The moral of the story?  There’s nothing wrong with fractional reserve banking that getting rid of central banking and its various interventions can’t cure.

For wealthy developed countries, however, inflation over the last few decades has in fact become a trivial source of government revenue. This outcome stems not merely from the worldwide decline in inflation rates that began in the 1980s. That disinflation was as much an effect of the way sophisticated financial systems now prevent governments from gaining much revenue from even severe inflation as it was a cause of falling inflation revenue. Yet most libertarians have overlooked this crucial development in the dynamics of government finance. They anachronistically harp on how the U.S. or European governments might cover significant fiscal shortfalls with the printing press, completely oblivious to how insignificant for such governments this hidden tax has become.

Governments can potentially gain revenue from inflation in three ways. The first is the most obvious and the one most emphasized by libertarians: by issuing fiat money the government benefits in the same way as an undetected counterfeiter. Simple fiat money, such as the Continentals issued during the American Revolution or the Greenbacks and Confederate currency issued during the Civil War, is easiest to understand. It is directly spent to cover government purchases, and the resulting increase in prices over what they otherwise would have been reduces the purchasing power of money held by the general public. The government gains by exactly the same amount the public loses in this implicit tax on real cash balances. Economists have dignified this implicit tax with the term seigniorage.

Currently nearly all fiat money is instead issued by central banks, such as the Federal Reserve. This arrangement makes seigniorage a bit more complicated, sometimes requiring a well-taught course in economics to comprehend it, but the final result is identical. One arm of the government, the central bank, creates fiat money and lends it to another arm of the government, the Treasury, which then spends it, in a process known as monetizing the debt. Legally the Fed cannot purchase securities from the U.S. Treasury directly, and must buy them on the open market from private holders, but that makes absolutely no difference since, in either case, more of the government’s deficit has been financed by new issues of fiat money.

Monetary cranks often attach undue importance to the fact that the Treasury pays interest to the central bank for these loans. Admittedly, interest earnings cover the operating expenses of the Fed, which therefore never has to go to Congress for an appropriation, and the precise incentives faced by these two separate arms of the government may differ. But the Fed ultimately rebates most of its interest earnings back to the Treasury (in 2008, for instance, $35.5 billion out of $41.0 billion, or 86 percent). If you consolidate the balance sheets of the central bank and the Treasury, the process looks exactly like simple fiat money. Even when much of the money the central bank creates is lent to private banks, as during World War I, or purchases private securities, as has been happening recently, the interest rebate to the Treasury still indirectly generates the same seigniorage as a direct purchase of Treasury securities. The new fiat money flowing into the private sector simply releases money held by others to purchase Treasuries.

Declining Purchasing Power

The second way that government can gain from inflation relates to transfers between debtors and creditors. If inflation is totally unanticipated or unexpectedly high, interest rates will not have risen enough to compensate for the decline in the purchasing power of any loans. Net debtors gain, and net creditors lose. Government is, of course, the economy’s biggest debtor. Unanticipated inflation therefore reduces the real value of government debt. During the Great Inflation of the 1970s private investors holding long-term U.S. Treasury securities actually earned negative real returns despite receiving positive nominal interest. As a consequence, from 1946 to 1982, while the nominal debt that the U.S. government owed to the general public rose from $242 billion to $925 billion, that debt in 1946 dollars had actually fallen to $201 billion.

The third way that government can gain from inflation stems from interaction with explicit taxes. Under a progressive income tax, inflation pushes people into higher tax brackets even if their real incomes remain constant. The U.S. government thus enjoyed automatic tax hikes requiring not one iota of change in the tax code throughout the 1970s. Under President Ronald Reagan the income tax brackets were indexed, but bracket creep continues with the alternative minimum tax. Moreover, indexing does not eliminate inflation’s tax on saving, both through the personal income and capital gains taxes. When interest rates rise to offset expected inflation, the tax rate applies to the higher nominal returns, which represent just inflation’s “phantom gains,” to borrow a phrase from David Henderson. Real returns quite likely remain constant. These tax interactions, along with seigniorage and real debt reduction, not only bring about transfers from the public to government, they also distort the economy’s performance, creating what economists call deadweight loss, additional losses to the general public that exceed any gains. But we are focusing here just on gains to government.

Fractional Reserve

Each of these three potential sources of inflation revenue has become attenuated in developed countries. The main factor impairing the first, seigniorage, is fractional reserve banking. Banks, as private institutions that increase the money stock, can magnify inflation but do not generate seigniorage. To the extent that bank-created money causes any inflationary fall in real cash balances, the offsetting gains remain within the economy, accruing to the banks themselves or, absent monopoly privileges, flowing back via competition to their customers. The government doesn’t just fail to realize any seigniorage, its ability to do so is diminished. We can visualize why by comparing an economy in which banks hold 100 percent reserves—in which every $10 in circulation is backed by $10 of government-issued fiat money—to an economy with fractional reserves—in which every $10 in circulation is backed up by only $1 dollar of fiat money. Now assume a $100 billion increase in the total money stock. With 100 percent reserves, government fiat money (also called the monetary base) increases by the full $100 billion, all of which constitutes seigniorage. With the 10-to-1 ratio, in contrast, the same increase in the money stock is driven by only a $10 billion increase in the fiat base, so seigniorage is only one-tenth as much. Nonetheless, in both cases, the $100 billion increase in the total money stock sets off the same price inflation.

In other words, the lower the reserve ratio in a fractional reserve banking system, the less seigniorage government gets from a given increase in the price level. Or what amounts to the same thing, the greater will be the inflation cost of any given amount of real seigniorage. Fractional reserve banking in effect lowers the demand for government-created base money, reducing the seigniorage tax base (that is, the public’s real holdings of non-interest-paying base money).

Public Choice and Seigniorage

This threat to seigniorage provided a major Public Choice motivation for the myriad government regulations of banking in the past, from the imposition of reserve requirements to the creation of central banks with a monopoly on the issue of bank notes, all of which helped hold up the demand for government base money. The financial innovations and regulatory changes of the last several decades, however, have all but swept away most of these constraints on bank-created money.

Outside of America’s two hyperinflations (during the Revolution and under the Confederacy during the Civil War), seigniorage in this country peaked during the Civil War under the Union, when it covered about 15 percent of the war’s cost. By World War II seigniorage was financing only a little over 6 percent of government outlays, which amounted to about 3 percent of gross domestic product (GDP). During the Great Inflation of the 1970s seigniorage was below 2 percent of federal expenditures, or less than half a percent of GDP. Consider today how little of your own cash balances is in the form of government-issued Federal Reserve notes and Treasury coin rather than in the form of privately created bank deposits and money market funds. Prior to the recent financial crisis, M2 (a broad measure of the money stock that includes all checking accounts, savings and small-time deposits, and retail money market funds) was more than eight times the size of the monetary base.

Partly that is because reserve requirements (which should not be confused with government-imposed capital requirements) became virtually a dead letter in the 1990s. Many countries, including Australia, Canada, New Zealand, Sweden, and the United Kingdom, abolished them outright. In the United States the Fed eliminated all reserve requirements on the forms of money M2 adds to M1 (a narrower measure of the money stock that includes only currency in circulation and certain checking accounts) and permitted banks to freely sweep customers’ money between M1 checking accounts and M2 accounts. Congress has furthermore given the Fed authority to abolish the remaining reserve requirements on M1 in 2012.

Conversion to Debt

The Fed’s response to the financial crisis has only accelerated these trends. It is true that in the three months after September 2008, the Fed doubled the monetary base, from $850 billion to $1.7 trillion, so that M1 now has over 100 percent reserves behind it. But the Fed simultaneously eliminated nearly all seigniorage from this unprecedented expansion of fiat money. It did so by starting to pay interest on bank reserves, something other major central banks, including the European Central Bank, were doing already. Essentially this converts any reserves that banks hold as deposit at the central bank into more government debt rather than proper fiat money. The Fed is now borrowing money from the banks and relending it to the Treasury or private parties. This means that the only forms of money that still provide the U.S. government full seigniorage are currency in the hands of the general public and the actual cash held in bank vaults (which are a small part of a bank’s total reserves).

And this new restraint on seigniorage will become tighter in the future as people replace currency with bank debit cards and other forms of electronic fund transfers.

What about the other two ways that governments have benefited from inflation? The unexpected inflation of the 1970s, through its reduction of the real value of the national debt, actually generated about twice as much revenue for the U.S. government as did seigniorage during the same period. That still is not a lot, and investors are much savvier these days. Globalization, with the corresponding relaxation of exchange controls in all major countries, allows them easily to flee to foreign currencies, with the result that changes in central-bank policy are almost immediately priced by exchange rates and interest rates. Add to this the ability to purchase from many governments securities that are indexed to inflation, and it becomes highly unlikely that investors will be caught off guard by anything less than sudden, catastrophic hyperinflation (defined as more than 50 percent per month)—and maybe even not then.

All Pain, Little Gain

As for inflation’s interaction with explicit taxes, while it definitely hurts taxpayers and the economy, it seems not to have helped the U.S. government much. Since the Korean War, federal tax revenue has been bumping up against 20 percent of GDP. That is quite an astonishing statistic when you think about all the changes in the tax code over the intervening half-century. Thus the Great Inflation had no obvious impact on explicit government revenues, even before the tax brackets were indexed. It would require a more complex quantitative analysis that adjusted for changes in the tax code and in the economy to determine just how much periods of high inflation boosted the tax bite, but we can safely say that the effect was not dramatic.

Because of all these factors combined, governments in developed countries have little incentive to resort to monetary expansion, which no doubt contributed to inflation’s worldwide decline after 1980. Reid W. Click, in a study of 90 countries between 1971 and 1990, finds that average annual seigniorage exceeded 5 percent of GDP in only eight countries: Egypt, Poland, Malta, Nicaragua, Argentina, Chile, Yugoslavia, and Israel. Almost none of the developed countries could boast seigniorage amounting to more than 1 percent of GDP, despite the fact that the study incorporated the inflationary years of the 1970s. Joseph H. Haslag’s smaller sample of 67 countries over a longer period, 1965 to 1994, finds that seigniorage averaged about 2 percent of total output for the entire sample, ranging from as low as 0.25 percent to as high as 9.98 percent (for Ghana). And Stanley Fischer puts the average seigniorage of industrial countries between 1973 and 1978, a period of high inflation, at 1.1 percent of gross national product. I know of no more recent studies, but with disinflation, the widespread paying of interest on bank reserves, and the consolidation of European countries under the European Central Bank, these averages should be lower for the period from 1990 to today.

How Much Would It Take?

By comparison, let us now run some numbers to estimate how much inflation might be needed to close the looming “fiscal imbalances” (as they are euphemistically styled) that face not merely the United States but most of the world’s welfare states. The 2010 report of the Congressional Budget Office (CBO) projects that in 25 years some combination of spending cuts or tax increases equivalent to no less than 12.3 percent of GDP will be needed to close the U.S. government’s fiscal gap. Assuming that revenues from explicit taxes remain capped at 20 percent of GDP, whether for structural or political reasons, and that politicians will have little incentive to cut spending, seigniorage will have to come up with the difference. Given that 10 percent inflation during the 1970s generated revenue amounting to 0.5 percent of GDP in the United States, a straight-line extrapolation suggests that covering the growing fiscal shortfall would require more than a tripling of the price level, year after year after year. Within three years the dollar would be worth only about 2.5 percent of its original value.

Such continual triple-digit inflation would be unprecedented, the highest the United States has ever experienced outside of its two hyperinflations. We admittedly have not included any short-term government gains from a reduction in the real value of its debt, which biases our inflation estimate upward, but we also have not adjusted for the loss of seigniorage on interest-earning reserves, pushing the bias downward. Moreover, seigniorage itself faces its own Laffer curve (known as the Bailey curve, after the economist Martin Bailey). To avoid higher taxes on their real cash balances, people spend money faster as inflation rises, thereby exacerbating the price increases. Higher rates of inflation thus generate proportionally ever-smaller revenue increases. Once we also acknowledge that the CBO’s projections are probably too optimistic, we can see why our estimate that financing the explosion in Social Security, Medicare, and Medicaid payments will necessitate a 246 percent annual inflation is far too low.

How likely is it that governments in the developed countries will be willing or even able to unleash such appalling currency depreciation? Recall how politically unpalatable the mere double-digit inflation of the 1970s was. Could central banks maybe cease paying interest on reserves and then reimpose or raise reserve requirements to generate more seigniorage at any given inflation rate? Although the answer is technically yes, the likelihood is slim indeed. Now that the genie is out of the bottle, any fiddling with reserve requirements (or other bank regulations) in a way that significantly increases seigniorage will destroy the banking industry as we know it. Think of reserve requirements as a tax on banks, requiring them to hold assets earning zero interest. The higher the requirement, the higher the tax rate. After ending interest on reserves, the Fed would have to multiply the current low reserve tax by a factor in the neighborhood of 15 or more, plus extend reserve requirements to money market funds, to make seigniorage truly lucrative. Given that the U.S. government has just engaged in a gigantic bailout of the banking system, I do not find this prospect probable.

I am not denying that the future may bring higher inflation, if for no other reason than expectations of a fiscal crisis could start a flight from the dollar (or pound or euro) without any immediate change in central-bank actions. But the bottom line is that inflation’s implicit tax on real cash balances will no more be able to resolve the escalating budgetary problems of the welfare states than would an excise tax on chewing gum.

In the nineteenth and early twentieth centuries, imperial and then republican China had no central bank. The monetary system was based on a diverse network of private banks operating in the various regions of the country. While copper was widely used in coins, the primary medium of exchange was silver, and the entire Chinese economy functioned on an informal silver standard for most of this time. A year after Chiang Kaishek’s Nationalist Party came to power in Nanking in 1927, the Central Bank of China was established with its headquarters in Shanghai, and the country was formally put on a Chinese silver-dollar standard.

For the first two years of the Great Depression, beginning in 1929, China not only weathered the international financial and economic storm, but actually experienced an export boom, with many domestic prices rising while the rest of the world suffered a serious price deflation. But in September 1931 Great Britain went off the gold standard and a growing number of countries engaged in currency depreciation, which adversely affected the value of the Chinese silver dollar on the foreign exchange markets.

The fatal blow came in 1933 and 1934, when, under Franklin Roosevelt’s New Deal, silver was remonetized. The U.S. government went on a silver-buying spree at a price above the world price in an attempt to push up price in the United States. As the export price for silver rose in the financial center of Shanghai, silver flowed from the Chinese countryside to the main port cities on the coast, followed by a massive export of silver from China to the United States. A resulting catastrophic price deflation severely hit both Chinese agriculture and industry.

In October 1934 the Nationalist government imposed foreign-exchange controls on silver exports. Then in November 1935 the Central Bank of China officially took the country off the silver standard, made its bank notes legal tender, and placed the country on a fiat currency with government in full control of the quantity of money. With no restraint now on the power of the Chinese government to turn the handle of the printing press, Central Bank policy soon led to monetary disaster with the coming of China’s war with Japan.

The war between China and Japan lasted eight years, from July 1937 to September 1945. The Japanese army occupied more than one-third of China, including virtually all of the country’s leading port cities and industrial centers. Over ten million Chinese civilians lost their lives in the fighting.

The end of the conflict only reopened the longstanding civil war between Chiang Kaishek’s Nationalist government and the large communist forces led by Mao Zedong. The civil war raged across China for four years, until Mao’s communists were triumphant on the mainland and the remnants of Chiang’s Nationalist army withdrew to Taiwan in late 1949. Another five million innocent civilians lost their lives in the civil war.

In the war years Chiang’s government resorted to the printing press to finance the majority of its spending, covering 65 to 80 percent of its annual expenditures through money creation. During the civil war years of 1946 – 1949, monetary expansion covered 50 – 65 percent of the government’s spending.

When war with Japan broke out in 1937, the total quantity of money in circulation (currency and demand deposits) was 3.6 billion yuan. By December 1941, when the United States entered the war, the Chinese money supply had increased to 22.8 billion yuan. For the remainder of the war years the figures were: 1942, 50.8 billion; 1943, 100.2 billion; 1944, 275 billion; and 1945, 1,506.6 billion.

The civil war brought a worse inflation. By the end of 1946, the money supply had increased to 9,181.6 billion yuan, with a more than six-fold increase to 60,965.5 billion by December 1947. Seven months later, in July 1948, the money supply had expanded to 399,091.6 billion yuan.

A New Currency

The Chinese government then created a new yuan to replace the old depreciated yuan, at a conversion rate of three million old for one new. In August 1948 the new money supply stood at 296.82 billion yuan.

But the government printing presses were set to work again, and by December 1948, the supply of this new yuan was 8,186.33 billion. Four months later, in April 1949, it had been increased to 5,161,240.0 billion yuan.

From 1937 to 1949, prices rose dramatically but to different degrees in the various regions of China, because of war-related scarcities and destruction, and the uneven impact of the monetary expansion. As one very rough indicator, we can use the wholesale price index of Shanghai during this period, with May 1937 equaling 1.

By the end of 1941 the Shanghai wholesale price index stood at 15.98. By December 1945 it had reached 177,088, and by the end of 1947 it was 16,759,000. In
December 1948 the index had risen to 36,788,000,000, and in April 1949 it was at 151,733,000,000,000.

The value of China’s paper money on the foreign-exchange market reflected this huge depreciation of the currency. In June 1937, 3.41 yuan traded for one U.S. dollar. By December 1941, on the black market 18.93 yuan exchanged for a dollar. At the end of 1945, the yuan had fallen to 1,222 to the dollar. And by May 1949, one dollar traded for 23,280,000 yuan.

It would be an exaggeration to say that China’s Great Inflation was the primary cause for the defeat of the Nationalist government and the victory of the Chinese communists. The Nationalist Party was dictatorial in its structure, notorious for its corruption and abuse of political power, and often as ruthless as the communists in its use of military force.

But it is nonetheless true that whatever basis of popular support Chiang’s government might have had against the communists was undermined by the inflation. It destroyed the wealth of the Chinese middle class and drove some segments of the rural population into severe poverty. During and after the war, the government imposed unworkable price and wage controls that only succeeded in creating even more distortions and imbalances throughout the Chinese economy.

Like a canary in a coal mine, the crisis in Greece should serve as a warning that polluting the fiscal air with large budget deficits, a growing public sector, and high debt-to-GDP ratios is a sure way to kill an economy. A serious examination of the situation in Greece should lead other Western countries to think carefully about the paths they are on. Continuing growth in government expenditures means continued deficits, which means growing debt—which means temptation to inflate and the possibility of default.

The cycle of deficits and debt leads down a dead-end road. Once a nation starts on that road, it must make a conscious decision to turn around or it will find itself with the same sorts of problems that plague Greece.

Understanding the crisis that faces Greece, and could face the United States, requires a short detour into the world of fiscal policy. In their path-breaking book, Democracy in Deficit, Richard Wagner and Nobel laureate James Buchanan offer one of the clearest examinations of the nature of the bind we find ourselves in. They argue that for most of the history of the West, governments treated their budgets much like a household would treat its budget: Expenses should be paid out of current income, with two exceptions. First, large expenditures on capital items with long lives could be financed with debt. Second, in times of crisis, especially war, debt was an acceptable way to pay. But, they note, the expectation was that any such debt incurred would be paid off with surpluses during the life of the capital item or after the war. Temporary deficits were acceptable, but permanent ones were not.

Permanent debt was problematic because its costs were borne by future generations. This reduced future economic growth while unjustly taxing not only those “without representation” but also those who had not even been born yet!

The rise of Keynesian economics changed all of this by offering a theory of government and the economy that drove a stake through the heart of the old implicit fiscal constitution. Keynesian economics removed the long-observed constraints on deficit spending by arguing that governments should use the budget to steer the economy: running deficits during recessions to stimulate macroeconomic aggregates and surpluses during good times to prevent the economy from getting out of hand.

Politicians were thrilled with this change, since increasing spending without raising taxes is a sure-fire way to get votes. Because most government spending concentrates benefits on a few identifiable groups but spreads the future costs of borrowing thinly across many people, it is easy to get votes for spending. Perennial deficits resulted because politicians had no incentive to do what Keynesian blackboard models advised: run surpluses in good times. Budget surpluses are generally vote losers for politicians. Buchanan and Wagner demonstrate that once the old restraints were broken, a cycle of spending, deficits, and debt was sure to follow.

To finance that rising debt governments must be able to sell bonds. As long as bond markets have confidence that governments will be able to pay back the debt, the bonds will be sold. And because most governments are considered politically stable, government bonds usually have no risk attached to them and thus provide safe, if low, returns.

If bond buyers hesitate, however, governments face one of two scenarios: They will have to sell their bonds at a lower price, which implies higher future interest payments, or they will use their central banks to create money to buy up their own bonds, which is likely to be inflationary. Rising debt is also self-perpetuating since continued deficits mean more interest payments, which increase future expenditures and contribute to future deficits.

Herculean Profligacy

Against this background, Greece found itself in trouble early this year. After the country moved to the euro in 2001 it had better access to investment markets; politicians naturally reacted by dramatically increasing government spending. Government accounts for approximately 40 percent of Greek GDP, and government workers there have some of the most lavish benefits in Europe, including the possibility of retirement at age 50 or earlier. That large State sector explains Greece’s low ranking (81st) on the Index of Economic Freedom. Not surprisingly, it has a high degree of economic and political corruption, as well as rampant tax evasion. By 2009 the budget deficit was 12.7 percent of GDP and the debt was 113 percent of GDP. The government tried to cover up the extent of its debt by fudging its numbers, which helped precipitate the crisis.

The most obvious sign of Greece’s problems was the rise in the interest rate on its ten-year bonds to 7 percent, which is high for government bonds. (By contrast, the yield on U.S. ten-year bonds averaged 3.5-4 percent for the first three months of 2010.) Those high rates reflected a loss of confidence in Greece’s ability to pay its debts. The problem, of course, is that those high rates exacerbate the self-perpetuating nature of deficits by requiring larger interest payments in the future, leading to greater deficits.

Since Greece, as a euro country, has no central bank of its own to buy up its bonds, and foreign investors (who own 80 percent of the debt) found the lending too risky, concerns about default rose substantially, prompting calls for emergency bailout loans from healthier European Union countries such as Germany.

The Greek government proposed a variety of measures to try to cut expenditures, including raising the retirement age, overhauling the tax system, and reducing government-employee pay and benefits. Government workers and other union members, predictably, reacted with protests and threatened social unrest if the austerity measures took effect.

This is the trap that Buchanan and Wagner identified. By concentrating benefits on the few, government spending creates beneficiaries who would sustain concentrated losses when spending was cut—giving them every reason to resist the cuts. So Greece finds itself in a bind: To reduce its debt and the possibility of default it must cut spending, which is enormously unpopular among influential constituencies. The near trillion-dollar bailout engineered in May only enables Greece and other beneficiaries to delay the difficult decisions they will eventually have to make.

If we look at some comparable numbers in the United States today, we can see how far the Bush and Obama administrations have taken us down Greece’s path. The most recent data from the Congressional Budget Office (CBO) are sobering. If the Obama administration’s proposed budgets pass, the deficit would be $1.5 trillion this year and $1.3 trillion in 2011, representing 10.3 percent and 8.9 percent of projected GDP, respectively. That is not far from the 12.7 percent Greece faced in 2009. The CBO estimates the deficit will fall as a percentage of GDP toward the middle of the coming decade, but that rests on the heroic assumptions that new reasons for major welfare-state, corporate-bailout, and military spending will not be found and that spending on the health insurance revamp does not grow in the exponential ways we have seen with other social programs.

At the end of 2009 the cumulative debt of the U.S. government was about $12 trillion, with $7.5 trillion—53 percent of GDP—held by the public. The CBO estimates that at the end of 2020 publicly held debt will be a staggering $20.3 trillion—90 percent of GDP—with total debt being notably higher than that. By 2020, therefore, we will not be far behind where Greece is now. Looked at differently, in 2020 the value created by the U.S. economy for the year would be just enough to pay off our total public holdings of debt, but barely. The CBO also provides some evidence for the self-perpetuation process: Between 2010 and 2020 net interest payments are projected to more than quadruple in nominal dollars, and as a share of GDP they will rise from 1.4 percent to 4.1 percent of GDP.

New Money for the New World

The United States, however, has one piece of the puzzle that Greece lacks, which could change the way this process unfolds. As noted, Greece is on the euro, so it lacks a domestic central bank with which to monetize its debt. The United States has the Federal Reserve, so one outlet the federal government has, if skeptical bond markets demand higher yields, is the Fed’s purchase of bonds with newly created money.

Buying bonds in the open market is how the Fed normally increases the money supply, so this is not a new process. When the Fed does this, it returns the yield to the Treasury, thereby giving the government an interest-free loan. Each time the Fed buys a government bond from the public, it enables the government to run additional debt—float more bonds—without a net increase in interest payments.

The Fed could also buy bonds directly from the Treasury and instantaneously extend an interest-free loan through the creation of new money. Historically, it has not done this, but since the current recession and financial crisis began in 2008, it has dipped its toe into those waters. Doing so will become increasingly tempting for the Fed if the rising level of U.S. debt begins to scare off bond buyers.

Of course the danger of doing this too much is inflation. The Greek economy has a very low rate of inflation at the moment, thanks to the relative stability of the euro. However, many other countries faced with similar fiscal situations have resorted to the printing press, generating high levels of inflation that did major damage to their economies.
The U.S. government will be tempted to monetize the debt. If China’s demand for U.S. bonds weakens, driving up yields, the alternative to reducing deficits and paying off debt, or getting a bailout, will be monetization and debasement of the dollar. It will be tempting because the costs of inflation are disguised, dispersed, and stretched over the long run. Politicians rarely get punished for it as they get punished for cutting expenditures.