Even if it managed to squeak through and survive—aided by massive taxpayer infusions along the way—the euro’s vulnerability underscores the folly of a political currency. More so than any other currency in history, the euro has been a creation of technocrats working for modern nation-states. That the euro may well be on its deathbed hardly a decade after its birth demonstrates the futility of central planning. A durable monetary system, free from recurring crises, can only emerge spontaneously from voluntary exchanges in the marketplace.

The European Union and euro were officially created by the Maastricht Treaty in 1993. In addition to the political and cultural objectives, the EU and the single currency, which went into circulation in 2002, were significant steps in the effort to turn Europe into a unified economic zone patterned after the United States.

Before the introduction of the euro, a large business based in France that, say, had a factory paying workers in Italy and which bought machine parts from Germany would be vulnerable to shifts in the exchange rate between the franc, lira, and mark. But with a single currency the firm could focus on its customers and product lines, rather than worrying about the foreign-exchange market. This stability across the continent would (supposedly) give European businesses the same advantages that U.S.-based firms enjoy, since Americans in all 50 states use the dollar.

Because a currency’s ability to facilitate transactions only increases as more people use it, at first we might expect that the nations adopting the euro would want as many of their neighbors as possible to join. Yet in reality there were formal rules (called the Maastricht criteria, also the “convergence criteria”) that new applicants needed to satisfy before adopting the euro. The rules set standards for countries’ inflation rates, budget deficits, government debt, exchange rates, and long-term interest rates.

At first glance it seems odd that the developers of a new currency would want to restrict its usage. To repeat, the whole point of a currency union is to reduce transaction costs among the individuals using it. Thus it would seem that these benefits would only increase as the group grew.

Yet there are other factors at work, which the designers of the euro understood (if only imperfectly). In particular the euro is a fiat currency, meaning that the printing press could be used to achieve political ends. This explains why governments already using the euro are reluctant to admit relatively spendthrift governments into their club: There is a danger that the more profligate members will hijack monetary policy directly, or that they will require a monetary bailout (as we are seeing in practice).

Benefits of a Commodity Standard

Notice that these potential problems would be nonexistent under a fully backed commodity standard. For example, suppose that the creators of the euro, rather than reading the work of mainstream monetary theorists such as Robert Mundell, instead had studied the proposals of Ludwig von Mises in The Theory of Money and Credit. In this alternate universe the authorities in Brussels would stand prepared to issue new paper euros to any individual or institution (including governments and central banks) that handed them a fixed weight of gold.

Under this Misesian scheme the monetary authorities would maintain 100 percent gold backing of the currency; there would be the required weight of actual gold sitting in the vaults in Brussels backing up every paper euro in existence. In this scenario the authorities in Brussels wouldn’t care about the creditworthiness or the spending habits of the institutions applying for new euros. So long as the applicants handed over the correct amount of physical gold, the authorities would be happy to print up the appropriate number of euros.

The reason for this nonchalance is that the various users of the euro—if it were backed 100 percent by gold—couldn’t affect the euro’s purchasing power because they couldn’t affect future “monetary policy” regarding the currency. If the people in Region A used the euro, they wouldn’t be affected by (say) a default on bond payments by some government in Region B that also used the euro. The euros in existence, as well as the ones to be issued in the future, would have a constant redemption rate in gold, regardless of the fiscal solvency of a particular user of the euro.

In case the Misesian thought experiment is too fanciful, we have a much more pedestrian (if imperfect) example: U.S. state governments and their use of the dollar. If the California or Illinois state governments default on the billions of dollars in outstanding bonds that they have issued, no one is worried that this will lead to a collapse of the dollar itself, or that the relatively frugal states (such as Idaho) will elect to leave the “dollarzone” and adopt their own currency.

Thinking through the logic of the situation, it becomes clear that the reason for the difference is that the Federal Reserve (at least in the past) wouldn’t bail out insolvent state governments. To be clear, the people in Idaho might be affected by a default on California state bonds, but not because both areas used dollars as their currency.

However, if the Fed did start bailing out insolvent state governments, then the various states in the “dollarzone” might sit up and take notice. People in Idaho would realize they were paying higher prices because the Fed was creating billions of new dollars out of thin air to prop up the market for state bonds. In this environment a coalition of frugal state governments might demand that their profligate peers adopt austerity measures or else the frugal states would indeed abandon use of the dollar.

As this thought experiment illustrates, we can imagine a situation analogous to the crisis in Europe right here in the United States. All it would take is a Federal Reserve willing to issue extra dollars because member governments ran irresponsible fiscal deficits. We don’t currently link state government finances and the fate of the dollar because the Fed thus far hasn’t altered its policies based on state spending. Under a fully backed commodity standard, this independence of monetary and fiscal policies would be more absolute and would have prevented a crisis like the one now unfolding in Europe.

Those who have followed the mainstream economists’ handling of these issues know that gold convertibility is hardly touted as a solution to the euro crisis. In fact Paul Krugman recently blamed the crisis on the attempts to foist a “nouveau gold-standard regime” on European countries.

This is quite an extraordinary spin. How in the world could Krugman take a fiat currency, explicitly designed from day one by technocrats and without even a historical connection to a commodity money, and denounce it as a modern-day gold standard?

The answer is that Krugman is relying on the mainstream theory of optimal currency area. This theory tries to outline the optimal jurisdictions for different fiat currencies. In this approach the downside of having too large a region using the same currency is that the “optimal” amount of inflation might differ within the region, leading to unnecessary economic pain and hence political conflict.

In the present crisis Krugman and many others think the “obvious” solution would be for Greece to devalue its currency. This would make it easier to repay its debts and would make Greek exports more competitive, thus boosting economic growth.

Alas the problem (according to people like Krugman) is that Greece is not the master of its own economic destiny. Since it adopted the euro it is now powerless to inflate its way out of trouble. Thus the Greeks are condemned to suffer from fiscal austerity and a painful deflation of wages and prices (also known by the misleading term “internal devaluation”).

Now we can understand the (tepid) connection that Krugman and others are drawing between the current situation in Europe and the classical gold standard. Under the latter, if one country printed too much money its domestic prices would rise faster than those of its peers. The country would experience a trade deficit as its own exports became relatively expensive. The outflow of gold from the country would force officials to tighten monetary policy until wages and prices had fallen (if not in absolute terms, at least relative to the levels of other nations) and international competitiveness had been restored. Under the classical gold standard each nation’s currency was pegged at a fixed exchange rate to gold, so that no country could gain an advantage by devaluing its own currency. All adjustments to ensure sustainable trading patterns had to occur through changes in relative prices and wages, not through fluctuations in exchange rates.

Further Integration

The mainstream theory of optimal currency area sheds light on another (alleged) lesson being drawn from the present crisis: the need for fiscal union among the eurozone states. For example, Mario Draghi, the incoming head of the European Central Bank, recently said Europe needs to “make a quantum step up in economic and political integration.” Mainstream theory shows that it is suboptimal to have a single currency covering areas with governments enacting different fiscal policies, and hence the “obvious” conclusion is that the European governments must be brought under the control of a single agency.

As usual one intervention leads to another. After historically co-opting and then suppressing the market-chosen monies (gold and silver), the European governments in recent years upped the ante by creating a new fiat currency. Even though the ostensible safeguards failed miserably—Greece and several other participating governments have come nowhere near obeying the Maastricht criteria—the alleged solution is the creation of even more centralized power, with even less control by the people being so ruled.

The people of Europe are being conned. They do not need to sacrifice even more political sovereignty to a group of international bureaucrats and bankers. The dream of the euro—an integrated economic zone with a stable currency—can be achieved through the classical-liberal tenets of free trade and sound money. Continued experiments with fiat money regimes will lead us through a perpetual series of crises, until we are left with a single global fiat currency, the issuer of which has zero accountability to the hapless citizens forced to use it. According to many cynical observers, this after all may be the ultimate plan.

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.

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.

Despite assertions that it has ended its policy of quantitative easing (QE), the Fed is unlikely to be able to do so until it also ends its zero-interest-rate policy (ZIRP). This deadly policy duo has had terrible consequences for the American economy and every country using U.S. dollars, which continue to depreciate.

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. As investors flee an enfeebled dollar and ponder S&P’s downgrade, the Fed is likely to be the “buyer of first resort” so that the price of Treasuries does not fall, pushing up interest rates. 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.

Excess Liquidity

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 with the Fed having 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 of mortgage securities and $100 billion of 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 an increase in the monetary base of 140 percent.

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 Treasuries using proceeds from maturing debt it already owns, allowing it to engage in continuing quantitative easing by another name.

With over $112 billion of the Fed’s government bond holdings maturing over the coming 12 months, replacement alone would involve purchases of Treasurys of over $9 billion 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.

Last Gasp

For all the fanfare about QE, it must be said that it constitutes a last-gasp step and admission of 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).

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 demur that previous amounts were too little and more is needed.

No Growth

But 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.

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

These reverse 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 the choice between holding risk-free, interest-bearing assets a much better bet than issuing new commercial loans.

Repressed Inflation

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 and unable to change course means that the U.S. and Japanese economies are doomed to painfully slow economic growth for the foreseeable future.

We can’t get anywhere with these questions until we agree on the meaning of inflation. At one time the word referred to an increase in the money supply. Over time it came to mean a general increase in prices, an unfortunate turn of events not just because we lost the nice metaphor of an inflating balloon, but also because the shift in meaning tended to obscure the relationship between the two phenomena. Some free-market authors hold out for the old definition, but I suggest this is wasted effort. In my classes I use the phrases “price inflation” and “money inflation” to keep the distinction alive without getting too sidetracked by semantics.

In 1970 Milton Friedman said, “[Price] inflation is always and everywhere a monetary phenomenon.” This is not entirely true but understandable because he was writing at a time when the causal relationship had nearly been forgotten. We can have price inflation without money inflation when there is a supply shock. An overthrow of the Saudi government, for example, might well disrupt the flow of oil from that country. A surging oil price, because it is so important to our economy, would likely pull up the price level with it. In this situation the monetary authorities can help things by doing exactly nothing—letting higher energy prices do the work of encouraging marginal users to cut back. Supply shocks, as such one-time events are called, do not of themselves generate sustained price increases and are therefore not classified as inflation by some economists.

Price inflation of a mild sort can also happen as new and more efficient payment systems are devised. When we acquire debit cards and credit cards, we find it less necessary to hold a supply of money for our daily needs or emergencies. We may reduce not just our currency holdings but also our checking account balances. But money is always in someone’s possession, so an aggregate decline in the demand to hold money results in faster spending, which generates price inflation. Those higher prices motivate people to increase their desired money holdings back to the previous level.

Expectations of future price inflation can also be a source of current price inflation. There is a great deal of inertia in inflation expectations. When there has been a long period of stability we tend to gloss over early signs of inflation, and it takes a long time for people to realize that price rises aren’t just temporary. Likewise, when prices have been rising steadily, people are skeptical of deflationary (or disinflationary) developments. During an inflationary period expectations can run ahead of the money supply. Thus during the German hyperinflation of the 1920s people spent their money faster than the authorities could print it, and almost until the end the authorities denied that money printing was the root of price inflation, believing instead that money creation should be stepped up.

Recently Fed Chairman Ben Bernanke said he was not worried about price inflation because investors are currently paying a very low premium for inflation-protected Treasury securities, adding, “The state of inflation expectations greatly influences actual inflation.” Gerald O’Driscoll, well known in free-market circles and a former Fed official, retorted that Bernanke “has the causation precisely backwards” (TheFreemanOnline, Feb. 28). In fact the causation runs both ways. Market participants try to figure out what the Fed will do, and the Fed tries to figure out how it can influence expectations, and on it goes, back and forth. But as in the stock market, expectations may turn out to be wrong, and in the long run only the fundamentals matter.

What of the converse of the Friedman proposition? If there is money inflation must there necessarily be price inflation? The first chart suggests not. Price inflation got ahead of money inflation in about 1980, as Fed Chairman Paul Volcker’s tight money policy did not at first overcome expectations. But since 2008 the monetary base has exploded without any significant price inflation. Why?

The Federal Reserve controls the monetary base, consisting of publicly held currency plus commercial banks’ reserve accounts at the Fed (this is also referred to as M1). The Fed increases the base when it purchases assets, typically government securities, using newly created money. Commercial banks then pyramid on top of the monetary base. A dollar of reserves can support up to about ten dollars in new loans—a multiplier effect. In the 1950s M1 was about 3.5 times the size of the monetary base. That multiplier declined sharply after 2000, until, as the first chart shows, the monetary base raced ahead of M1 money.

New money created by the Fed first goes to the bank accounts of the parties such as bond dealers from whom the Fed buys assets. Typically banks loan out most of that money because that’s how they seek profits. Bankers normally consider reserves in excess of the level required by the Fed as idle assets, which are to be avoided. Total reserves were around $2 billion until the crisis of 2008, at which time they began to skyrocket. They now exceed $1,100 billion. What motivated this huge increase? First, banks seem not to find a lot of attractive lending opportunities at this time. Second, since 2008 the Fed has been paying interest on reserves, currently a very modest 0.25 percent per year.

About Those Reserves . . .

Now for the $64 trillion question: What if banks reverse course and start deploying some of those idle reserves? Suppose they find good loan opportunities and jumpstart the pyramiding process? If the M1 money multiplier were to rebound from 0.8 to 1.6, where it stood just three years ago, assuming no change in the monetary base, we would get about $2 trillion flooding into markets. What could the Fed do to head off the price inflation that would follow?

In the past the Fed might have opted to drain reserves by selling Treasury securities. This would depress the price of those securities and raise interest rates—not good for the economy and not good for the Treasury, which counts on selling large quantities of new securities at low interest rates. The Fed now has an alternative that could restrain price inflation by keeping reserves in place. It could raise the interest it pays on reserves. This would discourage banks from expanding their loan portfolios. This latter method can be applied at a keystroke, in contrast to sales of Treasury securities, which takes time. Still, we have to wonder if Bernanke and friends will apply the brakes at just the right time. Given the dynamics of expectations and the uncertain prospects for supply shocks, it will be a difficult trick to say the least. Higher interest rates could wreak havoc on the federal budget. The President’s budget proposal for FY 2012 sees net interest payments rising from about $200 billion for FY 2011 to $928 billion for 2021. As always, the budget is based on optimistic assumptions about tax revenue growth and spending restraint. But it is also optimistic about interest rates. Higher rates could drive interest expense much higher, and because so much outstanding federal debt is of short duration, the effect might happen quickly.

Price Inflation: Mixed Signals

What of current price inflation? Is it really as low as the CPI suggests? It depends where you look. House prices are way down, and housing is part of the CPI. Homeowners are assumed to charge themselves rent, but lucky for them that charge is down. This may be scant comfort to homeowners facing increases in the prices of things they buy for cash, many of which are up.

The stock market has nearly doubled since the low of early 2009. Commodity prices have been soaring. A recent 12-month period saw increases of 31 percent in crude oil, 79 percent in wheat, 166 percent in cotton, 98 percent in rubber, 44 percent in copper, and 94 percent in silver. But natural gas prices fell 23 percent, and olive oil (extra virgin, that is) is off 12 percent. Firms that process these raw materials into retail products typically hedge their positions with futures contracts, but as those contracts expire they will begin paying more for raw materials. Some of those increases are already finding their way into retail prices.

Crude-oil prices spiked to $140 per barrel in 2008, then collapsed. But in late May they again passed $100. A disruption in supplies of Middle East oil could send the price much higher, or a return to stability could send them lower. No one knows. All we know is that crude-oil price changes make their way very quickly into retail gasoline prices. Truckers and others who are sensitive to fuel prices are adding fuel surcharges to their rates. Other effects lag further behind. Should oil remain above $100 we can certainly expect more retail price increases.

Wholesale price increases on foodstuffs have already affected retail prices. The Food and Agricultural Organization’s world Food Price Index has risen dramatically, as the second chart shows. This is becoming a crisis in poor countries, where food takes a large share of personal income. Prices are beginning to rise in the United States as well. Hershey, for example, announced a 10 percent increase across the board, citing increased raw material and transportation costs. The Agriculture Department is projecting a 5 percent price increase this year for a basket of common food items (basics, not chocolate).

What about other retail prices? Walmart CEO Bill Simon, who ought to know, recently said price inflation is “going to be serious.” The news media are full of articles about inflation. The last big U.S. inflation was in the 1970s, but should it heat up we can expect the younger generation to catch on fast—and for expectations to begin to run with or ahead of price increases.

What’s Ahead

Inflation hawks are inside the gates of the Fed. Kansas City Fed president Thomas Hoenig recently blamed the Fed’s highly accommodative policy for rapidly increasing global food prices and called for an increase in the target Fed funds interest rate to 1 percent in a “fairly short period of time.” Presidents of the Philadelphia, Richmond, and Dallas branches are also considered hawkish on inflation but are opposed by New York Fed president William C. Dudley and by Bernanke himself. Bernanke recently testified that food prices have risen in all currencies, not just the dollar, as if this exonerated the Fed. Markets, after all, are globally connected.

Could China export inflation to the United States? The Communist Party’s new five-year plan is supposed to focus on the well-being of the common folk. This would mean a reduction in the forced savings that have boosted Chinese export industries and thus higher prices for Americans.

The U.S. presidential election is next year, and the political business cycle is with us as ever. The administration, aided and abetted by the Fed, will be doing all it can to reduce unemployment before the election while keeping the lid on price inflation. On the fiscal side there will be no significant budget cuts, which nearly always have negative short-term consequences but benefits that accrue only long after the election.

We would all do well to prepare ourselves, without going overboard, for inflation. Personally, I’m bullish on cat food. Why not stock up on durable goods? Savings accounts pay nothing, and you’re going to consume the stuff anyway.

Stagflation, anyone?

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.

There is no indication that inflation is heating up this time, either. Investors wouldn’t be snapping up three-year Treasury notes at 1 percent if they were expecting their purchasing power to be ravaged by wolves any moment now….

The last epidemic of inflation, in the 1970s and early ’80s, was a searing experience, from which the Federal Reserve learned lessons it has no desire to repeat. Is inflation coming back? Sure. Right after the Ford Pinto.

It’s worth reading.

HT: Jeffrey Rogers Hummel

This policy, known as Quantitative Easing (QE), consists of buying longer-term financial instruments, notably U.S. Treasury bonds and private mortgage-backed securities. Since the Fed engaged in one round of quantitative easing in 2008–10, the current round (announced last November, but signaled for months prior) has been labeled QE2.

QE2 is a departure from the Fed’s usual procedures, which aim primarily to affect short-term interest rates through purchases of short-term (less than a year in maturity) Treasury bonds, or T-bills. This tool of monetary policy, known as open-market operations (OMO), has largely been on the sidelines for the past two years, since the Fed drove the key short-term rate to near zero in late 2008 and has kept it there. The Fed turned to QE that year because the Great Recession was so severe. QE1 was primarily aimed at buying up MBS, many of which were considered “toxic” due to mortgages that were unlikely to be repaid. These MBS were like albatrosses around the necks of many banks, leading the Fed to try to help by taking these liabilities off their hands. Astonishingly, through $1.75 trillion of such purchases, the Fed increased the monetary base (currency plus bank reserves) by nearly 200 percent between December 2008 and March 2010.

However, rather than stimulating the economy through increased lending, much of that new money has remained idle, locked up in vaults as banks have been unwilling and often unable to lend. (Regulators in the past two years have considerably tightened lending standards, making it much more difficult to qualify for a loan, especially in these uncertain times.) Moreover, the Fed started to pay banks interest on their reserves held at the Fed. This is why the massive increase in the monetary base has not brought about much increase in the active money supply (currency plus deposits), which is necessary to stimulate the economy. This is also why the official inflation rate has continued to stay so low.

Given the failure of QE1 to return growth and unemployment rates to normal levels, the Fed has embarked on another round. In early November it announced it aims to purchase $600 billion in long-term Treasuries to bring down their yields (which act as the benchmark for many long-term interest rates) and spur lending, especially in the hard-hit real-estate markets, as well as increase inflation, which, according to the Fed, is too low to be consistent with a robust rate of growth.

The announcement of QE2 was received with widespread skepticism or even outright derision— from distinguished monetary economists such as John Taylor as well as politicians like Sarah Palin. Chairman Ben Bernanke and the Fed governors have, in return, mounted a major defense, with Bernanke even appearing on 60 Minutes in early December. But his protestations ring hollow. Every Fed chairman has sworn that he was not to blame for the economic calamities that occurred on his watch, and that without his actions things would have been much worse. It is always only years later that subsequent Fed policymakers are willing to acknowledge the Fed’s previous failures.

Inflation Expectations

The critics of QE2 have pointed to two problems with the policy: First, the Fed is seemingly ignoring the key role that inflationary expectations play in its ability to effect a macroeconomic result. The Fed’s actions are reminiscent of the 1960s, when the Keynesian economic mainstream relied on the now-discredited Phillips Curve theory to control the economy. The Phillips Curve purported to show a stable trade-off between inflation and unemployment; therefore the policymakers needed only to increase inflation to lower unemployment to an acceptable level. It turned out that this only worked as long as people’s inflationary expectations did not change—but of course as inflation went up, inflation expectations followed, ultimately leading to increasing rather than decreasing unemployment. After the painful stagflation of the 1970s, as well as the theory’s thorough drubbing by some of the most highly respected economists of the past half a century (including Milton Friedman), one would have expected the Fed to have permanently learned how difficult it is to control inflation expectations, as well as how fundamental they are to the Fed’s ability to control inflation itself. However, the Fed now appears committed to taking us down that road again. (And in fact Treasury yields went up rather than down in the first six weeks of QE2, possibly due to inflation expectations—a key component of long-term interest rates—themselves going up).

If the Fed Had a Hammer

The second problem with QE2 is that the Fed is stuck in an inappropriate economic model, which embodies the adage that when all you have is a hammer, every problem looks like a nail. The Fed really only has one policy tool: raising and lowering interest rates, whether short- or long-term. Therefore all economic problems seem solvable to the Fed through the use of this tool. The Fed has used it enthusiastically over the past ten years, bringing interest rates down to then-record levels in 2003–05, spurring a massive boom in both private and public debt and pushing the average savings rate negative for the first time in U.S. history. It is now increasingly accepted that loose monetary policy was one of the major causes—maybe even the primary one—of the Great Recession. For the past two years individuals and businesses have been slashing expenditures, increasing savings, and paying down debt—trying to get through the Keynesian hangover. But the Fed will have none of that: If Americans are not borrowing and spending enough, the Fed will lower not only the short-term rates but also long-term rates. In other words, it’ll make us an offer we can’t refuse—and we’ll be back on that not-so-merry-go-round yet again.

In response to these and other criticisms (leveled even by some of the Fed’s own, such as Kansas City Fed president Thomas Hoenig), Bernanke and other Fed officials responded in an unexpected way: They claimed the current policy isn’t actually “quantitative easing,” since the money used to purchase the Treasuries will not be newly created and therefore the monetary base will not increase. With QE1 the Fed “printed money” to purchase the assets, but this time it is simply “reinvesting” the funds that it receives from the maturing MBS in its portfolio.

This is a rather strange turn of events, as the Fed itself initially emphasized the $600 billion, making it appear that this will be a new injection and therefore a stimulus. But if the monetary base stays the same, it means only that the Fed is changing the composition of its balance sheet: fewer MBS, more Treasuries. That may have some macroeconomic effect (currently debated in the blogosphere), but certainly not very much, either on unemployment or inflation. Yet Bernanke and others have made a big deal about QE2 lowering long-term interest rates, stimulating the economy, lowering unemployment, and diminishing the danger of a deflationary spiral, something that they cannot possibly believe if QE2 isn’t really a quantitative easing.

So what exactly is going on here?

It is difficult to know. Economists are increasingly noticing the inconsistencies between the Fed’s words and deeds, but so far it has led mostly to head scratching. A likely explanation is that the Fed is trying to fool us—to convince us that there is an ongoing monetary stimulus, hoping that this will comfort investors and real-estate markets, while simultaneously reassuring inflation hawks that the policy will not further increase the monetary base, which has already gone up quite enough. If this conjecture turns out to be right, a notable victim of QE2 will be Bernanke’s commitment to his own ideals. He has been a leading proponent of inflation targeting, which stresses the importance of continuous and thorough communication with the public for the sake of transparency and accountability. All that appears to be out the window now. Not only is the Fed failing to be transparent, it may be guilty of actively misleading us. After three decades of increasing transparency, it seems that the Fed may be returning to its old ways.

It might be difficult to accept that the Fed would be willing to risk its hard-won credibility just to get some more short-term stimulus. Yet it is possible that this is all driven by a much bigger issue: U.S. fiscal policy, which has gone over the cliff in the past three years. The federal government has racked up $5 trillion in new debt in that time, with much more to come, financed through new Treasuries. Such a massive increase in supply has been driving down their price and pushing up yields—along with long-term interest rates. Given the extremely fragile real-estate market, rising long-term interest rates are the last thing the Fed wants, so it is not surprising that it would attempt to counteract them.

More problematically, the Fed may also be buying up Treasuries to keep down the financing costs of the federal government’s growing debt burden. If this is indeed what has been driving QE2—which the Fed, not surprisingly, vehemently denies—it would mark a sharp break with modern history. In the Accord of 1951, the Fed reasserted its control over monetary policy after ten years of pegging bond rates very low to make it cheaper for the federal government to fight World War II. If it begins to be perceived as the Treasury’s puppet again, investors could rapidly lose confidence in the prospect of both an economic recovery and low inflation, not to mention the long-term viability of the massive federal government debt.

Eventually the economy will start growing faster, likely leading to a rapid dislodging of currently idle reserves through cheap loans. As that cash starts entering the economy, inflation rates will inevitably be driven higher. The Fed may or may not keep this process under control, but it doesn’t even matter all that much, as the damage will already have been done. What Bernanke and most others at the Fed clearly fail to understand is Ludwig von Mises’s and F. A. Hayek’s fundamental point that artificial manipulation of interest rates by a central bank distorts microeconomic reality, perverting relative prices and sending the wrong signals to both entrepreneurs and consumers. This leads to faulty decision-making, resulting in more misallocations, malinvestments, and asset bubbles. In other words, by not allowing prices to fall to correct for the past artificial stimuli, the Fed is actually preventing the economy from adjusting and beginning a true recovery. QE2 continues this error.

There is always an easy solution to every human problem – neat, plausible, and wrong. –H. L. Mencken

I have devised a simple plan for improving Americans’ health by drastically reducing everyone’s weight, significantly increasing longevity and reducing medical costs.  All we need to do is revalue the pound.  Instead of a pound being 16 ounces, it will now be 32, cutting everyone’s weight in half.  We adjust our bathroom scales, our weight drops, and our health is improved.

Of course this “solution” rests on two fallacies.  First, it conflates measurement with what is measured.  Adjusting my bathroom scale does not change my weight, only my perception of my weight.

Second, the solution confuses cause and effect.  My weight is not necessarily the cause of my health or lack thereof; in fact, my weight may be caused by my health – an injury that keeps me from exercising or a thyroid condition, for example.  More commonly, good health is the result of responsible actions taken over many years: moderating calorie and alcohol intake, eating the right foods, engaging in regular exercise, getting quality dental and medical care.  Such actions are likely to result in both moderate weight and good health.  Conversely, I can no more make myself healthy by adjusting my bathroom scales than a doctor can cure a child’s cold by adjusting the thermometer he uses to measure her fever.

Brilliant Fools

The two fallacies are so obvious that no one could possibly fall for them, right?  Sadly, no.  Many brilliant people have fervently believed in nearly identical fallacies for decades and are even now basing our country’s monetary policy on them.

Historian T. S. Ashton noted in his book The Industrial Revolution, 1760 – 1830 (9-10):

If we seek – it would be wrong to do so – for a single reason why the pace of economic development quickened about the middle of the eighteenth century, it is to low interest rates we must look.  The deep mines, solidly built factories, well-constructed canals, and the houses of the Industrial Revolution were the productions of relatively cheap capital.

John Maynard Keynes, making this same observation years before, concluded that simply by manipulating a country’s monetary supply and financial markets to produce artificially low interest rates, “deep mines, solidly built factories, well-constructed canals and houses” would spring into being.  But Keynes is confusing “cheap capital” with easy money.  Capital – inventories, pre-consumer goods, and the methods and means of production – cannot be conjured into being by manipulating interest rates.  They must be produced through saving, that is, deferred consumption.

Capital goods can be relatively cheap only if they are relatively plentiful.  Increasing capital, all else equal, will lower interest rates.  Interest rates are a measure of capital’s availability. Dictating low rates will not improve a nation’s fiscal health any more than manipulating my bathroom scale will improve my physical health.

But low interest rates depend on more than just the availability of capital goods.  They are also a function of the risk in lending.  Risk in turn can be affected by such things as the reliability and efficiency of transportation, communication, and capital markets.

Transporting goods by human or animal power is slow and costly.  Sailing ships can carry far more goods far more quickly.  Steam-powered ships are faster and more efficient still.  Transportation costs, then, are inversely proportional to the level of technology.  But costs also depend on the rule of law.  When local barons can block mountain passes and extort steep tolls, or when highwaymen and pirates can exact their own tolls with impunity, transportation becomes risky and expensive.  Conversely, both transportation costs and lending risks are reduced if private property rights are respected and enforced.

Efficient capital markets foster trade by reducing transaction costs.  Such markets depend on property rights and laws of exchange and on fast and reliable methods of communicating information such as prices, weather, and changing market conditions.  Like transportation, communication depends on the level of technology.

Doing the Right Thing

Low capital costs are the result of a lot of people doing the right things for a lot of years: institutions protecting private property and preserving the rule of law, inventors devising new and useful products, entrepreneurs bringing those products to market and finding ever more efficient ways to satisfy customers, individuals producing more than they consume and saving for the future.

Artificially driving interest rates down cannot raise a nation’s level of technology, magically bringing railroads or fax machines into being.  Manipulating markets through monetary policy destroys rather than secures property rights and does nothing to establish rules of law that constrain both the rulers and the ruled.

The costs of fooling ourselves can be high.  By readjusting my bathroom scale I disable an indicator that might warn me when I need to change my eating and exercise habits.  By overriding market money prices we similarly deny ourselves important data about the country’s fiscal health.  Our weight and the real price of money are both valuable pieces of information providing vital feedback on our actions.  Manipulating that feedback destroys the value of the information and, rather than giving us control, gives us only the illusion of control.

Money of any sort, commodity-based or not, derives its value in large part from what economists call a “network effect.” Like a fax machine, whose value depends largely on how many other people have fax machines, we value money because other people value it. We feel confident our money will buy us what we need tomorrow. A strong network effect means that something drastic has to happen before people will give up their familiar form of money.

Something drastic was happening when U.S. Rep. Ron Paul’s Gold Commission was set up in 1979. By the time the commission’s report was issued in 1980, inflation had reached alarming levels: The consumer price index was at 14 percent and rising. The prime rate was over 20 percent, and in 1980 silver exploded to $50 an ounce and gold surpassed $800 (about $2,300 in today’s dollars). Bestselling books urged people to buy gold, silver, diamonds, firearms, and rural hideouts.

We now know that inflation was peaking and that the silver price spike was a fluke caused by a failed attempt to corner the silver market. But none of this was apparent at the time, so it was reasonable to wonder whether our monetary system would survive. What did happen, of course, was that the new Fed chairman, Paul Volcker, stepped on the monetary brakes hard enough to break the back of inflation. Two back-to-back recessions resulted but were followed by a long period of recovery in which both inflation and interest rates dropped steadily. The Gold Commission was largely forgotten, though the U.S. Mint did get into the business of producing gold coins in a big way.

We have a crisis of a different sort at present, featuring unprecedented levels of public and private debt rather than inflation. In addition, global trade has advanced significantly and worldwide financial markets are tightly linked. Many new financial innovations have emerged since 1980, not just the sophisticated derivatives that were at the center of the 2008 crisis, but also innovations such as exchange-traded funds (ETFs) that are available to everyone. The euro is in trouble, and there is a real possibility that a Chinese property bubble is about to burst. Gold is above $1,400 an ounce, up from $250 a decade ago, while silver has advanced from about $5 to over $30 an ounce.

Ron Paul is no longer a lone voice calling for a return to gold. Robert Zoellick, president of the World Bank, astonished everybody recently when he wondered out loud whether gold should again play a monetary role. Although he drew praise from some quarters, most comments were dismissive. Berkeley economist Brad DeLong, for example, nominated Zoellick for the “Stupidest Man Alive.” One is reminded of Gandhi’s four steps to victory: First they ignore you, then they ridicule you, then they fight you, then you win.

In 2010 the Central Bank of China imported over 200 tons of gold, more than offsetting recent IMF sales. This is in addition to the 350 tons that are mined in that country annually. Wealthier Chinese citizens are adding it to their portfolios. While substantial, Chinese gold holdings are still dwarfed by their holdings of U.S. Treasury securities. The gold purchases may be intended mainly as a signal of its displeasure with dollar hegemony. Other central banks are acquiring gold in smaller amounts.

Monetary Links to Gold

Within just a few years ETFs have attained a prominent place in the investment world. None has been more amazing than the SPDR Gold Trust (GLD), which purchases and stores gold bullion for the benefit of its shareholders. This fund was launched in 2002 by the World Gold Council, an industry group, as a means of stimulating demand. The results have exceeded their wildest dreams. GLD now holds about 1,300 tons of gold bullion, a hoard larger than that of any central bank save four. (A metric ton of gold would fill a large suitcase and have a market value of about $45 million.) Competing funds of the same sort now offer silver, platinum, and palladium in addition to gold.

Gold coins are also selling at a brisk pace. The U.S. Mint offers Gold Eagles along with an array of silver and platinum coins. But it’s difficult to get one-ounce Eagles at present, and the smaller sizes have been discontinued entirely because the Mint has run short of bullion inventory. Presumably this is bureaucratic ineptness, because the bullion markets are highly liquid. Canadian Maple Leafs, South African Krugerrands, and others that compete with the U.S. coins are readily available. These are all “bullion coins,” so-called because their value is only marginally above their gold content.

The one-ounce Gold Eagle and the Maple Leaf have an interesting feature: They are legal tender, the Eagle for $50 and the Maple Leaf for C$100. While the gold price will surely never again see such low levels, it is interesting that the authorities saw fit to establish this modest link between gold and money.

Soaring prices for precious metals and unprecedented demand for bullion gold and silver coins are an obvious sign that investors are worried. Anyone who buys bullion or coins has to be concerned enough to forgo interest income and pay, directly or indirectly, storage and insurance costs. If and when confidence in the world’s monetary and banking institutions returns, we can expect a rush out of precious metals and into productive assets.

Now to the central question: Will gold again be money?

Don’t Call It a Comeback. Yet.

Gold is too volatile, say some. If, for example, the Fed were to adopt a stable gold price as its monetary target, it would be hitching the U.S. economy to a wild horse. If the Fed had tried to track gold’s recent rise, it would have had to engage in massive quantitative “dis-easing.” Monetary deflation added to falling aggregate demand would have been a disaster.

The problem with this argument is that it takes the gold price as given. Had the Fed hitched its wagon to gold some years ago, it would have added significant inertia to the “wild horse” and it is likely that the run-up would have been milder or nonexistent.

Still, gold targeting by the Fed is probably not a good idea. The Fed has lost a great deal of credibility of late, thanks in part to Chairman Ben Bernanke’s recent declaration on 60 Minutes that the Fed would not “print money” to carry out the next round of quantitative easing. The chairman’s life will only get more complicated now that Ron Paul has become chairman of the House Subcommittee on Domestic Monetary Policy. Should the Fed adopt gold targeting, markets would need to be shown over a long period that it was serious about hewing to gold in the face of political pressures to the contrary.

One hundred years ago it was common to link contracts such as railroad bonds to gold. I have in my possession such a bond, issued in 1893 (it’s a beautifully engraved document, incidentally), which promises to pay at maturity “one thousand dollars in gold coin of the present standard of weight and fineness.” Borrowers probably didn’t expect to be paid with a stack of 50 gold coins, which would have been inconvenient. Rather, the phrase was meant to protect the borrower from future government debasement of money. But sanctity of contract went out the window in 1933, when Franklin Roosevelt abrogated all such private contracts at a stroke. Predictably, 50 one-ounce gold coins now fetch nearly $70,000.

Gold Clauses

A comeback of gold clauses in business contracts is a realistic possibility, provided they could survive legal challenges based on legal tender laws. Imaginative clauses could be created that guaranteed a return in dollars at least partially linked to the gold price. Such things already exist, in fact. Everbank, an online bank, currently offers, among other innovative products, a five-year certificate of deposit whose return is tied to the price of a basket of precious metals. At worst, investors get their principal back. At best, their five-year return is capped at 50 percent. Everbank is not, of course, issuing gold-backed money, but it is coupling gold to money’s role as a store of value.

Another possibility is that shares of GLD could assume an informal monetary role. Those shares currently trade for about $135 each. Originally they represented one-tenth of an ounce but have lost some value as administrative charges have been deducted. New sub-shares, perhaps representing one gram each, would equate to $45. Getting such sub-shares into circulation would be much easier via the Internet than getting paper shares into circulation. Such schemes would of course require government forbearance backed by political pressure. That pressure would not likely arise until and unless the current financial crisis grew to alarming proportions.

In 2003 e-gold.com was established as an online gold-payment service, growing to five million accounts in 2008, according to its owners. That year the company pleaded guilty to conspiracy to engage in money laundering and conspiracy to operate an unlicensed money-transmitting business. The company’s problems seem to have had more to do with security than with gold per se. Still, the e-gold case serves as a reminder that innovators in gold payments may face legal problems.

Recently J.P. Morgan Chase announced that in addition to Treasury securities, it would begin accepting gold as collateral for certain loans. “Many clients are holding gold on their balance sheets . . . and are looking to make these assets work for them as collateral,” said a company spokesman. “It gives another use to gold as a cash instrument,” added a commodities analyst, exaggerating only slightly. Indeed, Treasury securities are considered very close to money itself in terms of safety and liquidity, so it is rather remarkable to see gold accepted as substitute collateral even in this minor sector of the financial markets. It suggests a gradual movement of gold toward monetary status.

New Currencies

What about a new currency backed by the Fort Knox holdings? There would be practical difficulties, assuming most of the gold is in 400-ounce bars, each with a dollar value exceeding a half-million. It would be expensive to convert all this to coin, and besides, the smallest practical coin, perhaps five grams, would still represent over $200. A $10 gold note would fetch a mere speck of gold. More realistic than gold notes would be a spinoff of a new gold exchange-traded fund. Shares of that fund might gain gradual acceptance as money, especially if a dollar crisis were in progress.

U.S. public or private institutions aren’t the only possible sources of a return to gold. Though globalization has been fostered by declining trade barriers and transportation costs, we still lack the considerable advantages of a uniform worldwide currency or rigidly linked currencies. In the late nineteenth century, when all major currencies were tied to gold, the dollar/pound exchange rate was no more worrisome than the inch/centimeter exchange rate. As things stand now, firms doing business in different currencies must divert significant resources away from satisfying customers and into managing exchange-rate risk. Currency fluctuations have not been minor, as Milton Friedman expected when he first proposed floating exchange rates. During 2010, for example, the euro ranged between $1.19 and $1.45—a variation wide enough to turn a multinational firm’s yearly profit into a loss or vice versa. The need for a new global currency may be an opportunity for some enterprising central bank—China’s perhaps—or some private firm to establish a new international form of gold-linked money or near-money.

There are those who defend the gold standard on ideological grounds, claiming near perfection for it. This is unrealistic. For example, price inflation can happen under a gold standard. Ironically, as confidence increases in a fractional-reserve gold standard, people are less inclined to hold monetary gold. The multiplier increases, and there is price inflation—mild, gradual, and predictable. Increasing prosperity and the consequent increasing demands for nonmonetary applications of gold such as jewelry or technology would work in the opposite direction: The supply of monetary gold would drop, causing deflation. New gold discoveries or better mining techniques dilute gold’s purchasing power—another inflationary development likely to be mild and gradual. But it is conceivable that someone could invent an economical process for converting base metals into gold—the alchemists’ dream. This very unlikely development could be a major disruption to an economy using gold-backed money. The most likely situation under a gold standard would be gradual, mild deflation as happened in the late nineteenth century. In short, a totally stable price level, if such could be defined, is not something to expect from a gold standard.

Resource Costs and Stability

We cannot overlook the resource cost of gold locked away as backing for money. Monetary gold cannot be used for jewelry or electronics. Friedman once dismissed a return to gold on the grounds that the resource cost would amount to 2 percent of GDP. But his estimate was predicated on 100 percent backing of the wider M2 money supply. Under a fractional reserve system, the cost would be much lower.

Of course, monetary gold lying “idle” in a vault is only idle in a naive physical sense. A gold bar sitting undisturbed in a vault is producing security for holders and users of money day in and day out. The irony here is that while the amount of monetary gold would likely decrease as a fractional-reserve gold system gained confidence, our present system seems to require the retention of 8,000 tons at Fort Knox, while leaving the control of money under the increasingly politicized Federal Reserve—the worst of both worlds.

It is possible that stability will return to our current monetary and banking systems. We could have a repeat of 1980 and a couple of decades of stability and growth. If not, there is good reason to believe that gold will make a return in some form.