To begin with some basics, what is work and what is a job? For economists, work is any activity that we would not perform without tangible compensation, usually money. In our work lives almost all of us are also motivated by nonmonetary considerations, and to the extent we diverge from the most remunerative activity available to us, we are blending work and leisure. A retired person who takes up college lecturing may do the work primarily for the satisfaction it brings. If his salary were withdrawn and he continued to teach, he would be enjoying leisure.

The goal of all economic activity is consumption, which to economists means not just mundane goods like faster cars but also “noble” ends like cathedrals. Jobs are therefore not ends in themselves, as much as public discussion would suggest otherwise. They are means to acquire income to be used for consumption and saving, in addition to personal satisfaction, learning opportunities, or socializing.

A person who lacks a job is unemployed if he or she wants work, has suitable skills, and has realistic expectations about compensation. These are vague terms; they make unemployment a murky concept. That goes double for underemployment, though both remain very real phenomena.

What is it about unemployment that makes it so problematic? Why can’t markets cure labor surpluses with lower wages as coffee surpluses are cured by lower coffee prices? Is government interference to blame, or is there something about free markets that allows unemployment to persist?

Both. Let’s look first at natural unemployment, which is unemployment not caused by government policies. Economists Milton Friedman and Edmund Phelps brought this concept to the fore during the 1960s even though, like most modern economic concepts, it had been recognized in various guises long before they wrote of it.

Labor markets, even when unhampered by government interference, are different from other markets. Nonmonetary considerations do not arise in other markets as much as in labor markets. Not just salary, but working conditions, job satisfaction, and advancement opportunities matter to most job seekers, often greatly.

A certain number of unemployed people are holdouts, people who might find some sort of job fairly quickly but are holding out for a higher salary, more job satisfaction, convenient location, and so on. Lumping all holdouts together is problematic. Some may harbor unrealistic expectations. Some feel constrained by their spouses’ wishes. Some have ample savings and can afford to hold out more stubbornly than others.

Some holdouts are reluctant to relocate. Moving is usually expensive and often emotionally distressful, especially to children. The current lingering housing crisis makes moving especially unattractive to some. People who are not only unemployed but also “underwater” in their mortgages—and particularly those who have simply stopped making payments, knowing that their lenders may not get around to their case for months or even years—are strongly inclined to stay put rather than accept distant job offers.

Efficiency Wages

Another form of natural unemployment is a bit subtle but very real. It goes by the name “efficiency wages,” based on the fact that recruitment and training costs are quite significant for most firms. Employers want their new hires to stick around so that these costs can be amortized over a reasonably long and productive term of employment. To motivate valuable new and old employees to stay, firms tend to offer compensation somewhat higher than the going rate for workers in any particular category. If the going rate is the wage that balances supply and demand for a particular labor category and if most offers are somewhat above this rate—efficiency wages—the result must necessarily be some unemployment. No one exemplified this theory better than Henry Ford and his outlandishly high $5-per-day wage beginning in 1914. According to one report, the policy eliminated complaints and reduced absenteeism by 75 percent. Total labor costs actually fell. There was a long waiting list for Ford jobs, but those men had other opportunities in the growing Detroit economy.

Government-Caused Unemployment

Government policies contribute to unemployment above and beyond natural unemployment. The most notorious of these policies are minimum wage laws. These laws make it illegal, effectively, for low-skilled workers to accept employment. Anyone who cannot generate $8 worth of production per hour cannot expect to be paid more than $8. Such unfortunate people might be productive at $6 per hour but are forbidden to accept employment at this rate and are instead condemned to joblessness and all its attendant miseries. This burden falls most heavily on black teenagers, whose unemployment rate (based on those seeking work and excluding those who are in school) is well over 40 percent. The benefits accrue mainly to slightly higher-skilled workers, who have climbed onto the metaphorical ladder leading to better jobs and who are shielded from competition from those excluded by minimum-wage laws.

Unemployment insurance softens the impact of joblessness and reduces the incentives to find a job. Recipients are supposed to show that they are actively seeking work, but this rule is easily sidestepped. There is nothing wrong with unemployment insurance per se. The problem is that the government forces all workers to buy this insurance whether it suits them or not. (Though nominally paid by employers, in fact the burden falls partly on workers and partly on employers.) Some workers might prefer to take that portion of their compensation in cash, but that choice is forbidden. Private carriers that might offer this insurance would, like all insurance providers, take steps to minimize adverse selection (the tendency for riskier workers to buy insurance) and moral hazard (the incentive for those covered to take risks that could get them fired).

Labor unions, as voluntary associations bargaining freely with employers, are unobjectionable. They did a lot of good in the past when working conditions in many places were pretty bad. But now they are granted special privileges by law—basically the privilege to engage in violent or coercive activities. The result is often wage agreements that are above market-clearing levels. Those left out are of course unemployed.

While labor unions can boost their members’ compensation at the expense of non-union workers, higher wages generally and higher living standards are due mainly to increased productivity, which in turn depends on high levels of capital investment. People are more willing to save and invest when they have confidence in the future, and that confidence comes from respect for property rights.

The Pain of Unemployment

Because unemployment, natural or government-caused, is such a personal matter, its impact is highly subjective, extending far behind lost wages.

A teenager looking for work may not be his family’s main source of income, but finding a job could be crucial to his life path. In my day teenagers could earn money delivering papers, mowing lawns, raking leaves, and shoveling snow. The work was unregulated and the income untaxed. Were we exploited? Hardly. We learned to take pride in our work, save for the future, and in contrast to our allowances, savor the special significance of money that we had earned.

A family breadwinner who loses his job and remains unemployed for an extended period of time will surely become discouraged, a term that only begins to describe the psychological devastation that can ensue. Men especially begin to see themselves as failures not just as breadwinners, but as husbands and fathers and more generally. Marital problems often arise. Children pick up on the distress and at certain ages wonder if they are to blame. Domestic violence and suicides are not uncommon. But losing a job may be no big deal for the senior citizen who works mainly for pleasure.

If anguish could be measured we would probably say that one year’s unemployment is more than twice as painful as six months’. As time goes by the jobless not only lose hope, but also suffer erosion of their work skills and attitude. Their former colleagues and clients tend to forget about them. Some without work turn to alcohol or worse in their despair.

Overqualification is a problem for many job-seekers. Employers are reluctant to hire people who are qualified to do better-paying work simply because those workers are likely to leave once they get a more lucrative offer. So some people simply “forget” to list that master’s degree on their résumé.

Unemployment and Macroeconomic Policy

Returning to Friedman and Phelps, the phrase they actually used was the natural rate of unemployment, the rate that would prevail when the economy is operating at full potential. Economies can operate below potential, as ours is presently, and they can sometimes operate above potential. Correspondingly we can have unemployment above the natural rate or, rarely, below. In the latter situation, we might see seniors lured out of retirement or young people lured into jobs before they finish school. But this situation is not our focus here.

Friedman was known for his opposition to Keynesian policies and his championship of free-market ideas. But that one word rate hints at the fact that Friedman fits squarely into the Keynesian macroeconomic project. Friedman viewed economics as an empirical science, not fundamentally different from physics, in direct opposition to the Austrian approach. He and Phelps spawned a cottage industry of searchers for the natural rate. Without that one word his work might not have received the broad attention that it did.

Some economists define the natural rate as an average rate (technically, a moving ten-year average). By this definition the actual rate must always lie above the natural rate at some times and below at other times. But this is simplistic. There is nothing “natural” about a moving average. Natural unemployment lies in the intentions and expectations of the people involved and is not so easily measured.

While the natural rate may be difficult to quantify and the highly subjective effects of unemployment cannot be measured, what about the amount of unemployment? Can it be measured? The Bureau of Labor Statistics (BLS) has that responsibility, and the numbers it announces get more attention nowadays than any others, with the possible exception of GDP growth figures. How does the BLS arrive at its numbers?

BLS Categories

To begin with, it must decide who is in the labor force and who is not. Among those who don’t hold jobs, infants, jail inmates, and people in nursing homes aren’t expected to work and shouldn’t be called unemployed. They are simply excluded from the labor force. Beyond that it starts to get fuzzy. Should that senior person who works mainly for nonmonetary reasons really be counted in the labor force? What about discouraged workers? A discouraged worker is one who wants work and has looked during the past 12 months, but not during the past four weeks. Do the statisticians really know who has looked and who hasn’t, and whether the reason was discouragement or something else?

Because of these and other ambiguities the BLS estimates unemployment in six different ways. U-3 gets the most attention. It is the number of unemployed divided by the size of the labor force. That number was 9.1 percent at press time. The next most widely followed version is U-6, which adds “marginally attached” workers—those who are out of the labor force but want work and have looked within the previous 12 months. It also adds those with part-time jobs who would like full-time work (again, how do they know?). This figure was a whopping 16.2 percent.

So which is the real unemployment figure, U-3 or U-6? There is no right figure, and the emphasis on U-3 is not some sort of conspiracy to hide the “real” situation. The figures are what they are, and it’s a mistake to read too much into them.

The biggest problem with unemployment statistics is not their fuzziness but, like GDP, the implications they carry: the idea that the government can and should proactively attempt to manage the unemployment rate. Such has been the presumption for at least 65 years.

Since 1948 the Federal Reserve System has operated under a dual mandate: maximize employment and stabilize prices. This is a direct reflection of the dominant macroeconomic theory of the time, which assumes the authorities could reduce unemployment by adding a little inflation, or vice versa. The theory seemed to work for awhile but fell apart in the 1970s, when the term “stagflation” appeared. We had the worst of both worlds for a time, and Friedman was ready with an explanation: Inflation could only temporarily boost unemployment—until such time as expectations caught up to reality. The Fed, as we all know, has injected massive amounts of reserves into the banking system with no discernible effect on growth or unemployment. So much for the dual mandate. More about this and other current conditions in part two, which will appear next month.

Here are some links from The Freeman archive:

“Milton Friedman (1912-2006)” by Richard M. Ebeling and Sheldon Richman

“Milton Friedman: A Personal Tribute” by David R. Henderson

“The Great Depression According to Milton Friedman” by Ivan Pongracic Jr.

“Security or Friedman” by Sheldon Richman

Find more in our archive.

Propositions About Gold

Gold has intrinsic value. Actually, nothing has intrinsic value. The value of any good or service resides in the minds of individuals contemplating the benefits they might derive from it. What gold does have is some rather remarkable physical properties that make it very likely that people will continue to value it highly: luster, corrosion resistance, divisibility, malleability, high thermal and electrical conductivity, and a high degree of scarcity. All the gold ever mined would only fill one large swimming pool, and most of that gold is still recoverable.

Only gold is money. Although gold was once used as money, that is no longer the case. Money is whatever is generally accepted as a medium of exchange in a particular historical setting. Right now, government-issued fiat money, unbacked by any commodity, is the only kind of money we find anywhere in the world, with some possible obscure exceptions.

Perhaps people who say this mean that gold is the only form of money that can ensure stability. That’s what future Federal Reserve Chairman Alan Greenspan thought in 1967, when he wrote “Gold and Economic Freedom” for Ayn Rand’s newsletter. “In the absence of the gold standard, there is no way to protect savings from confiscation through inflation,” he said. When later asked by U.S. Rep. Ron Paul whether he stood by that article, Greenspan said he did. But he weaseled out by saying a return to gold was unnecessary because central banks had learned to produce the same results gold would produce.

The gold standard is too rigid. The gold standard makes it impossible for a government central bank to conduct monetary policy—hooray! Under the Fed’s watch the dollar has lost more than 95 percent of its purchasing power and the economy was convulsed by the Great Depression of the 1930s, the stagflation of the 1970s, and the crash of 2008. Milton Friedman long ago explained the long and variable lags that follow monetary interventions and at one point called for replacing the Fed with a computer. The end of government economic manipulations in the form of monetary policy is a major potential benefit of a gold standard.

Gold is supposedly too rigid to accommodate increased demand for money at certain times of the year—historically harvest time and Christmas time—or in wartime. Falling prices are one way an economy can adjust to an increase in the demand for money, but this accommodation works best over a longer period. A short-term accommodation is possible when banks hold fractional reserves. On short notice and without any increase in monetary gold, fractional-reserve banks could simply issue more bank notes or their electronic equivalent during periods of high demand and retire them when demand subsided.

Inflation is impossible under a gold standard. Between 1897 and 1914 the gold stock rose at about 3.5 percent a year due to new discoveries and inflows from abroad. As a result, prices rose about 26 percent over this span, or about 1.4 percent per year. This was not a disruptive level of price inflation—but it was inflation.

The gold standard was tried and failed. This is a plausible proposition, not to be dismissed out of hand. Nor may we simply note that because we never had a pure gold standard, the concept was never really tested. We must do better than that.

During much of our history, money was linked to gold in some degree, and there were some serious monetary problems during that time. The record of gold is bound up with the institutional arrangements that prevailed at various times in our history. Snapshots from that history should help illuminate this claim.

Before proceeding, we need a definition. Under a gold standard either private banks or a monopoly central bank issues notes (or their electronic equivalent) redeemable in gold. Gold coins may circulate as well. Notes may be fully or fractionally backed, meaning a note issuer may not have sufficient gold to redeem all outstanding notes at one time. In passing I assert, contrary to some “hard money” advocates, that fractional-reserve banking is an institution that is entirely compatible with free markets and the rule of law.

The period between the War of 1812 and the Civil War is commonly called the “free banking era.” It is also called the era of “wildcat banks” because many banks were poorly capitalized, poorly if not fraudulently managed, and prone to failure. Conventional wisdom says that this era demonstrates conclusively the need for strict government regulation of money and banking. Like other free-market institutions, free banking rests on the sanctity of property rights, with no government involvement other than prosecution of theft or fraud. But there was substantial government involvement all along, so the “free banking” label is only accurate in relative terms.

The most egregious departure from free-banking principles was the frequent suspension of specie payments: banks’ refusal to honor their obligation to redeem their banknotes for gold. These breaches of contract, which should have triggered liquidation and perhaps criminal prosecution, were in many instances tolerated or even encouraged by government authorities, especially during times of war or economic contraction.

Second, the free-banking paradigm does not include a monopoly central bank. The Second Bank of the United States—roughly speaking, the U.S. central bank of its time—closed its doors in 1836. Its defeat, engineered by populist President Andrew Jackson, came with wide support from a public that had been generally suspicious of banks since the founding of the Republic. But the end of the Second Bank was by no means the end of federal government involvement in banking. With the Second Bank gone, the federal government still needed depositories for its funds. Certain private banks, which came to be known as “pet banks,” were selected for this privilege. This was one way in which the federal government continued to influence the banking system.

A third intervention, practiced by federal and state governments, was prohibition of branch banking. No banks were allowed to cross state lines to open branches, and there were significant restrictions within most states as well. The strictest state laws forbade any branching whatever, while others allowed branching within their states on a limited basis. The result was that many communities could only be served by small, poorly capitalized, and often poorly managed local banks. Stronger city banks might have established branches in areas where early banks had failed or where none had emerged, particularly with the spread of the telegraph and railroads. But they were not allowed to do so. For confirmation of the ill effects of branch prohibition, we need only look as far as Canada, which has always had a few strong nationwide banks. During the Great Depression, when some 9,000 U.S. banks failed, not a single Canadian bank went under.

Fourth, many state governments required banks to hold their bonds as part of their reserves. This of course provided a captive market for such bonds. The National Banking System, established after the Civil War, imposed a requirement to hold federal Treasury securities. Thus the five-dollar gold note (see photo), issued by the Farmers Gold Bank of San Jose, California, in 1874 promises to “pay the bearer on demand five dollars in gold coin.” But it also says the note is “secured by bonds of the United States deposited with the U.S. Treasurer at Washington.” In other words, the government gave the banks incentive to substitute bonds for some of the gold they might have held as reserves.

The gold standard is to blame for severe downturns in 1893 and 1907. The panic of 1893 was quite severe. That year saw numerous railroad bankruptcies, bank failures, and declining stock prices. Among the causes were general overbuilding of railroads, the Silver Purchase Act of 1890, and the protectionist McKinley tariff of 1890. Perhaps a modern central bank, with unlimited money-creation power, could have mitigated some of the immediate pain. But as we have seen, the record of the Federal Reserve, which acquired that power in the following century, suggests a failed institution. As it was, the panic was over in fairly short order and economic growth resumed.

The Panic of 1907 was marked by bank runs, numerous bankruptcies, and sharp drops in stock prices. A trigger for the Panic was a failed attempt to corner the stock of United Copper using borrowed money. Other factors included the San Francisco earthquake and the Hepburn Act, which gave the Interstate Commerce Commission power to set maximum railroad rates, suppressing the shares of those companies.

The Panic was ended largely through the efforts of J. P. Morgan. Again, things turned around in fairly short order and growth resumed.

The dollar-gold link established by the 1944 Bretton Woods agreement didn’t work. Indeed it didn’t, at least not for long. Under Bretton Woods the United States and its currency were accorded a special role. The United States was obliged to redeem dollars for gold, but only dollars tendered by foreign central banks. No one else could get gold for dollars, and no other currencies were directly redeemable. There was a tacit agreement that foreign governments would not “abuse” their redemption privilege, but the French under Charles de Gaulle and his gold-oriented finance minister, Jacques Rueff, saw things differently and insisted on redemption—which, oddly enough, entailed moving gold bars from one part of the New York Fed’s vault to another, since the Fed was storing gold as a service to the French. By 1971 it had become clear that far more dollars were likely to be tendered than could be covered by gold, and President Nixon unilaterally ended gold redemptions. This cut the last (very indirect) link between the dollar and gold. By then silver had disappeared from U.S. coins as well.

De Gaulle cannot be blamed for the failure of Bretton Woods. All he did was to point out the emperor’s lack of clothing. As the Federal Reserve created more and more fiat money, some of which made its way overseas, the redemption promise rang more and more hollow. By the time Nixon took action there was no other choice but to slam the gold window shut.

Milton Friedman was one of the first to propose floating exchange rates. The notion seemed radical and unworkable at the time (around 1960). That of course is the system we have now, and while it has eliminated sudden devaluations, currency markets are much more volatile than Friedman anticipated. Nor did he anticipate the degree to which governments would enter the markets to manipulate their own currencies, as when the Chinese authorities sell their currency to keep it from rising too fast against the dollar. And he would have been appalled at the “race to the bottom” that threatens to break out as governments seek to boost their domestic economies by driving down their currencies to make their exports more competitive.

In his wonderful little book Money Mischief, Friedman asked himself whether the pure fiat standard, which has been in force only since 1971, could endure. He didn’t give a definite answer but expressed grave doubts. The possibility of a general loss of confidence in fiat money is reason to believe that gold could once again play a monetary role, as I will argue in the second part of this series.

The gold that was once locked up at Fort Knox is gone. It has been 40 years since the last indirect link between the dollar and gold was severed, and yet the government continues to hold some 8,000 metric tons of gold bullion—the world’s largest single stash. Oddly enough it is valued at $42 per ounce, the last official price before it was set free to be established in free trading. At today’s market price of around $1,300 per ounce, the hoard would be valued in the hundreds of billions of dollars, although that much gold could not be dumped precipitously without suppressing the price.

James Picerno, writing in a recent issue of The Atlantic, asked why the hoard remains. Three hundred billion dollars may not be a huge sum in this new era of trillions, but it’s not chump change either. His conclusion: A selloff would be seen as a sign of weakness or even desperation and might trigger a loss of confidence in the government’s money and/or its debt. He also cites a poll which indicates that 87 percent of Americans believe the government shouldn’t sell its gold reserves. We can only conclude that gold still plays a very indirect role in maintaining confidence in the government.

But is the gold still there? Yes, almost certainly, though we hear occasional calls for an outside audit. A more plausible accusation is that some of it has been leased to short sellers. This is a common practice among central banks that offers distinct benefits to the government. First, it earns a bit of interest income. More important, it can covertly suppress the gold price. Rising gold prices annoy Treasury secretaries and central bankers because the rise implies falling confidence in their currency. Leased gold remains in the vault and on the balance sheet even though it (or rather a paper claim on it) has been sold to someone else. Although one can find rumors on the Internet, there is no way, short of a thorough audit, to know the extent of gold leasing by the U.S. government, if any.

With the global economic downturn continuing and the prospect of currency wars looming, scattered voices are again suggesting a role for gold in our money. One of those voices belongs to Robert Zoellick, president of the World Bank. Could gold stage a comeback in some form? In Part 2 we will examine those prospects.

I have been asked what was my first introduction to libertarian thought. I find that hard to answer, involving as it does looking back nearly three quarters of a century. But if I had to make a guess, I would conjecture that it was John Stuart Mill ‘s Essay on Liberty, which I must have read in my first or second year of college.

Herewith are my five favorite libertarian books.

Adam Smith’s The Wealth of Nations

First, Adam Smith’s The Wealth of Nations. This book, published in 1776, founded economic science. It introduced the notion of the “invisible hand” and explained how free trade could produce cooperation among people in achieving economic productivity. It remains a book well worth reading, full of wonderful comments to warm a libertarian’s
heart.

Mill’s Essay on Liberty

Second, John Stuart Mill’s Essay on Liberty. The most concise and clearest statement of the fundamental libertarian principle, “The only purpose for which power can be rightfully exercised over any member of a civilized community, against his will, is to prevent harm to others …. ”

Dicey’s Lectures on Law and Public Opinion

Third, A. V. Dicey’s Lectures on the Relation between Law and Public Opinion in England during the Nineteenth Century. A remarkable work initially presented as lectures at Harvard in the 1890s and reprinted with a new and very important preface in 1914. Dicey saw clearly the ultimate outcome of initial social welfare measures in the first decade of the twentieth century. He essentially predicted the emergence of the full-fledged welfare state. More than a century ago, Dicey explained why the rhetoric in terms of the general interest is so persuasive: “The beneficial effect of state intervention, especially in the form of legislation, is direct, immediate, and so to speak, visible while its evil effects are gradual and indirect and lying out of sight …. Hence the majority of mankind must almost of necessity look with undue favor upon governmental intervention.”

Hayek’s The Road to Serfdom

Foutth, F. A. Hayek’s The Road to Serfdom. This profound book was highly influential in the immediate post-World War II period when it was a lone voice presenting the case for libertarian philosophy and pointing out the consequences of an increase in the role of the state. It was certainly one of the most effective works leading people to take libertarian principles seriously.

My Own Favorite: Capitalism and Freedom OR Free to Choose?

Fifth, I have been asked to include one of my own books. I am torn between Capitalism and Freedom, published in 1962 with the assistance of Rose D. Friedman, and Free to Choose, published in 1980 jointly with Rose D. Friedman. Both present the same philosophy and cover many of the same topics. Capitalism and Freedom is more succinct, scholarly, and abstract; it was a product of a series of lectures that I gave in June 1956 at a conference at Wabash College directed by John Van Sickle and Benjamin Rogge [a long-time FEE trustee] and sponsored by the Volker Foundation.

Free to Choose, based on the television program of the same title, is more popular, less abstract, more concrete. It presents a fuller development of the philosophy that permeates both books; it has more nuts and bolts, less theoretical framework. The TV program on which Free to Choose is based is available in videocassette and, if I were to consider it as a book, would clearly be my favorite.

*Excerpted from an insert that appeared in the April 2002 issue of The Freeman.

That’s a remarkable story. But just as remarkable is what that pamphlet led to. When it was issued, Stigler, then teaching at Columbia University (his University of Chicago days still lay ahead), told a young student about it, perhaps changing American intellectual history.

The student was Murray Rothbard.

“Rothbard,” writes Brian Doherty in Radicals for Capitalism: A Freewheeling History of the Modern American Libertarian Movement, “was delighted to learn of an organization promoting his political and economic values. . . . By 1948, Leonard Read had already noted young Rothbard’s deep knowledge of market economics and libertarian principles (and their history) and began to lean on him to vet articles for FEE.”

On visits to FEE Rothbard met Frank Chodorov, the prolific libertarian author who edited The Freeman the first year after Read acquired it. “Chodorov helped introduce Rothbard to the works of [Albert Jay] Nock, Herbert Spencer, Garet Garrett, and Isabel Paterson, among others,” Doherty reports. It wasn’t long before he encountered Ludwig von Mises, an adviser to Read.

Thus Rothbard, who went on to become one of the great natural-law libertarian figures in history and an indefatigable advocate/elaborator of Misesian (Austrian) economics in method and substance, can be said to have received vital intellectual nourishment at FEE’s Irvington-on-Hudson estate.

Rothbard, who died 15 years ago, was at once a beloved and controversial figure. He was one of the very few individuals who shaped the modern freedom movement at its start. Even advocates of the freedom philosophy who never read a word he wrote have been influenced by him. With a passion nonpareil, Rothbard set out to create a self-conscious libertarian movement, which he accomplished through his activism and charisma, as well as through his writings—from the scholarly to the popular—in economics, history, political philosophy, and social criticism. For one man to have turned out Man, Economy, and State/Power and Market; America’s Great Depression; The Ethics of Liberty; Conceived in Liberty (four volumes on American history through the Revolutionary War); For a New Liberty—and so much more—is something astounding. We probably won’t see his likes again. (See David Gordon’s Freeman article, “Murray Rothbard’s Philosophy of Freedom.”)

I feel lucky to have known Murray. He was always a delight to be around, whether talking about some obscure historical figure, traditional jazz (before the electric guitar intruded), classic movies, or the future of liberty. He was unfailingly optimistic and ever ready for a laugh. He was what he called H. L. Mencken (whom he treasured): “the joyous libertarian.”

To say that he was controversial even within the freedom movement is an obvious understatement. His application of libertarian and market principles to even the “traditional functions” of limited government—that is, his belief that the free market can and should provide all legitimate services competitively—stirs heated debate today. While his originality in the matter he called “anarcho-capitalism” is clear, he himself might say he was simply picking up the baton carried by the pioneering nineteenth-century free-market economist Gustave de Molinari, whose seminal essay, “The Production of Security,” Rothbard first brought to American libertarians.

Whatever one thinks of Rothbard’s answer to the question raised therein, there can be no doubting the value of the question itself; it forces one to examine the contours of liberty, the nature of the State, and therefore the very possibility of limiting its powers.

Those who cherish liberty cannot calculate their debt to Murray Rothbard.

* * *

We lead off with the winning essay in the second annual Eugene S. Thorpe writing competition: Richard Fulmer’s “Legends of the Fall: The Real and Imagined Sources of Our Bubble Economy.” Of the 182 entries addressing the causes of the current housing and financial debacle, Richard Fulmer’s was judged the best. Congratulations, Richard!

As the practice of medicine becomes more bureaucratized by government intervention, the profession will change subtly and gradually, but patients will eventually notice the degradation in service. Such is where “reform” will lead, says Theodore Levy.

All during the debate over the reinvention of medical insurance, it was taken for granted that individuals should be forced to buy coverage. James Payne, who refuses, is ready to accept his status as a criminal.

Nien Cheng suffered unimaginable oppression at the hand of the Chinese communist regime but went on to be a passionate spokeswoman for freedom. On the occasion of her death, James Dorn offers a tribute to this heroic woman.

When people think of Africa, sadly, they think of poverty and oppression. But that has not been true for Botswana. Scott Beaulier explains this little-known success story.

Nassim Nicholas Taleb is a provocative writer who scoffs at the idea that human affairs can be predicted scientifically. Robert Murphy introduces us to the man who popularized the term “black swan.”

Ethanol is still in our gasoline, and besides all the bad things you’ve heard about it, it also harms engines. Michael Heberling has the details.

Broadly speaking, there are only so many ways for society to be organized, and only one is in harmony with freedom and human nature. Paul Cleveland and Art Carden elaborate.

Here’s what our columnists have whipped up: Lawrence Reed says he doesn’t care what you call yourself as long as you oppose aggressive force. Donald Boudreaux defines the rule of law. Robert Higgs discusses capital consumption during World War II. John Stossel dissects crony capitalism. Charles Baird anticipates how health care “reform” will help labor unions. And Ivan Pongracic, Jr., reading Paul Krugman’s claim that more government spending will fend off a 1937-style recession, responds, “It Just Ain’t So!”

Books on private schools for the poor, political capitalism, Herbert Hoover, and the Federal Reserve occupy our reviewers.

In Capital Letters, Thomas Szasz answers a reader’s concerns about religious identification and George Schwappach explains how carrying less health insurance saved him money.

The key to understanding deflation is to realize that it comes in three forms: the Good, the Bad, and the Ugly. To make sense of these three forms we need to be clear on some terminology and definitions. First, the word “deflation” itself requires additional clarity. Normally, the definition is something like “a sustained decline in the average level of prices.” That definition immediately raises the question of why anyone would think deflation is bad. After all, what could be bad about things getting cheaper? For one thing, “prices” are normally understood to include “wages” (although in the Ugly version we’ll see what happens when this isn’t the case), so whatever gains one gets from lower prices are likely to be offset by lower wages. For another, that definition says nothing about whether the process by which prices fall is a painful one. (Could not one say of inflation: “What’s the big deal? Sure, prices are going up, but your wages will too, so aren’t you just even?” We know enough about the process by which prices rise to know it’s not that simple and the same is true of the process by which they fall.)

With that common definition in mind, we then need to make a further distinction about the cause of falling prices. A decline in the general level of prices can come from two broad sources: improvements in economy-wide efficiency (the decreased relative scarcity of some large number of goods) or a deficient supply of money. We might further distinguish between these two by referring to the first as “price deflation” and the latter as “monetary deflation.” Price deflation, as it turns out, is the “Good” of the Good, the Bad, and the Ugly. Monetary deflation is the “Bad” and can lead to the “Ugly.”

Price deflation, sometimes called “benign deflation,” is, or at least should be, the normal by-product of a growing economy. To see why, we need one last digression, this time into monetary theory. Understanding both inflation and deflation requires that we recognize that the demand for money is a demand to hold real cash balances: We demand money when we hold balances in our wallets or our checking accounts. When we spend money we actually reduce our demand for money as we shift how we hold our wealth from money to whatever we buy. Think of a wallet or checking account as part of a larger portfolio of assets we choose to hold at any given time. We want a certain portion of our wealth in the form of housing, some in the form of food, some in the form of clothing, and some in the form of money. Thus our demand for money is a demand to hold money balances, and we care about the real purchasing power of those money balances—what they are capable of buying, not just what number is stamped on the bills.

A correct understanding of the demand for money helps us to understand why sometimes people can have either more or less money than they would prefer. For example, during inflation the monetary authority has created more money than people wish to hold at current prices, so they spend those “excess” money holdings on goods and services, driving up their prices. During a monetary deflation, as we shall see, a deficient supply of money means that people do not have large enough money balances and will act to get more.

All of this implies that a good monetary system is one that supplies exactly the amount of money the public wishes to hold at the current level of prices. It is worth noting that this view, called “monetary equilibrium theory,” implies that not every increase in the supply of money is inflationary. Should the demand for money rise, it is the appropriate response of the monetary system to increase the supply to match it. In our discussion of monetary deflation below, we will see why monetary equilibrium theorists make this argument. This argument also distinguishes those Austrian economists who work from the monetary equilibrium tradition from those who work from a more Rothbardian tradition, in which any increase in the money supply not matched by an increase in the quantity of gold is necessarily inflationary and the ideal monetary system is not one that matches changes in money demand with changes in the money supply.

The Good

If the monetary system is doing its job and matching changes in money demand with changes in supply, the long-term trend of the price level will be gently downward as economy-wide productivity rises. Put differently, increased productivity will cause benign price deflation as the real cost of goods and services falls. This sort of deflation is not only not harmful; it is beneficial because the cost of living is lower. In the United States this is precisely what happened to the price level during the last few decades of the nineteenth century, since the pre-Federal Reserve banking system based on gold was reasonably effective at getting the money supply right much of the time and productivity gains caused a steady, slow fall in the price level. Over the last few decades the same downward pressure on prices from productivity gains has been taking place, but it has been outweighed in the aggregate by the inflationary policies of the Fed, so the price level continues to climb in spite of these productivity-induced deflationary pressures.

One implication of this last observation is that consumer price index figures may well understate the real degree of monetary inflation in a given economy. For example, if productivity increases are pushing prices down 3 percent per year, but excesses in the money supply are pushing prices up by 3 percent per year, the common measures of inflation would show stable prices. However, on the monetary equilibrium view, that stable price level is disguising underlying inflation of 3 percent, as prices should have fallen by 3 percent. Austrian economists have long argued that something like this may well have been at work in the 1920s, where relatively stable prices concealed a multiyear inflationary boom that culminated in the recession and then the stock market crash of 1929.

To the extent that a fall in the overall level of prices reflects increased productivity, it is Good. Similarly, a decline in the price level caused by the decreased relative scarcity of key goods is not problematic. The dramatic fall in oil prices in the autumn of 2008 was enough to cause the average level of prices in the United States to fall, which is the source of much of the concern about deflation. However, this sort of deflation is not the type to be concerned about, and certainly does not warrant the comparisons to the Great Depression. In fact, falling oil prices in this case probably did much to prevent the early months of the recession from being any worse than they were, as lower gasoline prices eased financial pressures on many households.

The Bad

The “Bad” sort of deflation arises from an insufficient supply of money. When people do not have as much of their wealth in the form of money as they would like, they will make attempts to increase those money balances. Assuming that in the short run additional income is not possible, people have essentially only two other options: sell off other assets or reduce their expenditures. Either one will work, but selling off assets is problematic for two reasons. First, it is not totally under the individual’s control since it requires a buyer, and second, if everyone is short on money, finding a buyer will be especially difficult because everyone else is looking to sell. Therefore, the most likely result of a deficient money supply is that people will restrict their expenditures to allow more of their income to build up as checking account or currency balances.

As everyone reduces spending, firms see sales fall. This reduction in their income means that they and their employees may have less to spend, which in turn leads them to reduce their expenditures, which leads to another set of sellers seeing lower income, and so on. All these spending reductions leave firms with unsold inventories because they expected more sales than they made. Until firms recognize that this reduction in expenditures is going to be economy-wide and ongoing, they may be reluctant to lower their prices, both because they don’t realize what is going on and because they fear they will not see a reduction in their costs, which would mean losses. In general, it may take time until the downward pressure on prices caused by slackening demand is strong enough to force prices down. During the period in which prices remain too high, we will see the continuation of unsold inventories as well as rising unemployment, since wages also remain too high and declining sales reduce the demand for labor. Thus monetary deflations will produce a period, perhaps of several months or more, in which business declines and unemployment rises. Unemployment may linger longer as firms will try to sell off their accumulated inventories before they rehire labor to produce new goods. If such a deflation is also a period of recovery from an inflation-generated boom, these problems are magnified as the normal adjustments in labor and capital that are required to eliminate the errors of the boom get added on top of the deflation-generated idling of resources.

Over the course of U.S. history the economy has been subject to a number of deflationary episodes, all of which were the consequence of a variety of government interventions in the monetary system. In each of those cases before the Great Depression, policymakers largely allowed the economy to repair itself by standing by and doing little to nothing while prices and wages fell sufficiently to get the demand for money back into alignment with the supply. No doubt these were painful recessions that could have been avoided by having a banking system that responded to changes in money demand by more quickly adjusting the money supply, rather than allowing the price-level adjustment process to cause the problems noted above. However painful they were, these recessions did not become the “Ugly” version of deflation precisely because policymakers allowed the necessary downward adjustments to take place, which was the correct thing to do given the monetary system’s errors that caused the monetary deflation in the first place.

The Ugly

During the Great Depression, what should have just been a Bad deflation became an Ugly one. This deflation was unlike earlier ones for two reasons. First, the scale of the deflation was unmatched. The U.S. money supply fell over 30 percent between 1929 and 1933, a period in which the demand for money was actually rising as a consequence of the stock market crash and the bank failures that followed it. The combined effect was a massive downward pressure on prices. The Fed did not actively reduce the money supply during this period; it failed to react strongly enough to actions the public and banks were taking, such as the public’s holding more currency rather than bank deposits, which caused a multiplied reduction in the total money supply. As Milton Friedman and Anna Schwartz’s A Monetary History of the United States describes it, there was a great deal of internal debate within the Fed over whether it had the power to respond as we now believe it should have and whether, even if it had the power, such a response was the right one. Those who argued in favor of doing nothing won the day and substantially worsened the depression in the process.

The second difference from earlier recessions was that policymakers adopted the view that the key to recovery was to “maintain” prices and wages at their pre-deflation levels. Both Presidents Hoover and Roosevelt strong-armed business leaders into keeping prices and wages up and pushed laws that directly or indirectly did the same.

The effects of these misguided attempts at price and wage maintenance were devastating. Firms continued to pay unjustifiably high wages, while watching sales slacken because prices also stayed high; they covered their losses out of their profits, causing some firms to fail and others to see severe declines in their stock prices. This contributed to the low levels of private investment that prolonged the depression since firms did not have profits to recycle back into their own activities. More brutally, keeping wages so high led to the horrific unemployment rates of the Great Depression, which peaked at around 25 percent in 1933. Only by around 1934 did prices and wages fall enough to start bringing unemployment rates back down. However, unemployment remained at historic highs because even with the declines in prices and wages, private investors were hesitant to take risks in light of the policymakers’ earlier mistakes and the constantly shifting political environment. During the Great Depression, unemployment stayed above 14 percent from 1931 through 1940.

Current observers are quite right to point to the Great Depression as an example of what can go wrong from deflation. There is no doubt that the very large monetary deflation of the early 1930s made the recession that began in the summer of 1929 much deeper and more severe than it would have been otherwise. But even so, had prices and wages been allowed to adjust, that recession would have been Very Bad, but not Ugly. Attempting to keep prices and wages high during the monetary deflation prevented the cleansing price adjustments from taking place and forced sellers to make “quantity” adjustments in the form of reduced production and historic levels of unemployment.

Avoiding the Last Big Mistake

The price level declines seen in the fall of 2008 and early 2009 do not seem to be harbingers of significant deflation. As noted earlier, the decline in oil prices is the leading factor pushing down the overall price level, and this is the benign price deflation that we have labeled Good. In fact, the Fed’s initial response to the troubles in the banking system in the fall of 2008 was to flood the system with reserves, remembering the mistakes the Fed made at the onset of the Great Depression. Given the worries about a cascade of bank failures and the major deflationary effects this would have had on the money supply and the economy as a whole, injecting some additional reserves was probably the right reaction at the time. Two key questions remain, however:

1) Did the Fed overreact and create too many reserves? A look at the Fed’s balance sheet suggests it may well have done so, especially given how many of those new reserves are just sitting in the banks right now (helped along by the Fed, now paying interest on such reserves).

2) Will the Fed be able to withdraw those reserves as the economy recovers and thereby avoid a potentially massive and damaging inflation? If it cannot do so, we will face a much bigger threat in the near future from inflation than from deflation.

All of that said, we do not know for certain what is going on with the demand for money. We know that expenditures are down, which suggests that people are quite possibly increasing their demands for money. But in the absence of the thousands of bank failures that characterized the 1930s and with evidence that banks, on the whole, are continuing to lend (despite scare-mongering media and government stories to the contrary), the concern that any increase in money demand will translate into significant monetary deflation seems remote. As Milton Friedman once said, central banks are always trying to avoid their last big mistake. In this case, that big mistake was the Great Depression, and the Fed has clearly shown a willingness to err on the side of inflation rather than deflation, even at the cost of putting itself in a difficult position once the recovery starts.

What all of this goes to show is that the best way to avoid both Bad and Ugly deflation and to generate the Good kind is to minimize the role of government intervention in both the monetary system and the regulation of prices and wages. A competitive banking system—one without a central bank but with fractional reserves—would avoid both deflation and inflation. Even under a central bank, the effects of a monetary deflation can be minimized by restricting government’s involvement in the setting of prices and wages. In a free economy the only deflation we would see is the slow, long-run decline in prices that results from the productive powers of competitive capitalism. That deflation would be just another Good produced by truly free markets.

For a socialist Shaw demonstrated good sense with that quotation. Unfortunately, America has become a laboratory in which his hypothesis is being tested.

The theory of government I was taught says that government provides benefits, primarily security, to the entire population. In return we pay taxes. But lately the government has been a distributor of special privileges, taking money from some and giving it to others. America is now about evenly split between those who pay income taxes and those who consume them.

The Urban-Brookings Tax Policy Center recently disclosed that close to half of all households will pay no income tax this year. Some will pay less than zero—that is, they’ll get money from those of us who do pay taxes.

The Tax Policy Center adds that this year the average income-tax rate for the bottom 40 percent of earners will be negative and that their cash subsidy will equal 10 percent of the total amount the income tax brings in, thanks to the Earned Income Tax Credit and President Obama’s “Making Work Pay” program.

The view from the top also shows the lopsidedness of the tax system. The top 20 percent of earners make about 53 percent of the income in America but pay 91 percent of the income tax. The top 1 percent pay 36 percent. The IRS says the bottom half of earners pay less than 3 percent.

How the Other Half Votes

This presents a serious problem because government has such vast powers to dispense favors. As Shaw suggested, people who pay no tax will not hesitate to vote for politicians who promise big spending. Why not? They will get stuff without having to pay for it.

Yes, working people who pay no income tax still pay taxes: sales tax and payroll (Social Security and Medicare) taxes. But the income tax is big and visible, so it’s a problem that a growing number of people don’t pay but get benefits from those who do.

Frédéric Bastiat, the great nineteenth-century French economist, defined the State as “that great fiction by which everyone tries to live at the expense of everyone else.” I don’t know if he envisioned one half of the population living off the other half.

It’s important not to confuse the interests of the taxpayers with the interests of the politicians and other tax consumers. Yet that is done all the time. When the government bought toxic assets (of zero market value) from the banks, it said taxpayers would profit when the economy recovered and the assets once again commanded a positive price in the market. Even if we make the dubious assumption that the government is savvy enough to buy low and sell high, it’s not the taxpayers who would benefit from any profits. The politicians will spend every penny rather than cut taxes.

To put it bluntly, we are not the government.

The built-in unfairness of the tax system has prompted a range of tax-reform proposals, such as a flat tax and replacing the income tax with a sales tax. These alternatives are better, but they have their drawbacks, too. For that reason, there is something more urgent than tax reform: spending reform.

The true burden of government, the late Milton Friedman said, is not the tax level but the spending level. Taxation is just one way for the government to get money. The other ways—borrowing and inflation—are also burdens on the people. The best way to lighten the tax burden is to lessen the spending burden. If government spends less, it takes less. And if it takes less, the tax system will weigh less heavily on us all.

Once again, we find wisdom in Adam Smith: “Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things.”

In contrast, many Austrian economists reject both forms of intervention. They argue that the free market would respond in the most efficient manner possible after a major disruption (such as the 1929 stock market crash or the housing bubble in our own times). As we shall see, the U.S. experience during the 1920–1921 depression—one that the reader has probably never heard of—is almost a laboratory experiment showcasing the flaws of both the Keynesian and monetarist prescriptions.

The 1929–1933 Great Contraction

Despite what many readers undoubtedly “learned” in their history classes as children, Herbert Hoover behaved like a textbook Keynesian following the 1929 stock market crash. In conjunction with Treasury Secretary Andrew Mellon, Hoover achieved an across-the-board one percentage point reduction in income tax rates applicable to the 1929 tax year.

Hoover didn’t stop with tax cuts to bolster “aggregate demand”—though analysts at that time would not have used the term. He also signed into law massive increases in the federal budget, with fiscal year (FY) 1932 spending rising 42 percent above 1930 levels. Hoover ran unprecedented peacetime deficits, which stood in sharp contrast to his predecessor Calvin Coolidge, who had run a budget surplus every year of his presidency. In fact, in the 1932 election FDR campaigned on a balanced budget and excoriated the reckless spending record of the Republican incumbent.

It wasn’t merely that Hoover spent a bunch of money. He spent it on just the types of things that we associate today with Roosevelt’s New Deal. For example, he signed off on numerous public-works projects, including the Hoover Dam. Of particular relevance today is the Reconstruction Finance Corporation (RFC) established under Hoover, which quickly injected more than $1 billion to prop up troubled banks that had made bad loans during the boom years of the late 1920s—and this was when $1 billion really meant something.

It is true that Hoover eventually blinked and raised taxes in 1932, in an effort to reduce the federal budget deficit. Today’s Keynesians point to this move as proof that reducing deficits is a bad idea in the middle of a depression. Yet an equally valid interpretation is that it’s horrible to hike tax rates in the middle of an economic disaster. After the bold tax cuts pushed through by Andrew Mellon in the 1920s, the top marginal income-tax rate in 1932 stood at 25 percent. The next year, because of Hoover’s desire to close the budget hole, the top income tax rate was 63 percent. Given this extraordinary single-year rate hike, it is no wonder that 1933 was the single worst year in U.S. economic history. (For what it’s worth, the FY 1933 budget deficit was still huge, coming in at 4.5 percent of GDP. Despite the huge rate hikes, federal tax revenues only increased 3.8 percent from FY 1932 to FY 1933.)

So we see that the standard Keynesian story, which paints Herbert Hoover as a do-nothing liquidationist, is completely false. Yet Milton Friedman’s explanation for the Great Depression is almost as dubious. Following the stock market crash, the New York Federal Reserve Bank immediately slashed its discount rate—how much it charged on loans—in an attempt to provide relief to the beleaguered financial system. The New York Fed continued to slash its discount rate over the next two years, pushing it down to 1.5 percent by May 1931. At that time, this was the lowest discount rate the New York Fed had ever charged since the establishment of the Federal Reserve System in 1913.

It wasn’t merely that the Fed (along with other central banks around the world) was charging an unusually low rate on loans it advanced from its discount window. The entire mentality of central bankers was different during the early years of the Great Depression. Writing in 1934, Lionel Robbins first noted that during previous crises, the solution had been for central banks to charge a high discount rate to separate the wheat from the chaff. Those firms that were truly solvent but illiquid would be willing to pay the high interest rates on central-bank loans to get them through the storm. Firms that were simply insolvent, on the other hand, would know the jig was up because they couldn’t afford the high rates. Yet this tough love was not administered after the 1929 crash, as Robbins explained: “In the present depression we have changed all that. We eschew the sharp purge. We prefer the lingering disease. Everywhere, in the money market, in the commodity markets and in the broad field of company finance and public indebtedness, the efforts of Central Banks and Governments have been directed to propping up bad business positions.”

We therefore see an eerie pattern. When it came to both fiscal and monetary policy during the early 1930s, the governments and central banks implemented the same strategies that the sophisticated experts recommend today for our present crisis. Of course, today’s Keynesians and monetarists have a ready retort: They will tell us that their prescribed medicines (deficits and monetary injections, respectively) were not administered in large enough doses. It was the timidity of Hoover’s deficits (for the Keynesians) or the Fed’s injections of liquidity (for the monetarists) that caused the Great Depression.

The 1920–1921 Depression

This context highlights the importance of the 1920–1921 depression. Here the government and Fed did the exact opposite of what the experts now recommend. We have just about the closest thing to a controlled experiment in macroeconomics that one could desire. To repeat, it’s not that the government boosted the budget at a slower rate, or that the Fed provided a tad less liquidity. On the contrary, the government slashed its budget tremendously, and the Fed hiked rates to record highs. We thus have a fairly clear-cut experiment to test the efficacy of the Keynesian and monetarist remedies.

At the conclusion of World War I, U.S. officials found themselves in a bleak position. The federal debt had exploded because of wartime expenditures, and annual consumer price inflation rates had jumped well above 20 percent by the end of the war.

To restore fiscal and price sanity, the authorities implemented what today strikes us as incredibly “merciless” policies. From FY 1919 to 1920, federal spending was slashed from $18.5 billion to $6.4 billion—a 65 percent reduction in one year. The budget was pushed down the next two years as well, to $3.3 billion in FY 1922.

On the monetary side, the New York Fed raised its discount rate to a record high 7 percent by June 1920. Now the reader might think that this nominal rate was actually “looser” than the 1.5 percent discount rate charged in 1931 because of the changes in inflation rates. But on the contrary, the price deflation of the 1920–1921 depression was more severe. From its peak in June 1920 the Consumer Price Index fell 15.8 percent over the next 12 months. In contrast, year-over-year price deflation never even reached 11 percent at any point during the Great Depression. Whether we look at nominal interest rates or “real” (inflation-adjusted) interest rates, the Fed was very “tight” during the 1920–1921 depression and very “loose” during the onset of the Great Depression.

Now some modern economists will point out that our story leaves out an important element. Even though the Fed slashed its discount rate to record lows during the onset of the Great Depression, the total stock of money held by the public collapsed by roughly a third from 1929 to 1933. This is why Milton Friedman blamed the Fed for not doing enough to avert the Great Depression. By flooding the banking system with newly created reserves (part of the “monetary base”), the Fed could have offset the massive cash withdrawals of the panicked public and kept the overall money stock constant.

But even this nuanced argument fails to demonstrate why the 1929–1933 downturn should have been more severe than the 1920–1921 depression. The collapse in the monetary base (directly controlled by the Fed) during 1920–1921 was the largest in U.S. history, and it dwarfed the fall during the early Hoover years. So we hit the same problem: The standard monetarist explanation for the Great Depression applies all the more so to the 1920–1921 depression.

The Results

If the Keynesians are right about the Great Depression, then the depression of 1920–1921 should have been far worse. The same holds for the monetarists; things should have been awful in the 1920s if their theory of the 1930s is correct.

To be sure, the 1920–1921 depression was painful. The unemployment rate peaked at 11.7 percent in 1921. But it had dropped to 6.7 percent by the following year, and was down to 2.4 percent by 1923. After the depression the United States proceeded to enjoy the “Roaring Twenties,” arguably the most prosperous decade in the country’s history. Some of this prosperity was illusory—itself the result of subsequent Fed inflation—but nonetheless the 1920–1921 depression “purged the rottenness out of the system” and provided a solid framework for sustainable growth.

As we know, things turned out decidedly differently in the 1930s. Despite the easy fiscal and monetary policies of the Hoover administration and the Federal Reserve—which today’s experts say are necessary to avoid the “mistakes of the Great Depression”—the unemployment rate kept going higher and higher, averaging an astounding 25 percent in 1933. And of course, after the “great contraction” the U.S. proceeded to stagnate in the Great Depression of the 1930s, which was easily the least prosperous decade in the country’s history.

The conclusion seems obvious to anyone whose mind is not firmly locked into the Keynesian or monetarist framework: The free market works. Even in the face of massive shocks requiring large structural adjustments, the best thing the government can do is cut its own budget and return more resources to the private sector. For its part, the Federal Reserve doesn’t help matters by flooding the shell-shocked credit markets with green pieces of paper. Prices can adjust to clear labor and other markets soon enough, in light of the new fundamentals, if only the politicians and central bankers would get out of the way.

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

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

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

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

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

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

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

Stability Found and Lost

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

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

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

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

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

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

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

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

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

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

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

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

What Failed

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

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

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

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

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

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

Controlling or Creating Risk?

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

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

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

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

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

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

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

Government Intelligence and the Nirvana Fallacy

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

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

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

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

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

My discussion will focus on four distinct components of the 2008–09 stimulus: Federal Reserve policy, the Troubled Asset Relief Program (TARP), the Obama stimulus spending package, and the bailouts of automobile and financial firms. Because there is a temptation to stereotype political parties, labeling the Democrats the party of big government and the Republicans the party of limited government and fiscal conservatism, it is worth emphasizing that these policies were bipartisan. The Federal Reserve policies came during the Bush administration and under Fed Chairman Ben Bernanke, a Bush appointee. TARP was implemented by Bush and his Treasury Secretary Henry Paulson, and the bailouts of automobile and financial firms were initiated in the Bush administration.

My message is one of hope and change. The change is the four stimulus programs. The hope is this: I hope I am wrong about the permanent negative effects these programs will have on America.

Federal Reserve Policy

Two fundamental elements of Federal Reserve policy changed in 2008: The Fed began making loans to nonbank financial institutions and buying financial assets other than securities issued by the U.S. Treasury.

The Fed was established in 1913 primarily to lend money to member banks based on their assets that could be used to pay off the loans. Until 2008 the only firms the Fed would lend to were member commercial banks. Then the Fed began making loans to nonbank financial institutions. It did so to provide those firms with liquidity, but in doing so it broke with precedent in two ways. First, it made loans to firms that were not members of the Federal Reserve System, and second, it made loans based on questionable assets, running the risk that the borrowers might not be able to repay the loans.

The second major change was that the Fed bought financial assets not issued by the Treasury–so-called toxic assets held by private banks and other firms. The true value of the assets was questionable, so the Fed risked losses. The Fed can afford to take those losses, however. The biggest problem with this change in policy is that by buying some assets rather than others, the Fed was supporting some firms over others.

For example, it bought assets from AIG, an insurance company, to keep it from failing and ultimately has taken over ownership of AIG with an 80 percent equity interest. The Fed also purchased assets of questionable value from investment bank Bear Sterns to facilitate its acquisition by JPMorgan Chase. Meanwhile, investment bank Lehman Brothers went into bankruptcy and failed. Why save Bear Sterns but not Lehman Brothers? The Fed also initiated the Term Asset-Backed Securities Loan Facility (TALF) to make loans to holders of various types of securities. TALF borrowers do not have to be banks.

These two new policies are problematic because they constitute an “industrial policy.” I am not questioning the effects of these policies. Hindsight will provide a better answer. Rather, I am questioning the precedent that the policies create for future Fed involvement in the economy.

The Fed has now established the precedent of making loans to firms that, at its discretion, it deems worth supporting, based on assets of questionable value. That puts the Fed in the position of picking winners and losers in the economy. Similarly, by choosing to buy “toxic assets” only from some sellers it is supporting some investors while letting others fend for themselves. Again, the Fed is picking winners and losers.

Its conduct is much like what the Japanese government has done for decades. In the 1980s that government, coupled with Japanese banks, directed assets to the firms they viewed as most important to the economy. This industrial policy was hailed by many observers as giving the Japanese economy a growth advantage. In the early 1990s the booming Japanese real-estate market collapsed, much as the U.S. market did in 2006–08, and many Japanese banks were left holding assets of questionable value, collateralized with mortgages with higher face values than the mortgaged property. Rather than allow insolvent banks to fail, the Japanese propped them up, maintaining their precarious positions, and the Japanese economy has stagnated ever since.

Japanese industrial policy is no longer held in such high regard, but the Federal Reserve’s recent actions have it engaging in the same type of industrial policy. Having set that precedent, the long-run effects are likely to be pernicious. Unless the Fed firmly repudiates its industrial policy, clearly saying it made a mistake that won’t be repeated, financial firms will take the same risks, believing the Fed will step in to help if the market turns against them.

Many think that to avoid a repeat of the 2008 meltdown, the government should more tightly regulate the financial markets. President Obama has proposed a major overhaul of the regulatory apparatus.Yet financial firms are already among the most highly regulated firms in the nation, and it is implausible to think that the problems were the result of too little regulation. If anything, they were the effect of too much government involvement in those markets.

Market discipline is far superior to government regulation because firms that choose losing strategies will and should be allowed to fail. This would give every firm an incentive to choose profitable strategies and would weed out those that do not. The Fed’s industrial policy moves in the opposite direction, so more regulation would change nothing.

TARP

In September 2008 Bush Treasury Secretary Henry Paulson announced that the financial markets had frozen. Lending had ground to a halt, he said, and banks would not even lend to each other because their “toxic assets” called into question their solvency. Paulson asked Congress to pass emergency legislation providing him $700 billion to buy up those assets, creating liquidity in the financial sector so that normal lending activities could resume. TARP, approved on October 3, 2008, provided the money and gave the secretary the discretion to spend it as he saw fit.

Paulson claimed the money was needed immediately to prevent a collapse of the financial system. However, none of the TARP money went toward buying toxic assets. Instead the Treasury used the money to purchase equity interest in banks–that is, to partially nationalize many banks.

Paulson also pressured the nine largest banks to take the TARP money whether they needed it or not because if only some took the money, they would be stigmatized as weak, which could further undermine their financial positions. So now the federal government is the owner of a substantial share of the American banking industry.

Some of the strings attached to that money did not appear until after the government already bought into those banks. Obama and Treasury Secretary Timothy Geithner wanted to regulate the pay of bank executives, claiming that the federal government, as part-owner of those banks, should limit excessive pay. As a result, many recipients of TARP money are anxious to repay it and to buy back the stock the federal government now owns. But the federal government has put roadblocks in the way of banks that want to get out from under the burdens that come with TARP. The government likes that control. One fear that Geithner expressed is that if some banks escape the strings attached to TARP, they might raise executive pay, leading the better bank execs to leave the TARP-encumbered institutions for the higher pay at those banks that are free of TARP. (Some banks have started to pay the money back.)

The Obama Stimulus Package

Immediately after his election, Obama pushed hard to get Congress to pass a nearly $800 billion spending bill to stimulate the economy, which some claimed was mired in the worst recession since the Great Depression. While history will judge whether the recession was that severe, the rhetoric served to pass the bill. However, it is difficult to identify the features that make it a stimulus bill rather than just a big spending bill. In fact, the spending is largely for items Obama campaigned on. Much of it will occur after 2009 and so does not qualify as a stimulus for a depressed economy.

A lot of the alleged stimulus money was directed toward sectors that were holding up relatively well during the recession, such as healthcare and state and local governments. Government employment was steadier than private-sector employment when the bill was passed and can be expected to do even better with the money. Directing money toward relatively strong sectors is hardly the best way to stimulate the economy, even though it does further the goals that Obama campaigned on when he was running for president.

Even the economic analysis underlying the stimulus program can be called into question. The Keynesian idea is that by running budget deficits and increasing government spending, aggregate demand will be increased, pushing the economy toward prosperity. Of course, to spend that money, the government must first borrow it from elsewhere in the economy. There’s no free lunch. Moreover, if increasing government spending and running large budget deficits really led to prosperity, the economy would have been in nirvana by 2008. When Bush was elected in 2000 the federal budget was in surplus, and for Bush’s eight years government spending and the budget deficit continually increased, which by Keynesian logic should have produced a robust and maybe overheated economy, not an economy mired in recession. The Obama stimulus package was simply a continuation, on a much grander scale, of the eight years of Bush fiscal policy, a policy of continually increasing government spending and continually increasing budget deficits.

The Obama stimulus package was really just a big spending bill that did not offer much stimulus, but that will saddle the economy with bigger government from now on, hindering economic growth, slowing the recovery, and reducing prosperity

Bailouts

In addition to bailing out many failing banks and other financial firms, Bush and Obama also used taxpayer money to bail out Chrysler and General Motors. Bear in mind that when Obama campaigned for office and gasoline prices spiked above $4 a gallon, he advocated a windfall profits tax on oil companies. That idea fell by the wayside as prices fell in 2009, but these two policies provide a chilling example of how to undermine the very foundation of the market: When companies are successful and profitable–like oil companies in 2008–single them out for extra taxes, and when companies are unsuccessful and unprofitable–like auto companies in 2009–single them out for government subsidies.

One need understand only the most basic of economic principles to see how pernicious these policies are. If firms in an economy can take resources and combine them into products that are more valuable than the resources they started with, they are adding value to the economy and should be rewarded. In a market economy they are–through profits. If firms take resources and combine them into products that are less valuable than the resources they started with, they are harming the economy and they should be penalized. In a market economy they are–through losses. Profit and loss are essential to the operation of a market economy and provide the signals and incentives that have led to the remarkable economic progress that has characterized America (hampered as the economy is by government).

The bailouts began as loans to Chrysler and General Motors, which the firms had no chance of being able to pay back. The administration’s way of addressing this has been to negotiate to convert those loans into an equity interest in the firms, thus nationalizing the automobile companies in a manner similar to how TARP has nationalized banks. The federal government carries a big stick and is in a position to use that stick to its advantage. Under Obama’s bankruptcy plan for General Motors, the government will control 60.8 percent of the company, with 17.5 percent for a United Auto Workers trust fund. Bondholders could wind up with a 10 percent equity interest in the company.

On the surface this appears quite unfair to bond holders, whose bonds had a face value of $27 billion. Some bondholders objected, rightly saying that the claims of holders of secured debt should come before the claims of the firm’s employees in any bankruptcy proceeding. But while some bondholders objected, many did not–because they were recipients of TARP money and therefore effectively under government control. TARP recipients JPMorgan Chase, Citigroup, Morgan Stanley, and Goldman Sachs owned about 70 percent of Chrysler’s debt. The government supported them with bailout money and then bullied them to give up their assets to the UAW.

The pernicious consequences go well beyond these transactions. How will this affect other union-heavy companies when they try to raise money in the bond market? The precedent is set for employees to move ahead of secured-debt holders in bankruptcy proceedings. Debt finance will become much more difficult for firms with unionized labor forces. One critic argued that the favoring of the UAW over bondholders amounted to shaking down lenders for the benefit of Obama’s political supporters, which is corruption and abuse of power. We would have done better to let the market and the bankruptcy court determine the fate of Chrysler and GM.

Fundamental Transformation

When we step back and look at the bipartisan efforts to rescue the economy from recession, those changes represent a fundamental transformation in the nature of the American economy. In the longer run Obama wants to substantially increase government’s role in health care, which is already largely in government’s hands with Medicare, Medicaid, SCHIP (health insurance for children), and the regulations that govern healthcare providers and pharmaceutical companies. Obama has also stated his intention to further regulate the energy industry to limit emissions and to shift production toward renewable energy sources. His cap-and-trade initiative would impose billions in costs on the economy and would effectively dictate the technologies by which energy is produced.

Few commentators are looking at the long-run implications of these changes, focusing instead on how much the proposed Obama deficits will increase the national debt or on how the Federal Reserve’s increases in the monetary base will impact inflation in coming years.

Déjà Vu All Over Again

I have described the changes. My hope is that I am overestimating their long-run impact. Indeed, the nation has found itself in similar situations before. In the 1970s we faced economic stagnation, rising unemployment, and rising inflation, which soared into the double digits. There were government-mandated price controls and frequent lines at the gas pumps as a result of shortages caused by those price controls. There was every reason to be pessimistic, but in the 1980s the Reagan administration turned many of those things around. Tax rates were slashed; the price controls were abandoned; and a more deregulated  economy led to two decades of growth and prosperity. At least some of the credit for this, as well as much of what happened in Margaret Thatcher’s England, must be attributed to the power of ideas emanating from Milton Friedman and other free-market thinkers.

Similarly, in the 1940s socialism seemed such an attractive alternative to American capitalism that F. A. Hayek wrote The Road to Serfdom, arguing that socialism was that road, and Joseph Schumpeter, in Capitalism, Socialism, and Democracy, lamented that in democracies people could vote away their freedoms and that the people who benefited the most from a free economy were unwilling to defend it. Yet America prospered. When the Berlin Wall collapsed in 1989, followed by the demise of the Soviet Union in 1991, there was every indication that everyone would recognize that market allocation of resources is better for everyone than government planning.

Now we stand, two decades later, on the brink of the most significant erosion of the market economy since the New Deal, with relatively few dissenters. In a few short centuries markets have taken much of the world’s population from subsistence to remarkable prosperity and continuing economic progress. Are we really ready to abandon that system and replace it with something similar to what resulted in the collapse of the Soviet Union?