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

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

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

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

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

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

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

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

Money, International Trade, and Economic Growth

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

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

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

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

The Rise of Central Banking

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

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

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

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

The Predictable Aftermath of 1971

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

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

A Path to Reform

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

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

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

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

My family’s number was TI3-8597. The letters were meant to honor a man I never knew of or appreciated until long after the switch to all digits—Samuel J. Tilden. He deserves to be much better remembered as something other than part of a defunct phone number. A strong case can be made that he was, as the subtitle of a recent book by screenwriter Nikki Oldaker suggests, “The Real 19th President.”

Tilden was born nearly two centuries ago on February 9, 1814, in New Lebanon, New York. After studies at Yale and New York University, he became a successful lawyer, a shrewd investor, a wealthy man, and a promising politician in the Democratic Party. A crusader against the corruption of the infamous Tammany Hall political machine in New York City, Tilden was catapulted from the New York state assembly to the governorship in 1874. From that perch he quickly earned a national following and gained the Democratic Party’s nomination for president in 1876.

No Democrat had occupied the White House since James Buchanan passed the office to Abraham Lincoln in 1861. Fifteen years later the country was ready for a change. Tilden comfortably beat Ohio Republican Rutherford B. Hayes in the popular vote, 51 to 47.9 percent, but a nasty political battle resulted in a dubious deal. Behind closed doors Hayes was awarded enough disputed votes in the Electoral College to edge Tilden there by one vote. In exchange the Republicans agreed to withdraw federal troops from the South and end Reconstruction. Tilden remains one of only four presidential candidates in U.S. history to win the popular vote but lose the Electoral tally—the others being Andrew Jackson (1824), Grover Cleveland (1888), and Al Gore (2000).

Tilden was known for assessing policy options according to right and wrong versus the typical political (and Machiavellian) rule of what can get you elected and reelected. “Successful wrong never appears so triumphant as on the very eve of its fall,” he once said. “We must believe in the right and in the future. A great and noble nation will not sever its political from its moral life.”

Hayes turned out to be a clean and decent one-term president, but Tilden just might have shined as one of our best. I’ve come to admire him because he was rigorously committed to all the right things: limited government, sound money, free trade, and low taxes—which is to say that he’d have a hard time getting to first base today, particularly within his own party. Most 21st-century libertarians would be very comfortable with the 1876 Democratic Party platform on which Tilden ran.

Money. The big money questions of the 1870s were 1) what to do with the hundreds of millions of paper dollars (“greenbacks”) issued during the Civil War; and 2) whether to subsidize and re-monetize silver as a means of inflating the currency. Tilden and the Democrats were the country’s leading advocates of fulfilling the original promise to redeem greenbacks in gold and in opposing subsidies for silver. As advocates of sound money they had no interest in monetary expansion to goose the economy and help debtors because they believed it was fundamentally dishonest.

“Reform is necessary,” asserted the Tilden platform, “to establish a sound currency, restore the public credit, and maintain the national honor. We denounce the failure for all these eleven years of peace to make good the promise of the legal tender notes (the greenbacks), which are a changing standard of value in the hands of the people, and the non-payment of which is a disregard of the plighted faith of the nation.” Taking direct aim at the Republicans, it went on to declare: “We denounce the financial imbecility and immorality of that party which . . . has made no advance towards resumption—no preparation for resumption—but instead has obstructed resumption by wasting our resources and exhausting all our surplus income.”

Tariffs: Taxes on imported goods were the primary source of federal revenue for most of the nineteenth century. Since Lincoln, the Republican Party stood for high tariffs not just for the revenue but also for the “protection” of domestic industries. The free-trade Democrats saw protectionism for what it really is: an attack on consumers for the benefit of producers with political connections. The Tilden platform’s critique of it is as relevant today as it was in 1876:

We denounce the present tariff, levied upon nearly four thousand articles, as a masterpiece of injustice, inequality, and false pretence. It yields a dwindling, not a yearly rising, revenue. It has impoverished many industries to subsidize a few. It prohibits imports that might purchase the products of American labor. It has degraded American commerce from the first to an inferior rank on the high seas. It has cut down the sales of American manufactures at home and abroad, and depleted the returns of American agriculture—an industry followed by half our people. It costs the people five times more than it produces to the treasury, obstructs the processes of production, and wastes the fruits of labor. It promotes fraud, fosters smuggling, enriches dishonest officials, and bankrupts honest merchants. We demand that all custom-house taxation shall be only for revenue.

Government spending: Virtual one-party (Republican) dominance since 1865 had produced huge increases in federal expenditures, largely for pork-barrel projects. Tilden denounced the spending explosion, and his people inserted strong language against it in the 1876 platform: “Since the peace, the people have paid to their tax-gatherers more than thrice the sum of the national debt, and more than twice that sum for the federal government alone. We demand a rigorous frugality in every department, and from every officer of the government.” The Tilden Democrats were squarely in the tradition of their Jefferson-Jackson forebears and light-years apart from their Democratic descendants of today. It was a tradition that would continue through the last great Democratic president, Grover Cleveland, only to be thoroughly forsaken by the next (and arguably the worst) Democratic president, Woodrow Wilson.

On many other vital issues of the day Tilden and the Democrats staked out the moral high ground. They opposed an imperialistic foreign policy and favored Civil Service reform to minimize political patronage and corruption. Because they respected the rights and sovereignty of free individuals, they fought against sumptuary laws to regulate personal behavior. They denounced the use of government power to advantage one group over another. And they pushed to treat the southern states once again as equal partners in the Union.

Today dozens of streets, townships, libraries, and schools from Wichita Falls, Texas, to Washington, D.C., bear the Tilden name. A statue of him and his home, both in New York City, still stand. But otherwise, sadly, the memory of this man who stood for liberty and should have been president is fading as surely as my old phone number.

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

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

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

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

Historian T. S. Ashton noted in his book The Industrial Revolution, 1760–1830:

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

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

Capital goods can be relatively cheap only if they are relatively plentiful. Increasing capital, all else equal, will lower interest rates. But interest rates are more than just a measure of capital availability; they also reflect lending risk. Risk in turn can be affected by such things as inflation and the reliability and efficiency of transportation, communication, and capital markets.

A lender would hardly agree to make a $100 loan unless he could reasonably expect to get at least $100 in purchasing power in return. If the government is debasing the currency, loans will be made only if interest rates are higher than the anticipated rate of inflation.

Costs and Lending Risks

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

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

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

False Signals

Artificially low interest rates signal the existence of capital goods that were never actually created. While these low rates may spark investment bubbles, the bubbles must eventually burst when competition for scarcer-than-expected capital goods, services, and labor drives prices up.

Manipulating markets through monetary policy devalues a nation’s currency, destroys rather than secures property rights, and does nothing to sustain the rule of law constraining both the rulers and the ruled.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Inflation Expectations

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

If the Fed Had a Hammer

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

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

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

So what exactly is going on here?

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

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

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

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

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

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

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

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

Brilliant Fools

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

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

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

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

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

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

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

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

Doing the Right Thing

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

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

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

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.

This massive money injection is supposed to work as follows: buying up Treasury bonds will make their prices rise, and their yields—hence long term interest rates in general—fall. (Recall that previous monetary stimulus has already pushed short-term rates close to zero.) Lower interest rates mean investment capital will be even cheaper than it already is, pushing idle investment money “off the sidelines” and into productive, labor-demanding business activity. And because all the fresh money starts its life as bank reserves, banks will be in a position to extend new loans six ways from Sunday.

Keynesians insist that this kind of massive stimulus is the only weapon the monetary authorities have left in their struggle to cure unemployment. This is a short-term fix, mind you; all economists realize that printing money does not call new goods or services into existence, and not even Keynes himself would tell you that straight-up money printing is a recipe for long-term prosperity. But can printing money induce entrepreneurs to expand output? Can it make unemployed resources suddenly employable? The answer depends on why those resources became unemployed—“underutilized” in Fedspeak—in the first place. This is precisely the question that Austrian economists are asking: What exactly went wrong in the economy such that so many resources are now not being utilized? By addressing this crucial question, only the Austrian perspective can adequately dissect the very concept of “underutilization” and offer a coherent critique of this mad-hatter monetary stimulus.

Let’s deconstruct this notion of resource “underutilization.” Resources are only resources to the extent that they have value, or usefulness, to somebody. Resources, properly speaking, are components of a broader plan of entrepreneurial action that brings more and better goods into existence, which people can use to improve their lives. Not all things are resources—things that can’t be used to enhance life aren’t resources, just objects; things that used to be resources but are now worn out, obsolete, or otherwise have lost their usefulness aren’t resources. They’re just junk.

Context matters when we’re talking about resources. The mere fact that a good was produced at some point and sold for some price does not mean it is still as valuable as originally anticipated. For example, if I took the trouble to fatten 100 steers in hopes of selling 50 tons of beef, only to later discover that everyone has become a vegetarian in the meantime, the beef I produced, economically speaking, would not be a resource. Nor would the beef-producing equipment, tools, and knowledge I invested in have the same value to me once I found out the true state of people’s dietary preferences. While some cattle-raising equipment could be converted to other uses, much of it—like the squeeze chute used for medicating and branding cattle—was highly specific to beef production and would be worth no more than its scrap-metal value in a world where nobody wanted to consume beef. My plan to be a cattleman turned out a big mistake entailing a loss on investment. Losing investments mean economic waste has occurred—to some degree, resources have been turned into junk.

This example may be ridiculous, but is it really that far-fetched? It is highly unlikely that people’s preferences would change so drastically or that entrepreneurs would be so clueless at forecasting market trends. But a strong enough outside influence might induce enough entrepreneurs into misreading the true state of the market such that they become overoptimistic and invest too much. If, for instance, politicians were dedicated to stimulating the beef industry and promoting beef consumption, and built policy on policy to that purpose over the decades—a labyrinthine mixture of subsidies, tax breaks, and cheap credit—they just might generate an investment boom in beef production. The boom, however, would be destined to end as soon as the policy changed or, more likely, the oversaturation of the market became evident.

At this point, with declining beef prices and (now-apparent) excess capacity in beef production, market forces would oust marginal producers from the industry and induce even the large, established operators to scale back production. As for the now “underutilized” resources, it would take some time and a lot of extra work to melt down those excess squeeze chutes, to convert cattle pasture into other crops, and for the reluctant surplus cowboys to eventually accept city jobs mopping floors, answering phones, ringing up sales, and so on.

The value of capital—both capital equipment, or physical capital, and people’s knowledge, experience, and training, or human capital—is critically dependent on how well it can fit into the structure of actual consumer demands and the structure of existing complementary capital (both physical and human). It is precisely this kind of interconnectedness among different kinds of resources that mainstream economists tend to disregard. Yet the extent of economic losses revealed by the recent financial crisis and recession is making the malinvestment (waste) of resources hard to ignore. Even at the Fed, some people show signs of understanding the relevance of the structure of capital resources, as opposed to sheer quantities or supposed dollar values. As Naranya Kocherlakota, president of the Minneapolis Fed, recently stated: “[T]he Fed does not have a means to transform construction workers into manufacturing workers. . . . Most of the existing unemployment represents mismatch that is not readily amenable to monetary policy.”

In other words, no amount of money-printing will change the real relationship of any particular object to its economic context. But the term “mismatch” implies mistakes have been made—entrepreneurial error—and raises the question: What went wrong to cause such massive mistakes in the first place? Again, Austrian capital theory provides the answer: The Fed itself, with its cheap money, along with a host of government “affordable housing” policies, severely overstimulated the housing construction market in the years of the boom.

Entrepreneurs always have many options for how to employ their time, labor, and capital. During the housing boom the amazing increase in home prices relative to construction costs made projects like new home construction and even flipping condos seem an obvious profit opportunity. Following the price signals, people expanded their investments appropriately: Young entrepreneurs learned about real estate and construction management, and new workers learned construction trades; building companies were started and existing companies expanded, purchasing more new equipment like nail guns, Skilsaws, and pickup trucks; upstream suppliers similarly expanded investment in things like cement plants, timber plantations, sawmills, and the like.

Regardless of whether these workers and entrepreneurs were cognizant of the temporary, cheap credit- and subsidy-induced nature of the boom, the lure of high prices and high profits proved irresistible. In retrospect it is easy to see how the Fed’s cheap money policy, along with a host of government subsidies to homebuyers and lenders, set the stage for an unsustainable boom—a boom that did not match well the actual, long-term consumer demand and for which the credit that financed it was not fully funded by actual savings. (For an excellent explanation of the government’s role in the housing boom and bust, see Peter Boettke and Steven Horwitz’s FEE publication “The House That Uncle Sam Built” [PDF]). Nonetheless, the slew of political interventions into the housing market led these entrepreneurs on for years before the inevitable market correction occurred. The net result was that too much investment capital went into home building, and not enough into other economic activities—a mistake of grand proportions.

The housing bust revealed that many of the capital investments of the boom period—from concrete trucks on up to skilled construction tradesmen—were actually malinvestments whose value turned out to be less (in some cases much less) than anticipated. The capital resources created to build houses are, to varying degrees, ill-suited to other tasks. They will necessarily be underutilized relative to the boom era, precisely because they have lost value (usefulness) in light of the new economic reality. Indeed, economic reality in the bust indicates that many of these resources will have to find other ways to be productive, as attested by the overbuilt housing market. (According to National Association of Realtors figures, there were between 1.02 and 1.77 million “excess” homes as of September. Supply was converted into excess units on the basis of six-to-eight months’ supply representing “normal” conditions.)

But this adjustment takes time, and the more specialized the resource, the longer the wait. Some excess concrete trucks can be sent overseas or converted to other industrial uses, but many will simply sit, awaiting the next boom or the scrap heap. Indeed, in some cases, when a particular resource loses its usefulness, leaving it idle can be its optimal “use.” Likewise, the surplus low-skilled construction laborers can perhaps get jobs washing dishes, but skilled tradesmen, engineers, and jobsite managers must retrain to find different jobs that match their boom-era earnings. Not surprisingly, some choose to wait (and take unemployment benefits) rather than risk retraining. For those who have thrown in the towel on a construction career, retraining and reemployment can take years. No amount of money-printing can change this reality.

Political efforts to “stimulate” economic activity will necessarily alter the capital structure of the economy. Government-based stimulus for industry Z necessarily detracts from what the market would have provided industries A through Y. Even a nonspecific stimulus, if such a thing is possible, will only stimulate the investment fad du jour; there is no such thing as neutral government policy. The key policy implication of Austrian capital theory is that any attempt to stimulate the economy will, by spurring malinvestment, doom some resources to superfluousness. From a statistical standpoint this may look like underutilization; from an economic standpoint, however, it’s simply the waste that results from too many investment plans gone bad. Attempting to undo the waste by further stimulus will only exacerbate the problem: more stimulus, more malinvestment, more wasted resources.

So what should the wise and munificent monetary central planners do? Ironically, the optimal monetary policy is not to have one, but to let the competitive market process function for money and credit the way it does for countless other goods. If we must have central banking, the ideal policy is simply this: First do no harm.

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

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

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

The Keynesian Story

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

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

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

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

The Monetarist Story

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

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

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

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

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

The Austrian Story: The Adjustment Problem

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

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

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

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

Regime Uncertainty

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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