Recently by Gary North: A Regional Fed President Torpedoes Bernanke
Within the American conservative movement, opponents of the gold standard — any form of gold standard — have always dominated the leadership. Newcomers may be unaware of this.
The average political conservative today is suspicious of the welfare state. He opposes price inflation. He wants “sound money.” But his knowledge of money and banking is limited. Until Ron Paul’s 2007—8 run for President, the average conservative voter had heard little about the Federal Reserve System.
Discussions of the FED are usually limited to the financial media. Debates are limited to whether the FED is wise in holding to, or changing, the federal funds rate. Few readers of the “Wall Street Journal” or viewers of CNBC could tell you exactly what the federal funds rate is, why it is important, or how the Federal Reserve controls it.
Discussions of the Federal Reserve in the mainstream media are also limited to policy matters. No one raises the fundamental issue of why and how it possesses the legal authority to set the federal funds rate, enforce banking rules, and control the money supply — sort of. No one argues that the Federal Reserve is the most powerful private agency that is covered by a veneer of public accountability. No one raises the issue of why the Web addresses of the 12 regional Federal Reserve Banks end in .org, but the Board of Governors ends in .gov.
The only exception in the mainstream media is Glenn Beck. He does give some time to this topic. His 2008 interview with Ron Paul did raise this issue.
Ron Paul for the first time in American history made the Federal Reserve an issue in a Presidential campaign. He called for the re-establishment of the gold standard. He warned that the FED would make bad policy decisions. Then the economy unraveled in late 2008, and the FED intervened to bail out the big New York City banks with fiat money and sweetheart deals. Paul was the right man (a 30-year critic of the FED) in the right place (the Web) at the right time (a Presidential election year and a monetary crisis). For Ben Bernanke, this was a perfect PR storm.
Tea Party recruits began their venture into politics with Ron Paul’s message. They do not understand that the American conservative movement has generally been anti-gold and pro-fiat money throughout its post-World War II history. Here is why.
MISES VS. FISHER
The early years of the Great Depression were a time of monetary deflation. At least 9,000 banks went bankrupt (bank + rupture) in the United States, 1930—33. Whenever one did, the money supply shrank. The fractional reserve process of credit leveraging, which had led to monetary inflation and economic boom in the 1920’s, reversed. It produced monetary deflation and economic bust in the early 1930’s.
One economist who predicted this was Ludwig von Mises. He warned in the late 1920’s about the coming contraction. He was opposed by an American economist, Irving Fisher of Yale, who announced a plateau for the American stock market in September 1929. Fisher was rich at the time, the inventor of the Rolodex. He lost his fortune and his sister-in-law’s fortune over the next four years.
Fisher wrote The Purchasing Power of Money in 1911. Mises wrote The Theory of Money and Credit in 1912. He criticized Fisher’s methodology and conclusions. Mises argued that the gold standard had arisen as a market phenomenon because gold is the most marketable commodity. The international gold standard of the 19th century arose because citizens perceived the advantages of gold as a means of restraining government spending. It was a century of free trade, expanding civil rights, and relatively stable prices. Civil governments were restricted.
In sharp contrast, Fisher in Chapter XII dismissed the gold standard as an historical accident. He said the gold standard would be difficult to dislodge, but someday people would abandon it. Why? Because gold “is a substance of which the supply is excessive.” His role as a forecaster was as poor as his role as an economic analyst. World War I ended the international gold standard by the end of 1914. The supply of fiat money then proved to be far more excessive than gold’s supply had ever been, and therefore fiat money was favored by governments.
In 1933, by then destitute, Fisher said that the United States should go off the gold standard — the last nation to adhere to it. Roosevelt did so that year, but not because of Fisher. By 1933, Fisher had lost his credibility, along with his fortune.
Fisher’s academic reputations reversed after World War II. Academic economists became Keynesian in their views of fiscal policy: pre-deficit. They also became Fisherites in their adoption of his anti-gold standard, pro-fiat money concept of money, which he had said was scientific. They adopted his famous (and analytically useless) formula: MV=PT. There is no case in American history of a comparable career in academic economics: rise, fall, and resurrection.
The most famous advocate of Fisher’s monetary theory was Milton Friedman. Through Friedman, the academic free market economics community became committed to fiat money after 1950. Friedman was the dominant free market spokesman after 1960. He held a position at the University of Chicago. There was not a single gold standard proponent in the economics department in 1950 or later.
The only significant pro-gold standard opponents of the Fisherites were disciples of Mises, and there were no more than half a dozen of them — if that many — by 1950 who anyone in academia had heard of. The public had heard of only two of them, at most: Henry Hazlitt, a New York Times economic journalist who had never gone to college, and F. A. Hayek, author of The Road to Serfdom (1944), who by 1950 had ceased writing about money and banking. He was on the faculty of the University of Chicago, but not in the economics department, which had refused to hire him. He was funded by the William Volker Fund, the quiet dispenser of libertarian funds for two decades, 1945—65. The university did not pay his salary. The same was true of Mises at New York University.
The conservative movement’s leadership has been overwhelmingly pro-fiat money and silent on the Federal Reserve System. Critics of the FED have long been segregated out of the movement by the leadership. The Foundation for Economic Education (founded by a non-academic publicist with Volker money in 1946) and the Mises Institute (founded by a non-academic publicist in 1982) have at best been tolerated by Beltway conservatives. Only in the last decade have pro-gold standard economists appeared on the scene through www.mises.org.
In the early years of National Review, Hazlitt was given a forum. So were other pro-gold people. Even I wrote an occasional piece, though not on the money question. There were no attacks on the FED that I recall.
FRIEDMAN’S WAR ON GOLD AS MONEY
Friedman viewed gold as just another commodity. He believed that individuals should have the right to make contracts in gold. He promoted this back when it was illegal for Americans to own gold. But he always opposed the substitution of a gold standard for a fiat money standard. He accepted the Federal Reserve System as an institution with control over money. He just thought it should run things more predictably, meaning with fewer policy decisions.
He became famous for his suggestion that the FED should stick to a fixed increase in the money supply. At what rate? He was vague: 3% to 5%. Which definition of money? Again, this was not clear, although he seemed to prefer M2.
Few people know that Friedman abandoned this suggestion in the mid-1980’s. He figured out at long last what Austrian School economists had been saying since 1912: that the central bank wants to control events directly by manipulating money and credit. In 1986, his article appeared in the Western Economics Association’s journal, Economic Inquiry. It was titled “Economists and Economic Policy.” He admitted that his advocacy of a fixed rule for the expansion of central bank-created money had been a waste of time. Such a restraint was not in the self-interest of central-banking officials.
That public admission was barely perceived at the time and is long forgotten. This was always the biggest problem with Friedman’s policy recommendations. Whenever they were conceptually wrong from the point of view of liberty, they got picked up by the mainstream, even occasionally implemented. His most influential recommendation was income tax withholding in 1943. He was one of the Treasury Department’s staff economists who wrote the defense of the idea, which had been recommended by the Chairman of the New York FED, a former Rockefeller foundation director, Beardsley Ruml. (Ruml was a statistician, had a Ph.D. in psychology, and became chairman of R. H. Macy & Co. in 1945, while serving as chairman of the New York FED.)
He favored tax-funded vouchers for education, which would automatically transfer tax money and thereby Supreme Court control over private education. He and I debated this issue in the pages of the Foundation for Economic Education’s monthly magazine, The Freeman, in 1993.
Then there is his most famous example in academia: his retroactive policy recommendation for the Federal Reserve System. It should have inflated more, 1929—33, he argued in his most academically influential book, A Monetary History of the United States (Princeton University Press, 1963). His co-author, Anna J. Schwartz, did the grunt work in gathering the statistics. He provided the theory. His policy recommendation was straight out of Fisher’s playbook. So was his monetary theory.
The theory was wrong because it did not take cognizance of the distortions produced by Federal Reserve policy in the 1925—29 period, in which the New York FED, under the control of Benjamin Strong, deliberately kept interest rates low in the United States in order to prevent an outflow of gold from Great Britain, which had returned to the gold standard in 1925.
The Bank of England, under the influence of Winston Churchill, the Chancellor of the Exchequer, had returned to the gold standard at the pre-War price. This was far too low, given the inflation of World War I. Gold had immediately begun flowing out at this bargain price. People could sell the gold and invest in Treasury debt in the USA at higher rates. So, the head of the Bank of England, who was an intimate companion of Strong, prevailed on Strong to keep rates low. This led to the stock market bubble of 1925—29.
Friedman did not discuss this FED-Bank of England relationship. Murray Rothbard did. In the same year that Friedman’s book appeared, published in the same town by a small, less influential publisher (Van Nostrand), Rothbard’s book, America’s Great Depression, told the story in full detail. The FED had created the bubble. Then, in the year after Strong’s death in 1928, it stabilized monetary growth; this collapsed the stock market. Rothbard showed that Mises’ theory of the business cycle explains this phenomenon.
So, in 1963, the old debate between Fisher and Mises was revived. Friedman’s book became widely quoted. Rothbard’s sank without a trace.
Here is an important fact to remember. Friedman’s book covered 1867—1960. You almost never see it referred to, except for the section on Federal Reserve policy in 1930—33. For example, you do not see it quoted when it shows that the period extending from 1867 to about 1910 was a period of relatively stable money, falling prices, and increasing per capita wealth due to large increases in productivity. Only when he was critical of the FED as insufficiently inflationary is the book ever mentioned.
The problem facing the FED was that thousands of banks were going under. They took deposits with them. This shrank the money supply. There was no FDIC until 1934. There was no means of saving all of these banks apart from direct loans to them, collateralized by what today is called toxic assets.
The FED really was pushing on a string. Bankers were terrified. They called in loans. They increased reserves at the FED. In short, they did exactly what bankers are doing today.
Here is a chart of the money supply, the monetary base, and Federal Reserve credit, 1929—38.
The money supply fell sharply: busted banks and currency hoarding. The monetary base did not contract, 1929—32. Federal Reserve credit did until late 1931. It was limited in its collateral. After 1931, the FED actively inflated. The money supply still fell, because thousands of banks went bankrupt in 1932—33.
CAUSE AND EFFECT
It was Federal Reserve policy that caused the stock market bubble and the boom, 1925—29. It was Federal Reserve stabilization policy that popped the bubble in 1929—30. It was Federal Reserve expansionary monetary policy that failed to revive the economy in 1932 and 1933.
The Federal Reserve has been the problem ever since 1914. It could not be trusted to bring either price stability or a corrective for recessions. It did not adhere to a predictable monetary policy. It was not governed by a single policy. It was erratic. It created the economy in its own image.
The textbooks do not reveal this. The textbooks parrot the Party Line of the Federal Reserve: it has saved the American economy repeatedly by its intervention. Without the FED, there would have been far greater instability. This was Irving Fisher’s line. It was Milton Friedman’s line with respect to the post-1933 era of fiat money and FDIC protection of bank deposits.
The Austrian Party line, from Mises in 1912 until today, has never made its way into the textbooks. It has rarely made its way into conferences of academic economists . . . and no historians’ conferences. It fell out of favor after Keynes’ General Theory (1936), and it has come back in favor among a hard core of younger, untenured economists only because of the Mises Institute and the World Wide Web. The guild is still closed to such a view of economic causation. Such a view teaches that central banking is the problem, not the solution. This view is anathema in academia and the mainstream media.
The Fisher-Friedman view has been at war with the Mises-Rothbard view for almost a century. It will not go away. The two views are based on rival views of economic methodology. The Austrians believe that government-enforced fiat money economies are inherently unstable, subject to booms and busts. They favor a gold coin standard. The monetarists believe that government-licensed central banks are preferable to any gold standard. Gold is wasteful, they teach. By implication, central banking and fiat money are less wasteful.
Until Ron Paul’s candidacy and the rise of the Tea Party movement, most conservatives have accepted Friedman’s view. The leaders still do. Hostility to central banking on principle has not been a hallmark of mainstream conservatism since 1945. Friedman has been the most prominent economist, and on money, he followed the pied piper of fiat money, Irving Fisher.
Just for the record, Fisher was a member of Yale’s Skull & Bones. He was also a devotee of scientific racism and a promoter of eugenics: government-forced sterilization. He thought science could solve mankind’s problems when used by government elites to run the affairs of men. The fact that Friedman believed anything that this elitist purveyor of government-implemented scientific planning wrote never ceases to amaze me. Fisher was consistent in his devotion to socialism, racism, and fiat money. Friedman was not.
February 25, 2010
Copyright © 2010 Gary North