The Revolution (15 page)
I mention this example not because it is the most pressing issue facing our republic today but simply because it is so revealing: a report commissioned by the executive branch casually recommends mandatory mental-health screening of all American children, and it receives next to no attention. Even a generation ago the media would have picked up on this, and American parents would have rejected it so contemptuously that no one would have dared to bring it up again. This program is also a useful object lesson in how assaults on our liberties sometimes begin—limited in scope and full of benign language—and how special interests, in this case the psychiatric establishment and the pharmaceutical industry, adopt the line that they’re just looking out for the common good. (I am sure it is just a coincidence that thanks to the proposal they will happen to get millions of additional clients for free.)
Our Constitution was written to restrain government, not the people. Government is always tempted to turn that maxim upside down. Little wonder that George Washington, the father of our country, once said, “Government is not reason; it is not eloquent; it is force. Like fire, it is a dangerous servant and a fearful master.”
Money: The Forbidden Issue in American Politics
A
mericans are concerned about our financial picture: the housing bubble, the collapsing dollar, the specter of inflation. Most don’t know what’s causing it, but they correctly sense that something in our economic system is rotten.
Neither political party will speak to them frankly and honestly. Instead, the people are told by the talking heads on television that their rulers know just what is wrong and will promptly put things right. A little more monetary manipulation by the Federal Reserve is all the economy needs, and there is nothing fundamentally wrong with the system.
These contrived, self-serving answers satisfy very few, but they are all the answers the American people are ever given.
Once again, Americans are deprived of a full and fruitful debate on a subject of the utmost importance. The entire range of debate is limited to minor tinkering: should the Fed make this trivial adjustment or that one? Read the major newspapers and watch the cable news channels: you will not see any fundamental questions raised. The debate will be resolutely confined to superficialities.
In the year 2000, I wrote: “The relative soundness of our currency that we enjoy as we move into the twenty-first century will not persist. The instability in world currency markets, because of the dollar’s acceptance for so many years as a reserve currency, will cause devastating adjustments that Congress will eventually be forced to deal with.” As 2007 and 2008 wore on, the precipitous decline of the dollar dramatically undercut all the promises and assurances that the system was just fine. It wasn’t.
More half-measures will only prolong the inevitable day of reckoning. It is long past time for Americans to look beyond the snake oil salesmen whose monetary system has destroyed the value of our dollar and seek wisdom instead from the free-market economists who spent much of the twentieth century warning about exactly the kind of money we have right now. The more knowledge the American people have, the more likely is our return to a sensible monetary system. As John Adams wrote to Thomas Jefferson in 1787, “All the perplexities, confusions, and distress in America, arise, not from defects in their Constitution or Confederation, not from a want of honor or virtue, so much as from downright ignorance of the nature of coin, credit, and circulation.”
The Constitution is clear about the monetary powers of the federal government. Congress has a constitutional responsibility to maintain the value of the dollar by making only gold and silver legal tender and not to “emit bills of credit.” The records from the Founders make perfectly clear that that was their intention. The power to regulate the value of money does not mean the federal government can debase the currency; the Framers would never have given the federal government such a power. It is nothing more than a power to codify an already existing definition of the dollar (which antedated the Constitution) in terms of gold; it also refers to the government’s power to declare the ratio between gold and silver, or gold and any other metal, based on the market values of those metals.
This responsibility was carried out relatively well in the nineteenth century, despite the abuse the dollar suffered during the Civil War and despite repeated efforts to form a central bank. This policy served to maintain relatively stable prices, and problems arose only when the rules of the gold standard were ignored or abused. (Superficial economic histories of the nineteenth century blame economic hard times, absurdly enough, on the gold standard; a good antidote is Murray N. Rothbard’s
A History of Money and Banking in the United States: The Colonial Era to World War II
.)
The Founding Fathers had had plenty of experience with paper money, and it turned the great majority of them firmly against it. The Revolutionary War was financed in part by the government-issued Continental currency, which was not backed by gold, which people were forced to use, and which the government issued in greater and greater abundance until its value was completely destroyed. Little wonder that most American statesmen opposed the issuance of paper money by the government, and the Constitution they drafted nowhere granted the federal government such a power.
For that reason, James Madison once wrote that the constitutional prohibition of bills of credit (what we would understand as paper money) should
give pleasure to every citizen in proportion to his love of justice and his knowledge of the true springs of public prosperity. The loss which America has sustained since the peace, from the pestilent effects of paper money on the necessary confidence between man and man, on the necessary confidence in the public councils, on the industry and morals of the people, and on the character of republican government, constitutes an enormous debt against the States chargeable with this unadvised measure.
Throughout most of American history the dollar has been defined as a specific weight in gold. Until 1933, in fact, 20 dollars could be redeemed for one ounce of gold. But that year, the U.S. government went off the gold standard, and henceforth American currency would be redeemable into nothing. The government actually confiscated Americans’ holdings of monetary gold, nullified even private contracts that called for payment for a good or service in gold, and declared the dollar no longer redeemable into gold by American citizens—but made allowances for redemption by foreign central banks at 35 dollars an ounce, a devaluation of the dollar from its previous ratio of $20.67 an ounce. And even this tenuous link to gold was severed in 1971, when Richard Nixon declared that within a year, at the $35 exchange rate, we would not have an ounce of gold remaining. Other governments had begun to realize that the dollar, which was being massively inflated, was losing its value, and more and more were demanding gold in exchange for dollars. At that point Nixon officially closed the gold window, so that not even foreign central banks could get gold for dollars. In so doing, he cut the dollar’s last lingering tie to gold.
Now let’s consider at least a few of the nuts and bolts of how the Federal Reserve System typically operates. When we read that the Federal Reserve chairman is cutting interest rates, what does that mean? Analysts are referring to something called the federal funds rate, the rate that banks charge when they borrow from each other. The banks are required to keep a specific fraction of their deposits on reserve, as opposed to lent out, to be available for customer withdrawal. Banks can find themselves below the reserve requirement set by the Fed if they have made a lot of loans or if an unusually large number of people have withdrawn funds. Banks borrow from each other when they need additional cash reserves to meet the reserve requirement.
The federal funds rate rises when there is too much demand from banks looking to borrow and too little supply from banks willing to lend. For reasons we shall see in a moment, the Fed often wants to prevent the federal funds rate from rising. Although it cannot directly set the rate, it can intervene in the economy in such a way as to push it upward or downward. The way it pushes the rate down is by buying bonds from the banks. That gives the banks more money and therefore more reserves on hand to lend to banks that need it. Funds available to be lent to other banks are now less scarce, and a correspondingly lower federal funds rate reflects this.
Where does the Fed get the money to buy the bonds? It creates it out of thin air, simply writing checks on itself and giving them to banks. If that sounds fishy, then you understand it just fine.
Here, finally, is how the Fed’s activity leads to lower interest rates offered by banks. Thanks to Fed purchases of bonds from the banks, the banks now have excess reserves they can lend (either to other banks or to individuals or corporations). In order to attract additional borrowers, though, they must lower their interest rates, reduce their lending standards, or both.
When the Fed intervenes like this, increasing the money supply with money and credit it creates out of thin air, it causes all kinds of economic problems. It decreases the value of the dollar, thereby making people poorer. And in the long run even the apparent stimulus to the economy that comes from all the additional borrowing and spending turns out to be harmful as well, for this phony prosperity actually sows the seeds for hard times and recession down the road.
First, consider the effects of inflation, by which we mean the Fed’s increase in the supply of money, on the value of the dollar. By increasing the supply of money, the Federal Reserve lowers the value of every dollar that already exists. If the supply of Mickey Mantle baseball cards were suddenly to increase a millionfold, each individual card would become almost valueless. The same principle applies to money: the more the Fed creates, the less value each individual monetary unit possesses. When the money supply is increased, prices rise—with each dollar now worth less than before, it can purchase fewer goods than it could in the past. Or imagine an art auction in which bidders are each given an additional million dollars. Would we not expect bids to go up? The market works the same way, except in a free market there are numerous sellers instead of the one seller in an auction.
All right, some may say, prices may indeed rise, but so do wages and salaries, and therefore inflation causes no real problems on net. This misconception overlooks one of the most insidious and immoral effects of inflation: its redistribution of wealth from the poor and middle class to the politically well connected. The price increases that take place as a result of inflation do not occur all at once and to the same degree. Those who receive the new money first receive it before prices have yet risen. They enjoy a windfall. Meanwhile, as they spend the new money, and the next wave of recipients spend it, and so on, prices begin to rise throughout the economy—well before the new money has trickled down to most people. The average person is now paying higher prices while still earning his old income, which has not yet been adjusted to account for the higher money supply. By the time the new money has made its way throughout the economy, average people have all this time been paying higher prices, and only now can begin to break even. The enrichment of the politically well connected—in other words, those who get the newly created money first: government contractors, big banks, and the like—comes at the direct expense of everyone else. These are known as the distribution effects, or Cantillon effects, of inflation, after economist Richard Cantillon. The average person is silently robbed through this invisible means and usually doesn’t understand what exactly is happening to him. And almost no one in the political establishment has an incentive to tell him.
I have already discussed health care, but it’s important to understand that rising health care costs cannot be understood apart from the money question. With government so heavily involved in medicine, that is where so much of the new money is directed. Thus health costs tend to rise faster than other costs because of the distribution effects of inflation: wherever government spends its new money, that is where higher prices will be most immediate and evident.
When the value of Americans’ savings is deliberately eroded through inflation, that is a tax, albeit a hidden one. I call it the inflation tax, a tax that is all the more insidious for being so underhanded: most Americans have no idea what causes it or why their standard of living is going down. Meanwhile, government and its favored constituencies receive their ill-gotten loot. The racket is safe as long as no one figures out what is going on.
Incidentally, wise Americans from our nation’s past understood the damage that unbacked paper money could do to society’s most vulnerable. “The rise of prices that follows an expansion of [paper money],” wrote William Gouge, Andrew Jackson’s Treasury adviser, “does not affect all descriptions of labor and commodities, at the same time, to an equal degree. . . . Wages appear to be among the last things that are raised. . . . The working man finds all the articles he uses in his family rising in price, while the money rate of his own wages remains the same.” Jackson himself warned that an inflationary monetary policy by means of “spurious paper currency” is “always attended by a loss to the laboring classes.” Likewise, Senator Daniel Webster maintained that “of all the contrivances for cheating the laboring classes of mankind, none has been found more effectual than that which deludes them with paper money.”
Moreover, the “inflation rate” itself, which is tracked using the Consumer Price Index (CPI), tends to be measured in a misleading way. Ask the average American if he thinks prices are going up by only a few percent per year, as the official figures would have it. So-called core inflation figures do not include food or energy, whose prices have been rising rapidly.
But there is another, more significant way in which these kinds of measurements of “inflation” are designed to obscure rather than reveal. Ludwig von Mises used to say that governments will always try to get people to focus on prices when thinking about inflation. But rising prices are a
result
of inflation, not inflation itself. Inflation is the increase in the money supply. If we understood inflation that way, we would instantly know how to cure it: simply demand that the Federal Reserve cease increasing the money supply. By focusing our attention on prices instead, we are liable to misdiagnose the problem, and we are more apt to accept bogus government “solutions” like wage and price controls, as in the 1970s.
Let’s now consider what really happens when the Fed lowers interest rates. We often hear calls for the Fed to do just that, as if forcing rates down were a costless way to bring about permanent prosperity. The alleged prosperity it brings about is neither costless nor permanent. When the Fed artificially lowers rates, it misrepresents economic conditions and misleads people into making unsound investments. Investments that would not have been profitable beforehand suddenly seem attractive in light of the lower interest rates. These are
malinvestments
, which would not have been undertaken if the business world had been able to view the economy clearly instead of being misled by the Fed’s false signals.