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Meltdown's Monetary Heresy

Mises Daily: Wednesday, July 15, 2009 by


[Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse • By Thomas E. Woods Jr. • Regnery 2009 • Xi + 194 pages]

In these troubled times inflationists take comfort in knowing that the central bank can always add any amount of money it wishes to the nation's money supply. Such comfort is short-lived, though, because people aren't going to use it. They wouldn't, at least, if government didn't severely impede monetary competition. And even with monetary freedom legally suppressed, the majority will reject the fiat standard when it becomes too onerous to use.[1]

As the dollar continues its descent, the prospects for sound money are alive, but much more so are the prospects for a new fiat currency. The top decision makers in the federal government regard the money machine as their right arm, and they aren't about to cut it off. Political money, not sound money, provides life-support for their ambitions.

Does the president want to lay a heavy hand on a third-world country that happens to be rich in resources or strategically positioned? As long as government can create money at will, funding will not be a problem. How about a politician who wants to pay off political supporters with lush contracts, bailouts, or a new entitlement? Tap the monopoly fiat-paper-money producer whose notes are legal tender, the producer whose leaders are politically appointed, and it's done.

No need to take more money out of people's paychecks through direct taxation. Let the manipulated market forces handle the theft. The inflation will eventually drive the economy into a crisis, but most experts will blame the market itself, not the manipulators — or worse, they'll claim the manipulators are an inseparable part of the market. And the victims will often agree, seeing the crisis as more evidence that the market is indisputably a cesspool of corruption. Is it any wonder sound money is never a policy consideration, even when elected officials roll up their sleeves and declare everything is on the table?

Sound Money, the New York Times, and Tom Woods

Tom Woods's Meltdown is a well-deserved bestseller. It is scrupulously researched, cogently argued, and entertainingly written.[2] And it became a big hit without the benefit of a review in a major media outlet, including the Times.

In identifying the culprits in the current crisis, Woods names one villain as the driving force behind the others. All of the proximate causes — the CRA, Fannie, Freddie, the cartel of ratings agencies that blessed mortgage-backed securities with AAA approval, the widespread campaign to lower lending standards, the politically-connected enterprises that are "too big to fail" — promote reckless risk-taking, but the big kahuna that sets the stage is the "elephant in the living room that everyone pretends not to notice" (p. 9), "the institution whose fingerprints are all over our current mess": the Federal Reserve (pp. 2–3).

The Fed, he says, "is dedicated to central economic planning, the great discredited idea of the twentieth century" (p. 8). The secondary villains named above "played a role in channeling into the housing market the new money the Fed was creating. But it was the Fed, ultimately, that made the boom in housing possible in the first place" (p. 27).

If Meltdown had gone no further than blaming the Fed's cheap credit for the crisis, it might have made the Times review page. Mainstream criticism of the Fed's artificially low interest rates does exist, though usually in the form of indirect reprimands. For example, in a November 2008 presentation titled "Why is the Country Facing a Financial Crisis?"Download PDF Julie L. Stackhouse, senior vice president of the St. Louis Fed, includes several slides with the headline "Easy money meant that more and more subprime mortgages were financed."

Of course, since March 2005, Bernanke has been hitting the lecture circuit, with one hand on the Bible, telling his audiences that the easy money was due to a "saving glut" in the emerging economies, thereby exonerating the Fed from any malfeasance. But Ms. Stackhouse's slides say "Easy money," not "Easy money resulting from an inflow of foreign saving," and there is no reference anywhere in her presentation to saving as the cause of the low mortgage rates. It's hard to imagine someone in her position being that careless with her wording if she didn't mean to implicate the Fed. (Granted, it's a presentation, not an article, and she could have clarified the headline in delivering her talk, but the slides alone don't give us her view on where all the money came from, and it's only the slides that internet visitors will see.)

Another suggestion that the Fed was at fault comes from CNBC, which offers a comprehensive crisis timeline that begins with a section called "Greenspan's Cheap Credit":

[L]ess than a week after 9/11, the Fed began a series of interest rate cuts that made it easier and cheaper to borrow money … The cuts continued for nearly two years, through June 2003, and created incredible new demand for mortgages, home equity loans, automobile financing, and other kinds of credit.

Neither CNBC nor Julie Stackhouse come close to condemning the Fed as the primary culprit in the crisis, though their comments do provide support for Woods's thesis. But regardless of the kind and extent of mainstream criticism, the Fed is not Woods's undoing. It's his Austrian view of money that makes him an outcast among mainstreamers.

"Easy money," "cheap credit," "artificially low interest rates," and the artfully opaque "quantitative easing," are only possible with a "flexible" currency, and it's that kind of money Meltdown rejects. As a supporter of government stimulus efforts, the Times would logically reject Woods's position. Indeed, sound money is an abomination to all inflationists. Helicopter Ben didn't earn his nickname because he promised to drop gold coins on our front lawns. When he decides to open the monetary floodgates, he doesn't whistle his way to the mines with a pick over his shoulder. He doesn't break a sweat at all — other than perhaps to worry about what his latest "liquidity injection" will do.

The Fed's one policy tool is manipulating the money supply or hinting that it might, but sound money by its nature resists manipulation.[3] From the perspective of those who wish to profit from credit expansion — primarily those closest to the money production process, meaning government and the banking system — sound money has to be outlawed. Outlawed and ridiculed. In January 1974, two-and-a-half years after President Nixon severed the dollar's tenuous tie to gold, the Ninth Circuit Appeals Court dismissed as frivolous an appellant's demand that banks redeem his Fed notes for gold or silver coin.

Woods's Monetary Heresy

"If there's one issue that fashionable opinion doesn't want discussed in connection with the economic crisis, it's money," Woods says (p. 109). We're not supposed to question a monetary system that's left the dollar as valuable as a nickel once was; we're not supposed to wonder if it's desirable for government to create money out of thin air, as a counterfeiter would; we're not supposed to explore the connection between artificially low interest rates and the boom-bust cycle. Most importantly, we're not supposed to ask what money is.

A money economy, he says, arises spontaneously out of a barter economy from the free choices of market participants. In the process of bartering, certain goods become more marketable than others, and over time they become accepted in trade not for their own sake but to use for future exchanges. Such goods are called money. In a money economy, it is somewhat misleading to say goods are exchanged for money; it is more accurate to say, as Woods does, that in a money economy "goods are exchanged indirectly for each other" (p. 111) or "that goods exchange against other goods, and the exchanges are simply denominated in money" (p. 133, emphasis in original). As a good becomes a money, it acquires an array of prices of other goods in terms of itself. Instead of a pair of shoes trading for 10 loaves of bread, say, it would trade for a certain weight of the money commodity, and a loaf of bread would trade for one-tenth that weight, and so on, throughout the rest of the economy.

If this is how money originated, how did we get to the point where the Fed can create money at will and depreciate the dollars we use and save? Woods lists three steps:

  1. society adopts a commodity money (such as gold or silver, or both);

  2. government or the banks issue paper notes that can be redeemed in a given weight of the commodity money; the notes begin to circulate as a convenient substitute for the precious metal coins;

  3. government confiscates the commodity to which the paper note holders are entitled, leaving them with paper money only (pp. 112–13).

As a result of government favors, only the Fed and the fractional-reserve banking system it influences can inflate the supply of unbacked paper money. And through legal tender laws, the government forces us to accept the Fed's depreciating paper issues in the settlement of debts and for spot payments, even if we would prefer a money that's not subject to bureaucratic manipulation.[4]

The upshot is a fiat paper money system that is said to be more "flexible" than a commodity money system because bankers can make more loans, which allegedly boosts prosperity. But what is it the banks are actually lending people when entrepreneurs receive money from Fed credit expansion? An adequate pool of savings must exist before any production process can be completed. Fed credit doesn't come from savings: it comes from nowhere. As Woods points out,

A bank issuing loans based on credit it creates out of thin air, and which possesses no gold backing, is "flexible" enough to make more loans, but unless it has the magical ability to create real resources out of thin air, it can never increase the number of projects the economy can complete. (pp. 130–31, emphasis in original)

Manufacturing more money to lower the interest rate will usually stimulate the economy but it is a "sugar high," as Woods calls it. Some of the investments made during the boom "will prove to be unsustainable and will have to be abandoned, with the resources devoted to them having been partially or completely squandered" (p. 70).

The Deflation Argument

Some charge that the supply of precious metals cannot keep up with the growth in the supply of goods, and therefore the economy will suffer from falling prices. But, as Woods notes, falling prices are the natural outcome of a growing economy that uses a commodity money. This "growth deflation," as he calls it (borrowing a term from Joseph SalernoDownload PDF), "characterized the American economy from 1789 through 1913, a period in which the American economy reached extraordinary heights of prosperity." More recently, China experienced growth deflation from 1998 to 2001. Retail prices declined between 0.8 percent and 3.0 percent in each of those years, while real GDP increased at an annual average of 7.6 percent (pp. 135–36). Even in an inflationary environment, both consumers and companies have benefited from sector-specific growth deflation in high-tech products. Computer shipments increased from 490,000 units in 1980 to roughly 43 million units in 1999, while quality-adjusted prices fell by 90 percent over the same period.

It's true, as Woods says, that under a commodity money, government wouldn't have the tools to push prices back up after a bubble bursts. But under a commodity money, "we would never have had the inflated prices in the first place, since the money supply wouldn't substantially increase" (p. 137).

A Breakthrough

Economist Judy Shelton has shown that the mainstream is not impregnable to radically sound reasoning. Writing in the Wall Street Journal on February 11, 2009, she calls for a return to the gold standard because "it stands in the way of runaway government spending." People should have the choice of switching to gold as an alternative to government fiat money — too much of which, she says, "results in inflation." Furthermore,

Inflation is the enemy of capitalism, chiseling away at the foundation of free markets and the laws of supply and demand. It distorts price signals, making retailers look like profiteers and deceiving workers into thinking their wages have gone up. It pushes families into higher income tax brackets without increasing their real consumption opportunities.

In short, inflation undermines capitalism by destroying the rationale for dedicating a portion of today's earnings to savings. Accumulated savings provide the capital that finances projects that generate higher future returns; it's how an economy grows, how a society reaches higher levels of prosperity. But inflation makes suckers out of savers. (emphasis added)

As Woods notes in his closing chapter, the WSJ has not been sympathetic to the classical gold standard, yet they've published several articles by Shelton in which she argues convincingly for its adoption (and for dispensing with the Federal Reserve). As long as government is not part of the "standard," Woods would agree. "The 'gold standard' of the nineteenth century as it existed in the West … often involved the coercive suppression of alternative monies," he says (p. 153). What we need is freedom to choose the money that suits us best.

If the Times's editors truly reject the arguments of a book on their bestseller list, one would hope they would at least explain why in a review. If they're having trouble composing a rebuttal, Meltdown readers will understand.


[1] Adam Fergusson, When Money Dies: The Nightmare of the Weimar Collapse, Ch. 8, "Autumn Paper Chase."

[2] In the current autocratic crisis environment, one can appreciate Woods' satirical skills. In discussing the Fed's bailout of AIG, he explains how the Fed would lend the insurance giant eighty-five billion dollars in exchange for 80 percent of the company. "Congress, as usual, was not consulted. Meanwhile, social studies teachers across the country continued to report for work to detail how a bill becomes a law, how the will of the people is the guiding principle of the U.S. government, and how the public good motivates their government officials." (p. 40)

[3] See Ludwig von Mises, The Theory of Money and Credit, Yale University Press, 1953, p. 414.

[4] For a discussion of legal tender laws, see Jorg Guido Hulsmann, The Ethics of Money Production, Ch. 10.