This article is adapted from a presentation given
before a Freeman Society gathering in suburban Philadelphia in May 1995.
Are inflation, currency depreciation, and business
cycles inevitable facts of life? Are they part of the very laws of
nature? Or do their origins stem from the actions of man? If so, are
they discoverable by economic science? And, if economics can teach us
their origins, can it also teach us how to avoid them?
The particular need which all money, even fiat money
which we now use, serves is to facilitate exchange. People accept money,
even if it is not backed by a single grain of precious metal, because
they know other people will accept it in exchange for goods and
services.
But people accept the U.S. dollar today in exchange for
much less than they used to. Since 1933, the U.S. dollar has lost 92
percent of its domestic purchasing power.1 Even at its
"moderate" 1994 inflation rate of 2.7 percent, the dollar will lose
another half of its purchasing power by 2022. In international markets,
the dollar has, since 1969, depreciated 65 percent against the Deutsche
Mark, 74 percent against the Swiss franc, and 76 percent against the
yen.2
Many economists claim that this is the price we pay for
"full employment." If so, I'd like to ask who among you thinks we've
gotten our money's worth. We've experienced 11 recessions 3
since the advent of inflation as the normal state of affairs in 1933,
with the unemployment rate reaching 10.8 percent as recently as 1982.
Clearly, the demise of the business cycle - a forecast made during every
boom since the 1920s - is but a mirage.
Other things being equal, if the quantity of anything
is increased, the value per unit in the eyes of its users will go down.
The quantity of U.S. money has increased year in and year out every year
since 1933. The narrow M1 measure of the quantity of U.S. money
(basically currency in circulation and balances in checking accounts)
stood at $19.9 billion in 1933. By 1940, it had doubled to $39.7
billion. It surpassed $100 billion in 1946, $200 billion in 1969 (and
1946-1969 was considered a non-inflationary period), $400 billion in
1980, $800 billion in 1990, and today it stands at almost $1.2 trillion.
That is over 60 times what it was in 1933.
For all practical purposes, the quantity of money is
determined by the Federal Reserve System, our central bank. Its increase
should come as no surprise. The Federal Reserve was created to make the
quantity of money "flexible." The theory was that the quantity of money
should be able to go up and down with the "needs of business."
Under the Fed, "the demands of government funding and
refunding ... unequivocally have set the pattern for American money
management." 4 Right from the start, the Fed's supposed
"independence" was compromised whenever the Treasury asserted its need
for funds. In World War I, this was done indirectly as the Fed loaned
reserves to banks at a lower discount rate to buy war bonds. In 1933,
President Roosevelt ordered the Fed to buy up to $1 billion of Treasury
bills and to maintain them in its portfolio in order to keep bond prices
from falling. From 1936 to 1951, the Fed was required to maintain the
yields on Treasury bills at 3/8 percent and bonds at 2.5 percent.
Thereafter, the Fed was required to maintain "an orderly market" for
Treasury issues.5 Today, the Federal Reserve System owns
nearly 8 percent of all U.S. Treasury debt outstanding.6
The Fed granted access to unprecedented resources to
the federal government by creating money to finance (i.e., to monetize)
its debt. It also served as a cartellization device, making it
unnecessary for banks to compete with each other by restricting their
expansion of credit. Before the emergence of the Fed upon the scene, a
bank which expanded credit more rapidly than other banks would soon find
those other banks presenting their notes or deposits for redemption. It
would have to redeem these liabilities from its reserves. To safeguard
their reserve holdings was one of the foremost problems which occupied
the mind of bankers. The Fed, by serving as the member banks' banker, a
central source of reserves and lender of last resort, made this task
much easier. When the Fed created new reserves, all banks could expand
together.
And expand they did. Before the Fed opened its doors in
November 1914, the average reserve requirement of banks was 21.1
percent.7 This meant that at a maximum, the private banking
system could create $3.74 of new money through making loans for every $1
of gold reserves it held. Under the Fed, banks could count deposits with
the Fed as reserves. The Fed, in turn, needed 35 percent gold backing
against those deposits. This increased the available reserve base almost
three-fold. In addition, the Fed reduced member bank reserve
requirements to 11.6 percent in 1914 and to 9.8 percent in
1917.8 At that point, $1 in gold reserves had the potential
of supporting an additional $28 of loans.
Note that at this juncture in time, gold still played a
role in our monetary system. Gold coins circulated, albeit rarely, and
banknotes (now almost all issued by the Federal Reserve) and deposits
were redeemable in gold. Gold set a limit on the extent of credit
expansion, and once that limit was reached, further expansion had to
cease, at least in theory. But then limits were never what central
banking was about. In practice, whenever gold threatened to limit credit
expansion, the government changed the rules.
Cutting off the last vestige of gold convertibility in
1971 rendered the dollar a pure fiat currency. The fate of the new paper
money was determined by the whim of the people running the Fed.
The average person looks to central banks to maintain
full employment and the value of the dollar. The historical record makes
clear that a sound dollar was never the Fed's intention. Nor has the
goal of full employment done more than provide them with a plausible
excuse to inflate the currency. The Fed has certainly not covered itself
with glory in achieving either goal. Should this leave us in despair?
Only if there is no alternative to central banking with fiat money and
fractional reserves. History, however, does provide us with an
alternative which has worked in the past and can work in the future.
That alternative is gold.
There is nothing about money that makes it so unique
that the market could not provide it just as it provides other goods.
Historically, the market did provide money. An economy without money, a
barter economy, is grossly inefficient because of the difficulty of
finding a trading partner who will accept what you have and who also has
exactly what you want. There must be what economists call a "double
coincidence of wants." The difficulty of finding suitable partners led
traders to seek out commodities for which they could trade which were
more marketable in the sense that more people were willing to accept
them. Clearly, perishable, bulky items of uneven quality would never do.
Precious metals, however, combined durability, homogeneity, and high
value in small quantity. These qualities led to wide acceptance. Once
people became aware of the extreme marketability of the precious metals,
they could take care of the rest without any government help. Gold and
silver went from being highly marketable to being universally accepted
in exchange, i.e., they became "money."
If we desire a money that will maintain its value, we
must have a money that cannot be created at will. This is the real key
to the suitability of gold as money. Since 1492 there has never been a
year in which the growth of the world gold stock increased by more than
5 percent in a single year. In this century, the average has been about
2 percent.9 Thus with gold money, the kind of inflations that
have plagued us in the twentieth century would not have occurred. Under
the classic gold standard, even when only a fractional reserve was held
by the banks, prices in the United States were as low in 1933 as they
had been 100 years earlier. In Great Britain, which remained on the gold
standard until the outbreak of World War I, prices in 1914 on the
average were less than half of what they were a century
earlier.10
Traditionally, the gold standard was not limited to one
or two countries; it was an international system. With gold as money,
one need not constantly be concerned with exchange rate fluctuations.
Indeed, the very notion of an exchange rate is different under a gold
standard than under a fiat money regime. Under flat money, exchange
rates are prices of the different national currencies in terms of one
another. Under a gold standard, exchange rates are not prices at all.
They are more akin to conversion units, like 12 inches per foot, since
under an international gold standard, every national currency unit would
represent a specific weight of the same substance, i.e., gold. As such,
their relationships would be immutable. This constancy of exchange rates
eliminates exchange rate risk and the need to employ real resources to
hedge such risk. Under such a system, trade between people in different
countries should be no more difficult than trade among people of the
several states of the United States today. It is no accident that the
closest the world has come to the ideal of free international trade
occurred during the heyday of the international gold standard.
It is common to speak of the "collapse" of the gold
standard, with the implication that it did not work. In fact,
governments abandoned the gold standard because it worked precisely as
it was supposed to: it prevented governments and their central banks
from surreptitiously diverting wealth from its rightful owners to
themselves. The commitment to maintain gold convertibility restrains
credit creation, which leads to gold outflows and threatens
convertibility. If government were not able to resort to the issue of
fiat money created by their central banks, they would not have had the
means to embark on the welfare state, and it is possible that the
citizens of the United States and Europe might have been spared the
horrors of the first world war. If those same governments and central
banks had stood by their promises to maintain convertibility of their
currencies into gold, the catastrophic post -World War I inflations
would not have ensued.
In recent years, some countries have suffered so much
from central banks run amok, that they have decided to dispense with
those legalized counterfeiters. Yet they have not returned to the gold
standard. The expedient they are using is the currency board. Argentina,
Estonia, and Lithuania have all recently instituted currency boards
after suffering hyperinflations. A currency board issues notes and coins
backed 100 percent by some foreign currency. The board guarantees full
convertibility between its currency and the foreign currency it uses as
its reserves. Unlike central banks, currency boards cannot act as
lenders of last resort nor can they create inflation, although they can
import the inflation of the currency they hold in reserve. Typically,
this is well below the level of inflation which caused countries to
resort to a currency board in the first place. In over 150 years of
experience with currency boards in over 70 countries, not a single
currency board has failed to maintain full convertibility.11
While currency boards may be a step in the right
direction for countries in the throes of central-bank-induced monetary
chaos, what keeps such countries from returning to gold? For one thing,
they have been taught by at least two generations of economists that the
gold standard is impractical. Let's examine three of the most common
objections in turn:
1. Gold is too costly. Those who allude to the
high cost of gold have in mind the resource costs of mining it. They are
certainly correct in saying that more resources are expended to produce
a dollar's worth of gold than to produce a fiat dollar. The cost of the
former at the margin is very close to a dollar, while the cost of the
latter is under a cent. The flaw in this argument is that the concept of
cost they employ is too narrow. The correct concept economically
speaking is that of opportunity cost, defined as the value of one's best
sacrificed alternative. Viewed from this perspective, the cost of fiat
money is actually much greater than that of gold. The cost of flat money
is not merely the expense of printing new dollar bills. It also includes
the cost of resources people use to protect themselves from the
consequences of the inevitable inflation which fiat money makes
possible, as well as the wasted capital entailed by the erroneous
signals emitted under inflationary circumstances. The cost of digging
gold out of the ground is minuscule by comparison.12
2. Gold supplies will not increase at the rate
necessary to meet the needs of an expanding economy. With flexible
prices and wages, any given amount of money is enough to accomplish
money's task of facilitating exchange. Having the gold standard in place
in the United States did not prevent industrial production from rising
534 percent from 1878 to 1913.13 Thus it is a mistake to
think that an increase in the quantity of money must be increased to
assure economic development. Moreover, an increase in the quantity of
money is not tantamount to an increase in wealth. For instance, if new
paper or fiat money is introduced into the economy, prices will be
affected as the new money reaches individuals who use it to outbid
others for the existing stocks of sport jackets, groceries, houses,
computers, automobiles, or whatever. But the monetary increase itself
does not bring more goods and services into existence.
3. A gold standard would be too deflationary to
maintain full employment. As for the relationship of a gold standard
to full employment, the partisans of gold have both theory and history
on their side. The absolute "level" of prices does not drive production
and employment decisions. Rather the differences between prices of
specific inputs and outputs, better known as profit margins, are keys to
these decisions. It is central bank creation of fiat money which alters
these margins in ways that ultimately send workers to the unemployment
line. Historically, the gradual price declines which characterized the
nineteenth century made way for the biggest boom in job creation the
world has ever seen.
The practical issues involved in actually returning to
a gold standard are complex. But one of the most common objections,
determining the proper valuation of gold, is fairly minor. After all,
the market values gold every day. Any gold price other than that set by
the market is by definition arbitrary. If we were to repeal legal tender
laws, laws which today require the public to accept paper Federal
Reserve Notes in payment of all debts, and permit banks to accept
deposits denominated in ounces of gold, a parallel gold--based monetary
system would soon arise and operate side-by-side with the Federal
Reserve's fiat money.14
A more difficult problem than that would be how to get
the gold the government seized in 1934 back into the hands of the
public. But even that surely can't be more difficult than returning the
businesses seized by the Communists in Eastern Europe to their rightful
owners. If the Czech Republic can do that, we should be able to get
government--held gold back into circulation.
In all likelihood, the biggest problem gold proponents
face is that people simply aren't ready to go back to gold. Most people
aren't aware of the extent of our monetary disarray and many of those
who are don't understand its source. Two generations of Americans have
known nothing but un-backed paper as money; few realize that there is an
alternative. In contrast, when the United States restored gold
convertibility in 1879 and when Britain did so in 1821 and 1926, gold
money was still seen as the norm. That is no longer the case.
It might take a hyperinflationary disaster to shake
people's faith in fiat money. Let's hope not. In addition to the
horrendous costs of such a "learning experience," it's not even a sure
thing that it would lead us back to gold. Recent hyperinflations in
places as disparate as Russia and Bolivia have not done so.
The desire to get something for nothing dies hard.
Governments use central banks with the unlimited power to issue fiat
money as their way to get something for nothing. By "sharing" some of
that loot with us, those governments have convinced us that we too are
getting something for nothing. Until we either wise up to the fact that
governments can't give us something for nothing or, better yet, when we
realize the moral folly of taking government handouts when of-fered, we
will continue to get money as base as our desires.
At the time of the original publication, In addition
to editing the book review section of The Freeman, Dr. Batemarco was a
marketing research manager in New York City and taught economics at
Marymount College in Tarrytown, New York.
1. Arsen J. Darnay, editor, Economic Indicators
Handbook (Detroit, London: Gale Research Inc., 1992), p. 232 and Survey
of Current Business, vol. 75, February 1995, p. C-5 .
2. The Wall Street Journal, April 7, 1995, and The
Economic Report of the President, 1995.
3. As measured by the National Bureau of Economic
Research.
4. Robert J. Shapiro, "Polities and the Federal
Reserve," The Public Interest, Winter 1982, p. 123.
5. Shapiro, pp. 126-127.
6. Federal Reserve Bulletin, February 1995, p. A30.
7. Murray N. Rothbard, "The Federal Reserve as a
Cartellization Device: The Early Years, 1913-1930," in Barry N. Siegel,
editor, Money in Crisis (Cambridge: Ballinger Publishing Company, 1984),
p. 107.
8. Rothbard, pp. 105-106.
9. Richard M. Salsman, Gold and Liberty (Great
Barrington, Mass.: American Institute for Economic Research, 1995), p.
26.
10. Michael David Bordo, "The Classical Gold Standard:
Some Lessons for Today," Federal Reserve Bank of St. Louis Review, May
1981, pp. 8-9.
11. Steve H. Hanke, "Critics Err-Mexico Still Needs a
Currency Board," The Wall Street Journal, February 22, 1995.
12. For a fuller treatment of this issue, see Roger
Garrison, "The Cost of a Gold Standard," in Llewellyn H. Rockwell, Jr.,
editor, The Gold Standard: An Austrian Perspective (Lexington Books,
1985), pp. 61-79.
13. Alan Reynolds, "Gold and Economic Boom," in Sicgel,
p. 256.
14. Hans Sennholz, Money and Freedom (Spring Mills,
Pa.: Libertarian Press, 1985), pp. 81-83.
Reprinted with permission from The
Freeman, a publication of the Foundation for Economic Education, Inc.,
November 1995, Vol. 45, No. 11.
Yourname@libertyhaven.com
