A Gold Currency for North Carolina?

In a recent N&O article (found here), it is reported that a state legislator, Glen Bradley-R Youngsville, has introduced a bill to create a State currency backed by gold and silver.  The reporter is perplexed by such an odd bill, and he basically ridicules the sponsor.  In the article, he talked to an economist at the State University, the Democratic State Treasurer and a Democratic State Legislator.  (I guess that's "Fair and Balanced.")

While I know that this bill is going nowhere today, it is worth thinking about.  What would happen if a state decided to go on the gold standard without the rest of the nation?  (I know that the bill says gold and silver, but bimetalism is a whole different set of problems, so let's just focus on the gold standard.)

The advantages of a gold standard, at least nationally, is that it forces the government to live within its means and is a brake on hyperinflation.  Additionally, it reduces the ability of the Federal Government to grow the Welfare/Warfare state.  While it might not eliminate the business cycle, it does help reduce the artificial bubble (boom) the preceeds the painful, but necessary, liquidation process.

Why should a State like North Carolina consider it?  The benefit of owning a currency that is not depreciating is obvious to the guy who has the gold coins in his pocket.  In fact, I'd rather be paid in such a currency.  Furthermore, the adoption of a sound currency would mean a big positive jump in investment into the NC economy.  If the people of the state adopt the gold currency, then it would attract businesses the world over who are afraid of doing business in a coming hyperinflation.  (While those in power cannot forsee a collapse of the US dollar, does not mean that such a thing is all that far off.  I doubt the Germans in 1922 forsaw the inflation awaiting them in the next year.)  And finally, since the State already has a balanced budget rule, the impact on the budgetary process would be small. 

The problem of going it alone, when we have legal tender issues, is that of Gresham's Law.  The law says that with legal tender laws, bad money drives out good money.  (It also says, but is less commonly known, that good money drives out bad money in a competitive market.)

So, unfortunately, Gresham's Law will fully apply to North Carolina.  Why?  Suppose that Bradley is correct on the dollar's purchasing power falling through the floor.  Now to pay my taxes I have the choice of choosing between using a state gold coin or a depreciated dollar.  I will always choose to pay in the least valuable currency.  So I will hoard the state gold coins and spend the increasingly devalued fiat dollars. 

Unless...

The only way that the Gresham's Law will work to the advantage of the state gold coins is if it is allowed to compete with the US paper dollar.  If the paper dollar and state gold coins value are fixed, then the paper money will drive out the gold.  However, if value of the state gold coin was allowed to float against the paper dollar, then it would, indeed, drive out the use of the paper money.  Not entirely, of course, but to the extent that residents of North Carolina can demand payment in gold coins, it would. 

And that is the catch.  The paper dollar says that it is good for all debts public and private.  So that means you have to accept it.  If the buyer can force the seller to accept the paper, then there is no chance of its success.

Austrian Economics Forum Spring 2011 #3--Non-Neutral Money

This session we had three readings: “The Non-Neutrality of Money” by Ludwig von Mises (1938 [1990]), “Neutrality of Money” by Don Patinkin (1987/1989) and “The Problem of Monetary Equilibrium,” by J.G. Koopmans (1936).  We started with Mises’ article and, sadly, ran out of time before we could really get into the Koopmans piece.  The Koopmans piece is a lecture that he gave at the LSE on June 15, 1936.  The copy we used comes from Professor Richard Ebeling.  He hopes that it will be soon published as a journal article.  We shall see.

The idea of money's non-neutrality seems to be fairly straight forward, while the idea of neutral money is the idea that seems to be alien.  Nevertheless if we examine the economics profession, the idea of non-neutral money is almost summarily rejected or, on a good day, it is given some lip service--and then tossed aside.  So what is neutral money and where does the idea come from?

In the mid-1700s, David Hume (Scottish philosopher and teacher of Adam Smith) was arguing against mercantilism.  Mercantilism was the political economic doctrine that held that a nation is richer if it has more gold and silver.  These riches could then be transformed into military power and then ultimately into national supremacy.  Hume argued that the wealth of a nation could not be simply measured by counting the amount of money (gold and silver) that existed in the economy.  He said that ultimately wealth was found in the goods and services in a country and not the amount of money.  For example, suppose that an economy doubles its money supply overnight.  Is it doubly as rich?  The obvious answer is, "No, all that changes is prices."

So far the neutral and the non-neutral money theorists agree.  The next step is where the two groups part company.

The neutral money theorist says that if the money supply doubles, then all prices will double.  The modern version of this position is that the "Price Level" doubles.  In other words, on average, prices will double. 

The non-neutral money theorist says that this analysis is drawing conclusions with assumed facts.  The neutral money supporter is implicitly assuming his conclusions: increasing the money supply has no effects on anything real. 

So let's get into the details of the debate.

First of all, the Austrian asks what is meant by the "Price Level"?  Mises explicitly rejects the metaphorical use of the term "level."  It conjures up an image of a pool of water in which water is added or withdrawn.  The height of the water in the pool then reflects the change in the injections--i.e., a doubling of the amount of water, doubles the height of the pool's level.  Money is not diffused into an economy so quickly.  Hayek has said that instead of water, we might envision the pouring of honey.  Mises argues that positing all prices and wages simultaneously rising or falling to the same extent simply cannot be assumed. 

Patinkin, on the other hand, argues that nothing other than exactly that can occur.  He sets up a general equilibrium model of an economy and then increases the money supply by "k."  He then shows, mathematically, that in order for all the equations to reequilibrate, all prices and wages must increase by exactly "k."  The assumption is made at the moment when we assume unique general equilibrium conditions.  If there is only one solution for general equilibrium, then of course the only solution is to change prices by "k."  However, that is a huge assumption that is never (rarely?) justified.  In his defense, Patinkin does admit that in the short-run there may be some non-neutral effects, however, his argument is that the long-run patterns must reemerge.

But, let's take Patinkin at face value.  The entire focus of Austrian analysis is on the short-run effects of monetary injections and their distortionary effects.  So, why should the Austrian even take the bait and argue the implications of a hypothetical long-run, which will never emerge?  Furthermore, as we will see below, the role of heterogeneous capital will make returning to an original hypothetical long-run equilibrium impossible.

So then what is the Austrian position and why is it so important?

The Austrians do not view money as some mystical numeraire that simply measures the height of purchasing power.  Instead, money is a good that is also subject to the same laws of diminishing marginal utility (demand) and increasing opportunity costs (supply) that govern all other goods and services.  Since the valuation of money is governed by marginal appraisals and the goods and services purchased are also governed by marginal appraisals, then the concepts such as "Price Level" and "velocity" must be viewed with extreme suspicion.  Indeed, Mises outrightly rejects the use of either.  Mises states,

Monetary problems are economic problems and have to be dealt with in the same way as all other economic problems.  The monetary economist does not have to deal with universal entities like volume of trade meaning total volume of trade or quantity of money meaning all the money current in the whole economic system.  Still less can he make use of the nebulous metaphor "velocity of circulation."  He has to realize that the demand for money arises from the preferences of individuals. ... Money is never simply in the economic system, ..., money is never simply circulating. ... The decisions of individuals regarding the magnitude of their cash holdings constitute the ultimate factor in the formulation of purchasing power.

As a result, it makes no sense to aggregate all of the money into a graph containing Money Supply and Money Demand to determine the "Purchasing Power" of money.  Furthermore, the Austrians reject the "equation of exchange," MV = PQ. 

So without such mechanisms for analysis, what is the proper method for examining macroeconomic and monetary problems?

The Austrians use a stepwise approach.  Austrians argue that money is injected into specific points into the economy and that these injection effects have specific impacts and implications.  Suppose that the central bank creates and injects new money into the economy.  Economists agree that this money creation favors debtors and harms creditors.  Additionally, economists agree that a signal extraction problem might emerge; that it is a hidden tax and can distort the incidence of the tax code; and that it can blossum into hyperinflation, which can be very difficult to reverse.  However, the Austrians focus on the emergence of the Cantillon Effects. 

If the central bank creates $100, it is injected into the economy and not scattered evenly throughout it.  As a result the first person (firm, institution, etc.) to get the new money has an advantage over everyone else.  He is able to obtain $100 worth of goods and services at today's prices without first contributing to the general welfare.  The buyer who uses this new money competes against everyone else in the economy.  The effect of his purchases is an increase in the demands for those specific goods, resulting in the prices for those goods inching up.  Now those who have the new money are able to buy goods and services with only some prices slightly higher.  The effect ripples through the economy.  As the new money passes from person-to-person, prices inch up as a real goods and services are exchanged. 

While this process continues there are those people who do not yet have the new money.  Nevertheless, the prices that they face are rising.  Their real wealth falls.  Thus, there is a real wealth transfer from those who get the new money last to those who got the new money first. 

The next step is to add heterogeneous capital to the analysis.  To the degree that capital has specificity, these distortionary effects create illiquid malinvestments.  As these malinvestments are built up in the economy, their removal becomes more difficult.  This idea is the underlying framework for Austrian Business Cycle Theory.

None of these issues emerge if money is assumed to be neutral.  Indeed, many economic problems become difficult to analyze when neutral money is assumed.  This is probably why Mises concludes his article with this important observation:

I wish to emphasize that in a living and changing world, in a world of action, there is no room left for a neutral money.  Money is non-neutral or it does not exist.

Ron Paul on the Fed

There was an article yesterday on CNBC.com "Fed Will 'Self Destruct,' Policy 'Deeply Flawed': Ron Paul." 

Ron Paul is very much in tune with the Austrian perspective of the economy.  He argues that the Fed's actions are in the wrong direction and that when he becomes chairman of the committe that oversees Monetary Policy, his approach will be very different.  He is in favor of opening up the dollar to domestic competition.  Competitive currencies would allow individual citizens the ability to escape from the mismanaged, inflationary policies of the Fed set forth in the post-gold standard era.

To read this article, it is here: http://www.cnbc.com/id/40068994/

Twisting the Yield Curve--Again!

The more things change, the more they stay the same.

Today the central bank of the US, the Fed, has announced that it will buy 600 billion dollars worth of “longer-term” Treasuries. By the end of second quarter 2011, they are planning on buying $75 billion in 30-year bonds per month. (I suppose that 20-yr bonds would also fall under the heading of “longer-term” as well.) They again hope that this additional liquidity, “stimulus” will jump start economic growth.

The Fed also announced that they will target Fed Funds rates between 0.00% and 0.25%. This is eerily similar to an announcement they made on March 18, 2009. In that announcement they said that they were going to target Fed Funds rates between 0.00% and 0.25% and inject $850 billion into the economy. $300 billion were to go into the purchasing of longer-term Treasuries. I have already described how such a scheme is pure folly here.  In that article, I also pointed out that it didn’t work when they tried it in the Kennedy Administration. Have we started to notice a pattern forming?

It is odd to find that we have tried this before and have not achieved the desired result. The key to impacting the so-called “real economy” by using expansionary monetary policy is by catching people unaware. If businesses see how much is injected and when, then they will adjust in anticipation of the injection. In other words, the only effect that the monetary stimulation will have is the immediate devaluation of the currency.

Our National Debt, the Age of the Universe and Our Future

There has been a lot of controversy centered on the size of the U.S. National Debt and rightly so, because it has never been a larger number. Today, the national debt is approximately $13,550,000,000,000 dollars. Such a large number needs context. I could say that if we stacked a trillion $1 bills on each other that this stack would stretch around the Earth 2.72 times. Unfortunately, that boggles the mind, especially if I say that our debt is 13.55 times that. Clearly, we need another way to understand the vastness of this number.

Using the Hubble Space Telescope, scientists have a clearer picture of the origin of the universe. Scientists estimate that the universe is approximately 13.7 billion years old. When we compare the age of the universe with the size of our national debt, our national debt is a 1,000 times larger. In other words, if we had spent about $1,000 a year, every year, since the beginning of time, we would have a number about the size of our national debt. Or, suppose you had spent $2.71 a day, every day, since the universe began. You would have spent as much as our current national debt.

How did the debt get so large if there was a surplus in the Clinton years? It is true that the federal government collected more tax revenue than it spent in the late ’90s and national debt shrank, however the debt did not fall to zero. (The last time the national debt was zero was in 1836, under President Andrew Jackson.) We have since had budget deficits—with each borrowed dollar adding to the debt. With the TARP funds, bail-outs, stimulus injections, and other spending programs, there is little wonder that the resulting deficits are so large.

There are three ways that we can get ourselves out of this hole. The first is to monetize the debt. In essence, this means that we can convert the debt into dollars and pay everyone we owe. In fact, this can be done tomorrow. How? Quite simply, allow the central bank of the U.S., the Federal Reserve, to buy up all the existing debt. Let it buy up all the T-Bills, Treasury Notes and Bonds—all of it. Dollars would replace the outstanding debt. Where would the Federal Reserve get all this money? The answer is simply that the Fed would get it out of a big black hole of nothingness. The dollar isn’t backed by anything—not gold, not silver, nothing but the “full faith and credit” of the United States (whatever that is). That means the Federal Reserve can just create money at will. It can create an infinite supply. It doesn’t even need to print new bills. The Fed could simply type numbers into a computer account and it’s done.

What is the problem with monetizing the debt? When $13.55 trillion new dollars hit the economy, the banking system multiplies the new dollars by a factor of a little more than 9. That means the money supply will swell by more than $120 trillion. (The current size of the money supply, as measured by M2, is $8.7 trillion.) If we took this route, we would be well on our way to hyperinflation. There have been several historical instances of hyperinflation, which wipes out life savings and destroys resources that form capital. The most famous instance was the German hyperinflation of 1923. Prices were rising so fast that people had to be paid multiple times a day. When workers were paid mid-morning, the men would run to the gates to give the money to their wives so that they could buy something before the money became worthless. Inflation was so bad that the price of a cup of coffee tripled by the time one finished drinking it. And this was happening for all prices! Germany could not continue with this situation. It had to abandon the Paper Mark and eventually switched to the Reichsmark.

The second way out of this deficit is to increase the amount of tax revenue that flows into the Federal Treasury. This approach has failed miserably for two reasons. The first is that the politicians always seem to find ways to spend all the additional money brought in and leave us no better off. The second reason is that increasing taxes is like having the economy drop an anchor. Taxation slows the economy, stunts business activity and penalizes the behavior of entrepreneurs. As a result, the higher tax rates take a larger percentage from a smaller pie, leaving a small and short-term increase in the revenues flowing into the Treasury followed by a drop-off in tax revenue a year or two down the line leaving a large debt and a stagnant economy.

This leaves the third option: a cut in spending. By a cut in spending, I don’t mean what politicians have been calling a cut, “a reduction in the rate of spending.” I mean, “Stop the car, put it in reverse, and back it up.” We need to cut spending to levels that are below our revenues. This will constitute many broken promises and real pain. The federal government has made very large promises. In fact, the size of the Unfunded Liabilities for the federal government exceeds $110.7 trillion. In other words, just to fulfill the promises already made, another $110.7 trillion are needed in the bank collecting interest right now. (U.S. GDP is only $14.5 trillion.)

So where can we cut our spending? If we look at the amount that we have spent on national defense this year (and I mean all of it), add up the total money spent on all the branches of the military—including equipment, personnel, operations, the wars in Iraq and Afghanistan—we have a year-to-date total of a little more than $527 billion. That is a lot of money and there are certainly areas that could be cut. Yet, if we look at how much we have spent on Social Security over the same period of time, we see the total to be above $534 billion. Furthermore, if we look at Medicare and Medicaid, that number is nearly $604 billion. Unlike defense spending, Social Security, Medicare and Medicaid are currently considered “Non-discretionary” budget items, so radical structural changes are needed to fix this problem, as well as the courage to solve this deficit issue.

I recently heard a good analogy. Imagine that you received some terrible news: your child has an awful, horrible disease. This disease will cause a lot of pain and suffering and could possibly result in the child’s death. Any parent’s natural reaction would be to fall to one’s knees and pray to God, “Give it to me. I will take the pain. I will suffer the burden, but please spare my child.”

Our National Debt is that disease. Why are we so willing to pass on the pain and suffering to the next generation, to our sons and daughters? Why are we so unwilling to bear the burden of our past excesses? The country is already broke. At this point, we are simply piling on. We have to address this issue now; it is getting worse. We have to look in the mirror and ask ourselves, “What kind of a person am I? What am I willing to do? What am I willing to sacrifice?” It has come to the point where the only way to fix this problem is through a sacrifice in today’s comforts. Will we try to spare our children from this disaster or will we impose this debt on them for our own comfort today? What are we willing to sacrifice for our children? What are you willing to sacrifice?

Mises' "Latest" Book

Bettina Bien Greaves is a living treasure.  She has worked for decades at the Foundation for Economic Education (FEE) and attended just about every lecture that Mises gave at FEE and at NYU.  She would take shorthand notes of all that he said.  Today she is converting those notes back into text.  She has recently come out with a synthesis of several Mises lectures.  It is called: Ludwig von Mises on Money and Inflation: A Synthesis of Several Lectures.  You can find the book here and for sale here.

I am so excited about this that I am posting a short chapter below.  It is called, "The Constitutional Side of Inflation."  Enjoy...

When we talk about these things we must not forget that they do not have only an economic side; they also have a constitutional side. You may say that government is the most important institution. The government is very important in many regards. Perhaps one overrates the importance of the government, but one does not overrate the importance of good government.

Modern constitutions, the political systems of all nations that are not ruled by barbarian despots, are based upon the fact that the government depends financially upon the people, indirectly upon the men that the voters have elected for the constitutional assembly. And this system means that the government has no power to spend anything that has not been given it by the people, through the constitutional procedures which make it possible for the government to collect taxes. This is the fundamental political institution. And it is a fundamental political problem if the government can inflate. If the government has the power to print its own money, then this constitutional procedure becomes absolutely useless.

Our whole political system is based upon the fact that the voters are sovereign, that the voters are electing Congress and other such institutions in the various states that rule the country. We call the United States a democracy because the rule of the country is in the hands of the voters. The voters determine everything. And this distinguishes the system, not only from the despotic systems of other countries, but also from the conditions as they prevailed in earlier days, in countries that already had parliamentary institutions and parliamentary government, at that time. However, there has developed, especially in the last decade, a problem of  constitutional law, that is whether the government must get the approval of the people through Congress when it wants to spend, or whether the government, because it is established and has at its disposal a number of armed men, is free to spend as it wishes, simply by increasing the quantity of money. People must realize that the question is “Who should be supreme? The parliaments elected by the voters, who can restrict government spending by refusing to grant the power to tax? Or institutions that want to override the interests of the people by increasing the quantity of money to expand government spending and so do away with the prerogative and independence of the individual voter?”

If we do not succeed in restoring the monetary system that makes the individual independent to some extent of the interference of government institutions, government banks, government monetary authorities, government price ceilings, and so on, we will lose all the achievements of the free market and of the free initiative of the individuals, whatever methods of constitutional law we follow. If the government can inflate whenever it wants to spend, it can take away from the people without their agreement everything, their purchasing power, their savings, and so on. From this point of view there disappears even the fundamental principle which everybody sees as the difference between a Communist government and a government based on the idea of individual freedom, the preservation of free markets and the ability of the people to control the government.

If you look at the constitutional history of England in the 17th century, you learn that the Stuarts had problems with the British Parliament. The conflict consisted precisely in the fact that the Parliament was not prepared to give to the King of England the money he needed for purposes of which the Parliament didn’t approve. The people disapproved of a great part of the government expenditures and Parliament was not anxious to impose taxes. The Stuart kings wanted to spend more than Parliament was prepared to give them. If the King at that time, in 1630 let us say, had asked one of those who are considered experts today in government finance, “What can I do? I don’t have the money!” the “expert” would have said, “Unfortunately, your family, the Stuarts, came too early to their position as rulers. Two hundred years, three hundred years later, it would be much easier for such a government as you want to rule the country. A printing press would have been sufficient to make it possible for your government to spend all the money it needed to have an army and the other things needed to protect the King against the people.” But the poor Stuarts were living in an age in which the technique of producing paper money had not been developed to a considerable extent. Charles I couldn’t inflate, you know. There was no solution for him; he could not engage in deficit spending. This was the undoing of the Stuart family and the Stuart regime. And in the conflict which originated out of this, one member of the Stuart family lost his life in a very disagreeable way—Charles I lost his head. (fn1) And the Stuart family as such lost the crown of England. What the poor Stuarts didn’t have was the facility of the printing press as it exists today.

The monetary problem we have to struggle with today is the problem of paying for government expenditures which are not accepted or, let us say, not approved, by the people. The conduct of government affairs, public affairs, is not different from the conduct of the financial and monetary conduct of private affairs. If the government wants to spend, it has to collect the money; it must tax the people. If it doesn’t tax, but increases the quantity of money in order to spend more, then it brings about an inflation. The difference between the conditions in 18th century England and the conditions in other countries, let us say for instance in Russia, consisted of the fact that the Russian government was free to take away from its subjects what it wanted while the British government was not. The British government had to comply with the provisions of a set of laws that limited the amount of money the government had the right to collect from its citizens. And it had to spend this money precisely according to the wishes of the people.

All our constitutional laws and our system of government are based upon the fact the government is not permitted to do anything that violates this system of laws representing the moral and actual ideas and philosophies of our people. But if the government is in a position to increase the quantity of money, all these provisions become absolutely meaningless and useless. If it is said that the government has to spend, is entitled to spend, a definite amount of money for keeping people in prisons, this means something. There is a definite reason for its spending. All our legal provisions are influenced to some extent by the fact that this is the amount of money which is given to the government for this purpose. But if the government is in a position to increase the quantity of money to use for its own purposes, then all these things become merely a theoretical expression of something which has practically no meaning at all. We must not forget that all the protection given to individuals through constitutions and laws disappears if the government is in a position to  destroy the meaning of every inter-human relation by undermining the system of indirect exchange and money which is called the market. And this is much more importantthan any other problems we talk about today. It is the interference of the government with violence that has spoiled money, that has destroyed money in the past, and that is perhaps destroying it again today.

Some years ago you could frequently read quotations saying that Lenin said that the best method to destroy the free enterprise system would be to destroy the monetary system. Now a professor in Germany has demonstrated that Lenin never said this. But if Lenin had said this, it would have been the only correct thing that he ever said.

The monetary problem which we have in this country, which you have in every country today, is the same—to keep the budget in equilibrium, to balance income and outgo, revenue and expenditure without printing an additional quantity of banknotes, without increasing the quantity of the monetary units. This is not only a problem of economics. It is also the fundamental problem of constitutional government, you know.  Constitutional government is based upon the fact that the government can only spend what it has collected in taxes. And it can only tax the people if the people accept it by the vote of their representatives in parliament. And in this way the voters are the sovereigns. The problem of monetary management in a modern country cannot, therefore, be separated from the constitutional problem, from the doctrine that says that all problems of government, all governmental matters are decided ultimately by the vote of the people. Whether you call this democracy or popular government doesn’t make any difference. But there is no monetary or budgetary problem that can be separated from the constitutional problem of who rules the country, who determines ultimately what has to be done in the country.

Fn 1 Charles I was beheaded on January 30, 1649.

Recessions and Recoveries

Two weeks ago the National Bureau for Economic Research (NBER) announced that we are out of the recession and have been since June 2009.  So, how does this recession compare to previous recessions?

The earliest date that the NBER uses is 1854.  The average length of a U.S. recession between 1854 and 2010 is 17 months.  If one uses post-WWII data, the average length of a business contraction is 10 months.

If we compare the current recession, which started in December 2007, with that of previous recessions, we see that the duration is longer than either average.  Now that the NBER says we hit bottom in June 2009, we have had 19 official months of recession.

We are now entering the 34th month since the beginning of the recession and many are questioning whether we have truly hit bottom.  While I believe that we have stopped falling, I think that the so-called recovery has started yet.  In fact, there are signs that the recovery is still far off.  For example, private investors are unwilling to make a move until they have a clearer understanding of the government's next regulatory moves.  This situation precisely mirrors investors' sentiments in the 1930s.

The Bush administration reigned over the first 14 months of this recession.  By historical averages, we should have been recovering by inauguration.  What does this tell us?  It says very clearly that the Bush administration made the wrong move by bailing out banks and propping up failing businesses.

It  is now more than 20 months since the Bush administration has left office, and the current government has also done much to hamper any prospect of recovery.  The Obama administration has not unleashed the economy (and reverse the Bush agenda), but instead, it has further shackled it.  By supporting TARP and the Bush bank bail outs and adding to the situation the GM bail out, the ineffective stimulus package, a new health care burden and more financial regulation, the Obama administration has set us on a path towards economic stagnation.  The looming fear is whether the stagnation will be coupled with Jimmy Carter style inflation.

It is time to recognize that taxing, spending and regulating are not the instruments for economic recovery. Money creation, artificially lower interest rates and government accumulation of debt are sending us down the wrong road.

Governments at all levels are stalling the recovery and it seems that no one trusts the market enough to let it do its job.

Perhaps we should listen to our 30th President Calvin Coolidge:

“The people cannot look to legislation generally for success. Industry, thrift, character, are not conferred by act or resolve. Government cannot relieve from toil. It can provide no substitute for the rewards of service. It can, of course, care for the defective and recognize distinguished merit. The normal must care for themselves. Self-government means self-support.”

Twist and Shout

On March 18th, the Federal Reserve announced it will keep the Fed Funds rate between 0 and 0.25%, buy $750 billion in mortgage backed securities, and buy $100 billion in agency debt. While injecting $850 billion into the economy is problematic, the almost unnoticed announcement is that the Fed plans to buy $300 billion in long-term Treasury securities.

The last time the government tried to manipulate long-term interest rates was in 1961, during the Kennedy Administration. The goal of a project called “Operation Twist” was to flatten the yield curve by raising short-term rates while maintaining long-term rates. Legislators thought that higher short-term rates would reduce the flow of capital from the US, while lower long-term rates would encourage domestic investment. Operation Twist was a disaster because the result was the opposite of what the Fed intended.

Unfortunately, our economy is in a recession – the downside of the business cycle. The business cycle works something like the following. Suppose that a student is assigned a research paper that is due tomorrow at 8am. Since the student hasn’t started the paper, she is in for a long night. By 11pm, the student is getting tired but hasn’t finished the paper. What does the student do? Quite naturally, she reaches for some coffee, a sugary soda, or whatever else that has a lot of caffeine. The jolt of caffeine gets her moving again; but, around 3am, she’s slowing down. What does she do? Grab more caffeine! However, now to get the same jolt, she needs a bigger dose. Each artificial jolt cannot last, and the next jolt requires an even larger dose. Eventually, 8am arrives and the student hands in the paper. Then, she crashes! A long sleep is necessary to flush the junk out of her system and restore her to a normal state.

Our economy has been on an artificial all-nighter for the past several years. It is now time to clear the “junk” out of the system. The junk that needs to be cleared out consists of malinvestments, which were built up during the artificial boom of the last several years of expansionist monetary policy. Now, the time has come to hand in the paper and flush these malinvestments from our economy.

The only way that we can get back to a solid foundation for economic growth is by increasing saving. Savings provide the wherewithal for investment. Investment allows for capital accumulation. Capital includes better tools, better machines, and better equipment, which are necessary for workers to become more productive and raise the standard of living. This is the “Magic Formula” for economic growth; but it’s really not magic. The formula has been known and followed since the beginning of the 1800s. Following this magic formula transformed the US from a bunch of backwater colonies into the largest economy in history.

The opposite approach, the one we are currently taking, is to encourage consumption, except that method doesn’t work. We cannot consume our way to prosperity. A basic tenant of economics is that our wants and desires are unlimited; however, supply is the limiting factor. Stimulating demand alone will not increase the amount of stuff that is being produced.

Furthermore, the Fed is engaging in a policy that allows the entrepreneurs who malinvested capital to persist unnaturally. Unfortunately, those businesses must fail for the economy to recover. When they go out of business, other entrepreneurs can buy their assets for pennies on the dollar. This process allows new firms to use those very same resources (and perhaps the very same employees) with a much lower cost structure. Lower costs are good for firms and very good for consumers, especially those without jobs.

The Fed policy is propping up failing firms while attempting to keep prices high. This policy is backwards. The Fed’s action of pumping money into the economy today will force prices to be much, much higher in the future. The last thing those who have lost their jobs or suffered wage cuts need is for prices to remain high.

Every delay in the painful liquidation phase of the business cycle makes the future reckoning worse. It’s like not going to the dentist when you have a cavity. The drilling will be bad, but if we let it fester, it will become much worse.

We need to shout to the Fed, “Stop drinking those heavily caffeinated, sugary sodas! Stop flooding the market with all of this artificial credit! And let the economy wash out the malinvestments!” Perhaps the song “Twist and Shout” will always be in style; unfortunately Operation Twist is a policy that should have remained in the past.

The Real Bills Doctrine of 2009

In the late 1920s and early 1930s the Federal Reserve System followed a theory called “The Real Bills Doctrine.” While the theory has been totally discredited, it nevertheless emerges in the news and in political circles from time to time. The real bills doctrine makes a distinction between the financial sector of the economy and the “real” economy.

In the late 1920s, the central bank was worried about the amount of money flowing into Wall Street. Many claimed that there was too much speculation, which was creating a false stock market boom. As a result, the central bank stated that it would only loan money to banks and corresponding projects that were “productive.” In others words, the central bank would only loan money to projects that were to be used to produce real goods and services. With the production of real goods and services, the loans would not be inflationary. Or so the theory goes. The reality is that all monetary creation is inflationary regardless of what it is used for.

Today, we are suffering from the real bills doctrine again. It is just dressed up a little differently. The politicians are calling for more economic stimuli to “jump start” the economy. Some politicians are objecting to the direction that Washington is taking not because the theory of increasing government spending to create an economic recovery is flawed (which it is); but rather politicians are objecting to the idea that the money isn’t going toward “real stimulus” projects. They claim that instead of using the money for balancing state budgets, the federal monies should go to “shovel ready” projects. It is in this distinction that the real bills doctrine emerges. When it comes to inflationary pressures, there is no difference between balancing state budgets, shovel ready projects, road construction, stock market speculation, and so on. The more dollars put into the economy devalue each and every dollar, regardless of how it gets into the system.

Furthermore, spending federal dollars will not restart economic growth. The source of economic growth ultimately comes from savings and capital accumulation. Capital accumulation means the production of better tools, better machines, and better equipment. More capital is necessary because it allows each worker to become more productive and raise the standard of living for everyone. This formula has been known and followed by the US since our revolutionary days. Following it has transformed the US from a bunch of small, backwater colonies into the largest economy in human history.

The current stimulus package cannot be funded by using today’s tax receipts. The government will try to get the money to cover these expenditures through borrowing, which will result in the largest deficit ever. Unfortunately, there is simply not enough money to borrow to cover all of the spending. The balance will have to come from money creation. Regardless of what is done with this money, it will cause prices to rise in the near future. Furthermore, since our banks adhere to a fractional reserve system, it means that the newly created base money will be loaned, deposited and reloaned, over and over. This credit creation process will multiply the money supply throughout the economy by a factor of about nine.

We are standing at the edge of a very nasty inflationary period. We can turn back or we can make things worse. If we follow the path of monetary expansion, it will come at a very high cost. Not today, but not too far into the future. It will be at that point when the real bills will have to be paid.