Joe Cobb

Can government spending help repair the current economic recession? This is a debate sponsored by Phoenix College, March 10, 2009. The short video segments here are my presentations.

Opening Remarks, “What can we do to get out of the problem?”

Follow up, “What can any government do to solve a macroeconomic problem?”

As someone who knows a little about monetary theory, banking, and government finance, it is frustrating to listen to the news reports and to read about the Euro crisis. Let me set out some observations.

First, the Euro was created as a credit unit managed by the European Central Bank. The governments of 17 European countries adopted it as their legal tender and discontinued their previous legal tender systems. The European Central Bank (ECB) was incorporated with a charter that made monetary value stability, in terms of what the Euro can buy in the future, its only objective. The ECB does not have additional political mandates, like the U.S. Federal Reserve, such as to promote economic growth or employment.

There are four distinct problems today in the “eurozone,” which does not encompass all of the European Union, but certainly affects all of the others, like Britain and Poland, which continue to use their older national currencies.

Distinguish among

1. The accounting unit itself, “Euro.”
2. Maintenance of the payments system using the Euro as a medium of exchange.
3. The solvency of banks, which are central to the payments system, that unwisely invested in the government bonds denominated in Euros.
4. The solvency of governments that issued bonds in Euro units. Those governments must somehow continue to borrow, both to keep on financing deficits and to pay off maturing bonds.

These are four entirely distinct issues, although the news reports do not make any distinctions. Because of the “money illusion” between credit markets, government accounting, and payments for goods and services, with banks at the center, the news reporters focus on the crisis as if the problem were the single currency instead of the foolishness of governments and bankers.

The crisis in Greece made the news when it became clear that government was insolvent. It has bonds maturing soon and it cannot pay principal and interest. Because of the distortion based on the Basel III Accords, designating government bonds as risk-free assets, not requiring any capital reserves, it was quickly discovered that major banks all over Europe and in the United States faced a massive solvency crisis as well.

One of the first victims was Jon Corzine and MF Global, which had invested heavily in the bonds of fiscally weak EU governments, because they paid higher yields. Those bonds were understood to be weak and were selling at slight discounts – as junk bonds ought to do – except former Governor and Senator Corzine, a man of great faith in the power of governments, believed his investments were safe and sound. After all, did not the Basel III Accords make them solid investments? Would governments allow them to fail?

At least MF Global was not linked into the EU payments system, as most major European banks seem to be. The failure of the payments system would be a major crisis for the entire world, and a disaster for Europe, so the European banks, and politicians, are working very hard for a massive bail out.

The German chancellor is not quite willing simply to coerce the ECB to bail out the banks, as the Federal Reserve chairman did do. The ECB was not given any charter to be a bail out agency, but the Federal Reserve since 1913 has always been a bail out agency; it was founded for that explicit purpose. (The corruption of Corzine and his managers, embezzling funds, is not the issue.)

The Fallacy of “Fiscal Union”

There is confusion in the news reports about items 3 and 4 in the list above. In a classical economic system that used gold coins as money, and both taxes and government bonds were denominated in gold coins, the integrity of the coins, and banks that operated with gold coins as accounting units, was never threatened when a government could not collect sufficient taxes to pay off maturing bonds. (The crude method of debasing or clipping coins is another story.)

Any banker who owned such bonds would, of course, take a hit, but like any other bad debt, it would be written off. The bank might become insolvent and have to close. The banker, like Jon Corzine, might go to jail for losing depositors’ money; customers might be shafted, like MF Global’s customers, but the payments system based on the coins would not be jeopardized.

The bankrupt government would keep on collecting taxes in gold coins and paying soldiers and police salaries, although it would not be able to run a fiscal deficit because nobody would trust it to sell honest bonds.

The irony of the situation is that if Greece had a government running a fiscal surplus, it could repudiate all its bonds and laugh at the bankers who had bought them. But Greece has to keep on borrowing because it runs a fiscal deficit.  Beggers cannot be choosers.

If Greece had had its own national currency, based on a gold standard, it would already have “gone off” and devalued. But there is no way Greece can go off the Euro standard and start now to issue a new fiat currency. Who would use it, even in Greece? Who would buy Greek government bonds promising only to repay in those new, politicized accounting units?  According to the news, even now in Athens people are bank-running to have Euros under their beds.  Trust in the ECB is greater than their trust in the Greek government. 

What is different in Europe today is the Euro payments system is jeopardized because it is a pyramid of bank credit based on government bonds. Saving the payments system is the really important task since all economic activity and growth depends on it.  Modern society can not be maintained on barter.

To save the payments system, saving the banks seems to be necessary.  The political drama is all about preserving the ability to borrow for the governments of Greece, Italy, Spain, and Portugal, and to pay off their bonds as they mature.  This is basic for saving the banks, who own the bonds. 

The fallacy of “fiscal union” is that it confuses the Euro, the accounting unit, with the overspending (or under-taxing) of the governments whose bonds are exposed as junk. The complaint about lacking a “fiscal union” is that Greece has no power to increase taxes in Germany or France to pay its debts. With the Euro, like the gold standard case above, the insolvent governments cannot resort to printing-press inflation to keep going. “Fiscal union” is a fancy name for a systemic “Robin Hood” solution.

The German chancellor and French president are trying to devise a way to bail out the insolvent governments because they want to save their own banks. They need to save their banks in order to save the payments system, and themselves. The common Euro currency itself is not a problem – the Euro is just the accounting unit. The “problem” is that it cannot be debased to make the junk bonds payable, as some hypothetical national Greek currency could have been ["coin-clipped"].

The Proposal for Joint EU Bonds

Since Greece cannot tax Germans, and since Germans do not feel like taxing themselves to bail out the Greek government, the gimmick in the news is for (1) the entire European Union to issue bonds and (2) give the money to the Greek, Italian, Spanish, and Portugese governments, but only if (3) those irresponsible politicians give up their “sovereignty” to bureaucrats in Brussels and submit to fiscal austerity.

This would bail out the banks, which is why it is the preferred political solution. It would preserve the payments system, which is why it is necessary. But the cries about “democracy” and “sovereignty” are loud and emotionally attractive. What is at stake is 100 years of European social welfare and labor union dominance, finally crashing into the stone wall of economic reality.

Consider the alternatives, which nobody wants to discuss because millions of innocent people would suffer and the EU, as well as much of the world, would probably face a massive credit collapse. Since the world is a single capital market, neither the United States nor Brazil/Russia/India/China would get out of it unharmed.

Let the bonds default?
Assume the banks could be compensated separately, or penalized separately, which is a huge political assumption. In the defaulting countries, pensioners and government workers then would not be paid more than tax collectors could gather at the point of a gun. Civil disorder might follow, and economic activity would certainly be disrupted. Thousands of people would try to emigrate. Ayn Rand fans might look approvingly at the logical consequences of the collapse of a parasite state, which might describe Greece and others, but the other European countries would not welcome large-scale immigration by economic refugees.

Compensate the Banks Separately?
There might be no justice in compensating the bankers who made stupid investments under the rules of the Basel III Accords in junk government bonds, but depositors and creditors of those banks are not to blame, and the payments system is administered by the banks. Perhaps the banks could be taken over by their governments and merged with the postal savings (giro) system.

The bank bail out in Ireland a few years ago tried something like this, but the debts almost overwhelmed the Irish government. It was given some assistance by the EU and Ireland seems to be recovering. But the problem in Ireland pales in comparison with the banking crisis in the rest of Europe if Italy and Spain go under – and the fear this problem might expand has caused the capital markets to choke. The United States is enjoying a flood of frightened capital, which is one reason U.S. government bonds are paying negative real interest rates.

Break Up the Euro Zone, or At Least Expel Greece and a Few Others?
This idea solves no problem, and is not different in substance from either of the two previous suggestions. Hyperinflation would hit Greece within a day of the attempt to introduce a new currency there, and no Greek government bonds would be purchased by any private investor.  The bank runs in Greece show what the people think about it.

Was the Single Currency a Mistake?

There is an interesting question in economics about what might be the size of an “optimal currency area,” and how it would work with floating exchange rates among regional currencies – not just “national” currencies. Much of this analysis looks at labor markets and natural resource markets and considers how local conditions might make different circumstances work better. An exchange rate that devalues can make labor cheaper, due to money illusion, and an economy mostly based on exports of natural resources might want some local immunity from shifts in world demand or supply conditions that can cause wide price swings in commodity markets.

In macroeconomics, if central banks can control money and credit, and national governments can finance deficit budgets without depending on free international capital markets, sometimes a serious social crisis can be manipulated to create different winners and losers. Politicians and socialists love this idea because it gives so much power to the governing elite.

The real question, of course, in any social crisis is why the situation needing “management” arose in the first place? And why are the losers almost always the weakest and least powerful in society – as the politicians and fat cats get away with it?

In the Euro crisis, it would be good if a result can be found to cushion the punishment of the innocent, and instead ruin the lives of the political leaders who created the insolvent governments in the first place. The most likely result, however, will be the opposite. The bad judgment of the European bankers will probably become as profitable as the bad judgment on Wall Street did when the housing bubble collapsed.

Of course, Wall Street a century ago created the Federal Reserve to ensure that happy outcome. We shall see if the European Central Bank holds fast, or caves under the pressure to pollute the Euro.

by Joe Cobb

The concept of “money illusion” was identified by John Maynard Keynes in his masterly book on the Economic Consequences of the Peace (1919), and the brilliant American economist, Irving Fisher, also wrote a book with that title (1928). Economists have used the term to describe the tendency for people to think of money in terms of its face value. Money, of course, does not have any fixed value since what money can buy depends on what prices producers and sellers ask for real things. [ See this discussion from Wikipedia for a general introduction to the ideas of economists on money illusion. ]

Money illusion was famously described by Thomas Mann in a story about a friend in Germany, after the first World War, who had borrowed 10,000 marks from the famous author before the war. After the great German inflation of the 1920s had begun, Mann’s friend gave him a nearly worthless 10,000 mark note. That the paper money could not possibly repay the debt he owed he failed even to understand.

John Maynard Keynes seriously proposed using inflation as a way to reduce unemployment in his General Theory of Employment, Interest and Money (1936) because he believed workers would be too stupid to figure out that nominal wages, even after pay increases, could be lower in real terms if the pay increases did not keep up with inflation. Cutting the wages of labor is one prescription for reducing unemployment, since with lower wages employers can find it economical to hire more workers or to forego layoffs.

Keynes knew a major cause of the massive unemployment in Britain in the 1920s was due to the deflationary collapse of the money supply, which also happened in the United States in the 1930s. The purchasing power of a U.K. pound and the American dollar skyrocketed. The U.S. consumer price index in 1929 was 53.1 but by 1933 it had deflated to 38.8 and didn’t return to its pre-Depression level until 1943. Anyone who had money could buy a lot more with it in 1933.

Since there was a national effort under presidents Hoover and Roosevelt not to reduce wages paid, it is no surprise unemployment skyrocketed in that decade. A worker receiving $1.00 per hour in 1929 enjoyed a 37 percent real wage increase, if he still had his job in 1933 at the same $1.00 per hour. Keynes understood if you double the prices a worker has to pay for food and rent, it is a real pay cut. Cutting wages by inflation could get the unemployed back to work. Keynes was not a friend of the working class. Karl Marx, by contrast, supported the gold standard as did other famous socialists like George Bernard Shaw.

A Different Form of Money Illusion

Yet a more serious form of money illusion has seldom been noticed by economists due to one of the most useful things about money itself: You can add it up. Money (and credit) have a mathematical property that apples and oranges do not have. You cannot add up apples and oranges. If an accountant combines the dimes and quarters in a bag of coins with the Federal Reserve notes in his wallet, he can calculate his money supply. Adding apples and oranges does not create a “fruit supply.” Accountants will disregard the differences between the coins and paper money, although it might be impossible to spend the coins to buy many things in the market. Some things require different forms of payment.

When a market system operates smoothly and many people are willing to trade different forms of money at zero or minimal expense it is easy to disregard this essential difference between the forms of money. But consider the example of someone offering to sell a bag of pre-1964 silver dimes and quarters. Most people would immediately recognize the greater value of the old coins, but it took more than a decade after 1964 for people no longer to receive old silver coins in change as most retail cashiers failed to understand the difference between copper clad quarters and old silver quarters.

One of the primary services banks provide in a modern economic system is to provide what seems to be a par value payments system. Indeed, one of the primary requirements of the National Banking Act of 1863 was to establish a uniform currency, issued by private banks. Other national banks had to accept deposits of the “national currency” at face value. Prior to the Civil War, it was common for money issued by private banks to be discounted when it was used in trade or deposited in banks a few miles away.

It is of course very useful not to have to worry about different forms of money circulating in a “floating exchange rate” system, but since 1971 this is exactly what has changed in the world economy. Under the broken Bretton Woods Agreement, national governments were supposed to keep their money units fixed for international trade and finance, just as the National Banking Act did for trade between different cities and states in America.

Today it might seem to be more complicated to make international payments, exchanging between yen and euro and dollar (often requiring derivative contracts to hedge against exchange risk) but the system is also more transparent now. When a currency grows weaker, buyers and sellers immediately see the change in the market. Sellers of the weak currency have to pay more to buy stronger valued money.

The attempted ideal of a par value payments system is the source of this more subtle form of money illusion. Under par value payments, weakness of a currency is only seen – after a delay – in rising retail and wholesale prices. The delay is eliminated by arbitrage in basic commodities, as prices of gold and oil in different currencies reflect the strengths and weakness of currencies themselves under flexible exchange rates.

The Changing Role of Banks

The popular idea of a bank is symbolized by the bank vault. Children are taught you deposit your money in a bank and it will be there when you want to take it out. Banks have always solved the problem of robbery or forgery by offering people a more secure way to save their money. But savings is not the most important service the banks perform. Only a child would believe a bank will take his deposit and keep the money in its vault, like a toy chest, and give it back when the child demands it.

The banker does not operate a warehouse for money.

Bankers are “community bookkeepers” who make it easier for people to make payments to each other and to keep track of how much different parties owe each other (measured in terms of accounting units).

Bankers fundamentally perform accounting as a free public service, while managing investments for their own account – like an insurance company.

A bank customer comes to do business not by “depositing” but by “purchasing” from his banker a line of credit. A customer may not know the difference when he pays $100 cash in exchange for a $100 line of credit, but the difference between what bankers do for the economic system and what government coins and paper money do are very different. A bank offers its credibility as a payor, and it will pay your bills when you ask – if you buy its line of credit.

One of the truly misleading ideas from the British Neo-Classical School of economics, which dominates economic journalism and universities worldwide today, is the idea that bank credit, coins, and government money can be added up like “the fruit supply” to measure M-1, M-2, etc. In the past 30 years, this idea has proven less and less useful in making economic forecasts. In the United States today, even our understanding of what causes price index inflation is seemingly disconnected from “money supply,” mostly because credit has entirely displaced money and the “supply” of credit defies measurement.

By servicing the payments activity of millions of customers, bankers perform one of the essential roles in our modern economy. A banker is always the largest debtor in town, because he owes every one of his customers the nominal value of their bank balance. He does not owe them “money”; he maintains for them lines of credit, which they can switch among themselves in the market for goods and services. When you buy gasoline with your debit card, the banker switches some amount he formerly owed to you and now he owes it to the oil company. Nothing changes hands, except a bookkeeping entry is switched in the bank’s ledgers.

These bank services are not free, of course. Even though bank customers may enjoy fixed exchange rates between different bank services, the bankers are covering their costs in different ways. For merchants, accepting your debit card will mean paying a fee to the bank for the transaction. Logically the bank could charge you, the spender/buyer, for the service, but Congress has passed laws since the 1960s to make the use of cards, checks, and electronic payments look like free services to most bank customers. The banking industry requested these legal restrictions in the early days because introducing credit cards was difficult in the 1960s when store keepers wanted to charge the bank fee to the customer, like a sales tax, on top of the prices marked on goods. Even today one can sometimes see a sign at a cash register that says “Discount for Cash” but it is against the law to say openly your price will be higher for payment by credit card.

The Banker as an Investment Manager

The modern banker operates like a money market mutual fund. Banks own specific assets with less than perfect liquidity and perform “community bookkeeping” for customers with abstract units of credit providing superior liquidity. Liquidity can be understood as the narrow degree of the bid/ask price spread for an asset.

It is a common misconception to say that “banks create money when the make loans.” The standard illustration in economics textbooks will have a bank accept a deposit for, say, $100 and with the magic of the “money multiplier” turn around and expand that amount to $1,000 by making loans to other customers.

If you model the business of a bank like an insurance company, you can understand this model of a bank, but it doesn’t fit today’s banking system.

What banks do is to invest in less-than-perfectly liquid assets and create more-nearly-perfectly liquid liabilities for others to use as assets in payments.

An insurance company is an example of a fractional reserve institution. It takes your deposits and promises to pay you back under certain conditions, like an accident or your death. The insurance company knows all its customers will not have accidents or die on the same day, so it keeps reserves on hand for daily payments and invests the rest.

A banker keeps enough cash in his vault to make daily payments and invests the rest. To the extent that a government requires a certain level of reserves, it might appear to make the bank safer, but actually when reserves are sterilized, they are no longer available to make daily payments. Bankers used to invest only with borrowers, who pledged mortgages or inventories, but the communications revolution has built financial markets that make it possible for banks to invest in any asset of value. Arrangements among banks permit efficient operations with nearly zero reserves for daily cash payments. When governments enforce central banking monopolies they substitute regulations for private agreements, and expose the system to “crony capitalism.”

Under the Bretton Woods system of fixed exchange rates, governments enforced controls on international capital payments to try to hold back pressures to devalue or revalue, which nevertheless happened frequently. Following the abandonment of the Bretton Woods Agreement in 1971, the newly freed international financial markets allowed much more fluid movement of capital among different economies around the world. Flexible exchange rates unmasked and destroyed protection from competition that had profited bankers for centuries.

Under the guise of safety and consumer protection, interest rates and bank costs had been regulated to restrict competition. During the 1970s, however, regulated interest rates were not able to keep up with the rapid depreciation of government money. The non-bank investment community was less severely regulated.

Mutual funds had operated for a century by pooling small investors and buying a portfolio of assets. A mutual fund would issue and redeem its own shares and manage its assets for profit. Wall Street entrepreneurs discovered the trick of investing in high grade, liquid government bonds and issuing shares for a fixed price of $1.00 each. As their bonds went up in value, the mutual funds would issue new “stock dividends” at $1.00 face value.

This looked exactly like what banks called “paying interest on savings,” and indeed the only difference was how each type of company was regulated. There was no economic difference. The regulated bankers begged for deregulation so they could compete, and government changed the rules.

The Payments System

In fewer than 30 years, the banks have been transformed from conservative community bookkeepers who made nearly risk free investments within their own local regions, like credit unions, to an international assets trading system. The old “legal tender” idea that money comes from governments is misleading.

Today you have to ask what is “money”?

Although there are many ongoing regulations imposed by governments regarding banks and what people can use to pay taxes, the old idea that governments “print money” is simply not true today. Governments print bonds. And banks turn them into liquidity.

The crisis in Europe over the debt of Portugal, Italy, Greece, and Spain highlight the fallacy that governments can leverage their power to tax and issue risk free bonds. It was an international government regulation, the Basel III Accord, that set the stage for the current Eurozone crisis. The Basel agreement designated all government bonds as risk free and encouraged banks to buy them. Now it is clear the PIGS bonds will probably default, and the banking system is threatened with collapse. Unfortunately the important role the banks play, as agents in the payments system, is also jeopardized.

Modern society cannot survive a disintegration of the payments system, since prices are the information data that makes worldwide division of labor possible. What is occuring in the Eurozone is a crisis threatening the payments system because too many banks hold questionable government bonds.

The governments that operate central banks, like the Federal Reserve, could impose a drastic reform that would stabilize and preserve the payments system, but even to describe it shows why it is not desirable: The government could take over every bank and make it a branch office of the Federal Reserve. Like the old postal savings system, so popular in Europe and even in Japan today, it could function with checking accounts and debit cards effortlessly. Private banks would still work as mutual funds or investment managers, but they would no longer be connected with the payments system – and bailing out banks from bad investments would not be a public policy issue.

Of course, to make the government the monopoly for payments would open the door for the Treasury printing press to cover the Federal deficit, and the next question in everyone’s mind would be a situation like Thomas Mann’s story in 1923 Germany. Before that, the French Revolutionary government had also tried to finance itself by establishing a payments system based on seized church land (assignats), and it failed with a massive inflation.

Some people who want to abolish the Federal Reserve think replacing Fed chairman Ben Bernanke with Treasury secretary Timothy Geither would be an improvement. [see H.R. 6550] They don’t see there is no example of monopoly government banking, even with legal tender laws, that has succeeded in providing a stable payments system.

The solution for monetary and economic stability has to be found in the other direction, more deregulation and freedom for banks to transform assets into liquid payments media.

Escaping the Money Illusion

The money illusion that dominates the world financial crisis is the mistake that money issued by governments – the government accounting system itself – provides a stable basis for private accounting systems. The illusion is sustained by the legal institutions of a par value payments system within countries, even though such a system does not exist between countries.

The crisis in Europe is rooted in the mistake of attempting to manage a single unit of accounting for both payments and investments, as well as for each government’s tax and accounting system. In the early days of the European Union, discussions of how to coordinate currency exchange rates were set upon the idea of creating a common currency.

The British Treasury, which wisely kept the U.K. out of the Eurozone, proposed an alternative. John Major, head of the Treasury under Margaret Thatcher, proposed a parallel currency in which the Euro would serve as a transnational unit for financial assets but not as a unit for local and consumer transactions. The legal tender status of the Franc, Mark, Lira, Peseta, and Drachma would have remained unchanged. In retrospect, it is a sad result the proposal didn’t command wider respect among European finance ministers.

Consider again the example of apples and oranges. An asset is something of value and it can have a market price. A financial asset is denominated in accounting units, but financial assets often do not sell at their nominal face value. Many financial assets do not have a face value. Since many financial assets in today’s market are worth less than their value at maturity – and their value at maturity is uncertain due to flexible exchange rates in currency markets – the concern about what information is actually conveyed by bank balance sheets is quite well placed. Government regulations don’t help to give clear information, and bank and bond rating agencies are growing more important in the role of economic policemen.

The Eurozone crisis is based on the uncertainty about the value of government bonds, which used to seem like nuggets of gold in portfolios of rising and falling private equity values. Private promissory notes and bonds were always at some risk, and their nominal yields reflected the risk, as well as discounts in the market from their face value. But now more than ever, it is clear that financial assets are more like apples and oranges and government bonds are more like Ponzi or Madoff investments.

The more distrust the common man can come to accept in his view of the payments system, the healthier the system will become.

Free Banking as a Model for the Future

Conventional wisdom changes slowly, and the system of central banks, national currencies, par value payments, and fixed exchange rates is still very recent in historical and social memory – only a few hundred years old. Flexible exchange rates are new.

The world as a whole does not have a central bank or a single currency. Par value payments and fixed asset values are impossible to create by governments, even by international regulations.

There is a reasonable case to make about preventing fraud and deception in financial markets, but looking at the Eurozone today it is clear that governments cannot be the source of those reasonable expectations against deception and fraud.

In a banking system that is not organized as a cartel, not based on a government central bank with a government monetary unit to defend, the model of free banking described in Adam Smith’s Wealth of Nations (1776) offers more stability. If all banks were private investment institutions, trading assets in a global market and offering “community bookkeeping services” in more than one legal tender unit of accounting, ordinary people as well as larger players would be able to look critically at what the exchange rates in the market are telling them about economic values and the risk of assets.

The private payments system has already developed the technological network, with the debit and credit card. A single card can make payments in any currency a merchant might want, and a bank customer could still keep his line of credit denominated in something else, or even multiple units of accounting.

Some card issuers hold liquid non-monetary assets instead of government money for customers, which might be how we escape from the curse of government bonds. Scottrade manages my assets and I can spend from my account using a Visa card or checkbook – in any and every monetary unit currency on earth, wherever I travel. “What’s in Your Wallet?”

The key to a more stable payments system is more information. Government regulation and government accounting are sources of disinformation. Protestors may stage publicity stunts decrying “crony capitalism,” but the real problem is the centuries-old relationship between bankers and the government, with its power to offer favors for funds. The story Adam Smith tells about the original charter of the Bank of England in 1694 is an illustration of what has evolved in 300 years (the bankers gave King William a deal in exchange for a monopoly charter).

Worldwide competition in the financial markets has the power to restore the stability of dynamic equilibrium to financial markets, but only if a transition away from government accounting and fictional financial assets (such as PIGS bonds) is allowed to evolve.

Any government guarantee of purity should be the signal of secret toxic ingredients.

I have been watching with amusement the progress Ron Paul has been making with cosponsors on his bill (HR 1207). The cosponsors tactic was one that I used in the mid-1980s to get the gold coin bill adopted (PL 99-185), in the face of Treasury opposition. Those assholes were so anti-gold they didn’t even want a bullion coin to compete in the market with Krugerrands and Maple Leafs! Our key success in 1985 was to enlist the Black Caucus, chaired by Rep. Julian Dixon (D-CA) and his good friend Rep. Jerry Lewis (R-CA).

Questioning the Federal Reserve “Church”

I think it is true that the “audit the Fed” issue is just a publicity stunt, as Forbes points out. But it is a useful publicity stunt because it has focused a lot of attention on the Fed and its position in American society.

Until very recently, the Fed was treated as some kind of church. Its pontiffs were treated as spokesmen for the Mystery, and every member of Congress was very shy of criticizing the Fed, except for a few old populists like Henry Gonzalez who would have abolished the Fed and replaced it with the Treasury issuing fiat paper money in order to push interest rates down to zero, etc. William Jennings Bryan exercised pernicious influence back in 1913 to convert what would have been a fairly benign private clearing house that issued banknotes (just as every other National Bank also in those days did) – into a government agency that issued “obligations of the United States.” Thus the Fed was born. Rosemary’s baby.

I say Ron Paul’s bill (HR 1207) is a “useful” publicity stunt, but it could backfire if

(1) the concerns Bernanke highlighted came true, namely that the Fed felt pressured by Congress to inflate; and
(2) some kind of “audit” is conducted and the Fed is whitewashed and the whole issue becomes covered up with a new cloak of pseudo-democratic appearances.

Certainly, if a government is going to enforce a monopoly currency, the monopoly agency should *NOT* be under popular or democratic control. It should focus strictly on maximizing profit. For a monopoly currency that means only sustaining and stabilizing the purchasing power of the monetary unit. If a central bank can do that, it will rule forever in its narrow sphere.

The business side of the Fed is already audited. The current “Tax on Federal Reserve Notes” (so called; not really accurately named), which is a line item in the Fed’s annual income statement, is a 100% tax on the Fed’s nominal monetary profits. The money goes directly to the U.S. Treasury, just as the coinage seigniorage from the Mint also goes. (Of course, the Fed gets “to skim” because it pays its operating expenses before remitting to the Treasury – but that is revealed in the audits already conducted and published.)

The three areas where the Fed is not today audited are all justified, in my view, under the system we have.

• First, transactions with foreign central banks and IMF, Bank for International Settlements, etc. are secret because the foreigners want it done that way. The Fed acts as a fiscal agent for a lot of foreign governments, particularly the smaller ones.
• Second the Federal Open Market Committee and the games it plays under the rubric, “monetary policy,” do have the power to move the stock and bond markets in powerful swings. If anyone had insider knowledge of what the FOMC were doing on any particular day, your profits from day-trading would be gigantic. A hedge fund manager’s dream come true.
• Third, the FOMC operations, buying and selling to impact the Fed Funds rate, would also be an area that should not be allowed to become something of daily, transparent knowledge. The claim that these things should be kept non-political and out of sight of speculators and day traders makes sense to me.

The Monopoly Problem

But, the real issue is WHY should the Fed be a monopoly, and WHY should the United States government even want to use an undefined F.R.A.U.D. monetary system? [Note acronym: "Federal Reserve Accounting Unit Dollar"]

The answer is because the British Neo-Classical School of economics, which developed under the Victorian era regime following Peel’s Act of 1844, had neglected and lost track of the debates among – yes, amateur for the most part – economists from 1800-1844. Lawrence H. White’s book on this history, “Free Banking in Britain,” is very informative. Even Milton Friedman changed his mind after reading about free banking.

The British Economists

The Briish economists after 1844 came to the conclusion that “scientific management” of a monetary monopoly would be superior to whatever crippled market process occurred under a “pseudo-gold-standard” (Milton Friedman’s label).

Yet, of course, the whole appeal of “scientific management” of an economic system ought to have passed away with the fall of the Soviet Union.

The observation that fewer business cycle downturns occurred after 1913 than before the Fed ignores a lot of economic history. First, it ignores the stupid regulations imposed by the National Bank Act of 1863 that forced banks to operated as undercapitalized agencies, because they were forced to buy government bonds in order to issue currency (but not demand deposits). This crippled the banking system and led to many more runs on banks and contractions than would have occurred without such rules.

Comparing the Canadian experience with the U.S. experience shows how much more stable the Canadian system was, with a more pure system of free banking. Canada didn’t create the Bank of Canada until the late 1930s, and by that time it was the mania of every government on earth to have its own central bank – and there was no longer any international gold payments system.

Second, although there was no Federal Reserve prior to 1913, there was the Bank of England, which acted like a global central bank for all the “gold standard” countries. And the Bank of England was very incompetent in running monetary policy, which is one reason the British Neo-Classical School economists were so critical of the classical pseudo-gold-standard. As the Bank of England induced expansion and contractions in the London financial markets, those markets affected all the rest of the world, New York in particular because of America’s close links with the British Empire. See Walter Bagehot, “Lombard Street” (1873) on “the unnatural system of centralization” and the mismanagement of the Bank of England. Bagehot was the editor of The Economist magazine.

Moreover after 1935, monetary policy was deliberately conducted with a bias never to allow a contraction and to promote a mild and gradual inflation. If you look at a graph of monetary expansion since WW2, many of what would have been contractions before 1913 are just flat spots on a rising chart. This is why Milton Friedman emphasized that it is the 2nd derivative (change in the rate of change) in monetary expansion that affects the growth of nominal GDP after a 6-18 month lag.

So, the bottom line is that I much prefer Ron Paul’s bill (HR 2779) to relax legal tender laws. If I could go all the way to utopia, I would urge a law having Congress make appropriations, budgets, and to assess taxes using the gram of gold as the government’s official unit of account, with a floating rate of exchange between the [thereafter] non-legal-tender F.R.A.U.D. units, which would continue to circulate and probably continue to dominate the financial markets. The U.S. national debt could still be payable in “dollars” but at a floating exchange rate with gold grams.

This might be the way to conform with the 14th Amendment, Section 4, and to pay off the national debt (in “dollars,” but not in gold grams).

Optimal Currency Areas

Indeed, in the literature of “optimal currency areas” it is not clear the whole United States should be a single currency area, much less all of Europe under the Euro. Labor markets in particular could operate more efficiently if wages were paid in local currencies. Michigan right now could experience a currency devaluation and that would help with unemployment.

Financial markets would probably operate more efficiently if prices were quoted in a global currency independent of national governments (e.g., gold grams).

And with floating exchange rates among them all.

The Massachusetts Debacle,
Coming Soon to Your Neighborhood.

The Wall Street Journal, Opinion & Outlook, March 27, 2009

Praise Mitt Romney. Three years ago, the former Massachusetts Governor had the inadvertent good sense to create the “universal” health-care program that the White House and Congress now want to inflict on the entire country. It is proving to be instructive, as Mr. Romney’s foresight previews what President Obama, Max Baucus, Ted Kennedy and Pete Stark are cooking up for everyone else.

In Massachusetts’s latest crisis, Governor Deval Patrick and his Democratic colleagues are starting to move down the path that government health plans always follow when spending collides with reality -i.e., price controls. As costs continue to rise, the inevitable results are coverage restrictions and waiting periods. It was only a matter of time.

They’re trying to manage the huge costs of the subsidized middle-class insurance program that is gradually swallowing the state budget. The program provides low- or no-cost coverage to about 165,000 residents, or three-fifths of the newly insured, and is budgeted at $880 million for 2010, a 7.3% single-year increase that is likely to be optimistic. The state’s overall costs on health programs have increased by 42% (!) since 2006.

Like gamblers doubling down on their losses, Democrats have already hiked the fines for people who don’t obtain insurance under the “individual mandate,” already increased business penalties, taxed insurers and hospitals, raised premiums, and pumped up the state tobacco levy. That’s still not enough money.

So earlier this year, Mr. Patrick appointed a state commission to figure out how to control costs and preserve “this grand experiment.” One objective is to change the incentives for preventative care and treatments for chronic disease, but everyone says that. It sometimes results in better health but always more spending. So-called “pay for performance” financing models, on the other hand, would do away with fee for service – but they also tend to reward process, not the better results implied.

What are the alternatives? If health planners won’t accept the prices set by the marketplace – thus putting themselves out of work – the only other choice is limiting care via politics, much as Canada and most of Europe do today. The Patrick panel is considering one option to “exclude coverage of services of low priority/low value.” Another would “limit coverage to services that produce the highest value when considering both clinical effectiveness and cost.” (Guess who would determine what is high or low value? Not patients or doctors.) Yet another is “a limitation on the total amount of money available for health care services,” i.e., an overall spending cap.

The Institute for America’s Future – which is providing the intellectual horsepower (we use the term loosely) for reforms like those in Massachusetts – argues that the cost overruns prove the state must cap how much insurers are allowed to charge consumers and regulate their profits. If Mr. Patrick doesn’t get there first, that is. He reportedly told insurers and hospitals at a closed meeting this month that if they didn’t take steps to hold down the rate of medical inflation, he would.

Even the single-payer cheerleaders at the New York Times have caught on to this rolling catastrophe. In a page-one story this month, the paper reported on the “expedient choice” that Mr. Romney and Democrats made to defer “until another day any serious effort to control the state’s runaway health costs. . . . Those who led the 2006 effort said it would not have been feasible to enact universal coverage if the legislation had required heavy cost controls. The very stakeholders who were coaxed into the tent – doctors, hospitals, insurers and consumer groups – would probably have been driven into opposition by efforts to reduce their revenues and constrain their medical practices, they said.”

Now they tell us. What really whipped along RomneyCare were claims that health care would be less expensive if everyone were covered. But reducing costs while increasing access are irreconcilable issues. Mr. Romney should have known better before signing on to this not-so-grand experiment, especially since the state’s “free market” reforms that he boasts about have proven to be irrelevant when not fictional. Only 21,000 people have used the “connector” that was supposed to link individuals to private insurers.

Which brings us to Washington, where Mr. Obama and Congressional Democrats are about to try their own Bay State bait and switch: First create vast new entitlements that can never be repealed, then later take the less popular step of rationing care when it’s their last hope to save the federal fisc.

The consequences of that deception will be far worse than those in Massachusetts, however, given that prior to 2006 the state already had a far smaller percentage of its population uninsured than the national average. The real lesson of Massachusetts is that reform proponents won’t tell Americans the truth about what “universal” coverage really means: Runaway costs followed by price controls and bureaucratic rationing.

by Judy Shelton

Let’s give the Fed some competition. Abolish legal tender laws and see whose money people trust.

Let’s go back to the gold standard.

If the very idea seems at odds with what is currently happening in our country – with Congress preparing to pass a massive economic stimulus bill that will push the fiscal deficit to triple the size of last year’s record budget gap – it’s because a gold standard stands in the way of runaway government spending.

Under a gold standard, if people think the paper money printed by government is losing value, they have the right to switch to gold. Fiat money – i.e., currency with no intrinsic worth that government has decreed legal tender – loses its value when government creates more than can be absorbed by the productive real economy. Too much fiat money results in inflation – which pools in certain sectors at first, such as housing or financial assets, but ultimately raises prices in general.

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.

If capitalism is to be preserved, it can’t be through the con game of diluting the value of money. People see through such tactics; they recognize the signs of impending inflation. When we see Congress getting ready to pay for 40% of 2009 federal budget expenditures with money created from thin air, there’s no getting around it. Our money will lose its capacity to serve as an honest measure, a meaningful unit of account. Our paper currency cannot provide a reliable store of value.

So we must first establish a sound foundation for capitalism by permitting people to use a form of money they trust. Gold and silver have traditionally served as currencies – and for good reason. A study by two economists at the Federal Reserve Bank of Minneapolis, Arthur Rolnick and Warren Weber, concluded that gold and silver standards consistently outperform fiat standards. Analyzing data over many decades for a large sample of countries, they found that “every country in our sample experienced a higher rate of inflation in the period during which it was operating under a fiat standard than in the period during which it was operating under a commodity standard.”

Given that the driving force of free-market capitalism is competition, it stands to reason that the best way to improve money is through currency competition. Individuals should be able to choose whether they wish to carry out their personal economic transactions using the paper currency offered by the government, or to conduct their affairs using voluntary private contracts linked to payment in gold or silver.

Legal tender laws currently favor government-issued money, putting private contracts in gold or silver at a distinct disadvantage. Contracts denominated in Federal Reserve notes are enforced by the courts, whereas contracts denominated in gold are not. Gold purchases are subject to taxes, both sales and capital gains. And while the Constitution specifies that only commodity standards are lawful – “No state shall coin money, emit bills of credit, or make anything but gold and silver coin a tender in payment of debts” (Art. I, Sec. 10) – it is fiat money that enjoys legal tender status and its protections.

Now is the time to challenge the exclusive monopoly of Federal Reserve notes as currency. Buyers and sellers, by mutual consent, should have access to an alternate means for settling accounts; they should be able to do business using a monetary unit of account defined in terms of gold. The existence of parallel currencies operating side-by-side on an equal legal footing would make it clear whether people had more confidence in fiat money or money redeemable in gold. If the gold-based system is preferred, it means that people fully understand that the purpose of money is to facilitate commerce, not to camouflage fiscal mismanagement.

Private gold currencies have served as the medium of exchange throughout history – long before kings and governments took over the franchise. The initial justification for government involvement in money was to certify the weight and fineness of private gold coins. That rulers found it all too tempting to debase the money and defraud its users testifies more to the corruptive aspects of sovereign authority than to the viability of gold-based money.

Which is why government officials should not now have the last word in determining the monetary measure, especially when they have abused the privilege.

The same values that will help America regain its economic footing and get back on the path to productive growth – honesty, reliability, accountability – should be reflected in our money. Economists who promote the government-knows-best approach of Keynesian economics fail to comprehend the damaging consequences of spurring economic activity through a money illusion. Fiscal “stimulus” at the expense of monetary stability may accommodate the principles of the childless British economist who famously quipped, “In the long run, we’re all dead.” But it shortchanges future generations by saddling them with undeserved debt obligations.

There is also the argument that gold-linked money deprives the government of needed “flexibility” and could lead to falling prices. But contrary to fears of harmful deflation, the big problem is not that nominal prices might go down as production declines, but rather that dollar prices artificially pumped up by government deficit spending merely paper over the real economic situation. When the output of goods grows faster than the stock of money, benign deflation can occur – it happened from 1880 to 1900 while the U.S. was on a gold standard. But the total price-level decline was 10% stretched over 20 years. Meanwhile, the gross domestic product more than doubled.

At a moment when the world is questioning the virtues of democratic capitalism, our nation should provide global leadership by focusing on the need for monetary integrity. One of the most serious threats to global economic recovery – aside from inadequate savings – is protectionism. An important benefit of developing a parallel currency linked to gold is that other countries could likewise permit their own citizens to utilize it. To the extent they did so, a common currency area would be created not subject to the insidious protectionism of sliding exchange rates.

The fiasco of the G-20 meeting in Washington last November — it was supposed to usher in “the next Bretton Woods” – suggests that any move toward a new international monetary system based on gold will more likely take place through the grass-roots efforts of Americans. It may already be happening at the state level. Last month, Indiana state Sen. Greg Walker introduced a bill – “The Indiana Honest Money Act” – which would, if enacted, allow citizens the option of paying in or receiving back gold, silver or the equivalent electronic receipt as an alternative to Federal Reserve notes for all transactions conducted with the state of Indiana.

It may turn out to be a bellwether. Certainly, it’s a sign of a growing feeling in the heartland that we need to go back to sound money. We need money that works for the legitimate producers and consumers of the world – the savers and borrowers, the entrepreneurs. Not money that works for the chiselers.

Ms. Shelton, an economist, is author of “Money Meltdown: Restoring Order to the Global Currency System” (Free Press, 1994).

Published in The Wall Street Journal, Feb.12, 2009.