Archives: February, 2010

This is a guest post from Toby Baxendale, Chairman of The Cobden Centre.

The answer is that the US dollar has lost 98.17% of its purchasing power and the pound sterling 99.42% of its purchasing power. Well done then, I suppose, for surpassing even the great tyrants of old who plagued the citizenry of both nations!

Some History

Gold was money for a large part of mankind’s history.

It was discovered by early man to be the most marketable of commodities. As such, the free interaction of people led to this commodity being adopted as the final thing for which all goods and services were traded. This discovery allowed man to lift himself from direct exchange, or barter, of his goods and services to indirect exchange. This indirect exchange allowed the universal application of the division and specialization of labour that has, in turn, given us all the material prosperity we have today. The discovery of money, then, must rank along with language as arguably the most important invention or discovery in the whole course of human history.

Note that, like language, money was not created by the State but by the private and spontaneous interaction of free individuals.

There are many stories in history of wicked monarchs who, to fund their various despotic regimes or lifestyles, would call in the coinage of the realm, extract a small percentage of gold — a “clip” — and then add an impurity before giving them back to the public; this is debasing of the monetary unit. This embezzlement was unlawful for the minter in the private sector and many people over the ages have been executed for stealing from money owners in this way but the monarch usually got away with it. One of the most notable examples in history was when Emperor Nero reduced the value of the denarius from being pure silver weighing 4 grams to 3.8 grams. His financial gain was enormous.

Another great example of history is our very own tyrant per excellence, Henry the VIII. He reduced the weight of sliver in the silver penny to 1/3rd of its purity from 0.925 to 0.250. By the reign of Elizabeth I, the Tudor financier Sir Thomas Gresham had to negotiate a loan from the Antwerp traders to provide more money for her nation. Sir Thomas came back and said

It may please your majesty to understand, that the first occasion of the fall of exchange did grow by the King majesty, your late father, in abasing his coin … which was the occasion that all your fine gold was conveyed out of this your realm.

What became know as Gresham’s law is that “Bad money drives out good under legal tender laws”. In Europe this is know as the Copernicus Law, as he was saying the same thing on the continent. The great medieval philosopher and theologian Nicole d’Oresme was the inspiration of Copernicus on this matter.

Economics of the Matter

A debasement always meant an inflation. Why? As there was more coinage in circulation chasing a similar amount of goods and services for sale, prices rose.

No less a figure than John Maynard Keynes in Economic Consequences of the Peace (1920), said:

By a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some.

This is from a man whose current disciples are inflating the western world’s money supply to a point that can only lead to rampant inflation.

We should remember the names which we have used to label money historically.  In the UK “sterling” and in the USA “dollar” each described a fixed weight of gold . Gold was the money unit, not sterling or dollar in itself.

Before World War I the pound sterling was worth $4.86856 and a dollar was worth 1/20th of an ounce of gold. For the sake of simplicity I will say that the pound sterling was defined as ¼ of an ounce of gold and the USA dollar 1/20th of an ounce.

So How Much is my Pound Sterling Worth Today?

The Maths
One ounce of gold today is worth $1,093.40 and 1/20 oz therefore $54.67 but the dollar pre World War I was just a name in the USA for 1/20 of an ounce of gold: what would have cost $1 before World War I would cost $54.67 today. The dollar has lost its purchasing power. In fact it has lost 98.17% of its purchasing power in 100 years. One dollar today should buy something like a single person’s weekly food shop, not a single daily newspaper.

The fate of the pound sterling has been even worse than that of the dollar. One ounce of gold today is £692.26. So if a pound sterling pre World War I was just a name in the UK for 1/4 of an ounce of gold, it would imply that the pre World War I purchasing price was 1/4 of £692.26 or £173.06. In fact the pound sterling has lost 99.42% of its purchasing power in 100 years. One pound should buy something like a good week’s food shop for a familiy of four and not just one daily newspaper like it would today.

Conclusion

Our modern day Neros and Henry VIIIs are those we call our Prime Ministers and our Presidents. We are told they are all well meaning men and women. That may well be the case. They have however, since World War I, sat on the single greatest debasement of our wealth in human history.

They do this via the monetization of their nations’ debt. A politician in power might have promised to give X, Y or Z group of people £X, £Y and £Z in exchange for voting for them. If the tax revenue is not enough, then they simply, out of thin air, either create more money — old style monetizing the debt to pay off the debt obligation — or, with a computer key, they open up a new bank deposit for themselves to pay or buy back some of their debt. This is called “QE” or Quantitive easing and we discuss the errors associated with it here.

Last year the UK raised over £200 billion by one part of the government issuing debt and the other part buying it. So £200 billion of new money is now in circulation. Nero and Henry VIII would blush at the brashness of this debasement. This is done wholly at the expense of yours and my very own purchasing power.

The Cobden Centre exists to promote honest money and social progress. Honest money is money that cannot be debased by governments to pay off liabilities they have incurred over and above their tax revenue. I outlined a banking reform proposal which advocated 100% reserve money here.  Staying within the existing paper money regime, one would need a bill to prevent the new issuance of either paper money or computer generated new bank deposits by the government. Ultimately, we must look at fully re rooting our paper money back into solid commodities that the government cannot destroy or create at will.

Further Reading

• Huerta de Soto, Money, Bank Credit and Economic Cycles
• Baxendale, A day of reckoning: how to end the banking crisis now
• What is wrong with banking, part 1: the legal nature of banking contracts
• Frank Whitson Fetter, Development of British Monetary Orthodoxy 1797 – 1875
• F. A. Hayek, Denationalisation of Money: The Argument Refined
• Gordon Kerr, How To Destroy the British Banking System andBailing out the Banks – Glaring Evidence of Moral Hazard
• James Tyler, My Journey to Austrianism via the City, Money is not working and How to avoid future encounters with financial meltdown
• Irving Fisher, 100% Money, 1935

Toby Baxendale is an entrepreneur who owns, amongst other things, the UK’s largest fresh fish supplier to the Food Service sector, see www.directseafoods.co.uk. Toby is dedicated to furthering the teaching of the Austrian school of economics. He established and funded the 1st Distinguished Hayek Visiting Teaching Fellowship Program at the LSE in Honour of the Nobel Laureate F A Hayek. Toby is Chairman of The Cobden Centre. Richard Cobden’s timeless principles of the abolition of legal privilege of the few at the expense of the many – the Corn Laws, unilateral free trade, sound honest money and international peace – are worthy in this day and age to promote.

Steven Horwitz is the Charles A. Dana Professor of Economics at St. Lawrence University and the author of Microfoundations and Macroeconomics: An Austrian Perspective, now in paperback.

One of the more common complaints of critics of the market is that “the profit motive” works at cross-purposes with people and firms doing “the right thing.” For example, Michael Moore’s film Sicko was motivated by his desire to take the profit motive out of health care because, in his view, the ways people seek profits do not lead them to provide the level and kind of care he thinks patients should have.

Leaving aside for a moment whether the health-care industry is really dominated by the profit motive (given that almost half of U.S. health-care expenditures are paid for by the federal government, it is not clear which motives dominate) and whether Moore knows better than millions of individuals what their health-care needs are, the claim that a “motive” is a root cause of social pathologies is worthy of some critical reflection. The critics seem to suggest that if people and firms were motivated by something besides profit, they would be better able to provide the things that patients really need.

The overarching problem with blaming a “motive” is that it ignores the distinction between intentions and results. That is, it ignores the possibility of unintended consequences, both beneficial and harmful. Since Adam Smith, economists have understood that the self-interest of producers (of which the profit motive is just one example) can lead to social benefits. As Smith famously put it, it is not the “benevolence” of the baker, butcher, and brewer that leads them to provide us with our dinner but their “self-love.” Smith’s insight, which was a core idea of the broader Scottish Enlightenment of which he was a part, puts the focus on the consequences of human action, not their motivation.

What we care about is whether the goods get delivered, not the motives of those who provide them. Smith led economists to think about why it is that, or under what circumstances, self-interest leads to beneficial unintended consequences. It is perhaps human nature to assume that intentions equal results, or that self-interest means an absence of social benefit, as was often the case in the small, simple societies in which humanity evolved. However, in the more complex, anonymous world of what Hayek called “the Great Society,” the simple equation of intentions and results does not hold.

As Smith recognized, what determines whether the profit motive leads to good results are the institutions through which human action is mediated. Institutions, laws, and policies affect which activities are profitable and which are not. A good economic system is one in which those institutions, laws, and policies are such that the self-interested behavior of producers leads to socially beneficial outcomes. In mixed economies like that of the United States, the institutional framework often rewards profit-seeking behavior that does not produce social benefit or, conversely, prevents profit-seeking behavior that could produce such benefits. For example, if agricultural policy pays farmers not to grow, then the profit motive will lead to lower food supplies. If environmental policy confiscates land with endangered species on it, owners of such land who are driven by the profit motive will “shoot, shovel, and shut up” (that is, kill off and bury any endangered species they find on their land).

The same issues can be raised in the health-care industry. Before blaming the profit motive for the problems in the industry, critics might want to look at the ways in which existing government programs like Medicare and Medicaid, the interpretation of tort laws, and regulations such as those that limit who can practice what sorts of medicine might lead firms and professionals to engage in behavior that is profitable but unbeneficial to consumers. Labeling the profit motive as the source of the problem enables the critics to ignore the really difficult questions about how institutions, policies, and laws affect the profit-seeking incentives of producers and how that profit-seeking behavior translates into outcomes. Placing the blame on the profit motive without qualification simply overlooks the Smithian question of whether better institutions would enable the profit motive to generate better results and whether current policies or regulations are the source of the problem because they guide the profit motive in ways that produce the very problems the critics identify.

For example, high medical costs may well be a result of profit-seeking providers’ recognizing that government programs are notoriously bad at pricing services accurately and keeping good track of their expenditures. Ignoring the way institutions might affect what is profitable is often due to a more general blind spot about the possibility of self-interested behavior generating unintended beneficial consequences. Before we attempt to banish the profit motive, shouldn’t we see whether we can make it work better?

Placing blame for social problems on the profit motive is also easy if critics offer no alternative. What should be the basis for determining how resources are allocated if not in terms of profit-seeking behavior under the right set of institutions? How should people be motivated if not by profit? Often this question is just ignored, as critics are merely interested in casting blame. When it is not ignored, the answers can vary, but they mostly invoke a significant role for government. The interesting aspect of such answers is that critics do not suggest that we somehow convince producers to act on the basis of something other than profit, but that instead we replace them with presumably other-motivated bureaucrats or have those bureaucrats severely limit the choices open to producers. The implicit assumption, of course, is that the government personnel will not be motivated by profits or self-interest in the same way as the private-sector producers are.

How realistic this assumption is remains highly questionable. Why should we assume that government officials are any less self-interested than private individuals, especially when the door between the two sectors is constantly revolving? And if government officials do act in their self-interest and are motivated by the political analogs of profits (for example, votes, power, budgets), will they produce results that are any better than the private sector’s? If blaming the profit motive entails giving government a bigger role in solving problems, what assurance can critics of the profit motive provide that political officials will be any less self-interested and that their self-interest will produce any better results?

One will look in vain in Sicko, for example, for any analysis of the failures of state-sponsored health care in Cuba, Canada, Great Britain, or anywhere else. To blame the profit motive without asking whether an alternative will better solve the problems supposedly caused by the profit motive is to bias the case against the private sector.

How Will They Know?

Even this argument, however, does not go far enough. We are still, after all, focused on intentions and motivation. What critics of the profit motive almost never ask is how, in the absence of prices, profits, and other market institutions, producers will be able to know what to produce and how to produce it. The profit motive is a crucial part of a broader system that enables producers and consumers to share knowledge in ways that other systems do not.

Suppose for a moment that we try to take the profit motive out of health care by going to a system in which government pays for and/or directly provides the services. Suppose further that we could, somehow, ensure that the political officials would not be self-interested. For many critics of the profit motive, the problem is solved because public-spirited politicians and bureaucrats have replaced profit-seeking firms.

Well, not so fast. By what method exactly will the officials know how to allocate resources? By what method will they know how much of what kind of health care people want? And more important, by what method will they know how to produce that health care without wasting resources? It’s one thing to say that every adult should, for example, have a checkup every year, but should it be provided by an MD, an LPN, or an RN? What kind of equipment should be used? How thorough should it be? And most crucially, how will political decision-makers know if they’ve answered these questions correctly?

In markets with good institutions, profit-seeking producers can get answers to these questions by observing prices and their own profits and losses in order to determine which uses of resources are more or less valuable to consumers. Rather than having one solution imposed on all producers, based on the best guesses of political officials, an industry populated by profit seekers can try out alternative solutions and learn which ones work most effectively. Competition for profit is a process of learning and discovery. For all the profit-critics’ concern—especially but not only in health care—that allocating resources by profits leads to waste, few if any understand how profits and prices signal the efficiency (or lack thereof) of resource use and allow producers to learn from those signals. The most profound waste of resources in the U.S. health-care industry stems from the incentives and market distortions created by government programs such as Medicare and Medicaid.

Thus the real problem with focusing on the profit motive is that it assumes that the primary role of profits is to motivate (or in contemporary language “incentivize”) producers. If one takes that view, it might seem relatively easy to find other ways to motivate them or to design a new system where production is taken over by the state. However, if the more important role of profits is to communicate knowledge about the efficiency of resource use and enable producers to learn what they are doing well or poorly, the argument becomes much more complicated. Now the critics must explain what in the absence of profits will tell producers what they should and should not do. Eliminating profit-seeking from an industry doesn’t just require that a new incentive be found but that a new way of learning be developed as well. Profit is not just a motive; it is also integral to the irreplaceable social learning process of the market. Critics may consider eliminating the profit motive the equivalent of giving the Tin Man from Oz a heart; in fact it’s much more like Oedipus’ gouging out his own eyes.

This article has been published with FEE‘s permission.

Lawrence W. Reed is president of the Foundation for Economic Education in Irvington, New York—www.fee.org.This essay has been adapted for CEIL by the author from his essay of the same title in the September 1996 issue of FEE’s journal, “The Freeman.”

“Taxes,” said Oliver Wendell Holmes, Jr., “are what we pay for civilized society.” But as economist Mark Skousen once argued, a much better case can be made that taxation is actually the price we pay for the lack of civilization. If people took better care of themselves, their families, and those in need around them, government would shrink and society would be stronger as a result.

Skousen put it well when he stated, “[E]very time we pass another law or regulation, every time we raise taxes, every time we go to war, we are admitting failure of individuals to govern themselves. When we persuade citizens to do the right thing, we can claim victory. But when we force people to do the right thing, we have failed.” The triumph of persuasion over force—people helping people because they want to and not because government tells them they must—is the sign of a civilized people and a civil society.

For all people interested in the advancement and enrichment of our culture, this is a crucial observation with far-reaching implications. Cultural progress should not be defined as taking more and more of what other people have earned and spending it on “good” things through a government bureaucracy. Genuine cultural progress occurs when individuals solve problems without resorting to politicians or the police and bureaucrats they employ.

When the French social commentator Alexis de Tocqueville visited a young, bustling America in the 1830s, he cited the vibrancy of civil society as one of this country’s greatest assets. He was amazed that Americans were constantly forming “associations” to advance the arts, build libraries and hospitals, and meet social needs of every kind. If something good needed doing, it rarely occurred to our ancestors to expect politicians and bureaucrats, who were distant in both space and spirit, to do it for them. “Amongst the laws which rule human nature,” wrote Tocqueville in Democracy in America, “there is none which seems to be more precise and clear than all others. If men are to remain civilized, or to become more so, the art of associating together must grow and improve.”

It ought to be obvious today, with government in America and most Western countries consuming 40 to 60 percent of personal income, that lots of people don’t think, act, and vote the way their forebears did in Tocqueville’s day. So how can we restore and strengthen the attitudes and institutions that form the foundations of a vibrant, free and civil society?

Certainly, we can never do so by blindly embracing government programs that crowd out private initiatives or by impugning the motives of those who raise legitimate questions about those government programs. We cannot restore civil society if we have no confidence in ourselves and believe that government has a monopoly on compassion. We’ll never get there if we tax away 40 or 60 percent of people’s earnings and then, like children who never learned their arithmetic, complain that people can’t afford to meet certain needs.

We can advance civil society only when people get serious about replacing government programs with private initiative, when discussion gets beyond such infantile reasoning as, “If you want to cut government subsidies, you must be in favor of starving the elderly.” Civil society will blossom when we understand that “hiring” the expensive middleman of government is not the best way to “do good,” that it often breaks the connection between people in need and caring people who want to help. We’ll make progress when the “government is the answer” cure is recognized for what it is—false charity, a “cop-out,” a simplistic non-answer that doesn’t get the job done well, even though it makes its advocates smug with self-righteous satisfaction.

Restoring civil society won’t be easy. Bad habits and short-term thinking die hard. It is especially difficult to get the civil society message through the major news media’s filter unscathed. A recent editorial in a major Michigan newspaper is a good case in point. In arguing against suggested cuts in the state’s budget, the editorial equated the restoration of civil society with subjecting human life “to the largesse of the highest bidder in the marketplace.” What a shame that so many newspapers will routinely lament the superficiality of political campaigns and then employ bumper-sticker slogans when it comes to serious proposals to remove the bane of Big Government from our lives.

That editorial did not feed, clothe, or house a single needy person. It probably did very little to comfort the afflicted. It did not inspire a single act of voluntarism on behalf of a troubled family. It may, however, have lulled some readers into a deeper sleep of complacency. Government, after all, is taking care of things and that, the editorial implied, is as it should be.

Meanwhile, more thoughtful writers are noticing some encouraging trends. A remarkable article in a recent issue of U.S. News & World Report trumpeted the “revival of civic life.” Among the examples it cited was that of Frankford, Pennsylvania. Frankford had become a highly taxed, depressed, and government-dependent community desperate for answers. A spark of civil society was lit, and now people are solving problems themselves. “When a record 30 inches of snow was dumped on the city, . . . Frankford didn’t stand around moaning about the inefficiency of city workers. Residents rented snowplows and split the cost,” the article noted.

Perhaps if Tocqueville were to visit this little Pennsylvania town today, he would see a glimmer of the greatness he witnessed in the 1830s. He would be impressed with the spirit of the community and might even suggest that people everywhere should take note. The citizens, Tocqueville might remark, are not sitting back, bemoaning their plight, and editorializing about how the politicians should save them. “Once you get past the resentment of the government not doing it for you, you get it done yourself,” one local resident put it.

We can learn a whole lot more from the Frankfords of the world than from those who think charity means spending someone else’s money or just pontificating about social needs from behind a word processor. Restoring civil society requires that we “Just Say No” to shirking our personal responsibilities and expecting government to do for us what we can and should do on our own, within our personal lives, our families, and our local communities. It requires us to think creatively about stimulating private initiative, and then just doing it.

In fact, the more I think about it, the more I realize that doing it, not just talking about it or expecting others to do it for you, is one of the primary differences between adults and children. Maybe we all need to just grow up—and thereby grow out of the stultifying environment of the welfare state.

Henry Hazlitt

Mr. Hazlitt, noted economist, journalist and author, here examines perhaps the most important question facing us today.

For more than a century economists have toyed with the idea of designing or inventing an ideal money. So far no two of them seem to have precisely agreed on the detailed nature of such a money. But they do seem at the moment to agree on at least one negative point. I doubt that there is any economist today who would defend the international or American monetary system just as it is. No one openly defends the violent daily and hourly fluctuations in exchange rates, the steadily increasing unpredictability of future import, export, or domestic prices. Every newspaper reader fears that commodity prices will be higher next year and still higher the year after that. Even the man in the street, in brief, senses that the world is drifting toward monetary chaos.

But concerning the remedy, we find little agreement. Inflation is bad, some agree. Yes; but it isn’t as bad as depression and unemployment; and at least it puts off those greater evils, so we must have just a little more inflation as long as these evils threaten us. Inflation is bad, others agree; but it has nothing to do with the monetary system. Rising prices are brought about by the greed and rapacity of sellers; they could promptly be stopped by price controls. Or, inflation is bad, still others concede; and yes, it is brought about by the increase in the quantity of money and credit.

But this is not the fault of the monetary system itself, but of the blunders and misdeeds of the politicians or the bureaucrats in charge of it.

Even those who admit that there is something wrong with the monetary system itself cannot agree on the reforms needed in that system. Scores of such reforms have been proposed.

The reformers, however, tend to fall into two main groups. One of these would have nothing to do with a gold, a silver, or any other commodity standard, but would leave the issuance and control of the currency entirely in the hands of the State. The other group would return to some form of the gold standard.

Each of these two groups may again be divided into two schools. In what I shall call the statist or paper-money group, one school would leave everything to the day-to-day discretion of government monetary authorities, and the other would subject these authorities to strict quantitative controls. And in the gold group, likewise, one school would allow discretion, within vague but wide limits, to private bankers and government authorities, while the second would impose severe and definite limits on that discretion.

So we have, then, four main schools of monetary theorists.

Nearly every currency proposal can be classified under one of them.

Paper Money — No Controls

Let us begin with School One, the paper-money statists, who would leave the power of controlling the nature, quantity and value of our money solely in the hands of the politicians in office or the bureaucrats they appoint. This is the worst imaginable monetary system, but it is the one that prevails nearly everywhere in the world today. It has brought about practically universal inflation, unprecedented uncertainty, and economic disruption.

None of this is accidental. It was built into the system deliberately adopted at a conference of 44 nations at Bretton Woods in 1944, under the guidance of Harry Dexter White of the U.S. and Lord Keynes of England. The ostensible purpose of that conference was to increase “international cooperation” and — believe it or not — to “stabilize” currencies and exchange rates.

The chief architects sincerely believed (though they did not as openly avow) that this end could best be achieved by phasing gold out of the monetary system. So they put the world, in effect, not on a gold but on a dollar standard. The value of every other currency was to be maintained by making it convertible into the American dollar at a fixed official exchange rate.

The system still had one tie to gold. The dollar itself was to be kept convertible into that metal at $35 an ounce. But this tie was weakened in two ways. Other countries could keep their currencies stabilized in terms of the dollar, not through the operations of a free foreign exchange market (as under the pre-World War I gold standard) but by government sales or purchases of dollars — in other words by government pegging operations. And dollars were no longer convertible into gold on demand by anybody who held them; they were convertible only by foreign central banks. The U.S. could even (off-the-record) use its great political and economic power — which in time it did — to indicate to any central bank with the effrontery to ask for gold that this was not considered a friendly act.

So the artificial stability that the Bretton Woods system was able to maintain for a few years was not the result of any real attempt by each country to keep its own currency sound — by refraining from excessive issuance of money and credit — but of government pegging operations and gentlemen’s agreements not to upset the apple cart.

This arrangement proved, in the end, unwise, unsound, and unstable. The system was able to maintain the appearance of stability only by the stronger currencies constantly rushing to the rescue of the weaker. The U.S., say, would rush in and lend Britain millions of dollars, or buy millions of pounds. It would do the like for other currencies in crisis. But using the stronger currencies to support the weaker only weakened the stronger currencies. When the U.S. Treasury bought millions of pounds with dollars, it in effect got these dollars by printing them.

And so when the dollar itself, as the result of our own recklessness, began to turn bad, and when we went off the gold standard openly in August, 1971, other nations were affected. Germany, for instance, under the terms of the Bretton Woods agreements, had to buy billions of dollars to keep the D-mark from going above its official parity. And where did Germany get the billions of marks necessary to buy the billions of dollars? Why, by printing them.

So the faster-inflating nations almost systematically exported their inflations to the slower-inflating nations. And this almost systematically brought the world toward its present inflationary chaos.

True, the nations with stronger currencies, even when they felt obliged by their Bretton Woods agreement to buy weaker currencies, did not have to increase their own money supply to buy them. Neither Germany nor any other nation that acquired dollars had to use the dollars as added central bank “reserves” against which they could issue still more of their own currency. They could have “sterilized” their reserves of dollars. Or they could have reduced their other government expenditures correspondingly when they felt obliged to buy dollars, or raised the amount by added taxation, instead of simply printing more D-marks or whatever. But these would have been very difficult decisions. They might have endangered the tenure of the governments that made them. What they chose seemed under the circumstances the path of least resistance.

What has to be made crystal clear, if we are to lay the foundations for any permanent sound monetary reform, is that the present worldwide inflationary chaos is not a mere accident. It is not something that has happened in spite of the wonderfully modern and enlightened International Monetary Fund system. It is something that has happened precisely because of that system. It is, in fact, its almost inevitable result.

Steady Breakdown

It was precisely the kind of “international cooperation” it set up that led to its final breakdown. The countries whose policies were chronically leading them into currency crises should have been obliged to pay the penalty. The faltering currencies should not have been rescued by the central banks of other countries. It was exactly because the soft-currency countries knew that an American or international safety net would be almost automatically spread out to save them that they chronically got themselves into more trouble. As it was, the system kept breaking down anyway, but there was a sort of open conspiracy to ignore its fundamental unsoundness. In September, 1949, the British pound was devalued by 30 per cent, from $4.03 to $2.80. When this happened some 25 other countries devalued within a single week. In November, 1967 the British pound was devalued once more, this time from $2.80 to $2.40. There have been in fact hundreds of devaluations of currencies in the International Monetary Fund since it opened for business in 1946. In its Monthly Bulletin the Fund has printed literally millions of statistics a year, but it has steadfastly refused, up to now, to publish one figure — the total number of these devaluations.

Enough of this. It should no longer be necessary to prove how bad the Bretton Woods system turned out to be. Few people, aside from the bureaucrats whose jobs are at stake, would seriously try to glue it together again. The system is dead. Unfortunately the corpse has not been buried.

The Monetarists

Let us turn to the next candidate — the proposals of the so-called monetarists. Two things may by said in favor of the monetarists. First, they do recognize the close connection between the quantity of money and the purchasing power of the monetary unit. And second, they do acknowledge the importance of imposing strict and explicit limits on the issuance of money. But there are serious weaknesses both in their factual assumptions and in their policy proposals.

It is true that there is a close relation between the outstanding supply of money and the buying power of the individual monetary unit. But it is not true that this relation is inversely proportional or in any other way fixed and dependable. Nor is it true that there is any fixed “lag” between an increase of a given percentage in the “growth” of the money supply and an increase of the same percentage in prices. The statistics on which this conclusion is based are at best inadequate. They do not cover enough currencies over long enough periods.

What happens during a typical inflation, for example, is that in its early stages commodity prices do not rise as fast as the supply of money is increased and in its later stages prices rise much faster than the supply of money is increased.

Monetarists will dismiss this whole comparison as unfair and irrelevant. They do not regard themselves as proposing inflation at all. To them inflation is defined not as an increase in the money supply, but only as a rise in prices. And their proposal, as they see it, is to increase the stock of money 3 to 5 per cent a year just to keep the price “level” from falling. They propose an annual increase in the money stock merely to compensate for an expected annual increase of 3 per cent or more in the “productivity” of the economy.

The monetarists’ proposal rests on a false factual assumption. There is no automatic and dependable annual increase in “productivity” of 3 per cent or any other fixed rate. The increase in productivity that has occurred in the U.S. in recent years is the result of saving, investment, and technical progress. None of these is automatic. In fact, in the last two years or so, the usual “productivity” measures have actually been declining.

Wholly apart from the formidable mathematical and statistical problems involved, which space does not permit me to go into, the maintenance of the price “level” is a dubious goal. It is based on the assumption that falling prices are somehow “deflationary,” and that in any case they tend to bring about recession. This assumption is questionable. When the stock of money is not increased, falling prices are a normal result of increased production and economic progress. They need not bring recession, because the falling prices are themselves the result of falling production costs. Real profit margins are not reduced. Money wage-rates may not increase, but real wages will increase because the same money will buy more. Falling prices with continued or rising prosperity have occurred again and again in our history.

Abuses of Union Power

In our present world of powerful and aggressive labor unions, with legally built-in coercive powers, the monetarists do have a legitimate fear that such unions will not be satisfied with increased purchasing power for the same money wages. In that case, when such unions ask and get excessive wage-rates, they may bring on unemployment and recession. But this danger will exist under any monetary system whatever, as long as we retain our present one-sided labor laws and union ideology.

The central and fatal flaw of the monetarist proposal is its extreme political naïveté. It puts the power of controlling the quantity, the quality, and the purchasing power of our money entirely in the hands of the State — that is, of the politicians and bureaucrats in office.

I am tempted to add that it leaves this power entirely to the discretion, the arbitrary caprice, of the temporary holders of office in the State. The monetarists would deny this. They would limit the discretion of the monetary managers, they contend, by a strict rule. The managers would be ordered to increase the stock of money by only 2, or 3, or 4, or 5 per cent per year; and this figure would be written into the law, or into the Constitution.

It is a sign of the monetarists’ own vacillation that they have never quite decided whether this figure should be a month-to-month bureaucratic goal, or embodied in a law, or nailed into the Constitution. Nor have they ever definitely decided whether the figure itself should be 2 or 3 or 4 or 5. They can apparently hold their ranks together only by remaining vague.

Continuous Political Pressure

It is obvious that once the premises of this system were adopted there would be continuous political pressure for inflation. Those who contended that an annual increase of 2 per cent in the money stock would be enough would constantly have to combat the fears of their colleagues that this might be too low, and threaten to bring on recession. The 3 percenters, again, would have to fight a ceaseless rearguard action against the advocates of 4 per cent, or these in turn against the champions of 5 per cent. And so ad infinitum. Every time a recession seemed imminent, it would be blamed on the lowness of the existing rate of money increase. Agitation would be resumed to boost it.

None of this is a figment of my imagination. It is occurring today. On February 20, 1975, Henry Ford II, in presenting the disappointing annual report of his motor company, emphasized the need of measures to “assure strong recovery.” Among these, he stipulated: “The Federal Reserve must raise the monetary growth rate to the range of 6 to 8 per cent for a short period.”

I cite this as only one among scores of examples. It was especially instructive because it came from a businessman and not from a politician.

A month later there was a far more striking illustration. On March 18 the Senate of the U.S. adopted unanimously, 86 to 0, a resolution urging the Federal Reserve Board to expand the money supply in a way “appropriate to facilitating prompt economic recovery.” It also asked the board to consult with the House and Senate Banking Committee every six months on “objectives and plans” concerning the money supply. This was in effect an order to the Fed to continue inflating, and presumably to increase the rate of inflation. It also put the Fed on notice that whatever it may have previously supposed, it is not independent, but is subject to the directions of the politicians in office. The substance of this resolution was later adopted by the full Congress.

The monetarists’ program would inevitably make the monetary system a political football. What else could we expect? Isn’t it the height of naïveté deliberately to put the power of determining the money supply in the hands of the State, and then expect existing officeholders not to use that power in the way they think is most likely to assure their own tenure of office?

The first requisite of a sound monetary system is that it put the least possible power over the quantity or quality of money in the hands of the politicians.

This brings us to gold. It is the outstanding merit of gold as the money standard that it makes the supply and the purchasing power of the monetary unit independent of government, of office holders, of political parties, and of pressure groups. The great merit of gold is precisely that it is scarce; that its quantity is limited by nature; that it is costly to discover, to mine, and to process; and that it cannot be created by political fiat or caprice. It is precisely the merit of the gold standard, finally, that it puts a limit on credit expansion.

Fractional or Full Reserve?

But there are two major kinds of gold standard. One is the fractional-reserve system, and the other the pure gold or 100 per cent reserve system.

The fractional-reserve system is the one that developed and prevailed in the Western world in the century from 1815 to 1914. It is what we now call the classical gold standard. It had the so-called advantage of elasticity. And it made possible — we might justly say it was responsible for — the business cycle, the recurrent round of prosperity and recession, of boom and bust.

With the fractional-reserve system what typically happened is that in a given country — let us say Ruritania — borrowers would be given credit by the banks, in the form of demand deposits, and they would launch upon various enterprises. The new money so created, perhaps after taking up any slack in business and employment, would increase Ruritanian prices. Ruritania would become a better place to sell to, and a poorer place to buy from. The balance of trade or payments would begin to turn against it. This would be reflected in a fall in the exchange rate of the Ruritanian currency until the “gold export point” was reached. Gold would then flow out to other countries. In order to stop it, interest rates in Ruritania would have to be raised. With a higher interest rate or a smaller gold base, the volume of currency would be contracted. This would often mean a deflation or a crisis followed by a slump.

In brief, the gold standard with a fractional-reserve system tended almost systematically to bring about the cycle of boom and slump.

Under such a system, there is constant political pressure to reduce interest rates or the reserve requirements so that credit expansion — i.e., inflation — may be encouraged or continued. It is supposed to be the great advantage of a fractional-reserve system that it allows credit expansion. But what is overlooked is that, no matter how long the required legal reserve is set, there must eventually come a point when the permissible legal credit expansion has been reached. There is then inevitable political pressure to reduce the percentage of required reserves still further.

This has been the history of the system in the United States. The effect — and partly the intention — of the Federal Reserve Act was enormously to increase the potential volume of credit expansion. The required reserves for member banks were reduced under the new Federal Reserve Act from a range of 15 to 25 per cent for the previous national banks to 12 to 18 per cent for the new Federal Reserve member banks. In 1917 the required reserves for member banks were reduced still further to a range of 7 to 13 per cent.

Pyramiding Credit

But on top of the inverted pyramid of credit that the member banks were allowed to create, the newly established Federal Reserve Banks, which now held the reserves of the member banks, were permitted to erect a still further inverted credit pyramid of their own. The Reserve Banks were required to carry only a 35 per cent reserve against their deposits and a 40per cent gold reserve against their notes.

Later the Federal Reserve authorities became more strict in imposing reserve requirements on the member banks (they raised these sharply beginning in 1936, for example). But they continued to be very lenient in setting their own reserve requirements. Between June of 1945 and March of 1965 the reserve requirements were reduced from 35 and 40 per cent to a flat 25 per cent. And then they were dropped altogether.

So much for history. What of the future?

If the world, or at least this country, ever returns to its senses, and decides to re-establish a gold standard, the fractional-reserve system ought to be abandoned. If by some miracle the U.S. government were to make this decision tomorrow, it could not of course wipe out the already existing supply of fiduciary money and credit, or any substantial part of it, without bringing on a devastating and needless deflation. But the government would at least have to refrain from any further increase in the supply of such fiduciary currency. Assuming that the government were then able to fix upon a workable conversion rate of the dollar into gold — a rate that was sustainable and would not in itself lead to either inflation or deflation — the U.S. could then return to a sound currency and a sound gold basis.

But in the world as it has now become — sunk in hopeless confusion, inflationism, and demagogy — the likelihood of any such development in the foreseeable future is practically nil. The remedy I have suggested rests on the assumption that our government and other governments will become responsible, and suddenly begin doing what is in the long-run interest of the whole body of the citizens, instead of only in the short-run interest — or apparent interest —of special pressure groups. Today this is to expect a miracle.

But the outlook is not hopeless. I began by pointing out that for more than a century individual economists have tried to design an ideal money. Why have they not agreed? Why have their schemes come to nothing? They have failed, I think, because they have practically all begun with the same false assumption — the assumption that the creation and “management” of a monetary system is and ought to be the prerogative of the State.

This has become an almost universal superstition. It is tantamount to agreeing that a monetary system should be made the plaything of the politicians in power.

The proposals of the would-be monetary reformers have failed, in fact, for two main reasons. They have failed partly because they have misconceived the primary functions that a monetary system has to serve. Too many monetary reformers have assumed that the chief quality to be desired in a money is to be “neutral.” And too many have assumed that this “neutrality” would be best achieved if they could create a money that would lead to a constant and unchanging “price level.”

This was the goal of Irving Fisher in the 1920’s, with his “compensated dollar.” It is the goal of his present-day disciples, the “monetarists,” and their proposal for a government-managed increase in the money supply of 3 to 5 per cent a year to keep the “price-level” stable.

I believe that this goal itself is a c questionable one. But what is an even more serious and harmful error on their part is the method by which they propose to achieve this goal. They propose to achieve it by giving the power to the politicians in office to manipulate the currency according to the formula prescribed in advance by the monetarists.

Self-Serving Politicians

What such reformers fail to recognize is that once the politicians and their appointees are granted such powers, they are less likely to use them to pursue the objectives of the reformers than they are to pursue their own objectives. The politicians’ own objectives will be those that seem best calculated to keep them in power. The particular policy they will assume is most likely to keep them in power is to keep increasing the issuance of money; because this will:

(1)   increase “purchasing power” and so presumably increase the volume of trade and employment;

(2)   keep prices going up as fast as union pressure pushes up wages, so that continued employment will be possible; and

(3)   give subsidies and other handouts to special pressure groups without immediately raising taxes to pay for them. In other words, the best immediate policy for the politicians in power will always appear to them to be inflation.

In sum, the belief that the creation and management of a monetary system ought to be the prerogative of the State — i.e., of the politicians in power — is not only false but harmful. For the real solution is just the opposite. It is to get government, as far as possible, out of the monetary sphere. And the first step libertarians should insist on is to get our government and the courts not only to permit, but to enforce, voluntary private contracts providing for payment in gold or in terms of gold value.

A Movement Toward Gold

Let us see what would happen if this were done. As the rate of inflation increased, or became more uncertain, Americans would tend increasingly to make long-term contracts payable in gold. This is because sellers and lenders would become increasingly reluctant to make long-term contracts payable in paper dollars, or in irredeemable money-units of any other kind.

This would apply particularly to international contracts. The buyer or debtor would either have to keep a certain amount of gold in reserve, or make a forward contract to buy gold, or depend on buying gold in the open spot market with his paper money on the date that his contract fell due. In time, if inflation continued, even current transactions would increasingly be made in gold.

Thus there would grow up, side by side with fiat paper money, a private domestic and international gold standard. Each country that permitted this would then be on a dual monetary system, with a daily changing market relation between the two monies. And there would be a private gold system ready to take over completely on the very day that the government’s paper money became absolutely worthless — as it did in Germany in November 1923, and in scores of other countries at various times.

A Private Gold Standard?

Could there be such a private gold standard? To ask such a question is to forget that history and prehistory have already answered it. Private gold coins, and private gold currencies, existed centuries before governments decided to take them over — to nationalize them, so to speak. The argument that the kings and governments put forward for doing this — and it was a plausible one — was that the existing private coins were not of uniform and easily recognizable size, weight, and imprint; that the fineness of their gold content, or whether they were gold at all, could not be easily tested; that the private coins were crude and easily counterfeited; and finally that the legal recourse of the receiver, if he found a coin to be underweight or debased, was uncertain and difficult. But, the kings went on to argue, if the coins were uniform, and bore the instantly recognizable stamp of the realm, and if the government itself stood ever ready to prosecute all clippers or counterfeiters, the people could depend on their money. Business transactions would become more efficient and certain, and enormously less time-consuming.

Still another specious argument for a government coinage applied especially to subsidiary coins. It was impossible, it was contended, or ridiculously inconvenient, to make gold coins small enough for use in the millions of necessary small transactions, like buying a quart of milk or a loaf of bread.

What was needed was a subsidiary coinage, which represented halves, quarters, tenths, or hundredths of the standard unit. These coins, regardless of what they were made of, or what their intrinsic value might be, would be legally accept-table and convertible, at the rates stamped on them, into the standard gold coins.

It would be very difficult, I admit, to provide for this with a purely private currency, with everybody having the legal power to stamp out his own coins and guarantee their conversion by him into gold. A private coinage system might conceivably be able to solve this problem, but I confess I personally have been unable to think of any solution that would not be complicated, cumbersome, or undependable.

It is clear, in short, that a government-provided or a government-regulated coinage has some advantages. But these advantages are bought at a price. That price seemed comparatively low in the nineteenth century and until 1914; but today the price of government control of money has become excessive practically everywhere.

The basic problem that confronts us is not one that is confined to the monetary sphere. It is a problem of government. It is in fact the problem of government in every sphere. We need government to prevent or minimize internal and external violence and aggression and to keep the peace. But we are obliged to recognize that no group of men can be completely trusted with power. All power is liable to be abused, and the greater the power the greater the likelihood of abuse. For that reason, only minimum powers should be granted to government. But the tendency of government everywhere has been to use even minimum powers to increase its powers. And any government is certain to use great powers to usurp still greater powers. There is no doubt that the two great World Wars since 1914 brought on the present prevalence of the quasi-omnipotent State.

But the solution of the overall problem of government is beyond the province of this article. To decide what would be the best obtainable monetary system, if we could get it, would be a sufficiently formidable problem in itself. But a major part of the solution to this problem, to repeat once more, will be how to get the monetary system out of the hands of the politicians. Certainly as long as we retain our nearly omnipotent redistributive State, no sound currency will be possible.

This article has been published with FEE‘s permission and has been originally published at The Freeman November 1975 • Volume: 25 • Issue: 11.

Henry Hazlitt

A correspondent, heading a group of “Inflation Fighters,” recently sent me a one-page typewritten summary of their case against inflation, and asked for my opinion of it. The statement was sincere and well-intentioned, but as with the great bulk of what is being written about infla tion, it was confused in both its analysis and its recommendations.

I wrote approving his effort to “do something,” and approving also his idea of trying to state the cause and cure for inflation on a single page, but suggested the following substitute statement.

Cause and Cure of Inflation

1. Inflation is an increase in the quantity of money and credit. Its chief consequence is soaring prices. Therefore inflation—if we misuse the term to mean the rising prices themselves—is caused solely by printing more money. For this the government’s monetary policies are entirely responsible.

2. The most frequent reason for printing more money is the existence of an unbalanced budget. Unbalanced budgets are caused by extravagant expenditures which the government is unwilling or unable to pay for by raising corresponding tax revenues. The excessive expen ditures are mainly the result of government efforts to redistribute wealth and income—in short, to force the productive to support the unproductive. This erodes the working incentives of both the productive and the unpro ductive.

3. The causes of inflation are not, as so often said, “multiple and complex,” but simply the result of printing too much money. There is no such thing as “cost-push” inflation. If, without an increase in the stock of money, wage or other costs are forced up, and producers try to pass these costs along by raising their selling prices, most of them will merely sell fewer goods. The result will be reduced output and loss of jobs. Higher costs can only be passed along in higher selling prices when consumers have more money to pay the higher prices.

4. Price controls cannot stop or slow down inflation. They always do harm. Price controls simply squeeze or wipe out profit margins, disrupt production, and lead to bottlenecks and shortages. All government price and wage control, or even “monitoring,” is merely an attempt by the politicians to shift the blame for inflation on to producers and sellers instead of their own monetary policies.

5. Prolonged inflation never “stimulates” the economy. On the contrary, it unbalances, disrupts, and misdirects production and employment. Unemployment is mainly caused by excessive wage rates in some industries, brought about either by extortionate union demands, by minimum wage laws (which keep teenagers and the unskilled out of jobs), or by prolonged and over-generous unemployment insurance.

6. To avoid irreparable damage, the budget must be balanced at the earliest possible moment, and not in some sweet by-and-by. Balance must be brought about by slashing reckless spending, and not by increasing a tax burden that is already undermining incentives and pro duction.

Lawrence W. Reed is president of the Foundation for Economic Education in Irvington, New York—www.fee.org.This essay has been adapted for CEIL by the author from his essay of the same title in the May 2009 issue of FEE’s journal, “The Freeman.”)

For a society that has fed, clothed, housed, cared for, informed, entertained, and otherwise enriched more people at higher levels than any in the history of the planet, there sure is a lot of groundless guilt in America (and even more in most other Western countries).

Manifestations of that guilt abound. The example that disgusts me the most is the one we often hear from well-meaning philanthropists who adorn their charitable giving with this little chestnut: “I want to give something back.” It always sounds as though they’re apologizing for having been successful.

Translated, that statement means something like this: “I’ve accumulated some wealth over the years. Never mind how I did it, I just feel guilty for having done it. There’s something wrong with my having more than somebody else, but don’t ask me to explain how or why because it’s just a fuzzy, uneasy feeling on my part. Because I have something, I feel obligated to have less of it. It makes me feel good to give it away because doing so expunges me of the sin of having it in the first place. Now I’m a good guy, am I not?”

It was apparent to me how deeply ingrained this mindset has become when I visited the gravesite of John D. Rockefeller at Lakeview Cemetery in Cleveland a couple years ago. The wording on a nearby plaque commemorating the life of this remarkable entrepreneur implied that giving much of his fortune away was as worthy an achievement as building the great international enterprise, Standard Oil, that produced it in the first place. The history books most kids learn from these days go a step further. They routinely criticize people like Rockefeller for the wealth they created and for the profit motive, or self-interest, that played a part in their creating it, while lauding them for relieving themselves of the money.

More than once, philanthropists have bestowed contributions on my organization and explained they were “giving something back.” They meant that by giving to us, they were paying some debt to society at large. It turns out that, with few exceptions, these philanthropists really had not done anything wrong. They made money in their lives, to be sure, but they didn’t steal it. They took risks they didn’t have to. They invested their own funds, or what they first borrowed and later paid back with interest. They created jobs, paid market wages to willing workers, and thereby generated livelihoods for thousands of families. They invented things that didn’t exist before, some of which saved lives and made us healthier. They manufactured products and provided services, for which they asked and received market prices. They had willing and eager customers who came back for more again and again. They had stockholders to whom they had to offer favorable returns. They also had competitors, and had to stay on top of things or lose out to them. They didn’t use force to get where they got; they relied on free exchange and voluntary contract. They paid their bills and debts in full. And every year they donated some of their profits to lots of community charities no law required them to support. Not a one of them that I know ever did any jail time for anything.

So how is it that anybody can add all that up and still feel guilty? I suspect that if they are genuinely guilty of anything, it’s allowing themselves to be intimidated by the losers and the envious of the world–the people who are in the redistribution business either because they don’t know how to create anything or they simply choose the easy way out. They just take what they want, or hire politicians to take it for them.

Or like a few in the clergy who think that wealth is not made but simply “collected,” the redistributionists lay a guilt trip on people until they disgorge their lucre-notwithstanding the Tenth Commandment against coveting. Certainly, people of faith have an obligation to support their church, mosque, or synagogue, but that’s another matter and not at issue here.

Real Giving Back

A person who breaches a contract owes something, but it’s to the specific party on the other side of the deal. Steal someone else’s property and you owe it to the person you stole it from, not society, to give it back. Those obligations are real and they stem from a voluntary agreement in the first instance or from an immoral act of theft in the second. This business of “giving something back” simply because you earned it amounts to manufacturing mystical obligations where none exist in reality. It turns the whole concept of “debt” on its head. To give it “back” means it wasn’t yours in the first place, but the creation of wealth through private initiative and voluntary exchange does not involve the expropriation of anyone’s rightful property.

How can it possibly be otherwise? By what rational measure does a successful person in a free market, who has made good on all his debts and obligations in the traditional sense, owe something further to a nebulous entity called society? If Entrepreneur X earns a billion dollars and Entrepreneur Y earns two billion, would it make sense to say that Y should “give back” twice as much as X? And if so, who should decide to whom he owes it? Clearly, the whole notion of “giving something back” just because you have it is built on intellectual quicksand.

Successful people who earn their wealth through free and peaceful exchange may choose to give some of it away, but they’d be no less moral and no less debt-free if they gave away nothing. It cheapens the powerful charitable impulse that all but a few people possess to suggest that charity is equivalent to debt service or that it should be motivated by any degree of guilt or self-flagellation.

A partial list of those who honestly do have an obligation to give something back would include bank robbers, shoplifters, scam artists, deadbeats, and politicians who “bring home the bacon.” They have good reason to feel guilt, because they’re guilty.

But if you are an exemplar of the free and entrepreneurial society, one who has truly earned and husbanded what you have and have done nothing to injure the lives, property, or rights of others, you are a different breed altogether. When you give, you should do so because of the personal satisfaction you derive from supporting worthy causes, not because you need to salve a guilty conscience.

Steven Horwitz is the Charles A. Dana Professor of Economics at St. Lawrence University in Canton, NY. He has been a visiting scholar at Bowling Green State University and the Mercatus Center at George Mason University.

My RSS reader this morning brought me this post from Marginal Revolution, which contains a spectacular close-up picture of a snowflake, taken from a book of such pictures. As I hope it does for you, just looking at that photo brought me up short and made me stop in awe, reverence, and wonder. The intricacy, detail, complexity, and sheer beauty of that product of nature cannot be captured in words. And when you stop to consider the uncountable number of snowflakes that fall each year (most of them on my driveway it would seem), all of that awe is upped an order of magnitude.

When I see that snowflake, it engages my reverence for the beauty of the undesigned order of the natural world. Look at the symmetry and detail of that snowflake, and then consider that is the product of undesigned natural processes. I find it an object of awe that natural processes can produce a thing of such detail, complexity and beauty. It is said that only God can make a snowflake. Well for those who understand the science, or who are atheists, we know that you don’t need God to do so. But even to an atheist like myself, the spontaneous order of nature can (and should!) generate the same awe, reverence, and wonder that the contemplation of God generates in those who believe. Unfortunately, whenever my wonder at the beauty of nature is engaged, it is with a tinge of frustration.The frustration I feel is that so many smart and caring people seem unable to see and appreciate the identical processes of undesigned order in the social world. “Social snowflakes” are all around us, yet precious few seem to be able to understand and appreciate them to the degree we do the snowflakes found in nature. And too many people think that these “social snowflakes” require a “Creator.”

That snowflake produces in me the same aesthetic-emotional reaction I have when I begin to think about Leonard Read’s “I, Pencil,” or when I ponder the intricate, detailed, complex, and beautiful processes by which Chilean grapes appear in my grocery store in rural New York in the middle of winter. The pencil and the grapes are “social snowflakes”: they look simple, but when we hold them still and examine them with the analogous level of detail as that photo produces in the snowflake, they turn out to be the products of extraordinarily complex and intricate social processes that were designed by no one. My aesthetic reaction of awe and wonder is a response to what Pete Boettke, in a perfect turn of phrase, recently referred to as “the mystery of the mundane.” What is more mundane than a snowflake? And yet what, it turns out, is more beautiful and complex than a snowflake? And in the way their mundane surface appearances hide processes of production whose awesome complexity was the product of human action but not human design, and should equally be a source of aesthetic and intellectual contemplation, the pencil and grapes are indeed “social snowflakes.”

My fervent wish for the 21st century is that more smart and caring people can begin to see and appreciate “social snowflakes.” People who are so willing to accept the existence and beauty (and benevolence!) of undesigned order in the natural world should be more willing to open themselves to the possibility that there are processes of undesigned order at work in the social world too. These people know that no one can make a snowflake, but seem blind to the fact that much of the innocent blood that was spilled in the last century was because too many people thought they could intelligently design the social world. Not repeating those mistakes will require a renewed aesthetic appreciation of, and deep desire to understand, the awesome beauty and complexity of the undesigned order of “social snowflakes.”

Lawrence W. Reed is president of the Foundation for Economic Education in Irvington, New York—www.fee.org.This essay has been adapted for CEIL by the author from his essay of the same title in the December 1999 issue of FEE’s journal, “The Freeman.”

Perhaps the most important principle one can ever learn about the nature of government is this: It is different from all other institutions in society because it is the only one that can legally employ force. Unfortunately, it is a principle that has been largely erased from the Western memory bank. More than a hundred years of compulsory public education in most Western countries may be largely to blame.

Let’s get something straight before we go any further. To note that government rests on the use of force is not some radical anarchist idea. It is the very definition of the institution and its ultimate distinguishing feature. For much of the last half millennium, political scientists of virtually every stripe accepted the notion as fact. No respectable scholar tried to paper it over and pass government off as some kind of voluntary, benevolent society.

America’s founders understood this principle well and crafted a regime that never purported to eliminate force; they only sought to restrict it to a narrow sphere of life and thereby preserve a large measure of individual liberty. George Washington is often credited with saying (I’ve not been able to verify it), “Government is not reason. It is not eloquence—it is force! Like fire it is a dangerous servant and a fearful master.” In other words, even when government does no more than what Washington wanted it to do, and when it does those few things very well as a “servant” of the people, it’s still dangerous because behind it all is the employment of legalized force.

The Yellow Light

A deeply rooted understanding of this inherent character of government is a pillar of the free society. It’s the yellow caution light that prompts wise and peaceful citizens to deliberate long and hard before accepting an expansion of government duties. It creates a healthy skepticism about seductive schemes to supplant private initiative with public action. It discourages attempts to impose a collective conformity at the expense of the individual.

If you are an advocate of the free society today, you surely have noticed an erosion in the understanding of this principle. It may not be an exaggeration to assert that the erosion has been massive and far more deleterious to our liberty and well-being than all but a few ever imagined.

This point struck me hard recently when I read a letter to the editor of a local newspaper. The letter writer was responding to a previously published commentary by a man who had argued that novelist Ernest Hemingway opposed government funding of the arts because he felt that artists should be independent of political influence. She took issue with the commentator on the grounds that Hemingway “did accept money from benefactors.” Accepting money freely given by patrons, in the mind of the letter writer, was indistinguishable from accepting money from the government.

Similarly, I have witnessed countless occasions when individuals argued that if government does something and is well intentioned, it couldn’t possibly be coercive; or, that if it’s “democratic,” it’s somehow voluntary. The mere fact that politicians are elected validates almost whatever they do as nothing more than consensual acts between altruistic adults. A much more sober and rational view of the limitations of a democratic republic, preferable though it is to any other form of government, is the one that describes it as two wolves and a lamb voting on what to have for lunch.

So it is that we’ve arrived at the point described by Edgar Freidenberg’s 1964 classic, Coming of Age in America, where “American high school students viewed the government as a benign institution that one should obey because it was working for the benefit of all the people.”¹How is it possible for such a sad state of intellectual affairs to befall a nation founded on liberty and a rational view of the state? How did it come to be that millions of people in Western countries like America recoil at the “radical” suggestion that government and legalized force are one and the same?

I can think of no other source of the problem than a century of government (“public”) education. When nearly 90 percent of Americans are schooled for 12 formative years by government employees, most of whom earned their teaching degrees at government universities, why should we expect anything other than an obsequious citizenry that views government as the benevolent vicar of what Rousseau called “the general will”?

The history of American public education is replete with statements by professional government school advocates that reek of state-worship. Judge Archibald Douglas Murphey, founder of the public school system in North Carolina, said that government must educate because “parents know not how to instruct them. . . . The state, in the warmth of her affection and solicitude for their welfare must take charge of those children and place them in school where their minds can be enlightened.”²

A 1914 bulletin of the U. S. Bureau of Education stated, “The public schools exist primarily for the benefit of the State rather than for the benefit of the individual.” And Edward Ross, a prominent sociologist, offered the most chilling description of the role of government in education: “To collect little plastic lumps of human dough from private households and shape them on the social kneading-board.”³

This outcome was predictable from the earliest days of American public education, and it’s no different from anything else the government comes to dominate. He who pays the piper calls the tune. It just isn’t in the interests of the government or those who depend on it to sully their own nests with an honest admission that their handiwork is financed and imposed at gunpoint. As education scholar Joel Spring put it 20 years ago, “A teacher, school administrator, or elected official in charge of schools may believe that his personal values represent the general values of the community; worse, he may think that his values should be adopted by the community.”⁴The situation doesn’t appear to be any better, and arguably is worse, in most other Western countries.

Such explicit statements notwithstanding, it would be hard and perhaps politically counterproductive to argue that today’s deficient government school system derives from some grand conspiracy. To explain the appalling ignorance of the Western citizenry regarding the essential nature of government, conspiracy theories are not necessary. It’s sufficient simply to observe that few employees of the system will rise above immediate self-interest to even recognize, let alone propagate, the notion that government in general and their jobs in particular rest on legalized force.

What difference does all this make? A lot. I can think of no situation more hostile to liberty than a failure of a free people to tell the difference between government and everything else.

1.     Cited in William F. Rickenbacker, ed., The Twelve-Year Sentence (San Francisco: Fox & Wilkes, 1999 [1974]), p. 140.

2.     Quoted in Murray Rothbard, “Historical Origins,” in ibid., p. 11.

3.     Quoted in Joel Spring, The American School, 1642-1985 (New York: Longman, 1986), p. 155.

4.     Quoted in Joel Spring, Educating the Worker-Citizen (New York: Longman, 1980), p. 14.

by Steven Horwitz and Peter Boettke, Edited by Lawrence W. Reed

Introduction

The theme of “The House that Uncle Sam Built: The Untold Story of the Great Recession of 2008” is that government policy, not a failure of free markets, caused the economic trauma we have been experiencing. We do not live in a free market. We live in a mixed economy. The mixture varies by industry. Technology is primarily free. Financial Services is primarily government. It is not surprising that the most government regulated and controlled segment of the economy, financial services, experienced the biggest problems. These problems were created by actions by the Federal Reserve combined with government housing policy (especially the government- sponsored enterprises – Freddie Mac and Fannie Mae). Misguided government interference in the market is the real culprit in laying the foundation for the Great Recession.

This paper provides a “common sense” and understandable outline of fundamental causes and cures. The analysis is based on long proven economic laws. Despite the wishes and hopes of politicians, economic laws are just as immutable as the laws of physics. If you jump off a ten story building, hitting the ground will not be pleasant. If the Federal Reserve holds interest rates below the natural market rate by rapidly expanding the money supply (“printing” money) as Alan Greenspan did, individuals and businesses will make bad investment decisions and there will be negative consequences to our long term economic well-being. There are no free lunches.

When a doctor misdiagnoses a disease, his treatment will likely make the patient sicker. If we misdiagnose the causes of the Great Recession, our treatment will reduce our long term standard of living. While the U.S. economic system is highly resilient, and we will likely have some form of economic recovery, almost every significant government policy action taken in response to the Great Recession will reduce the quality of life in the long term. Understanding that failed government policies, not market failure, caused our economic challenges is critical to defining the appropriate cures. Since government created the problem, i.e. caused the disaster, it is irrational to believe that more government is the cure. We owe it to ourselves and to our children and grandchildren to take these issues very seriously.

John Allison, Chairman, BB&T

The House that Uncle Sam Built

The man who parties like there is no tomorrow puts his body through an “up” and a “down” course that looks a lot like the business cycle. At the party, the man freely imbibes. He has a great time before stumbling home at 2:00 a.m., where he crashes on the sofa. A few hours later, he awakens in the grip of the dreaded hang- over. He then has a choice to make: get a short-term lift from another drink or sober up. If he chooses the latter and endures a few hours of discomfort, he can recover. In any event, no one would say the hangover is when the harm is done; the harm was done the night before and the hangover is the evidence.

The Great Recession (or the Great Hangover) that began in 2008 did not have to happen. Its causes and consequences are not mysterious. Indeed, this particular and very painful episode affirms what the best nonpartisan economists have tried to tell our politicians and policy-makers for decades, namely, that the more they try to inflate and direct the economy, the more damage the rest of us will suffer sooner or later. Hindsight is always 20-20, but in this instance, good old-fashioned common sense would have provided all the foresight needed to avoid the mess we’re in.

In this essay, we trace the path of the recession from its origins in the housing market bubble to the policies offered to cure the aftermath.

There is no better way to understand a crisis that began in the housing sector than to begin by thinking about a house.

A house must be built on a firm, sustainable foundation. If it’s slapped together with good intentions but lousy materials and workmanship, it will collapse prematurely. If too much lumber and too many bricks are piled on top of a weak support structure, or if housing material is misallocated throughout the house, then an apparently solid structure can crumble like sand once its weaknesses are exposed. Americans built and bought a lot of houses in the past decade not, it turns out, for sound reasons or with solid financing. Why this occurred must be part of any good explanation of the Great Recession.

But isn’t home ownership a great thing, the very essence of the vaunted “American Dream”? In the wealthiest country in the world, shouldn’t everyone be able to own their own home? What could be wrong with any policy that aims to make housing more affordable? Well, we may wish it were not so, but good intentions cannot insulate us from the consequences of bad policies.

Politicians became so enthralled with home ownership and affordable housing – and the points they could score by claiming to be their champions – that they pushed and shoved the economy down an artificial path that invited an inevitable (and painful) correction. Congress created massive, government-sponsored enterprises and then encouraged them to degrade lending standards. Congress bent tax law to favor real estate over other investments. Through its reckless easy money policies, another creation of Congress, the Federal Reserve, flooded the economy with liquidity and drove interest rates down. Each of these policies encouraged too many of the economy’s resources to be drawn into the housing sector. For a substantial part of this decade, our policy-makers in Washington were laying a very poor foundation for economic growth.

Was Free Enterprise the Villain?

Call it free enterprise, capitalism or laissez faire – blaming supposedly unfettered markets for every economic shock has been the monotonous refrain of conventional wisdom for a hundred years. Among those making such claims are politicians who posture as our rescuers, bureaucrats who are needed to implement the rescue plans and special interests who get rescued. Then there are our fellow academics – the ones who add a veneer of respectability – trumpeting the “stimulus” the rest of us get from being rescued.

Rarely does it occur to these folks that government intervention might be the cause of the problem. Yet, we have the Federal Reserve System’s track record, thousands of pages of financial regulations, and thousands more pages of government housing policy that demonstrate the utter absence of “laissez faire” in areas of the economy central to the current recession.

Understanding recessions requires knowing why lots of people make the same kinds of mistakes at the same time. In the last few years, those mistakes were centered in the housing market, as many people overestimated the value of their houses or imagined that their value would continue to rise. Why did everyone believe that at the same time? Did some mysterious hysteria descend upon us out of nowhere? Did people suddenly become irrational? The truth is this: People were reacting to signals produced in the economy. Those signals were erroneous. But it was the signals and not the people themselves that were irrational.

Imagine we see an enormous rise in the number of traffic accidents in a major city. Cars keep colliding at intersections as drivers all seem to make the same sorts of mistakes at once. Is the most likely explanation that drivers have irrationally stopped paying attention to the road, or would we suspect that something might be wrong with the traffic lights? Even with completely rational drivers, malfunctioning traffic signals will lead to lots of accidents and appear to be massive irrationality.

Market prices are much like traffic signals. Interest rates are a key traffic signal. They reconcile some people’s desire to save – delay consumption until a future date – with others’ desire to invest in ideas, materials or equipment that will make them and their businesses more productive. In a market economy, interest rates change as tastes and conditions change. For instance, if people become more interested in future consump- tion relative to current consumption, they will increase the amount they save. This, in turn, will lower interest rates, allowing other people to borrow more money to invest in their businesses. Greater investment means more sophisticated production processes, which means more goods will be available in the future. In a normally functioning market economy, the process ensures that savings equal investment, and both are consistent with other conditions and with the public’s underlying preferences.

As was made all too obvious in 2008, ours is not a normally functioning market economy. Government has inserted itself into almost every transaction, manipulating and distorting price signals along the way. Few interventions are as momentous as those associated with monetary policy implemented by the Federal Reserve. Money’s essence is that it is a generally accepted medium of exchange, which means that it is half of every act of buying and selling in the economy. Like blood circulating in the body, it touches everything. When the Fed tinkers with the money supply, it affects not just one or two specific markets, like housing policy does, but every single market in the entire economy. The Fed’s powers give it an enormous scope for creating economic chaos.

When central banks like the Federal Reserve inflate, they provide banks with more money to lend, even though the public has not provided any more savings. Banks respond by lowering interest rates to draw in new borrowers. The borrowers see the lower interest rate and believe that it signals that consumers are more interested in delayed consumption relative to immediate consumption. Borrowers then begin to invest in those longer-term projects, which are now relatively more desirable given the lower interest rate. The problem, however, is that the demand for those longer-term projects is not really there. The public is not more interested in future consumption, even though the interest rate signals suggest otherwise. Like our malfunctioning traffic signals, an inflation-distorted interest rate is going to cause lots of “accidents.” Those accidents are the mistaken investments in longer-term production processes.

Eventually those producers engaged in the longer processes find the cost of acquiring their raw materials to be too high, particularly as it becomes clear that the public’s willingness to defer consumption until the future is not what the interest rate suggested would be forthcoming. These longer-term processes are then abandoned, resulting in falling asset prices (both capital goods and financial assets, such as the stock prices of the relevant companies) and unemployed labor in sectors associated with the capital goods industries.

So begins the bust phase of a monetary policy-induced cycle; as stock prices fall, asset prices “deflate,” overall economic activity slows and unemployment rises. The bust is the economy going through a refitting and reshuffling of capital and labor as it eliminates mistakes made during the boom. The important points here are that the artificial boom is when the mistakes were made, and it is during the bust that those mistakes are corrected.

From 2001 to about 2006, the Federal Reserve pursued the most expansionary monetary policy since at least the 1970s, pushing interest rates far below their natural rate.

In January of 2001 the federal funds rate, the major interest rate that the Fed targets, stood at 6.5%. Just 23 months later, after 12 successive cuts, the rate stood at a mere 1.25% – more than 80% below its previous level. It stayed below 2% for two years then the Fed finally began raising rates in June of 2004. The rate was so low during this period that the real Federal Funds rate – the nominal rate minus the rate of inflation – was negative for two and a half years. This meant that, in effect, banks were being paid to borrow money! Rapidly climbing after mid-2004, the rate was back up to the 5% mark by May of 2006, just about the time that housing prices started their collapse. In order to maintain that low Fed Funds rate for that five year period, the Fed had to increase the money supply significantly. One common measure of the money supply grew by 32.5%. A lot of economically irrational investments were made during this time, but it was not because of “irrational exuberance brought on by a laissez-faire economy,” as some suggested. It is unlikely that lots of very similar bad investments are the resut of mass irrationality, just as large traffic accidents are more likely the result of malfunctioning traffic signals than lots of people forgetting how to drive overnight. They resulted from malfunctioning market price signals due to the Fed’s manipulation of money and credit. Poor monetary policy by an agency of government is hardly “laissez faire.”

What about housing?

With such an expansionary monetary policy, the housing market was sent contradictory and incorrect signals. On one hand, housing and housing-related industries were given a giant green light to expand. It is as if the Fed supplied them with an abundance of lumber, and encouraged them to build their economic house as big as they pleased.

This would have made sense if the increased supply of lumber (capital) had been supported by the public’s desire to increase future consumption relative to immediate consumption – in other words, if the public had truly wanted to save for the bigger house. But the public did not. Interest rates were not low because the public was in the mood to save; they were low because the Fed had made them so by fiat. Worse, Fed policy gave the would-be suppliers of capital – those who might have been tempted to save – a giant red light. With rates so low, they had no incentive to put their money in the bank for others to borrow.

So the economic house was slapped together with what appeared to be an unlimited supply of lumber. It was built higher and higher, drawing resources from the rest of the economy. But it had no foundation. Because the capital did not reflect underlying consumer preferences, there was no support for such a large house. The weaknesses in the foundation were eventually exposed and the 70-story skyscraper, built on a foundation made for a single-family home, began to teeter. It eventually fell in the autumn of 2008.

But why did the Fed’s credit all flow into housing? It is true that easy credit financed a consumer-borrowing binge, a mergers-and-acquisitions binge and an auto binge. But the bulk of the credit went to housing. Why? The answer lies in government’s efforts to increase the affordability of housing.

Government intervention in the housing market dates back to at least the Great Depression. The more recent government initiatives relevant to the current recession began in the Clinton administration. Since then, the federal government has adopted a variety of policies intended to make housing more affordable for lower and middle income groups and various minorities. Among the government actions, those dealing with government-sponsored enterprises active in mortgage markets were central. Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) are the key players here. Neither Fannie nor Freddie are “free-market” firms. They were chartered by the federal government, and although nominally privately owned until the onset of the bust in 2008, they were granted a number of government privileges in addition to carrying an implicit promise of government support should they ever get into trouble.

Fannie and Freddie did not actually originate most of the bad loans that comprised the housing crisis. Loans were made by banks and mortgage companies that knew they could sell those loans in the secondary mortgage market where Fannie and Freddie would buy and repackage them to sell to other investors. Fannie and Freddie also invented a number of the low down-payment and other creative, high-risk types of loans that came into use during the housing boom. The loan originators were willing to offer these kinds of loans because they knew that Fannie and Freddie stood ready to buy them up. With the implicit promise of government support behind them, the risk was being passed on from the originators to the taxpayers. If homeowners defaulted, the buyers of the mortgages would be harmed, not the originators. The presence of Fannie and Freddie in the mortgage market dramatically distorted the incentives for private actors such as the banks.

The Fed’s low interest rates, combined with Fannie and Freddie’s government-sponsored purchases of mortgages, made it highly and artificially profitable to lend to anyone and everyone. The banks and mortgage companies didn’t need to be any greedier than they already were. When banks saw that Fannie and Freddie were willing to buy virtually any loan made to under-qualified borrowers, they made a lot more of them. Greed is no more to blame for these bad mortgages than gravity is to blame for plane crashes. Gravity is always present, just like greed. Only the Federal Reserve’s easy money policy and Congress’ housing policy can explain why the bubble happened when it did, where it did.

Of further significance is the fact that Fannie and Freddie were under great political pressure to keep housing increasingly affordable (while at the same time promoting instruments that depended on the constantly rising price of housing) and to extend opportunities to historically “under-served” groups. Many of the new mortgages with low or even zero-down payments were designed in response to this pressure. Not only were lots of funds available to lend, and not only was government implicitly subsidizing the purchase of mortgages, but it was also encouraging lenders to find more borrowers who previously were thought unable to afford a mortgage.

Partnerships among Fannie and Freddie, mortgage companies, community action groups and legislators combined to make mortgages available to many people who should never have had them, based on their income and assets. Throw in the effects of the Community Reinvestment Act, which required lenders to serve under-served groups, and zoning and land-use laws that pushed housing into limited space in the suburbs and exurbs (driving up prices in the process) and you have the ingredients of a credit-fueled and regulatory-directed housing boom and bust.

All told, huge amounts of wealth and capital poured into producing houses as a result of these political machinations. The Case-Shiller Index clearly shows unprecedented increases in home prices prior to the bust in 2008. From 1946-1996, there had been no significant growth in the price of residential real estate. In contrast, the decade that followed saw skyrocketing prices.

It’s worth noting that even tax policy has been biased toward fostering investments in housing. Real estate investments are taxed at a much lower rate than other investments. Changes in the 1990s made it possible for families to pocket any capital gains (income from price appreciation) on their primary residences up to $500,000 every two years. That translates into an effective rate of 0% versus the ordinary income tax rates that apply to capital gains on other forms of investment. The differential tax treatment of capital gains made housing a relatively better investment than the alternatives. Although tax cuts are desirable for promoting economic growth, when politicians tinker with the tax code to favor the sorts of investments they think people should make, we should not be surprised if market distortions result.

Former Fed chair Alan Greenspan had made it clear that the Fed would not stand idly by whenever a crisis threatened to cause a major devaluation of financial assets. Instead, it would respond by providing liquidity to stem the fall. Greenspan declared there was little the Fed could do to prevent asset bubbles but that it could always cushion the fall when those bubbles burst. By 1998, the idea that the Fed would always bail out investors after a burst bubble had become known as the “Greenspan Put.” (A “put” is a financial arrangement where a buyer acquires the right to re-sell the asset at a pre-set price.) Having seen the Fed bailout investors this way in a series of events starting as early as the 1987 stock market crash and extending through 9/11, players in the housing market had every reason to expect that if the value of houses and other instruments they were creating should fall, the Fed would bail them out, too. The Greenspan Put became yet another government “green light,” signaling investors to take risks they might not otherwise take.

As housing prices began to rise, and in some areas rise enormously, investors saw opportunities to create new financial instruments based on those rising housing prices. These instruments constituted the next stage of the boom in this boom-bust cycle, and their eventual failure became the major focus of the bust.

Fancy Financial Instruments – Cause or Symptom?

Banks and other players in the financial markets capitalized on the housing boom to create a variety of new instruments. These new instruments would enrich many but eventually lose their value, bringing down several major companies with them. They were all premised on the belief that housing prices would continue to rise, which would enable people who had taken out the new mortgages to continue to be able to pay.

Mortgages with low or even nonexistent down payments appeared. The ownership stake the borrower had in the house was largely the equity that came from the house increasing in value. With little to no equity at the start, the amount borrowed and therefore the monthly payments were fairly high, meaning that should the house fall in value, the owner could end up owing more on the house than it was worth.

The large flow of mortgage payments resulting from the inflation-generated housing bubble was then converted into a variety of new investment vehicles. In the simplest terms, financial institutions such as Fannie and Freddie began to buy up these mortgages from the originating banks or mortgage companies, package them together and sell the flow of payments from that package as a bond-like instrument to other investors. At the time of their nationalization in the fall of 2008, Fannie and Freddie owned or controlled half of the entire mortgage market. Investors could buy so-called “mortgage-backed securities” and earn income ultimately derived from the mortgage payments of the homeowners. The sellers of the securities, of course, took a cut for being the intermediary. They also divided up the securities into “tranches” or levels of risk. The lowest risk tranches paid off first, as they were representative of the less risky of the mortgages backing the security. The high risk ones paid off with the leftover funds, as they reflected the riskier mortgages.

Buyers snapped up these instruments for a variety of reasons. First, as housing prices continued to rise, these securities looked like a steady source of ever-increasing income. The risk was perceived to be low, given the boom in the housing market. Of course that boom was an illusion that eventually revealed itself.

Second, most of these mortgage- backed securities had been rated AAA, the highest rating, by the three ratings agencies: Moody’s, Standard and Poor’s, and Fitch. This led investors to believe these securities were very safe. It has also led many to charge that markets were irrational. How could these securities, which were soon to be revealed as terribly problematic, have been rated so highly? The answer is that those three ratings agencies are a government-created cartel not subject to meaningful competition.

In 1975, the Securities and Exchange Commission decided only the ratings of three “Nationally Recognized Statistical Rating Organizations” would satisfy the ratings requirements of a number of government regulations.Their activities since then have been geared toward satisfying the demands of regulators rather than true competition. If they made an error in their ratings, there was no possibility of a new entrant coming in with a more accurate technique. The result was that many instruments were rated AAA that never should have been, not because markets somehow failed due to greed or irrationality, but because government had cut short the learning process of true market competition.

Third, changes in the international regulations covering the capital ratios of commercial banks made mortgage- backed securities look artificially attractive as investment vehicles for many banks. Specifically, the Basel accord of 1988 stipulated that if banks held securities issued by government-sponsored entities, they could hold less capital than if they held other securities, including the very mortgages they might originate. Banks could originate a mortgage and then sell it to Fannie Mae. Fannie would then package it with other mortgages into a mortgage-backed security. If the very same bank bought that security (which relied on income from the mortgage it originated), it would be required to hold only 40 percent of the capital it would have had to hold if it had just kept the original mortgage.

These rules provided a powerful incentive for banks to originate mortgages they knew Fannie or Freddie would buy and securitize. The mortgages would then be available to buy back as part of a fancier instrument. The regulatory structure’s attempt at traffic signals was a flop. Markets themselves would not have produced such persistently bad signals or such a horrendous outcome. Once these securities became popular investment vehicles for banks and other institutions (thanks mostly to the regulatory interventions that created and sustained them) still other instruments were built on top of them. This is where “credit default swaps” and other even more complex innovations come into the story. Credit default swaps were a form of insurance against the mortgage-backed securities failing to pay out. Such arrangements would normally be a perfectly legitimate form of risk reduction for investors but given the house of cards that the underlying securities rested on, they likely accentuated the false “traffic signals” the system was creating.

By 2006, the Federal Reserve saw the housing bubble it had been so instrumental in creating and moved to prick it by reversing monetary policy. Money and credit were constricted and interest rates were dramatically raised. It would be only a matter of time before the bubble burst.

Deregulation, a False Culprit

It is patently incorrect to say that “deregulation” produced the current crisis [See Appendix A]. While it is true that new instruments such as credit default swaps were not subject to a great deal of regulation, this was mostly because they were new. Moreover, their very existence was an unintended consequence of all the other regulations and interventions in the housing and financial markets that had taken place in prior decades. The most notable “deregulation” of financial markets that took place in the 10 years prior to the crash of 2008 was the passing during the Clinton administration of the Gramm-Leach-Bliley Act in 1999, which allowed commercial banks, investment banks and securities firms to merge in whatever manner they wished, eliminating regulations dating from the New Deal era that prevented such activity. The effects of this Act on the housing bubble itself were minimal. Yet, its passage turned out to be helpful, not harmful, during the 2008 crisis because failing investment banks were able to merge with commercial banks and avoid bankruptcy.

The housing bubble ultimately had to come to an end, and with it came the collapse of the instruments built on top of it. Inflation-financed booms end when the industries being artificially stimulated by the inflation find it increasingly difficult to buy the inputs they need at prices that are profitable and also find it increasingly difficult to find buyers for their outputs. In late 2006, housing prices topped out and began to fall as glutted markets and higher input prices due to the previous years’ race to build began to take their toll.

Falling housing prices had two major consequences for the economy. First, many homeowners found themselves in trouble with their mortgages. The low- or no-equity mortgages that had enabled so many to buy homes on the premise that prices would keep rising now came back to bite them. The falling value of their homes meant they owed more than the homes were worth. This problem was compounded in some cases by adjustable rate mortgages with low “teaser” rates for the first few years that then

jumped back to market rates. Many of these mortgages were on houses that people hoped to “flip” for an investment profit, rather than on primary residences. Borrowers could afford the lower teaser payments because they believed they could recoup those costs on the gain in value. But with the collapse of housing prices underway, these homes could not be sold for a profit and when the rates adjusted, many owners could no longer afford the payments. Foreclosures soared.

Second, with housing prices falling and foreclosures rising, the stream of payments coming into those mortgage-backed securities began to dry up. Investors began to re-evaluate the quality of those securities. As it became clear that many of those securities were built upon mortgages with a rising rate of default and homes with falling values, the market value of those securities began to fall. The investment banks that held large quantities of securities were forced to take significant paper losses. The losses on the securities meant huge losses for those that sold credit default swaps, especially AIG. With major investment banks writing down so many assets and so much uncertainty about the future of these firms and their industry, the flow of credit in these specific markets did indeed dry up. But these markets are only a small share of the whole commercial banking and finance sector. It remains a matter of much debate just how dire the crisis was come September. Even if it was real, however, the proper course of action was to allow those firms to fail and use standard bankruptcy procedures to restructure their balance sheets.

The recession is the recovery

The onset of the recession and its visible manifestations in rising unemployment and failing firms led many to call for a “recovery plan.” But it was a misguided attempt to “plan” the monetary system and the housing market that got us into trouble initially. Furthermore, recession is the process by which markets recover. When one builds a 70-story skyscraper on a foundation made for a small cottage, the building should come down. There is no use in erecting an elaborate system of struts and supports to keep the unsafe structure aloft. Unfortunately, once the weaknesses in the U.S. economic structure were exposed, that is exactly what the Federal government set about doing.

One of the major problems with the government’s response to the crisis has been the failure to understand that the bust phase is actually the correction of previous errors. When firms fail and workers are laid off, when banks reconsider the standards by which they make loans, when firms start (accurately) recording bad investments as losses, the economy is actually correcting for previous mistakes. It may be tempting to try to keep workers in the boom industries or to maintain investment positions, but the economy needs to shift its focus. Corrections must be permitted to take their course. Otherwise, we set ourselves up for more painful downturns down the road. (Remember, the 2008 crisis came about because the Federal Reserve did not want the economy to go through the painful process of reordering itself following the collapse of the dot.com bubble.) Capital and labor must be reallocated, expectations must adjust, and the economic system must accommodate the existing preferences of consumers and the real resource constraints that producers face. These adjustments are not pleasant; they are in fact often extremely painful to the individuals who must make them, but they are also essential to getting the system back on track.

When government takes steps to prevent the adjustment, it only prolongs and retards the correction process. Government policies of easy credit produce the boom. Government policies designed to prevent the bust have the potential to transform a market correction into a full-blown economic crisis.

No one wants to see the family business fail, or neighbors lose their jobs, or charitable groups stretched beyond capacity. But in a market economy, bankruptcy and liquidation are two of the primary mechanisms by which resources are reallocated to correct for previous errors in decision-making. As Lionel Robbins wrote in The Great Depression, “If bankruptcy and liquidation can be avoided by sound financing nobody would be against such measures. All that is contended is that when the extent of mal- investment and over indebtedness has passed a certain limit, measures which postpone liquidation only tend to make matters worse.”

Seeing the recession as a recovery process also implies that what looks like bad news is often necessary medicine. For example, news of slackening home sales, or falling new housing starts, or losses of jobs in the financial sector are reported as bad news. In fact, this is a necessary part of recovery, as these data are evidence of the market correcting the mistakes of the boom. We built too many houses and we had too many resources devoted to financial instruments that resulted from that housing boom. Getting the economy right again requires that resources move away from those industries and into new areas. Politicians often claim they know where resources should be allocated, but the Great Recession of 2008 is only the latest proof they really don’t.

The Bush administration made matters worse by bailing out Bear Sterns in the spring of 2008. This sent a clear signal to financial firms that they might not have to pay the price for their mistakes. Then after that zig, the administration zagged when it let Lehman Brothers fail. There are those who argue that allowing Lehman to fail precipitated the crisis. We would argue that the Lehman failure was a symptom of the real problems that we have already outlined. Having set up the expectations that failing firms would get bailed out, the federal government’s refusal to bail out Lehman confused and surprised investors, leading many to withdraw from the market. Their reaction is not the necessary consequence of letting large firms fail, rather it was the result of confusing and conflicting government policies. The tremendous uncertainty created by the Administration’s arbitrary and unpredictable shifts – most notably Bernanke and Paulson’s September 23, 2008 unconvincing testimony on the details of the Troubled Asset Relief program – was the proximate cause of the investor withdrawals that prompted the massive bailouts that came in the fall, including those of Fannie Mae and Freddie Mac.

The Bush bailout program was problematic in at least two ways. First, the rationale for such aggressive government action, including the Fed’s injection of billions of dollars in new reserves, was that credit markets had frozen up and no lending was taking place. Several observers at the time called this claim into question, pointing out that aggregate new lending numbers, while growing much more slowly than in the months prior, had not dropped to zero.

Markets in which the major investment banks operated had indeed slowed to a crawl, both because many of their housing-related holdings were being revealed as mal-investments and because the inconsistent political reactions were creating much uncertainty. The regular commercial banking sector, however, was by and large continuing to lend at prior levels.

More important is this fact: the various bailout programs prolonged the persistence of the very errors that were in the process of being corrected! Bailing out firms that are suffering major losses because of errant investments simply prolongs the mal-investments and prevents the necessary reallocation of resources.

The Obama administration’s nearly $800 billion stimulus package in February of 2009 was also predicated on false premises about the nature of recession and recovery. In fact, these were the same false premises which informed the much-maligned Bush Administration approach to the crisis. The official justification for the stimulus was that only a “jolt” of government spending could revive the economy.

The fallacy of job creation by government was first exposed by the French economist Bastiat in the 19th century with his story of the broken window. Imagine a young boy throws a rock through a window, breaking it. The townspeople gather and bemoan the loss to the store owner. But eventually one notes that it means more business for the glazier. And another observes that the glazier will then have money to spend on new shoes. And then the shoe seller will have money to spend on a new suit. Soon, the crowd convinces them- selves that the broken window is actually quite a good thing.

The fallacy, of course, is that if the window was never broken, the store owner would still have a functioning window and could spend the money on something else, such as new stock for his store. All the breaking of the window does is force the store owner to spend money he wouldn’t have had to spend if the window had been left intact. There is no net gain in wealth here. If there was, why wouldn’t we recommend urban riots as an economic recovery program?

When government attempts to “create” a job, it is not unlike a vandal who “creates” work for a glazier. There are only three ways for a government to acquire resources: it can tax, it can borrow or it can print money (inflate). No matter what method is used to acquire the resources, the money that government spends on any stimulus must come out of the private sector. If it is through taxes, it is obvious that the private sector has less to spend, leading to losses that at least cancel out any jobs created by government. If it is through borrowing, that lowers the savings available to the private sector (and raises interest rates in the process), reducing the amount the sector can borrow and the jobs it can create. If it is through printing money, it reduces the purchasing power of private sector incomes and savings. When we add to this the general inefficiency of the heavily politicized public sector, it is quite probable that government spending programs will cost more jobs in the private sector than they create.

The Japanese experience during the 1990s is telling. Following the collapse of their own real estate bubble, Japan’s government launched an aggressive effort to prop up the economy. Between 1992 and 1995, Japan passed six separate spending programs totaling 65.5 trillion yen. But they kept increasing the ante. In April of 1998, they passed a 16.7 trillion yen stimulus package. In November of that year, it was an additional 23.9 trillion. Then there was an 18 trillion yen package in 1999 and an 11 trillion yen package in 2000. In all, the Japanese government passed 10 (!) different fiscal “stimulus” packages, totaling more than 100 trillion yen. Despite all of these efforts, the Japanese economy still languishes. Today, Japan’s debt-to-GDP ratio is one of the highest in the industrialized world, with nothing to show for it. This is not a model we should want to imitate.

It is also the same mistake the United States made in the Great Depression, when both the Hoover and Roosevelt Administrations attempted to fight the deepening recession by making extensive use of the federal government and only made matters worse. In addition to the errors made by the Federal Reserve System that exacerbated the downturn that it created with inflationary policies in the 1920s, Hoover himself tried to prevent a necessary fall in wages by convincing major industrialists to not cut wages, as well as proposing significant increases in public works and, eventually, a tax increase. All of these worsened the depression.

Roosevelt’s New Deal continued this set of policy errors. Despite claims during the current recession that the New Deal saved us from economic disaster, recent scholarship has solidly affirmed that the New Deal didn’t save the economy. Policies such as the Agricultural Adjustment Act and the National Industrial Recovery Act only interfered with the market’s attempts to adjust and recover, prolonging the crisis. Later policies scared off private investors as they were uncertain about how much and in what ways government would step in next. The result was that six years into the New Deal, unemployment rates were still above 17% and GDP per capita was still well below its long-run trend.

In more recent years, President Nixon’s attempt to fight the stagflation of the early 1970s with wage and price controls was abandoned quickly when they did nothing to help reduce inflation or unemployment. Most telling for our case was the fact that the Fed’s expansionary policies earlier this decade were intended to “soften the blow” of the dot.com bust in 2001. Of course those policies gave us the inflationary boom that produced the crisis that began in 2008. If the current recession lingers or becomes a second Great Depression, it will not be because of problems inherent in markets, but because the political response to a politically generated boom and bust has prevented the error-correction process from doing its job. The belief that large-scale government intervention is the key to getting us out of a recession is a myth disproven by both history and recent events.

The future that awaits our children

Commentators have had a field day adding up the trillions of dollars that have been committed in the Bush bailout, the Obama stimulus, and the administration’s proposed budget for 2010. The explosion of spending and debt, whatever the final tab, is unprecedented by any measure. It will “crowd out” a significant portion of private investment, reducing growth rates and wages in the future. We are, in effect, reducing the income of our children tomorrow to pay for the bills of today and yesterday.

Large government debt is also a temptation for inflation. In order for governments to borrow, someone must be willing to buy their bonds. Should confidence in a government fall enough (China, notably, has expressed some reluctance to continue buying our debt), it is possible that buyers will be hard to come by. That puts pressure on the government’s monetary authorities to “lubricate” the system by creating new money and credit from thin air.

So, even if the economy gets a lift in the near-term from either its own corrective mechanisms or from the government’s reinflation of money and credit, we have not recovered from the hangover. More of what caused the Great Recession of 2008 – easy money, regulatory interventions to direct capital in unsustainable directions, politicians and policy-makers rigging financial markets – is not likely to produce anything but the same outcome; asset price inflation and an eventual “adjustment” we call a recession or depression. Along the way, we will accumulate monumental debts which accentuate the future downturn and saddle us with new burdens.

Unless we can begin to undo the mistakes of the last decade or more, the future that awaits our children will be one that is poorer and less free than it should have been. With politicians mortgaging future generations to the tune of trillions, running and subsidizing auto and insurance companies, spending blindly and printing money hand- over-fist – all while blaming free enterprise for their own errors, we have a great deal to learn.

As Albert Einstein famously said, doing the same thing over and over again and expecting different results is the definition of insanity. The best we can hope for is that we learn the right lessons from this crisis. We cannot afford to repeat the wrong ones.

Attachment A: The Myth of Deregulation

Appendix B: Government Interventions During Crisis Create Uncertainty

Lawrence W. Reed is president of the Foundation for Economic Education in Irvington, New York—www.fee.org.This essay has been adapted for CEIL by the author from an essay he published in December 2006 issue of FEE’s journal, “The Freeman.”

In 25 years of traveling to 70 countries I’ve come across some pretty nasty governments and some darn good people. To be fair I should acknowledge that I’ve also encountered some rotten people and a half-decent government or two. The ghastliest of all worlds is when you have rotten people running nasty governments, a combination that is not by any means in short supply.

Indeed, as Nobel laureate and Austrian economist F. A. Hayek famously explained in The Road to Serfdom, the worst tend to rise to the top of all regimes—yet another reason to keep government small in the first place. “The unscrupulous and uninhibited,” wrote Hayek, “are likely to be more successful” in any society in which government dominates life and the economy. That’s precisely the kind of circumstance that elevates power over persuasion, force over cooperation, arrogance over humility.

So I take special note when I encounter instances of good people working around, in spite of, in opposition to, or simply without a helping hand from, government of any kind. Some might say this betrays an unwarranted bias. But in today’s dominant culture as represented by media elites, university bon vivants, and public-school mandarins, it is not government that gets shortchanged. By their thinking, the capacity of government to meet our needs is virtually limitless. It’s private initiative that gets the shaft. It’s the nonpolitician that is deemed unreliably compassionate, incorrigibly greedy, or hopelessly unorganized.

I offer here two stories of very good people I’ve met on opposite corners of the earth. If either story kindles anyone’s faith in what private initiative can accomplish, it’ll make my day as well as my point.

A man named Nicholas Winton is the centerpiece of the first story. He was a young London stockbroker as war clouds gathered across Europe in 1938-39. A friend convinced him to forgo a Christmas vacation in Switzerland and come to Czechoslovakia instead. Near Prague in December 1938 he was shocked to see Jewish refugees freezing in makeshift camps. Most had been driven from their homes by Nazi occupation of the Sudetenland , the part of Czechoslovakia handed over to Hitler at Munich the previous September.

Winton could have resumed his Swiss vacation, stepping back into the comfortable life he left behind. What could a lone foreigner do to assist so many trapped families? Despite the talk of “peace in our time,” Winton knew that Europe was sliding toward war and time was running out for these desperate people. The next steps he took ultimately saved 669 children from death in Nazi camps.

Victims of a socialist government’s persecution being helped by a stockbroker. Sort of makes mincemeat of Marx’s “class consciousness,” doesn’t it?

The parents were anxious to get their children to safety, even though it would mean sending them off alone. Getting the children to a country that would accept them seemed an impossible challenge. Nicholas Winton didn’t waste a minute. He wrote to governments around the world, pleading for an open door, only to be rejected by every one but two: Sweden and Great Britain . He assembled a small group of volunteers to assist with the effort. Even his mother pitched in.

With 5,000 children on his list, Winton searched for foster homes across Britain. British newspapers published his advertisements to highlight the urgent need for foster parents. When enough homes could be found for a group of children, he submitted the necessary paperwork to the Home Office and assisted his team of volunteers in organizing the rail and ship transportation needed to get the children to Britain . He took the lead in raising the funds to pay for the operation.

The first 20 of “Winton’s children” left Prague on March 14, 1939. Hitler’s troops devoured all of Czechoslovakia the very next day, but Winton’s team kept working, sometimes forging documents to slip the children past the Germans. By the time World War II broke out on September 1 the rescue effort had taken 669 children out of the country in eight separate groups by rail. The last batch of 250 would have been the largest of all, but war prompted the Nazis to stop all departures. Sadly, none of those children lived to see the Allied victory less than six years later. Pitifully few of the parents did either.

Why did Nicholas Winton take on a challenge ignored by almost everyone else? My colleague Ben Stafford and I asked him that very question at his home in Maidenhead, England in July 2006. He was then 97, but looked and spoke with the vigor of someone years younger. “Because it was the thing to do and I thought I could help,” he told us. Today, the “Winton children” plus their children and grandchildren number about 5,000 people. You can learn more about Winton at www.mackinac.org/7872. (Sir Nicholas turned 100 years of age last May.)

I do not have a name for the person who figures at the center of my second story. I met him in war-ravaged Cambodia in August 1989.

In advance of my trip to Southeast Asia, considerable local press attention focused on area doctors who donated medical supplies for me to take to a hospital in the Cambodian capital, Phnom Penh. A woman from a local church who saw the news stories called and explained that a few years before, her church had helped Cambodian families who had escaped from the Khmer Rouge communists and resettled in my town of Midland, Michigan. The families had moved on to other locations in the United States but stayed in touch with the woman who called me and other friends they had made in Midland.

The caller said she had told her Cambodian friends about my pending visit. Each family asked if I would take letters with cash enclosed to their desperately poor relatives in Cambodia . I said yes. Three of the families were in Phnom Penh and easy to find, but one was many miles away in Battambang. That would involve a train ride, some personal risk, and a lot of time it turned out I didn’t have. If I couldn’t locate any of the families, I was to give the cash to any needy Cambodian I could find.

When I realized I wasn’t going to make it to Battambang, I approached a man in tattered clothes in the hotel lobby. I had seen him there a few times before. He always smiled and said hello, and spoke enough English to carry on some short conversations. I told him I had an envelope with a letter and $200 in it, intended for a family in Battambang. I asked him if he could get it to them. “Keep $50 of it if you find them,” I instructed. We said goodbye. I assumed I would never hear anything of what had become of either him or the money.

Several months later I got an excited call from the woman who had originally called me about taking those letters. She said she had just received a letter from the Cambodians in Virginia whose family in Battambang that envelope was intended for. A line in the letter read, “Thank you for the two hundred dollars!”

That poor man found his way to Battambang all right. And he not only didn’t keep the $50 I offered, he somehow found a way to pay for the $10 train ride himself. I doubt that he applied for a federal grant.

The next time somebody tells me we can put our faith in politicians who spend other people’s money, I will tell them about what these two people did with their own.