Thursday, July 8, 2010

Competitive Currencies Instead of the Euro Monopoly by Richard M. Ebeling

A new study prepared by the Dutch financial institution, ING, called “Quantifying the Unthinkable,” has warned that a collapse of the Euro as the European single currency would lead to a global economy cataclysm. The worldwide banking system would face a new and far more disastrous crisis than the one experienced during the last two years. A real economic depression would threaten the planet.

If Europe is facing such a catastrophe it must not be forgotten that it is the making of the governments and the monetary central planners who imposed the Euro on the people of Europe. And like Dr. Frankenstein, they are now terrified of the consequences of the monster they have created.

It is important to remember that the Euro is not a market-generated institution. It is a political creation inspired by the French and German governments in opposition to the desires and choices of their own citizens. Public votes on the implementation of the Euro were avoided like the plague, and in those countries where the people had a say, the answer was often a resounding, “No.” Only “outside” political pressures and fears drove more countries into the Euro-Zone, when in fact economic integration and prosperity were all possible without a monopoly currency over the continent.

The political elites in Europe, and especially in France, wanted a European-wide currency as a means to have global power against the financial and political dominance of the United States in the post-Soviet era. It was viewed as a tool in the “great game” of international diplomacy and strategic influence. All the references to the “transaction costs” saving from a single currency stretching from the Atlantic to the borders of Russia were secondary propaganda to the wider political goals: a United States of Europe centrally controlled and regulated from Brussels, with special influence on its policies emanating from Paris and Berlin.

But even from the narrower economic perspective, all the rationales for a single currency issued and managed by a European central bank were examples of what Austrian economist and Nobel Laureate, Friedrich A. Hayek, once called the “pretense of knowledge.”

We need to remember that central banking is a form of central planning. A central bank possesses monopoly control of the money supply. It determines the quantity of money in circulation and therefore influences the value, or purchasing power, of the monetary unit. It can also influence (at least in the short run) some market rates of interest, which can affect the amount and direction of investment.

Throughout the twentieth century, governments again and again have used their central banks to finance budget deficits through money creation—and have continued to do so in the 21st century. The end-products of such monetary mischief have been prolonged periods of price inflation, which eat away at people’s accumulated wealth; distort market prices resulting in imbalances between savings and investment, and supply and demand; and create disincentives for long-term business planning and capital formation.

Thirty-five years ago, Hayek warned of the dangers from European-wide monopoly money, and made the case for competitive currencies among which the citizenry may freely choose (See, F. A. Hayek, Choice in Currency: A Way to Stop Inflation, published by the London-based Institute of Economic Affairs in 1975).

Hayek explained that due to the influence of Keynesian economics over monetary and macroeconomic policy, governments were invariably guided by short-run goals in the service of special interest groups. The consequence was the constant abuse of the printing press, with its resulting price inflation, to feed the seemingly insatiable demands of those privileged and politically influential groups.

Hayek concluded that some method had to be found to free ordinary citizens from the government’s monopoly control over the medium of exchange. The answer, he suggested, is to allow them to use whatever money they choose. Hayek said:

There could be no more effective check against the abuse of money by the government than if people were free to refuse any money they distrusted and to prefer money in which they had confidence. Nor could there be a stronger inducement to governments to ensure the stability of their money than the knowledge that, so long as they kept the supply below the demand for it, that demand would tend to grow. Therefore, let us deprive governments (or their monetary authorities) of all power to protect their money against competition: if they can no longer conceal that their money is becoming bad, they will have to restrict the issue.

Make it merely legal and people will be very quick indeed to refuse to use the national currency once it depreciates noticeably, and they will make their dealings in a currency they trust.

The upshot would probably be that the currencies of those countries trusted to pursue a responsible monetary policy would tend to displace gradually those of a less reliable character. The reputation of financial righteousness would become a jealously guarded asset of all issuers of money, since they would know that even the slightest deviation from the path of honesty would reduce the demand for their product.

Governments remain today, as much as when Hayek spoke these words, under the sway of political ideologies that insist it is the duty of the state to regulate the market in the service of powerful special-interest groups, to redistribute wealth, and to secure “safety nets” under most aspects of everyday life. The budgets and deficits of many EU countries, and the fiscal crisis they have now gotten themselves into demonstrate this beyond any doubt.

The Euro’s monetary central planners still presume to have the wisdom and ability to target rates of price inflation and move interest rates in directions they consider “optimal.” I would suggest that just as the central planners in the old Soviet Union were not wise or informed enough to successfully plan the supply of shoes and the production of bread, the managers of the European Central Bank cannot know what interest rates should be or what target to set for the general level of prices. Interest rates should be set by the market to bring the actual supply of savings into balance with the demand for loans. Both the general level and the relative structure of prices should be determined by those same market forces, that is, people’s willingness to trade money for goods and goods for money.

It is said that the Chinese word for “crisis” means both “danger” and “opportunity.” It is certainly the case that the fiscal irresponsibility of most of the European Union governments has put the economic and financial structures of their countries in grave danger. But hoping that the European Central Bank can set it all right – or to delay the inevitable until some “someday” when “something” will provide a way out without the consequences of decades of fiscal mismanagement – will only mean truly dangerous inflationary forces being set loose. Because the only way for the European Central Bank to try to “paper over” this problem is by printing a lot of paper money. And Europe has already seen several times where that leads during the last hundred years.

The “opportunity” from this crisis is to admit and accept that the Euro plan was a wrong idea. It is necessary for the member governments in the Euro-Zone to begin a new plan for an “orderly retreat” back to national currencies. This is not the first time that a single currency has had to be dissolved into separate national currencies. This happened in 1919, following the disintegration of the old Austro-Hungarian Empire in Central Europe; or more recently with the collapse in 1991 of the Soviet Union into fifteen independent republics, or the splitting of Czechoslovakia into two separate countries, or the breakup of Yugoslavia.

There are lessons to be learned from these historical cases that should be carefully studied and applied to begin and complete the process of bringing the Euro “experiment” to a close with the least pain and disruption in a financial and fiscal environment in which each of the European governments will have to get their own economic affairs in order.

Even in the short run, however difficult the transition will be, those European countries that have less of a fiscal problem to get into order will at least be able to avoid being pulled into a worst vortex by their more irresponsible fiscal neighbors, if they remained within a single currency zone.

In addition, if a new multi-currency world reemerged in Europe, it should be accompanied, as Hayek suggested, with the freedom for the citizens of all of these nations to choose which currencies they prefer to hold and use in exchange. National governments should not attempt to lock their respect citizens behind barbed-wire currency barriers and restrictions.

Market freedom in money would act as a powerful force and incentive for the individual European governments to move in a more fiscally responsible direction, if they do not want to see their own national currency dramatically depreciate relative to other monies. This would serve as an additional and important “external” discipline, as Hayek also emphasized, to try to get political elites to move their domestic policies into more stable and sustainable paths.

Or will Europe continue on its present course, and go over a fiscal and monetary cliff that it otherwise might have avoided?

Monday, July 5, 2010

The Hubris of Central Bankers and the Ghosts of Deflation Past by Richard M. Ebeling

In 2003, while the United States was at the end of another boom and bust cycle following the bursting of the "" bubble and the Y2K scare, there were many monetary central planners at the Federal Reserve and the European Central Bank who were expressing fears about the danger of "deflation" and the supposed perils it could create for the economies of the United States and the Europe.

Alan Greenspan and Ben Bernanke at the Federal Reserve and Otmar Issing at the European Central Bank were delivering speeches claiming to explain what they meant by "deflation" and what the U.S. and European central banks could and would do to prevent any deflationary forces that might come into play.

The same fears about deflation have been frequently expressed over the last two years during the current economic crisis. But the central bankers have not expressed what they mean by deflation and what they would do if it occurred with the clarity and detail with which they explained it in 2002 and 2003.

The following is an article that I wrote at that time on "The Hubris of the Central Banker and the Ghosts of Deflation Past."

I explain the different meanings of deflation and their significance. I also critically analyze what our central bankers', including the current chairman of the Federal Reserve, Ben Bernanke, generally mean by deflation and why their "solutions" would make any supposed deflationary "problem" even worse.

One fact should be pointed out in terms of the current economic crisis. There has been no monetary deflation -- that is, an absolute decrease in the quantity of money and credit in the economy. Just the opposite. Since 2008, the Federal Reserve has increased the total amount of reserves in the banking system by around $1.5 trillion, mostly by buying up many of those "toxic" mortgages that were guaranteed by Fannie Mae and Freddie Mac.

This huge expansion in the potential quantity of money and credit that could flood through the financial markets and generate significant price inflation has been held off the market due to the fact that the Federal Reserve has been paying banks interest to hold those sums as unlent reserves. With key market interest rates being kept artificially low at near zero or one percent through activist Fed policy, banks have found it more profitable earn that positive rate of interest at the Federal Reserve.

But unless the Fed finds some way to drain those "excess reserves" out of the banking system, significant inflationary -- not deflationary -- forces may be at work looking to the next few years ahead.


Nearly 75 years after the great stock-market crash of 1929, monetary policy is still haunted by the ghost of the Great Depression. The severity of the American stock-market decline during the last three years has again awakened fears among some policymakers that the economic downturn might bring about a deflationary period of collapsing output and employment like that experienced during the early 1930s.

Prominent members of the board of governors of the Federal Reserve System, as well as a senior member of the executive board of the European Central Bank, have delivered public addresses attempting to assure the financial community that it is in the power and ability of monetary central planners to prevent a repetition of the Great Contraction of 1930–33. On November 21, 2002, Federal Reserve governor Benjamin S. Bernanke delivered his address “Deflation: Making Sure ‘It’ Doesn’t Happen Here” to the National Economists Club in Washington, D.C.

About a month later, on December 19, 2002, Federal Reserve Chairman Alan Greenspan discussed the dangers of and remedies for any deflationary threat at the Economic Club of New York in an address entitled “Issues for Monetary Policy.” And on December 2, 2002, European Central Bank Executive Board member Otmar Issing evaluated “The Euro after Four Years: Is There a Risk of Deflation?” at the 16th European Finance Convention in London, England.

What is deflation? Its general connotation, of course, is something “bad.” During a period of deflation, prices in general in the economy are decreasing and this is considered to generate negative consequences in terms of falling output, rising unemployment, investment uncertainty, and broad market instability and collapse.

But before the rationales for an “activist” monetary policy to combat deflation can be judged, it is first necessary to know what can be the causes behind a general decline in prices. And it is additionally useful to clarify the role of government in past episodes of price deflation.

It is possible to distinguish at least three causal factors behind a general fall in prices. They are: supply-side deflation, price-wage rigidity deflation, and monetary deflation.

Supply-Side Deflation

A general decline in prices may accompany significant increases in output resulting from productivity increases and cost efficiencies. One of the competitive forces in the market economy is the never-ending drive of entrepreneurs to bring better and less-expensive goods and services to market to the consuming public. New technologies and cost-saving innovations introduced within business enterprises enable more goods to be manufactured and sold at lower per-unit costs. Sellers, in one sector of the economy after another, increase their supplies offered on the market, and competitive pressure results in a lowering of the prices of those goods over time to reflect their lower costs of production. The cumulative effect is that the general level of prices will have declined when measured by various statistical price indices over a period of time.

In the period between the end of the American Civil War in 1865 and 1900, the general level of prices in the United States declined by about 50 percent. While the American economy did experience short periods of economic depression during those years (mostly due to the federal government’s manipulation of the monetary standard), the nearly half-century era during America’s Industrial Revolution saw a dramatic rising standard of living even though accompanied by an expanding population.

An open, free-market system tends to foster the incentives and profitable rewards for capital investment and innovation that bring forth increasing prosperity. Greater output at falling prices provides people with higher real income as each dollar they earn now buys a larger quantity of goods and services in the marketplace. Supply-side deflation, therefore, is an indication of a growing and dynamic market system that is improving the economic conditions and opportunities of the general population.

Price-Wage Rigidity Deflation

All economic change brings with it shifts in market demand-and-supply conditions. Continuous adjustment and balance within the market requires those affected by change to adapt to the new circumstances. In a world of constant change, the demands for some goods increase while other demands decline. Innovations and technological advancements as well as changing resource availability bring with it shifts in the demand and supply of various forms of labor and capital. The information about these changes and the incentives to appropriately respond to them are provided to people in the market through changes in the structure of relative prices and wages.

Any failure of prices and wages to correctly reflect the new patterns of market supply and demand only generates distortions, imbalances, and maladjustments between the two sides of the market. Under the influence of Keynesian economics, for most of the last 70 years, the resulting unemployment and falling output due to price and wage rigidities has been called “aggregate-demand failures.”

The presumption has been that the level of total demand for goods and services in the economy in general falls short of the total supply of goods and services available for sale at prices equal to their costs of production. The problem, it is said, is not that prices and wages are “wrong” on the supply side but rather that aggregate spending is “too low” on the demand side. The policy presumption has been that government and its monetary authority must increase total demand, either through government deficit spending or the central bank’s printing money and providing it for private investment and other purposes.

The free-market economist W.H. Hutt gave a refutation to this Keynesian reasoning in his two works A Rehabilitation of Say’s Law (1974) and The Keynesian Episode (1979). Hutt argued that when the Keynesians referred to excess aggregate supply and an apparent weakness of aggregate demand to purchase that supply, they were looking through the wrong end of the telescope. There cannot be an “aggregate” excess supply unless there is a super-abundance of all resource inputs and consumer-demanded outputs, at which point there would no longer be an “economic problem” because there would no longer be scarcity. Why bother whether all are employed when the society has reached the point where it is so rich in all desired things that there is no longer any work left to be done?

What can exist is an oversupply of particular goods relative to the demand for them at the prices at which they are being offered for sale. What is preventing the buying of more of these goods is not that the aggregate demand is “too low” but rather that the particular prices for these goods are set too high, given the consumer demands for them.

In other words, the sellers of these goods or labor services are pricing themselves out of the market. As Hutt expressed it, “No one can purchase unless someone else sells.... Every act of selling and buying requires that the would-be seller price his product to permit the sale and that the would-be buyer offer a price which the seller accepts.”

It is in the unwillingness of resource owners to price their products and services at levels commensurate with consumer demand that Hutt found the cause of prolonged depressions. “Discoordination in one sector of the economy will, if there are price rigidities in other sectors, bring about those successively aggravating reactions, one decline in the flow of services inducing another,” he said. When a supplier is unwilling to lower his price or wage to induce greater sales when demand for his particular good or service turns out to be less than he had, perhaps, expected, then a part of his supply remains unsold and a portion of the labor services available for hire remains unemployed.

The loss of income due to a producer’s or worker’s maintaining his supply price too high relative to actual market demand results in a decrease in his ability to purchase the goods and services of others being offered on the market. If the suppliers of those goods and services, in turn, refuse to adjust their prices and wages downwards, given the now-lower demand for their output, then the circle of unsold products and unemployed labor starts to expand. A “cumulative contraction” of output and employment may develop in the face of such a network of relatively rigid prices and wages. As Hutt’s old teacher at the London School of Economics, Edwin Cannan, expressed the problem in 1933 during the Great Depression, “General unemployment appears when asking too much is a general phenomena.”

This problem arose in the early 1930s following an inflationary monetary policy by the Federal Reserve during most of the 1920s. What fooled many people at the time was the illusion of price-level stability through most of the 1920s. The high level of productivity increases and cost efficiencies during those years would have resulted in gently falling prices, as outputs of many goods and services were expanding. But the Federal Reserve’s expansionary policy prevented prices from falling as measured by most of the standard price indices.

This monetary expansion, however, fed an unsustainable investment boom that finally burst in 1929. The malinvestment of capital and the misallocation of resources, including labor, during the boom years required significant adjustments through various sectors of the economy to restore balance and economic growth. But numerous government economic policies prevented or delayed the necessary price and wage adjustments, causing the rising tide of increasing unemployment, falling production, business bankruptcies, and bank failures.

(For a detailed analysis of the causes and cures of the Great Depression from an "Austrian Economic" perspective in contrast to that of Keynesian Economics, see, Richard M. Ebeling, Political Economy, Public Policy, and Monetary Economics: Ludwig von Mises and the Austrian Tradition (New York: Routledge, 2010), Ch. 7: "The Austrian Economists and the Keynesian Revolution: the Great Depression and the Economics of the Short Run," pp. 203-272.)

Hutt also emphasized that since the problem is incorrect pricing of particular goods and services, or “disequilibrium,” the lowering of any such price or wage to its market-clearing level “will tend to initiate a positive ‘real multiplier’ effect — a cumulative rise in activity and real income. . ..” In other words, whenever a price or wage that is too high is lowered closer to its equilibrium or market-clearing level, suppliers of those goods and services increase their sales and potentially earn higher income. Their higher incomes from pricing their goods and services more correctly, in turn, enable them to increase their demands for other goods and services and thus start a process of expanding the circle of employment and production opportunities in the market. Market-guided pricing puts the unemployed back to work and releases the flow of demand for a growing circle of goods in the economy.

Monetary Deflation

A general decline in prices can also be brought about by a monetary deflation. A contraction in the supply of money and credit reduces the amount of money in people’s hands with which they can demand the various goods and services they wish to buy in the market. With less money to spend, there invariably results a downward pressure on prices and wages in general in the economy. If there are the kinds of price and wage rigidities discussed above, then the process of restoring balance between market supplies and demands at a required lower scale or level of prices can be prolonged and punctuated by “depressionary” unemployment and lower production.

Under central banking, monetary contractions are government-made. There have been instances when governments have intentionally contracted the money supply. The British government did so after the war with Napoleon in the early 19th century and then again after the First World War in the early 1920s. Other times it has happened as a result of the central-bank-managed fractional-reserve system, under which outstanding bank liabilities are a multiple of the actual reserves to meet all depositor obligations. In the early 1930s, bank loans went bad, depositors withdrew their funds out of fear of bank closings, and the amount of bank credit outstanding contracted as a multiple of the reserves withdrawn by depositors.

Throughout the second half of the 1990s, the Federal Reserve System maintained an expansionary monetary policy. By various measurements of the monetary aggregates, between 1995 and 2000 the supply of money and credit in the United States economy increased between 35 and 50 percent. During this same period, general consumer prices annually increased in the neighborhood of 1 to 2.5 percent. A leading explanation for the failure of prices to dramatically rise during these years was the significant increases in productivity, cost reductions, and increases in output of many goods across the economy. In other words, a replay in many ways of what was experienced in the second half of the 1920s before 1929.

But whereas there was a 30 percent decrease in the U.S. money supply between 1929 and 1933, since the stock-market decline began in 2000 the Federal Reserve has kept the monetary spigots wide open. Between 2000 and the end of 2002, the supply of money in the United States economy increased by about 18 percent, or about 9 percent a year. There is nothing in recent Fed monetary policy to suggest that there has been a decline in the supply of money and credit. If anything, the Federal Reserve has followed a high expansionary policy.

What then are Benjamin Bernanke, Alan Greenspan, and Otmar Issing concerned about? Each of them in his public address insisted that there were no signs or indications of present or immediate deflationary tendencies in either the U.S. or EU economies. They each seemed determined to assure those in the financial markets that if there were any tendencies for a deflationary process setting in, they — the monetary authorities of the United States and Europe — were ready and willing to work whatever monetary magic was needed to prevent a replay of the early 1930s.

Thus, they were soothing psychological fears, especially in a situation of already low interest rates. If nominal interest rates sank to zero percent, how could the central bank manipulate interest rates to try to stimulate private sector investment spending? Wouldn’t the central banking authority then be left with no weapons to fight a deflationary spiral, if one were to set in? How then would the economy escape from a collapse similar to that experienced in the Great Depression?

The questions, of course, imply that (a) the central bank should adopt an activist policy to influence the direction and currents of the market; (b) the central bank has the wisdom and ability to stabilize the economy; and (c) central-bank intervention and manipulation will not make the situation worse than if the market is left to find its own path back to balance and coordination.

Bernanke, Greenspan, and Issing are confident on all three points. But their believing does not make it so. Indeed, their statements and analyses of the danger of deflation show just how deeply ingrained is the hubris of the monetary central planners around the world.


In spite of the fact that the monetary policies of the Federal Reserve System in the United States and the European Central Bank (ECB) have been highly expansionary during the current economic downturn, central bankers at both institutions have taken the time to deliver addresses assuring their listeners that there is no need for the public to fear a return to the deflationary experiences of the early 1930s. Alan Greenspan and Benjamin Bernanke of the board of governors of the Federal Reserve Bank and Otmar Issing of the executive board of the European Central Bank have laid out their understanding of what deflation means and its consequences as well as their proposals to combat deflation if it appears.

Bernanke defined deflation as a persistent decline in the general level of prices and assigned its cause to:

"a collapse of aggregate demand — a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending — namely, recession, rising unemployment, and financial stress."

Greenspan added, “Although the U.S. economy has largely escaped any deflation since World War II, there are some well-founded reasons to presume that deflation is more of a threat to economic growth than is inflation.” And Issing insisted that “the ECB is concerned about risks of deflation as well as inflation.”

Lowering Interest Rates

The first piece of monetary weaponry at the disposal of the central bankers, they explained, is the tried and true method of lowering short-term interest rates by buying short-term government securities and supplying additional lending reserves to the banking system. The increased reserves at lower interest rates are meant to stimulate private-sector investment spending to generate the additional “aggregate demand” for goods and services in the economy.

But what if a deflationary process has set in and nominal interest rates have fallen to zero? How will the central bankers stimulate borrowing when there is no longer any room to lower interest rates?

Have no fear, because then the Federal Reserve can always start buying longer-term government securities with maturities extending out anywhere from 10 to 30 years. If this were still to fail to do the trick, then the Federal Reserve can coordinate its money-creation process with direct expenditure by the U.S. government by printing all the money required to cover additional government deficit spending.

As Greenspan expressed it,

"If deflation were to develop, options for an aggressive monetary response are available.
. . . The Federal Reserve has authority to purchase Treasury securities of any maturity and indeed already purchases such securities as part of its procedure to keep the overnight [interest] rate at its desired level. This authority could be used to lower interest rates on longer maturities."

And in the words of Bernanke,

"Indeed, under a fiat (that is, paper) money system, a government (in practice the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero…. The U.S. government has a technology, called a printing press (or, today, its electronic equivalent) that allows it to produce as many U.S. dollars as it wishes at essentially no cost.... We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

Since prevention is always better than having to suffer from a cure, the central bankers emphasize that the generally accepted standard of “price stability” for monetary policy does not mean zero inflation, i.e., a stable price level as measured by various price indices. No, price stability is defined as low inflation.

Issing says that the risk of any deflation “can be substantially reduced by making sure that inflation does not fall below some safety margin — say below a threshold of 1 percent — on a sustained basis.”

Bernanke concurs that “the Fed should try to preserve a buffer zone for the inflation rate; that is, during normal times it should not try to push inflation down all the way to zero.” Instead, the Federal Reserve should have an inflation target between 1 and 3 percent a year.

Monetary Bubbles

Greenspan sees the source of many economic downturns, and any deflationary dangers that may accompany them, in the bursting of asset-price bubbles on the financial markets. The problem, in his view, is that “bubbles tend to deflate not gradually and linearly but suddenly, unpredictably, and often violently.”

Thus the “evidence of recent years, as well as the events of the late 1920s, casts doubt on the proposition that bubbles can be defused gradually.”

But where do such “bubbles” come from? It is difficult to see how they are inherent in a free-market economy that is not being fed by increases in the supply of money and credit. If there were a wave of innovations that spark an increase in investment demand, the additional demand for borrowing would push up interest rates.

That would create an incentive for some income earners in the society to decrease their consumption spending and increase their savings to take advantage of the higher rate of interest.

Any direct purchase of equity shares of possibly more profitable enterprises available on the stock exchange also would have to be financed either through a decline in consumption or a decrease in bond purchases. Either way, there are no inflationary pressures, because the increase in one type of expenditure must be matched with a decrease in some other kinds, given no change in the total supply of money in the economy.

Of course, when there is investment in new products and technologies, there is always the possibility and danger of over-optimism about the cost-efficiencies being introduced or the degree of future consumer demand before the new product is actually marketed to the buying public. But even if there are losses suffered, due to a decline in the share prices of the companies applying the new technologies or marketing the new products, there would be share prices of other companies that would now be more attractive to purchase, given the actual pattern of consumer demand.

The only way that asset prices on the financial markets can be significantly rising while consumer goods and other prices do not decline, or even rise as well, is for the total quantity of money and credit available in the economy to have been increased. Then people would have enough money to maintain both their levels and patterns of spending and have the additional means to increase their demand for equity shares or bonds. If there is a financial and speculative “bubble,” it is due to the central banks providing the monetary means to feed it. Thus, the very financial bubble that has so worried Greenspan and other central bankers is the result of the expansionary policies of their own central banks.

Monetary Policy and Recession

If either the Federal Reserve or the European Central Bank pursues as its policy goal a rate of monetary expansion sufficient to keep prices from falling over time in a growing economy, or even if they pursue a policy of low inflation, they are likely to set the stage for the very type of economic downturn that they are so determined to prevent.

As Austrian economist Friedrich Hayek argued long ago, in a growing economy experiencing productivity increases and cost-efficiencies, prices for goods will have to fall over time as more goods and less expensively produced goods come on the market. Given the consumer demands for those goods, the only way the larger supplies coming on the market can find willing buyers is through decreases in the prices at which they are offered to the public.

If, however, the central bank wishes to prevent this “supply-side deflation” from occurring, it can do so only by injecting additional money into the economy. In the United States the Federal Reserve increases funds by purchasing government securities (through what are known as “open-market” purchases). This, in turn, increases the supply of reserves available in the banking system for lending purposes. To attract additional borrowing, banks lower their interest rates, which often stimulates an increase in longer-term investment projects.

But the additional borrowing at the lower rate of interest now causes total investment spending to be greater than the total amount of actual savings set aside for lending purposes by income earners in the society. In fact, savings may actually decrease: at the now lower market rates of interest the attractiveness of savings decreases even while investment spending is expanding. Thus, in the name of price stability (possibly defined as “low inflation”), an imbalance is created between savings and investment in the economy.

This imbalance eventually requires corrections, with investment spending reduced and redirected to be consistent with the actual available supply of savings. When this investment “bubble” bursts, the market value of some capital investments will have to be written down or possibly even written off. Labor suppliers in some of the overextended sectors of the economy will have to be redirected into alternative employment consistent with the actual patterns of consumer demands for various goods. The same applies to the utilization and applications of many other resources and raw materials.

If capital-asset owners or resource suppliers, including workers, resist the necessary and inevitable decline in the prices and wages for their products and services in these misdirected employments, they succeed only in pricing themselves out of the market. Their incomes fall and their ability to demand other goods declines commensurately.

The demands for an array of other goods now experience a decrease, with resulting downward pressure on prices and wages in the affected sectors of the economy. If those producing the goods and supplying the labor in those sectors also resist required reductions in prices and wages, then the circle of unemployment and idle resources expands. And the pressure for prices and wages to adjust downwards only intensifies over time as the overhang of unsold goods and unemployed labor increases.

It should be clear that this type of “price-wage rigidity deflation” cannot be cured by the magic of paper-money inflation, contrary to what Bernanke and Greenspan may think. It may be true that such a monetary expansion can directly increase the demand for goods and services when financing government deficit spending. And it may be true that if the central bank has room to lower interest rates, it might stimulate some investment borrowing that might not otherwise be occurring if interest rates remained at a higher level. But this does not solve the fundamental problems of malinvestments and misallocation of labor and resources resulting from the preceding “boom” and “bubble.”

Monetary Policy and Inflation

The product demand and employment opportunities created by direct government spending clearly can be maintained only for as long as the government continues its higher level of real spending. Any decrease in the amount of deficit expenditure for the particular goods and services demanded by the government will bring about a fall in the production of those goods and a decline in the employment opportunities of the workers drawn into those activities by the initial higher level of government spending.

Likewise, central-bank stimulus of additional private-sector investment spending to create production and employment opportunities in the face of deflationary pressures merely sets the stage for a future decline in investment activity. The investment projects that may have begun are dependent for their completion and maintenance on a continuing expansion of money and credit to sustain their existence.

Thus, an unstable inflationary process is set into motion in an attempt to get around the problem of unsold products, diminished investment activity, and unemployed workers caused by the unwillingness of some to adjust their price and wage demands in a downward direction to more correctly reflect the actual conditions prevailing on the market. As Austrian economist Ludwig von Mises noted years ago,

The course of the boom is not any different because, at its inception, there are unused productive capacity, unsold stocks of goods, and unemployed workers…. The beginning of every credit expansion encounters such remnants of older, misdirected capital investments and apparently “corrects” them. In actuality, it does nothing but disturb the workings of the adjustment process.

The continuing hubris of the central banker can be seen in his failure to fully appreciate that it has been his own monetary policies that have created the unstable booms and bubbles that he complains about and criticizes. And even when he admits that central bankers have erred in the past and have produced those very consequences to which they object, he continues to believe that “next time” they will get it right.

Otmar Issing has been more open about the limitations on the powers of central banking than others of his clan. For example, in an address delivered in Paris on December 9, 2002, he discussed these problems in “Monetary Policy in a World of Uncertainty.” He admitted that central bankers (a) know little about the prevailing economic conditions in the market because of imperfect information and faulty factual data; (b) have no way of knowing what the appropriate equilibrium patterns throughout the market should be, because they have no demonstrably “correct” model of the economy and its precise interdependent relationships; and (c) cannot be sure how and in what form private-sector actors in the market will interpret and react to policies implemented by the central bank, and thus what interdependent outcomes will be forthcoming when the policies of the central bank intersect with the actions of the market participants.

At the same time, if the central banker is to have some capacity to influence the direction of market activities, Issing believes that “there are limits to the degree of transparency that central banks can realistically be expected to supply.” In other words, the central banker cannot tell the public what it plans to do or why because then the market actors might respond in ways that would more or less completely foil the central banker’s plan.

Yet Issing wants monetary “policy to be predictable in order to reduce uncertainty and volatility in financial markets.” Thus, he wants the central banker to have his cake and eat it too. The reason he wants such secretive flexibility is that “a monetary authority should lead financial markets and not ‘follow them.’”

Why? Because, he says, private traders in financial markets operate on the basis of “ludicrously short time horizons” while the central banker maintains the proper “long-term” perspective.

Here is the monetary central planner who admits his inherent inability to know enough to plan but who just cannot give up the ghost and let the multitudes of market participants find their own way in the marketplace. The lingering appeal of social engineering just remains too strong. The hubris just cannot be foresworn.

(This article originally appeared in two parts in Freedom Daily (February and March 2003), published by the Future of Freedom Foundation, Fairfax, Va.)

Friday, July 2, 2010

A Declaration of Independence Against Big Government by Richard M. Ebeling

The Declaration of Independence, signed by members of the Continental Congress on July 4, 1776, is the founding document of the American experiment in free government. What is too often forgotten is that what the Founding Fathers argued against in the Declaration was the heavy and intrusive hand of big government.

Most Americans easily recall those eloquent words with which the Founding Fathers expressed the basis of their claim for independence from Great Britain in 1776:

"We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty, and the Pursuit of Happiness – That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed – That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness."

But what is usually not recalled is the long list of enumerated grievances that make up most of the text of the Declaration of Independence. The Founding Fathers explained how intolerable an absolutist and highly centralized government in faraway London had become. This distant government violated the personal and civil liberties of the people living in the 13 colonies on the eastern seaboard of North America.

In addition, the king’s ministers imposed rigid and oppressive economic regulations and controls on the colonists that was part of the 18th-century system of government central planning known as mercantilism.

“The history of the present King of Great Britain is a history of repeated injuries and usurpations, all having in direct object the establishment of an absolute Tyranny over these States,” the signers declared.

At every turn, the British Crown had concentrated political power and decision-making in its own hands, leaving the American colonists with little ability to manage their own affairs through local and state governments. Laws and rules were imposed without the consent of the governed; local laws and procedures meant to limit abusive or arbitrary government were abrogated or ignored.

The king also had attempted to manipulate the legal system by arbitrarily appointing judges that shared his power-lusting purposes or were open to being influenced to serve the monarch’s policy goals. The king’s officials unjustly placed colonists under arrest in violation of writ of habeas corpus, and sentenced them to prison without trial by jury. Colonists often were violently conscripted to serve in the king’s armed forces and made to fight in foreign wars.

A financially burdensome standing army was imposed on the colonists without the consent of the local legislatures. Soldiers often were quartered among the homes of the colonists without their approval or permission.

In addition, the authors of the Declaration stated, the king fostered civil unrest by creating tensions and conflicts among the different ethnic groups in his colonial domain. (The English settlers and the Native American Indian tribes.)

But what was at the heart of many of their complaints and grievances against King George III were the economic controls that limited their freedom and the taxes imposed that confiscated their wealth and honestly earned income.

The fundamental premise behind the mercantilist planning system was the idea that it was the duty and responsibility of the government to manage and direct the economic affairs of society. The British Crown shackled the commercial activities of the colonists with a spider’s web of regulations and restrictions. The British government told them what they could produce, and dictated the resources and the technologies that could be employed. The government prevented the free market from setting prices and wages, and manipulated what goods would be available to the colonial consumers. It dictated what goods might be imported or exported between the 13 colonies and the rest of the world, thus preventing the colonists from benefiting from the gains that could have been theirs under free trade.

Everywhere, the king appointed various “czars” who were to control and command much of the people’s daily affairs of earning a living. Layer after layer of new bureaucracies were imposed over every facet of life. “He has erected a multitude of New Offices, and sent hither swarms of Officers to harass our people, and eat out their substance,” the Founding Fathers explain.

In addition, the king and his government imposed taxes upon the colonists without their consent. Their income was taxed to finance expensive and growing projects that the king wanted and that he thought was good for the people, whether the people themselves wanted them or not.

The 1760s and early 1770s saw a series of royal taxes that burdened the American colonists and aroused their ire: the Sugar Act of 1764, the Stamp Act of 1765, the Townsend Acts of 1767, the Tea Act of 1773 (which resulted in the Boston Tea Party), and a wide variety of other fiscal impositions.

The American colonists often were extremely creative at avoiding and evading the Crown’s regulations and taxes through smuggling and bribery (Paul Revere smuggled Boston pewter into the West Indies in exchange for contraband molasses.)

The British government’s response to the American colonists’ “civil disobedience” against their regulations and taxes was harsh. The king’s army and navy killed civilians and wantonly ruined people’s private property. “He has plundered our seas, ravaged our Coasts, burnt our towns, and destroyed the lives of our people,” the Declaration laments.

After enumerating these and other complaints, the Founding Fathers said in the Declaration:

"In every stage of these Oppressions We have Petitioned for Redress in the most humble terms: Our repeated Petitions have been answered only by repeated injury. A Prince whose character is thus marked by every act which may define a Tyrant, is unfit to be the ruler of a free people."

Thus, the momentous step was taken to declare their independence from the British Crown. The signers of the Declaration then did “mutually pledge to each other our Lives, our Fortunes and our sacred Honor,” in their common cause of establishing a free government and the individual liberty of the, then, three million occupants of those original 13 colonies.

Never before in history had a people declared and then established a government based on the principles of the individual’s right to his life, liberty, and property. Never before was a society founded on the ideal of economic freedom, under which free men may peacefully produce and exchange with each other on the terms they find mutually beneficial without the stranglehold of regulating and planning government.

Never before had a people made clear that self-government meant not only the right of electing those who would hold political office and pass the laws of the land, but also meant that each human being had the right to be self-governing over his own life. Indeed, in those inspiring words in the Declaration, the Founding Fathers were insisting that each man should be considered as owning himself, and not be viewed as the property of the state to be manipulated by either king or Parliament.

It is worth remembering, therefore, that what we are celebrating every July 4 is the idea and the ideal of each human being’s right to his life and liberty, and his freedom to pursue happiness in his own way, without paternalistic and plundering government getting in his way.