Last week, a group of top economists, among them any number of Nobel laureates, signed a letter endorsing Republican presidential candidate Mitt Romney’s economic plan. These economists indicated that as president, Romney would do six salutary things.
Romney would reduce taxes, control spending, limit and improve regulation, make social security and Medicare sustainable, reform healthcare according to a market model, and devise sensible energy policy.
All very good stuff. After these past three years of quite the opposite, as we’ve suffered with 13 million unemployed, we need all of these things.
But one big thing is missing. Where is the plank on monetary reform?
Ever since the Federal Reserve started its money-printing exercises when the Great Recession hit (indeed even before, as the Fed stoked the housing bubble), the public has been onto the fact that something is wrong with this nation’s monetary order. Hence the Rep. Ron Paul (and Herman Cain) presidential candidacy last year, the big sales of Rep. Paul’s book End the Fed, and the run-ups in commodity prices typified by gold at $1600 an ounce.
It’s been pretty clear to people in general this past half decade that the Fed has acted inappropriately as we have endured the preamble to the economic crisis as well as the thing itself. It would appear that to the public at large, no program to rescue our economy from its terrible funk could possibly be credible unless it gives primacy of place to monetary concerns.
What is the set of principles behind the government’s conduct of monetary policy? It’s a hard question to answer. The Constitution gives the United States the power “to coin money” and “regulate the value thereof” and to fix exchange rates with respect to foreign coin. But clearly, the Federal Reserve has moved far beyond this little rubric as goes the basis of its operations. “Price stability in the context of full employment,” “smoothing out booms and busts,” “making an orderly environment for federal financing,” “being the lender of last resort,” “talking away the punch bowl before the party gets going,” “preventing another Great Depression”—these are the guiding lights, real winners all of them, you hear about when it comes to our central bank.
And what do we get? A banking system gorged with reserves, and an economic growth rate desperate for 2% coming out of a deep, dark recession. Where’d we go wrong?
Out of the gate, the U.S. economy doubled in size in a dozen years after the ratification of the Constitution in 1789. Over the next some hundred years, until the creation of the Fed in 1913, the economy increased only…75-fold. Pretty quaint, that monetary system outlined by the Constitution.
Something got lost in the transition after 1913, as the Fed started to pile on ersatz first principles of monetary policy, such as the laugh lines above. Now we have a “modern” economy with “modern” institutions—and modern sluggishness. Before our modern economy, we had one that grew like gangbusters.
One of the presidential candidates from last fall, Herman Cain, was shrewd enough to cut through the rationalizations and spell out, anew, what first principles for monetary policy should look like in the 21st century. These principles hark back to the things that made the American economy the greatest in the world in the years before the Fed: the Constitution and the gold standard.
I’ve seen the gold standard blamed for a lot of things in my day—the busts of the 19th century, the travails of the farmer back when, the Great Depression—but I’d never thought I’d see the blame for the serial economic crises we’re enduring today, in 2012, hung on the gold standard. After all, isn’t the gold standard long gone? Never say never, because here’s the headline that came last Friday, care of Project Syndicate: “Is Europe on a Cross of Gold?”
The article was written by Barry Eichengreen, the Berkeley economics professor and longstanding deprecator of gold. Alas, it disappointed; the headline was misleading. In the article, Professor Eichengreen had some things to say about gold’s culpability in past crises, but he did not bring himself to implicate gold in the Euro-travail of today. The article said that though the current European crisis has shades of old gold-era crises, it remains substantially different.
All right. The gold standard is not to blame for the current crisis. Good to hear. But do we have to have Barry Eichengreen piling on the old gold standard once again as he did in the introduction to the article? For Eichengreen has done more than arguably any other individual to create and sustain the false impression that the gold standard caused the Great Depression.
Here’s what professor Eichengreen said in the article: “I wrote the book on Europe and the gold standard. Literally. In Golden Fetters: The Gold Standard and the Great Depression , I argued that the deflationary engine that was the gold standard was a key cause of the 1930s depression, and that abandoning it opened the door to recovery.”
Now hold it right there. There is only one valid title, and it isn’t Golden Fetters: The Gold Standard and the Great Depression, that can issue from the following sentence: “I wrote the book on Europe and the gold standard. Literally.” Because the gold standard was generally in operation in Europe from the 1870s to 1914, sometimes before this period, but most certainly not after. The title has got to be something like The Great Gold Years: The Plumpest Prosperity the World Had Ever Known, 1871-1914. Heck, didn’t Roger Shattuck write a book about this period called The Banquet Years?
In the preface to the twenty-year anniversary (1982) edition of Capitalism and Freedom, Milton Friedman had reason to gloat. He got to point out that since its publication in 1962, the book had sold 400,000 copies despite not getting reviewed, as Friedman put it, “by any national publication—not by the New York Times…or by Time or Newsweek,” the latter having sponsored beginning in 1966, on the strength of Capitalism and Freedom, an immensely popular column of Friedman’s. Friedman also could observe that by the time his next magnum opus had rolled around (1980’s Free to Choose, co-authored with his wife Rose), it was already set up on publication with a television deal and the expectation of huge print runs.
In 1982, in addition, Ronald Reagan was president of the United States and Margaret Thatcher prime minister of the United Kingdom, with Friedman advising the former in an official capacity. It was fairly clear at that point that the principles and recommendations of Capitalism and Freedom stood an excellent chance of being realized in policy and practice over a good portion of the developed world.
And yet it remains true that today, even given the free-market revolution that swept through the advanced world a generation and some ago, there are not too many concrete things in Capitalism and Freedom that one can identify as normative. Indeed, the most commonly cited “victory” of Capitalism and Freedom is the institution of an all-volunteer military in the United States, and that achievement dates from quite early on, 1973.
Now to be sure, many things have moderated in the direction indicated by Capitalism and Freedom a half a century ago. There has been a considerable degree of trade liberalization across the globe since the 1980s; the progressive income tax got cut down such that since 1987, 40% is the closest we in the United States have come to the top rate that prevailed in 1962 of 91%; and there has been a round of welfare reform. But some signature items still seem a universe away, above all the cause to which the Friedmans dedicated their last years: voucher-led school reform.
There is one item in Capitalism and Freedom, however, that has had a rather splendid career since shortly after the book came out, and the results have been at best ambiguous. This concerns the very center of the Friedman expertise: monetary arrangements. Two chapters of the book, those on “The Control of Money” and “International Trade Arrangements,”go over policy reforms that by and large have been adopted. We can see, and not altogether to our pleasure, where we have been led by them.
Certainly, Friedman did not get his wish in “The Control of Money” chapter such that “I would specify that the Reserve System shall see to it that the total stock of money so defined rises month by month…at an annual rate of X percent, where X is some number between 3 and 5.” But in the 1980s and 1990s, it did become a rage in monetary policy circles, particularly in the Federal Reserve of the United States, to adhere to the central tenet of that chapter, which was for central banks to specify and follow a “rule” for monetary policy, instead of leaving things up to discretion.
The “Great Moderation” in economic performance that the United States enjoyed from 1982 to 2007, where yearly GDP growth was good (about the same as it had been in the generation after World War II), but with demonstrably less quarterly variation, is by and large understood to correlate to the Fed’s adoption of rule-like behavior, in particular its adherence in the 1990s to the “Taylor Rule.” Named after Stanford economist John B. Taylor, the Taylor Rule basically says that the Fed should watch the price level and tighten and loosen with an eye to keeping that level nearly flat. Friedman did not prefer price-level targeting in “The Control of Money.” But the larger point was in favor of rule-based monetary policy, and one should say that the salutary results that came from following this lead were for some time quite palpable.
Things are not so rosy when it comes to the success of Friedman’s recommendations for the international monetary system. For it is quite possible that absent Friedman’s strenuous efforts, fully on display in Capitalism and Freedom, for the dismantling and packing off of the international gold standard, its former advocates would not have dispatched it to the grave so comprehensively in the early 1970s, with results that have only given the world economy an air of general crisis since.
As the “International Trade Arrangements” chapter spelled out, “The U.S. should announce that it no longer commits itself to buy gold at any fixed price;” “The U.S. should announce that it will not proclaim any official exchange rates between the dollar and any other currencies….These would be determined in free markets;” and “Other nations might choose to peg their currencies to the dollar. That is their business….” All of these things happened in the early 1970s, first when the U.S. went off gold in 1971, then when the fixed exchange rate system blew up in 1973, and then when a few brave souls (eventually and most famously China) insisted on a peg to the dollar despite it all.
We need not remind ourselves, surely, that inflation took off like a rocket globally, and particularly in the United States, in the wake of these events. Friedman’s old dictum that “inflation is always and everywhere a monetary phenomenon” took on almost comic piquancy in that the abolition of the control which was gold convertibility gave central banks the go-ahead to print money with abandon. In turn, the prices of commodities, particularly gold, shot up beyond belief (gold went up 23-fold in the decade after 1971), indicating that a new cost had been imposed on the world economy. There needed to be some asset class (commodities) where one could hide in the event of the decimation of the very medium of exchange.
Now again, Friedman wanted there to be a two-step process whereby gold and fixed rates were abandoned and rule-based money stock growth was implemented. But in arguing so strenuously for the former, and perhaps not as audibly for the latter, Friedman advanced the process whereby we got the stagflationary 1970s. Indeed, it was once said by economics Nobel Prizewinner Robert A. Mundell (a colleague and interlocutor of Friedman’s at the University of Chicago) that it was an “alliance made in hell” that did away with gold and fixed rates. This functional alliance was between Friedman, whose “free-market” sensitivities were offended by the limitations of convertibility and fixed rates, and socialists who wanted to be loose of monetary-policy constraints so they could fund the state’s takeover of the real sector. It is fair to say that Capitalism and Freedom was not sufficiently attuned to the uses to which the opposition could put some of its arguments.
Inflation was not eliminated under the rule-based regimes of central banking of the 1980s and 1990s. 3% per year was the norm—this representing a more than 50% devaluation of the currency every generation. And in time—the early and mid-2000s—the rule-like behavior was departed from, resulting in mad dashes for the dollar hedges represented by commodities of all sorts, from gold to oil to land (which is to say housing). The conditions which had arisen by the time of the crash in 2008 are simply unthinkable had there been a commitment to a gold standard in years prior.
As for fixed exchange rates, it turns out that the one country that stuck to them against all advice and counsel, China, rode them to a most remarkable crescendo of economic development and modernization. When China pegged to the dollar in 1994, it was a backward command economy, its only point of light a small-scale agricultural sector made relatively free fifteen years before. By fixing to the dollar, the price structure of a free economy—the United States—was duplicated in the communist country, and information about the real costs of things began to roll in, touching off wave upon wave of investment and production that resulted in one of the most stunning growth stories of all time.
It is said that in later years Friedman came to regret the “money mischief,” so to speak, that his advocacy for floating exchange rates may have encouraged. At this late date, we may think it is difficult to return to the halcyon days when a dollar was a constant in value and massive swings in the worth of foreign exchange did not disrupt balance sheets and the financial sector the world over. But this is largely because we have become so inured, intellectually, to the misnomer that a free market in money must mean a departure from money’s convertibility to gold.
Federal Reserve Chairman Ben Bernanke has been taking a lot of flak for his series of speeches at George Washington University over the last few weeks. Commentators have marveled at his mischaracterization of the gold standard and his defensiveness at the suggestion that loose Fed monetary policy of the early and mid-2000s played a role in causing the housing bubble—and thus the Great Recession.
But today I come to praise Bernanke, not to bury him. There are some nuggets in these speeches that are positively meritorious. They should be put in lights and applauded.
In particular, in his second speech a week and a half ago, on March 22, Bernanke totally piled on the Phillips curve. The Phillips curve, you might remember, is that scourge of monetary policy the world over that holds that there is a trade-off between unemployment and inflation. The logic is that money-printing that gooses inflation will in turn increase employment, in that low interest rates will make it easier for firms to hire people.
In the 1950s, when the doctrine was first elucidated, and in the 1960s and 1970s, the Phillips curve gulled central bankers left and right, above all at the U.S. Fed. The memory of the Great Depression of the 1930s and its hideous unemployment rate was still fresh, and the Phillips curve appeared to offer a magic bullet for precisely that problem. Print money and get inflation—a disamenity, to be sure, but a mild one—and watch the most dreaded thing of all, unemployment, decline.