The Revolution (16 page)

In the short run, a false prosperity takes root. Business expands. New construction is everywhere. People feel wealthier. This is why there is always such political pressure on the Fed to lower rates around election time: the prosperity comes in the short run, and the painful correction comes much later, well after people have cast their votes.

As these borrowers spend the money they borrowed and compete with each other for resources, the result is a rise in prices and interest rates. This is how the economy reveals that more long-term projects have been begun than can be sustained in light of current resource availability. Some of them have to be abandoned, with all the dislocation that entails: layoffs, squandered capital, misdirected resources, and so on.

Interest rates were at their initial level for a reason: savings were low, and therefore with little for investors to borrow, the price of borrowing (i.e., the interest rate) was high. Had market-determined interest rates prevailed, investors would have been discouraged from excessive borrowing to finance long-term projects, and the result would have been sustainable investment and growth. Interest rates set by the market coordinate the production process in accordance with real economic conditions. Only the most profitable, socially demanded projects would have been undertaken. When the Federal Reserve artificially lowers rates, on the other hand, it systematically misleads investors and encourages unsustainable economic booms. F. A. Hayek’s Nobel Prize in economics, which was awarded to him in 1974, had to do with exactly this: showing how central bank manipulation of interest rates and money cause havoc throughout the economy, and set the stage for an inevitable bust.

The Fed often tries to delay the day of reckoning, the painful period when the malinvestments are liquidated and the economy is restored to true health. It will cut rates yet again. The false prosperity continues, but the problem of malinvestment only gets worse. The Fed cannot carry on the charade forever: if it inflates without end, it risks hyperinflation and the destruction of the currency. In some cases, central banks find, after resorting time and again to inflation as a way of encouraging economic activity, that their policies no longer have any discernible effect. The system is simply exhausted.

The Japanese economy provides a vivid example of the futility of manipulating interest rates. Japan was in the economic doldrums throughout the 1990s despite its central bank’s rate cuts. Ultimately, interest rates were cut to
zero
, where they remained for several years. The rate-cutting failed to stimulate the economy. Prosperity cannot be created out of thin air by a central bank.

This is one reason I was delighted to learn that comedian Jon Stewart, when he had former Fed chairman Alan Greenspan on his program, asked him why we needed a Federal Reserve, and why interest rates couldn’t simply be set freely on the market. That was a great question, the sort of question noncomedians in America never seem to ask, and Greenspan sputtered around for a response. Even Greenspan supporters were shocked to observe how poorly he responded to a simple question about the very purpose of the institution he headed for nearly two decades.

Central economic planning has been as discredited as any idea can possibly be. But even though we point to our devotion to the free market, at the same time we centrally plan our monetary system, the very heart of the economy. Americans must reject the notion that one man, whether Alan Greenspan, Ben Bernanke, or any other chairman of the Federal Reserve Board, can know what the proper money supply and interest rates ought to be. Only the market can determine that. Americans must learn this lesson if we want to avoid continuous and deeper recessions and to get the economy growing in a healthy and sustainable fashion.

Few Americans during his tenure knew that Greenspan had once been an outspoken advocate of the gold standard as the only monetary system that a free society should consider. Not long after my return to Congress in the election of 1996, I spoke with Greenspan at a special event that took place just before he was to speak in front of the House Banking Committee. At this event congressmen had a chance to meet and have their pictures taken with the Fed chairman. I decided to bring along my original copy of his 1966 article from the
Objectivist Newsletter
called “Gold and Economic Freedom,” an outstanding piece in which he laid out the economic and moral case for a commodity-based monetary system as against a fiat paper system. He graciously agreed to sign it for me. As he was doing so, I asked if he wanted to write a disclaimer on the article. He replied good-naturedly that he had recently reread the piece and that he would not change a word of it. I found that fascinating: could it be that, in his heart of hearts, Greenspan still believed in the bulletproof logic of that classic article?

Shortly afterward, I decided—perhaps a bit mischievously—to bring up that article and the arguments raised in it during a subsequent Greenspan appearance before the Committee. But the Federal Reserve Chairman was less sympathetic to those arguments when I raised the subject out in the open. He replied that his views had changed since that article was written, and he even advanced the preposterous assertion that the Fed did not facilitate government expansion and deficit spending.

Greenspan’s real views, however interesting as a piece of trivia, are ultimately unimportant. It is the system itself that matters. In the same way, it is absurd for the Fed chairman to come to Congress and complain that the real problems in the economy stem from deficit spending and that it is solely Congress and its recklessness with the budget that is at fault. That is not so: it is the
entire system
that is to blame. Congress could not get away with spending beyond our means year after year if we did not have a Federal Reserve System ready to finance it all by purchasing bonds with money it creates out of thin air.

What the issue boils down to is: do we want a monetary system that politicians can manipulate to their advantage? Do we want them to have the ability to pay for all their extravagance by printing the money they need, thereby imposing a hidden tax on all Americans by eroding the value of our dollar?

Gold cannot be mined as cheaply as Federal Reserve notes can be printed. Nor can its supply be manipulated on a daily basis. There is a great dispersion of power in a gold standard system. That is the strength of the system, for it allows the people to check any monetary excesses of their rulers and does not allow the rulers to exploit the people by debasing the money.

The gold standard has historically been a bulwark against inflation. It is politically manipulated money such as we have had since the 1930s that causes our inflation. That should not be unexpected, or difficult to understand. The supply of gold is relatively fixed and grows only modestly. But in a free economy, capital investment leads to ever-greater productivity, and the ability to produce more and more goods over time. So with gold relatively stable on the one hand and the supply of goods growing by leaps and bounds on the other, the gold will tend to be worth more and more, and the prices of these goods will be lower and lower.

History bears this out. An item that cost $100 in 1913 (when the Federal Reserve Act was passed) would cost $2014.81 in 2006. An item that cost $100 in 2006 would have cost $4.96 in 1913. As we can see, the dollar has lost nearly all its value since the Fed was established. Now, if the gold standard had brought about such an outcome, we would never hear the end of all the howls of outrage. But the Fed does it and . . . utter silence. The Fed has managed to insulate itself from the kind of criticism that is normally directed at all other institutions that harm Americans.

And in fact the gold standard did no such thing. People’s money increased in value under the gold standard. They were not looted by inflation. An item that cost $100 in 1820 would have cost only $63.02 in 1913.

The Federal Reserve now no longer reports the figures on M3, the total money supply. Spokesmen claim that among the reasons for this change is that it costs too much money to gather these figures—this from an institution that creates however much money it wants, is off the books, and is never audited. To the contrary, the real reason we don’t get these figures anymore, I am certain, is that they are too revealing. They tell us more about what the Fed has been up to and the damage it has been doing to our dollar than they care for us to know.

Any government that inflates the money supply runs the risk of hyperinflation, which occurs when the money supply is increased so much as to render the currency completely worthless. It can occur very quickly and suddenly, and has a very rapid snowballing effect.

The textbook case in the twentieth century took place in Germany in 1923 (although a worse hyperinflation occurred in Hungary after World War II). When in that year the French occupied the Ruhr Valley, an industrial and resource-rich part of western Germany, the German government encouraged workers there to go on a general strike and refuse to work. It paid their salaries during that strike by simply printing the necessary money.

But the process spun out of the government’s control. People could see their money was losing value. They knew that the longer they held it, the less it would buy. So they rushed out to buy anything they could, since just about anything was worth more than the valueless pieces of paper that German marks were rapidly becoming. And the more they spent, the higher prices rose, leading still more people to unload their currency on whatever was for sale in anticipation of still higher prices in the future. The result was the complete ruin of the German mark, which German children began gluing together to make kites and German adults burned in order to keep warm.

Who can be surprised to learn that it was also in 1923 that Adolf Hitler made his first attempt to seize power? Intolerance and extremism always find a readier audience in unfavorable or (as in this case) chaotic economic times.

In the United States, November 2007 alone saw wholesale prices increase by 3.2 percent—an annualized rate of nearly 40 percent. With all manner of bailouts contemplated for mortgage lenders and a Federal Reserve committed to ever more money creation, are we so sure that hyperinflation could not occur here? In fact, that outcome becomes more likely every day.

Inflation of the money supply also produces financial bubbles and instability. The monetary inflation of the 1990s helped yield $145 billion in profits for the NASDAQ companies between 1996 and 2000. That entire amount was then lost in a single year—not to mention the trillions of dollars of paper losses in stock values from their peak in early 2000. Politicians are all tears and pity about large stock-market losses, but they never make a connection between the bubble economy and the monetary inflation generated by the Federal Reserve. Congress has chosen instead to blame the analysts for misleading investors—a drop in the bucket compared to the misleading information for which the Federal Reserve has been responsible, what with the artificially low interest rates it has brought about and a financial market made flush with generous new credit at every sign of a correction over the past ten years. By preventing the liquidation of bad debt and the elimination of malinvestment and overcapacity, the Federal Reserve’s actions help keep financial bubbles inflated and make the eventual collapse all the more severe.

It is this, the Fed’s policy of artificially cheap credit, that caused the housing bubble that has caused so many Americans so much grief. Banks, awash in reserves created out of thin air by the Fed, began making mortgage loans to just about anyone. With credit freely available, people bought larger and more expensive homes than would otherwise have made sense. They were set up for disaster, when reality would inevitably reassert itself amid the fantasy world the Fed had created. Using Money Zero Maturity figures, we find that the increase in mortgage debt since the 2001 recession is equal to the Fed’s increase in the money supply. That is where the new money went, and it is where the housing bubble came from.

And it wasn’t just that people were enticed by all the available credit into living beyond their means. The housing bubble caused them to make other destructive and unwise decisions as well. With real estate prices artificially inflated, people felt wealthier. In light of how wealthy the value of their homes made them feel, they saved less. And as economist Mark Thornton puts it, Americans began using their homes as giant ATMs to withdraw cash from the equity they had built up.

The 1990s witnessed a dramatic upward trend in new housing starts. Revealingly, no downturn in housing starts was observed during the 2001 recession, the only recession on record in which no such downturn has taken place.

Few Americans will be surprised at the statistics: between 1998 and 2005, home prices increased by 45 percent. As Thornton points out, that figure is all the more remarkable when we remember all the forces that were simultaneously putting downward pressure on home prices, including new home-building technology, an increased supply of lower-priced labor, mainly from Mexico, and the fact that new housing tends to be built on lower-priced land. That prices could nevertheless rise so sharply is a sign of the severity of the bubble.

All this has real consequences for real people. As the bubble bursts, many will face foreclosure or bankruptcy and will see their credit ratings decimated. Construction firms will face hard times, and unemployment in the industry will rise sharply. The effects on the wider economy could be equally devastating.

In the midst of this disaster, where are those who will point the finger where it belongs? Who will call the Federal Reserve to account for injecting into the economy all the funny money that created the housing bubble in the first place?

Former Fed chairman Alan Greenspan once boasted that the Fed’s policy had helped many more people buy homes. Those boasts became scarcer as the bubble began to burst and people’s lives were thrown into turmoil. Government intervention always has unintended consequences that cause harm, a truism that applies just as strongly to interventions into the monetary system. Devastated homeowners are only the latest victims.