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11.01.2008 0

Without Sound Money, Markets Fail

  • On: 11/14/2008 12:22:45
  • In: Monetary Policy
  • ALG Editor’s Note: As we noted in our lead story today, sound monetary policy is critical to long-term economic growth. In the following featured commentary, economist Lawrence Hunter makes a good case for sound money:

    Without Sound Money, Markets Fail

    By Lawrence Hunter

    Nobel Economics Laureate F.A. Hayek summed up the enigma of money succinctly:

    “Money, the very ‘coin’ of ordinary interaction, is [hence] of all things the least understood and—perhaps with sex—the object of greatest unreasoning fantasy; and like sex it simultaneously fascinates, puzzles and repels.”

    John Maynard Keynes was right about money before he was wrong when he explained the consequences of the money enigma:

    “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

    One need go no further to understand the current economic distress spreading around the world. The process of debauching the world’s currencies began 37 years ago when President Nixon severed the dollar’s last remaining links to gold. The economic-crisis point we are at today is the culmination of this failed experiment in bureaucratically managed, floating fiat currencies.

    Every specific detail of the current crisis, from the collapse in housing prices, the flood of foreclosures, the deterioration of exotic mortgage-based financial securities and credit default swaps, to failing financial institutions is ultimately derivative of a debauched dollar. Even the mischief of politicians manifested in such policies as the Community Reinvestment Act and the Government Sponsored Enterprises (Fannie Mae and Freddie Mac) cannot reach critical mass and put the financial system in extremis without the fuel of excessive credit expansion, which can never occur with sound money.

    The Federal Reserve Board has no idea what it is doing or the damage it creates attempting simultaneously to manage the fiat dollar and the real economy by manipulating interest rates. One of the great mysteries of modern economics is why economists and policy makers believe bureaucratic price fixing can succeed with interest rates when it fails so spectacularly with everything else.

    After generating enormous inflationary pressure post 9-11 by keeping real short-run interest rates negative for five straight years and generating an unsustainable credit expansion, the Fed turned around and crunched the real economy by raising interest rates with the full intent of slowing economic growth. The Fed cannot conceive of any other way to halt and reverse the inflation it creates than by staunching economic growth because it persists in the Phillips-Curve superstition that too much economic growth generates inflation.

    This bureaucratically managed interest-rate crunch on the real economy did nothing to stem inflationary impulses because it did nothing to equate the supply and demand for money, the sine qua non of a stable currency. In fact, the Fed’s contractionary interest-rate policy succeeded simply in knocking the pins out from under the fragile paper pyramid of credit it had allowed to be erected, leaving inflation unattended to and rising.

    As usual, after the Fed stimulated economy wide mal-investment and induced an artificial economic boom, the central bank compounded the damage trying to correct its mistake. By raising interest rates, the Fed caused wage growth to stagnate, increased unemployment while allowing living costs to continue rising, which ultimately generated a middle-class squeeze that generated rising defaults on home mortgages and collapsed financial derivatives based on those mortgages, which in turn lit the fuse on today’s economic crisis.

    The truth is, the only direct effect interest-rate targeting produces is on the real economy, expanding it through credit expansion or contracting it through credit withdrawal. The Fed’s impact on inflation and the value of the dollar is indirect and secondary, brought about primarily as the market demand for money fluctuates in response to changes that interest-rate manipulation induces in the real economy and through changes in the availability of credit, which impacts the supply of money in unpredictable ways. Therefore, targeting interest rates, the Fed can only get monetary policy correct—equating the supply and demand for money—accidentally and for short periods like a broken clock gets the time right twice a day.

    The results of the 37-year experiment with funny money are in: It is a spectacular failure. It is now imperative for the Congress to restrict the Fed’s ability to wreck such economic destruction by restoring the dollar’s link to gold through a gold-price rule (

    If the United States persists in the failed experiment, America’s money will continue to rot, and the government will have no choice but to resort to drastically increased financial regulation to staunch the economic spoilage this monetary putrefaction begets. Absent a restoration of sound money, increased regulation will be an unavoidably necessary evil, lest the current crisis cascade into a full-blown, global economic collapse. While bureaucratic regulation may stave off economic collapse, it ultimately will fail to restore the U.S. economy to health and vigor. Instead, it will usher in lower standards of living in the United States and other developed economies and perpetuate misery in the rest of the world.

    When a nation’s currency is sound, i.e., as good as gold, the need for bureaucratic regulation is minimal and that includes regulation of financial institutions, the bedrock of modern economies. Contrary to much of the blather one hears today about “systemic risk” due to market failure, the truth is short of war, pestilence or massive government intervention/nationalization, unsound money is really the only market dislocation powerful enough to knock markets out of kilter for long—and unsound money is always and everywhere a governmental phenomenon, not an endogenous failure of markets.

    Sound money is the best regulator of financial markets and the firms that provide financial services, and it is the best means of preventing mischief by politicians who run wild when the currency is debased. Relative prices established in competitive markets and expressed in terms of sound money reveal the different rates of substitutions that prevail among the universe of goods and services available at a point in time and between different points in time. Credit can be extended proficiently, capital can be allocated efficiently, risks can be managed prudently, and all sectors of the economy can grow at their maximum achievable rate.

    Sound money acts as a flywheel on markets, providing a self-regulating mechanism that restrains greed by relentlessly hammering down margins and dampening profits, which in turn discourages excessively risky and dishonest behavior and channels capital to its best and highest use. Future rates of return on current investment can be estimated without fear that the value of the money in which those returns will be delivered in the future will be greatly different than it is today. Speculation is minimized because its primary fuel—the market dislocations and uncertainty created by unsound money—is not in abundance. The kinds of unreasonably large returns that make risky and corrupt behavior worth the risk are not widely available.

    With sound money acting as a governor on peoples’ behavior, markets are robust, and they provide continuous negative feedback, which combines with an intricate system of market rewards and penalties causing people to adjust their behavior automatically, providing the “self-control” of human vices civilization and prosperity require. People generally “behave” because the cost/benefit ratio of “misbehavior” is too high for most people’s tastes.

    When the money is unsound however, (e.g., a fiat currency managed by a central bank) negative feedback mechanisms short circuit; price signals go haywire; information is distorted; capital is misallocated; people make bad judgments and engage in crazy, risky behavior based on bad information and outsized rewards for “misbehavior.” Positive feedback replaces negative feedback; an unsustainable boom results which results invariably in a financial implosion. If government tries to prevent the implosion and keep the binge going with more hair-of-the-dog liquidity to prop up asset prices and keep credit widely available, it only prolongs and intensifies the economic damage and generates inflation. If government then tries to stem the inflation by imposing price controls (in all their mischievous forms) to hold down the price of consumer goods, it compounds the distortions and sends the real economy into a tailspin.

    An unsound currency is particularly debilitating for financial markets and the firms that provide the money-related services that power modern economies. Money, acting as a medium of exchange, eliminates the need for barter by making possible the indirect exchange of goods among a wide variety of traders spread out in time and over large geographic areas. Financial institutions provide services to facilitate that indirect exchange: Banks facilitate indirect investment of capital by extending loans to credit-worthy enterprises and entrepreneurs; insurance companies manage risks both real and financial by exchanging the promise of security in the future for current money premiums. Both endeavors require monetary certainty to make the inter-temporal exchanges work.

    When the value of money is certain, only a minimal amount of government regulation is required to ensure the safety and soundness of the financial system if, that is, society is willing to expose depositors and insurance policy holders to the risk of occasional failures of particular financial institutions—in other words subject them to the creative destruction that Joseph Schumpeter rightly characterized as the essence of free markets. To the extent that a nation’s money is debauched, the self-regulating character of markets is corrupted. And if in addition society tries to shield depositors and insurance policy holders from the consequences of any random failure of a financial institution (by re-insuring citizens through government programs such as deposit insurance and state-operated insurance programs), it introduces significant moral hazard that corrodes the market’s self-regulating capacity even further.

    The sad conclusion is, the greater the combined damage that government’s monetary and morally hazardous policies inflict on markets’ self-regulatory mechanism, the more that artificial bureaucratic regulation must substitute for the natural regulation markets otherwise produce. Markets do not fail spontaneously except in the most extraordinary circumstances; bad government policy makes them fail. The great irony is, once governments cause markets to fail, unless it changes the policies that created the failure, there is no option but for government to step in to “correct” the failure. It is, therefore, not “conservative” for politicians to resist bureaucratic regulation of financial institutions to mitigate the havoc they themselves wrought while simultaneously continuing to support the unsound monetary policy and morally hazardous financial policies that created the problem; it is hypocritical and foolhardy.

    Dr. Larry Hunter is a former staff director of the Congressional Joint Economic Committee and current President of the Social Security Institute.

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