economics articles

8/14/2019 Economics Articles

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Is it the "Economy, Stupid" by Murray N.Rothbard

Is it the "Economy, Stupid"?

One of the persistent Clintonian themes of the 1992 campaign still endures: if "it's theeconomy, stupid," then why hasn't President Clinton received the credit among the public forour glorious economic recovery? Hence the Clintonian conclusion that the resoundingDemocratic defeat in November, 1994, was due to their failure to "get the message out" tothe public, the message being the good news of our current economic prosperity.

Some of the brighter Clintonians realized that the President and his minions had beenrepeating this very message endlessly all over America; so they fell back on the implausible

alternative explanation that the minds of the voting public had been temporarily addled bylistening to Rush Limbaugh and his colleagues.

So what went wrong with this popular line of reasoning? As usual, there are many layers offallacy contained in this political analysis. In the first place, it's crude economic determinism,what is often called "vulgar Marxism." While the state of the economy is certainly importantin shaping the public's political attitudes, there are many non-economic reasons for public

protest.

The public is particularly exercised, for example, about crime, gun control, the flood ofimmigration, and the continuing wholesale assault by government and the dominant liberal

culture upon religion and upon "bourgeois" as well as traditional ethical principles.

Other non-economic reasons: a growing pervasive skepticism about politicians keeping theirpledges to the voters, a skepticism born of hard-won experience rather than of some infectionby a [p. 16] bacillus of "cynicism." Afortiori removed from economics is an intense revulsionfor the president, his wife, and their personal traits ("the character question"), a visceralresponse that made a powerful impact on the election.

But even apart from the numerous non-economic motivations for political attitudes andactions by the public, the common "it's the economy" argument even leaves out some of theimportant features of economic-based motivation in politics. For the famous Clintonian

slogan does not even begin to focus on all the relevant features of the economy.

Instead, to capture the Clintonian meaning, the sentiment should be rephrased as "it's thebusiness cycle, stupid." For what the Clintonians and the media are really advocating is"vulgar business-cycle determinism": if the economy is booming, the ins will be reelected: ifwe're in recession, the public will oust the ruling party.

The "Business cycle" may at first appear to be equivalent to "the economy," but in fact it isnot. There are vital aspects of the economy felt by the voters that are not cyclical, not part ofa boom-bust process, but that rather reflect "secular" (long-run) trends. What's happening totaxes and to secular living standards, and among such standards the intangible, unmeasurable

but vital concept of the "quality of life," is extremely important, often more so than whetherwe are technically in the expansion or contraction phase of the cycle.


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Indeed, the major economic grievance agitating the public has little or nothing to do with thecycle, with boom or recession: it is secular and seemingly permanent, specifically a slow,inexorable, debilitating decline in the standard of living that grinds down the people's spiritas well as their pocketbooks. Taxes, and the tax bite into their earnings, keep going up, on the

federal, state, county, and local levels of government. Semantic disguises don't work anymore: call them "fees," or "contributions," or "insurance premiums," they are taxesnevertheless, and they are increasingly draining the people's substance.

And while Establishment economists, statisticians, and financial experts keep proclaimingthat "inflation has been licked," that "structural economic factors preclude a return toinflation," and [p. 17] all the rest of the blather, all consumers know in their hearts andwallets that the prices they pay at the supermarket, at the store, in tuition, in insurance, inmagazine subscriptions, keep going up and up, and that the dollar's value keeps going downand down.

The contemptuous charge by economic "scientists" that all this experience by consumers ismerely "anecdotal," that hard quantitative data and their statistical manipulations demonstratethat economic growth is lively, that the economy is doing splendidly, that inflation is over,and all the rest, doesn't cut any ice either. In the end, all this "science" has only succeeded inconvincing the public that economic and statistical experts rank up there with lawyers and

politicians as a bunch of--how shall we put it?--"dis-information specialists."

If everything is going so well, the public increasingly wants to know, how come youngmarried couples today can no longer afford the standard of living enjoyed by their parentswhen they were newlyweds? How come they can't afford to buy a home of their own? One ofthe glorious staples of the American experience has always been that each generation expects

its children to be better off than they have been. This expectation was never the result ofmindless "optimism"; it was rooted in the experience of each preceding generation, whichindeed had been more prosperous than their parents.

But now the reality is quite the opposite. People know they are worse off than their parents,and therefore they rationally expect their children to be in still worse shape. Everywhere youturn you get a similar answer: "Why couldn't you construct a new building with the samesturdy qualities as this (50-year old) house? . . . . Oh, we couldn't afford to build it that waytoday."

Even official statistics bear out this point, if you know where to look. For example, the

median real income in dollars, (that is, corrected for inflation) of American families is lowerthan it was in 1973. Then, if we disaggregate households, we get a far gloomier picture.Family income has not only been slightly reduced; it has collapsed in the last twenty years

because of the phenomenal increase of the proportion of married women in the workforce.

This massive shift from motherhood and the domestic arts to the tedium of offices and timeclocks has been interpreted by our dominant liberal culture as a glorious triumph of feminismin [p. 18] liberating women from the drudgery of being housewives so that they can developtheir personalities in a fulfilling career. While this may be true for some occupations, one stillhears on every side, once again, that the "reason I went to work is because we could nolonger afford to live on one salary."

Again, since there is no way to quantify subjective motivations, we can't measure this factor,


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but I suspect that the great bulk of working women, i.e. those in non-glamorous careers, areonly working to keep the family income from falling steeply. Given their druthers, I suspectthey would happily return to the much-maligned "Ozzie and Harriet" family of the

Neanderthal era.

Of course, there are some sectors of the economy that are indeed growing rapidly, whereprices are falling instead of rising; notably the computer industry, and whatever emergesfrom the much-hyped "information superhighway," when, at some wonderful point in thenear or mid-future, Americans can drown their increasing miseries in the glories of 500interactive, digital, cybernetic channels, each offering another subvariant of mindless pap.

This is a future that may satisfy techno-futurist gurus like Alvin Toffler and Newt Gingrich,but the rest of us, I bet, will become increasingly unhappy and ready to lash out at thepolitical system that--through massive taxation, cheap money and credit, social insuranceschemes, mandates, and government regulation--has brought us this secular deterioration,and has laid waste to the American dream.

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Murray N. Rothbard (1926-1995) was professor of economics at the University of Nevada,Las Vegas.

Ten Great Economic Myths by Murray N.

Rothbard


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Ten Great Economic Myths

Our country is beset by a large number of economic myths that distort public thinking on

important problems and lead us to accept unsound and dangerous government policies. Hereare ten of the most dangerous of these myths and an analysis of what is wrong with them. [p.19]

Myth 1: Deficits are the cause of inflation; deficits have nothing to do with inflation.

In recent decades we always have had federal deficits. The invariable response of the partyout of power, whichever it may be, is to denounce those deficits as being the cause of

perpetual inflation. And the invariable response of whatever party is in power has been toclaim that deficits have nothing to do with inflation. Both opposing statements are myths.

Deficits mean that the federal government is spending more than it is taking in in taxes.Those deficits can be financed in two ways. If they are financed by selling Treasury bonds tothe public, then the deficits are not inflationary. No new money is created; people andinstitutions simply draw down their bank deposits to pay for the bonds, and the Treasuryspends that money. Money has simply been transferred from the public to the Treasury, andthen the money is spent on other members of the public.

On the other hand, the deficit may be financed by selling bonds to the banking system. If thatoccurs, the banks create new money by creating new bank deposits and using them to buy the

bonds. The new money, in the form of bank deposits, is then spent by the Treasury, andthereby enters permanently into the spending stream of the economy, raising prices andcausing inflation. By a complex process, the Federal Reserve enables the banks to create thenew money by generating bank reserves of one-tenth that amount. Thus, if banks are to buy$100 billion of new bonds to finance the deficit, the Fed buys approximately $10 billion ofold Treasury bonds. This purchase increases bank reserves by $10 billion, allowing the banksto pyramid the creation of new bank deposits or money by ten times that amount. In short, thegovernment and the banking system it controls in effect "print" new money to pay for thefederal deficit.

Thus, deficits are inflationary to the extent that they are financed by the banking system; theyare not inflationary to the extent they are underwritten by the public.

Some policymakers point to the 1982-83 period, when deficits were accelerating and inflation

was abating, as a statistical "proof' that deficits and inflation have no relation to each other.This is no proof at all. General price changes are determined by two [p. 20] factors: thesupply of, and the demand for, money. During 198283 the Fed created new money at a veryhigh rate, approximately at 15 % per annum. Much of this went to finance the expandingdeficit. But on the other hand, the severe depression of those two years increased the demandfor money (i.e. lowered the desire to spend money on goods) in response to the severe

business losses. This temporarily compensating increase in the demand for money does notmake deficits any less inflationary. In fact, as recovery proceeds, spending picked up and thedemand for money fell, and the spending of the new money accelerated inflation.

Myth 2: Deficits do not have a crowding-out effect on private investment.

In recent years there has been an understandable worry over the low rate of saving and


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investment in the United States. One worry is that the enormous federal deficits will divertsavings to unproductive government spending and thereby crowd out productive investment,generating ever-greater long-run problems in advancing or even maintaining the livingstandards of the public.

Some policymakers once again attempted to rebut this charge by statistics. In 1982-83, theydeclare deficits were high and increasing while interest rates fell, thereby indicating thatdeficits have no crowding-out effect.

This argument once again shows the fallacy of trying to refute logic with statistics. Interestrates fell because of the drop of business borrowing in a recession. "Real" interest rates(interest rates minus the inflation rate) stayed unprecedentedly high, how-ever--partly

because most of us expect renewed inflation, partly because of the crowding-out effect. Inany case, statistics cannot refute logic; and logic tells us that if savings go into government

bonds, there will necessarily be less savings available for productive investment than therewould have been, and interest rates will be higher than they would have been without the

deficits. If deficits are financed by the public, then this diversion of savings into governmentprojects is direct and palpable. If the deficits are financed by bank inflation, then thediversion is indirect, the crowding-out now taking place by the new money "printed" by thegovernment competing for resources with old money saved by the public. [p. 21]

Milton Friedman tries to rebut the crowding-out effect of deficits by claiming that allgovernment spending, not just deficits, equally crowds out private savings and investment. Itis true that money siphoned off by taxes could also have gone into private savings andinvestment. But deficits have a far greater crowding-out effect than overall spending, sincedeficits financed by the public obviously tap savings and savings alone, whereas taxes reducethe public's consumption as well as savings.

Thus, deficits, whichever way you look at them, cause grave economic problems. If they arefinanced by the banking system, they are inflationary. But even if they are financed by the

public, they will still cause severe crowding-out effects, diverting much-needed savings fromproductive private investment to wasteful government projects. And, furthermore, the greaterthe deficits the greater the permanent income tax burden on the American people to pay forthe mounting interest payments, a problem aggravated by the high interest rates broughtabout by inflationary deficits.

Myth 3: Tax increases are a cure for deficits.

Those people who are properly worried about the deficit unfortunately offer an unacceptable

solution: increasing taxes. Curing deficits by raising taxes is equivalent to curing someone'sbronchitis by shooting him. The "cure" is far worse than the disease.

One reason, as many critics have pointed out, raising taxes simply gives the government moremoney, and so the politicians and bureaucrats are likely to react by raising expenditures stillfurther. Parkinson said it all in his famous "Law": "Expenditures rise to meet income." If thegovernment is willing to have, say, a 20% deficit, it will handle high revenues by raisingspending still more to maintain the same proportion of deficit.

But even apart from this shrewd judgment in political psychology, why should anyonebelieve that a tax is better than a higher price? It is true that inflation is a form of taxation, in

which the government and other early receivers of new money are able to expropriate themembers of the public whose income rises later in the process of inflation. But, at least with


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inflation, people are still reaping some of the benefits of exchange. If bread rises to $10 aloaf, this is unfortunate, but at least you can still eat the bread. But [p. 22] if taxes go up, yourmoney is expropriated for the benefit of politicians and bureaucrats, and you are left with noservice or benefit. The only result is that the producers' money is confiscated for the benefitof a bureaucracy that adds insult to injury by using part of that confiscated money to push the

public around.

No, the only sound cure for deficits is a simple but virtually unmentioned one: cut the federalbudget. How and where? Anywhere and everywhere.

Myth 4: Every time the Fed tightens the money supply, interest rates rise (or fall); everytime the Fed expands the money supply, interest rates rise (or fall).

The financial press now knows enough economics to watch weekly money supply figureslike hawks; but they inevitably interpret these figures in a chaotic fashion. If the moneysupply rises, this is interpreted as lowering interest rates and inflationary; it is also

interpreted, often in the very same article, as raising interest rates. And vice versa. If the Fedtightens the growth of money, it is interpreted as both raising interest rates and loweringthem. Sometimes it seems that all Fed actions, no matter how contradictory, must result inraising interest rates. Clearly something is very wrong here.

The problem is that, as in the case of price levels, there are several causal factors operating oninterest rates and in different directions. If the Fed expands the money supply, it does so bygenerating more bank reserves and thereby expanding the supply of bank credit and bankdeposits. The expansion of credit necessarily means an increased supply in the credit marketand hence a lowering of the price of credit, or the rate of interest. On the other hand, if theFed restricts the supply of credit and the growth of the money supply, this means that thesupply in the credit market declines, and this should mean a rise in interest rates.

And this is precisely what happens in the first decade or two of chronic inflation. Fedexpansion lowers interest rates; Fed tightening raises them. But after this period, the publicand the market begin to catch on to what is happening. They begin to realize that inflation ischronic because of the systemic expansion of the money supply. When they realize this factof life, they will also realize [p. 23] that inflation wipes out the creditor for the benefit of thedebtor. Thus, if someone grants a loan at five percent for one year, and there is seven percentinflation for that year, the creditor loses, not gains. He loses two percent, since he gets paid

back in dollars that are now worth seven percent less in purchasing power. Correspondingly,the debtor gains by inflation. As creditors begin to catch on, they place an inflation premiumon the interest rate, and debtors will be willing to pay it. Hence, in the long-run anything

which fuels the expectations of inflation will raise inflation premiums on interest rates; andanything which dampens those expectations will lower those premiums. Therefore, a Fedtightening will now tend to dampen inflationary expectations and lower interest rates; a Fedexpansion will whip up those expectations again and raise them. There are two, oppositecausal chains at work. And so Fed expansion or contraction can either raise or lower interestrates, depending on which causal chain is stronger.

Which will be stronger? There is no way to know for sure. In the early decades of inflation,there is no inflation premium; in the later decades, such as we are now in, there is. Therelative strength and reaction times depend on the subjective expectations of the public, andthese cannot be forecast with certainty. And this is one reason why economic forecasts can

never be made with certainty.


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Myth 5: Economists, using charts or high speed computer models, can accuratelyforecast the future.

The problem of forecasting interest rates illustrates the pitfalls of forecasting in general.People are contrary cusses whose behavior, thank goodness, cannot be forecast precisely in

advance. Their values, ideas, expectations, and knowledge change all the time, and change inan unpredictable manner. What economist, for example, could have forecast (or did forecast)the Cabbage Patch Kid craze of the Christmas season of 1983? Every economic quantity,every price, purchase, or income figure is the embodiment of thousands, even millions, ofunpredictable choices by individuals.

Many studies, formal and informal, have been made of the record of forecasting byeconomists, and it has been consistently abysmal. Forecasters often complain that they can dowell enough as long as current trends continue; what they have difficulty in doing is [p. 24]catching changes in trend. But of course there is no trick in extrapolating current trends intothe near future. You don't need sophisticated computer models for that; you can do it better

and far more cheaply by using a ruler. The real trick is precisely to forecast when and howtrends will change, and forecasters have been notoriously bad at that. No economist forecastthe depth of the 1981-82 depression, and none predicted the strength of the 1983 boom.

The next time you are swayed by the jargon or seeming expertise of the economic forecaster,ask yourself this question: If he can really predict the future so well, why is he wasting histime putting out newsletters or doing consulting when he himself could be making trillions ofdollars in the stock and commodity markets?

Myth 6: There is a tradeoff between unemployment and inflation.

Every time someone calls for the government to abandon its inflationary policies,establishment economists and politicians warn that the result can only be severeunemployment. We are trapped, therefore, into playing off inflation against highunemployment, and become persuaded that we must therefore accept some of both.

This doctrine is the fallback position for Keynesians. Originally, the Keynesians promised usthat by manipulating and fine-tuning deficits and government spending, they could and would

bring us permanent prosperity and full employment without inflation. Then, when inflationbecame chronic and ever-greater, they changed their tune to warn of the alleged tradeoff, soas to weaken any possible pressure upon the government to stop its inflationary creation ofnew money.

The tradeoff doctrine is based on the alleged "Phillips curve," a curve invented many yearsago by the British economist A.W. Phillips. Phillips correlated wage rate increases withunemployment, and claimed that the two move inversely: the higher the increases in wagerates, the lower the unemployment. On its face, this is a peculiar doctrine, since it flies in theface of logical, commonsense theory. Theory tells us that the higher the wage rates, thegreater the unemployment, and vice versa. If everyone went to their employer tomorrow andinsisted on double or triple the wage rate, many of [p. 25] us would be promptly out of a job.Yet this bizarre finding was accepted as gospel by the Keynesian economic establishment.

By now, it should be clear that this statistical finding violates the facts as well as logicaltheory. For during the 1950s, inflation was only about one to two percent per year, and

unemployment hovered around three or four percent, whereas later unemployment rangedbetween eight and 11%, and inflation between five and 13 %. In the last two or three decades,


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in short, both inflation and unemployment have increased sharply and severely. If anything,we have had a reverse Phillips curve. There has been anything but an inflation-unemployment tradeoff.

But ideologues seldom give way to the facts, even as they continually claim to "test" their

theories by Facts. To save the concept, they have simply concluded that the Phillips curve stillremains as an inflation-unemployment tradeoff, except that the curve has unaccountably"shifted" to a new set of alleged tradeoffs. On this sort of mind-set, of course, no one couldever refute any theory.

In fact, current inflation, even if it reduces unemployment in the short-run by inducing pricesto spurt ahead of wage rates (thereby reducing real wage rates), will only create moreunemployment in the long run. Eventually, wage rates catch up with inflation, and inflation

brings recession and unemployment inevi tably in its wake. After more than two decades ofinflation, we are now living in that "long run."

Myth 7: Deflation--falling prices--is unthinkable, and would cause a catastrophicdepression.

The public memory is short. We forget that, from the beginning of the Industrial Revolutionin the mid-18th century until the beginning of World War II, prices generally went down, yearafter year. That's because continually increasing productivity and output of goods generated

by free markets caused prices to fall. There was no depression, however, because costs fellalong with selling prices. Usually, wage rates remained constant while the cost of living fell,so that "real" wages, or everyone's standard of living, rose steadily.

Virtually the only time when prices rose over those two centuries were periods of war (War of1812, Civil War, World War I), when the [p. 26] warring governments inflated the moneysupply so heavily to pay for the war as to more than offset continuing gains in productivity.

We can see how free-market capitalism, unburdened by governmental or central bankinflation, works if we look at what has happened in the last few years to the prices ofcomputers. Even a simple computer used to be enormous, costing millions of dollars. Now, ina remarkable surge of productivity brought about by the microchip revolution, computers arefalling in price even as I write. Computer firms are successful despite the falling prices

because their costs have been falling, and productivity rising. In fact, these falling costs andprices have enabled them to tap a mass market characteristic of the dynamic growth of free-market capitalism. "Deflation" has brought no disaster to this industry.

The same is true of other high-growth industries, such a electronic calculators, plastics, TVsets, and VCRs. Deflation, far from bringing catastrophe, is the hallmark of sound anddynamic economic growth.

Myth 8: The best tax is a "flat" income tax, proportionate to income across the board,with no exemptions or deductions.

It is usually added by flat-tax proponents, that eliminating such exemptions would enable thefederal government to cut the current tax rate substantially.

But this view assumes, for one thing, that present deductions from the income tax are

immoral subsidies or "loopholes" that should be closed for the benefit of all. A deduction orexemption is only a "loophole" if you assume that the government owns 100% of everyone's


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income and that allowing some of that income to remain untaxed constitutes an irritating"loophole." Allowing someone to keep some of his own income is neither a loophole nor asubsidy. Lowering the overall tax by abolishing deductions for medical care, for interest

payments, or for uninsured losses, is simply lowering the taxes of one set of people (thosethat have little interest to pay, or medical expenses, or uninsured losses) at the expense of

raising them for those who have incurred such expenses.

There is furthermore neither any guarantee nor even likelihood that, once the exemptions anddeductions are safely out of the way, [p. 27] the government would keep its tax rate at thelower level. Looking at the record of governments, past and present, there is every reason toassume that more of our money would be taken by the government as it raised the tax rate

back up (at least) to the old level, with a consequently greater overall drain from theproducers to the bureaucracy.

It is supposed that the tax system should be analogous to roughly that of pricing or incomeson the market. But market pricing is not proportional to incomes. It would be a peculiar

world, for example, if Rockefeller were forced to pay $1,000 for a loaf of bread--that is, apayment proportionate to his income relative to the average man. That would mean a world inwhich equality of incomes was enforced in a particularly bizarre and inefficient manner. If atax were levied like a market price, it would be equal to every "customer," not proportionateto each customer's income.

Myth 9: An income tax cut helps everyone; not only the taxpayer but also thegovernment will benefit, since tax revenues will rise when the rate is cut.

This is the so-called "Laffer curve," set forth by California economist Arthur Laffer. It wasadvanced as a means of allowing politicians to square the circle; to come out for tax cuts,keeping spending at the current level, and balance the budget all at the same time. In thatway, the public would enjoy its tax cut, be happy at the balanced budget, and still receive thesame level of subsidies from the government.

It is true that if tax rates are 99%, and they are cut to 95%, tax revenue will go up. But thereis no reason to assume such simple connections at any other time. In fact, this relationshipworks much better for a local excise tax than for a national income tax. A few years ago, thegovernment of the District of Columbia decided to procure some revenue by sharply raisingthe District's gasoline tax. But, then, drivers could simply nip over the border to Virginia orMaryland and fill up at a much cheaper price. D.C. gasoline tax revenues fell, and much tothe chagrin and confusion of D.C. bureaucrats, they had to repeal the tax.

But this is not likely to happen with the income tax. People are not going to stop working orleave the country because of a relatively small tax hike, or do the reverse because of a tax cut.[p. 28]

There are some other problems with the Laffer curve. The amount of time it is supposed totake for the Laffer effect to work is never specified. But still more important: Laffer assumesthat what all of us want is to maximize tax revenue to the government. If--a big if--we arereally at the upper half of the Laffer Curve, we should then all want to set tax rates at that"optimum" point. But why? Why should it be the objective of every one of us to maximizegovernment revenue? To push to the maximum, in short, the share of private product that getssiphoned off to the activities of government? I should think we would be more interested in

minimizing government revenue by pushing tax rates far, far below whatever the LafferOptimum might happen to be.


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Myth 10: Imports from countries where labor is cheap cause unemployment in theUnited States.

One of the many problems with this doctrine is that it ignores the question: why are wages

low in a foreign country and high in the United States? It starts with these wage rates asultimate givens, and doesn't pursue the question why they are what they are. Basically, theyare high in the United States because labor productivity is high--because workers here areaided by large amounts of technologically advanced capital equipment. Wage rates are low inmany foreign countries because capital equipment is small and technologically primitive.Unaided by much capital, worker productivity is far lower than in the United States. Wagerates in every country are determined by the productivity of the workers in that country.Hence, high wages in the United States are not a standing threat to American prosperity; theyare the result of that prosperity.

But what of certain industries in the U.S. that complain loudly and chronically about the

"unfair" competition of products from low-wage countries? Here, we must realize that wagesin each country are interconnected from one industry and occupation and region to another.All workers compete with each other, and if wages in industry A are far lower than in otherindustries, work-ers--spearheaded by young workers starting their careers--would leave orrefuse to enter industry A and move to other firms or industries where the wage rate is higher.[p. 29]

Wages in the complaining industries, then, are high because they have been bid high by allindustries in the United States. If the steel or textile industries in the United States find itdifficult to compete with their counterparts abroad, it is not because foreign firms are payinglow wages, but because other American industries have bid up American wage rates to such ahigh level that steel and textile cannot afford to pay. In short, what's really happening is thatsteel, textile, and other such firms are using labor inefficiently as compared to other Americanindustries. Tariffs or import quotas to keep inefficient firms or industries in operation hurteveryone, in every country, who is not in that industry. They injure all American consumers

by keeping up prices, keeping down quality and competition, and distorting production. Atariff or an import quota is equivalent to chopping up a railroad or destroying an airline for its

point is to make international transportation artificially expensive.

Tariffs and import quotas also injure other, efficient American industries by tying upresources that would otherwise move to more efficient uses. And, in the long run, the tariffsand quotas, like any sort of monopoly privilege conferred by government, are no bonanzaeven for the firms being protected and subsidized. For, as we have seen in the cases of

railroads and airlines, industries enjoying government monopoly (whether through tariffs orregulation) eventually become so inefficient that they lose money anyway, and can only callfor more and more bailouts, for a perpetual expanding privileged shelter from freecompetition.

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The World's Economic Outlook - Lord John Maynard Keynes

May 1932

The immediate problem for which the world needs a solution to-day is different from theproblem of a year ago. Then it was a question of how we could lift ourselves out of the state

of acute slump into which we had fallen and raise the volume of production back toward anormal figure. But to-day the primary problem is to avoid a far-reaching financial crisis.There is now no possibility of reaching a normal level of production in the near future. Ourefforts are directed toward the attainment of more limited hopes. Can we prevent an almostcomplete collapse of the financial structure of modern capitalism? With no financialleadership left in the world and profound intellectual error as to causes and cures prevailingin the responsible seats of power, one begins to wonder and to doubt. At any rate, no one islikely to dispute that for the world as a whole the avoidance of financial collapse, rather thanthe stimulation of industrial activity, is now the front-rank problem. The restoration ofindustry must come second in order of time. Nowhere, I believe, is this better understood thanin the United States.

The immediate causes of the world financial panic -- for that is what it is -- are obvious. Theyare to be found in a catastrophic fall in the money value, not only of commodities, but of

practically every kind of asset. The 'margins,' as we call them, upon confidence in themaintenance of which the debt and credit structure of the modern world depends, have 'runoff.' In many countries the assets of the banks are no longer equal, conservatively valued, totheir liabilities to their depositors. Debtors of all kinds find that their securities are no longerthe equal of their debts. Few governments still have revenues sufficient to cover the fixedmoney charges for which they have made themselves liable.

Moreover, a collapse of this kind feeds on itself. We are now in the phase where the risk of

carrying assets with borrowed money is so great that there is a competitive panic to getliquid. And each individual who succeeds in getting more liquid forces down the price ofassets in the process of getting liquid, with the result that the margins of other individuals areimpaired and their courage undermined. And so the process continues. It is, indeed, in theUnited States itself that this has proceeded to the most incredible lengths. The collapse ofvalues there has reached astronomical dimensions. I scarcely need to remind Americanreaders of the facts. But the United States only offers an example -- extreme, owing to the

psychology of its people -- of a state of affairs which exists in some degree almosteverywhere.

The competitive struggle for liquidity has now extended beyond individuals and institutionsto nations and to governments, each of which endeavors to make its internal balance sheetmore liquid by restricting imports and stimulating exports by every possible means, thesuccess of each one in this direction meaning the defeat of someone else. Moreover, each


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country discourages capital development within its own borders for fear of the effect on itsinternational balance. Yet it will only be successful in its object in so far as its progresstoward negation is greater than that of its neighbors.

II

We have here an extreme example of the disharmony of general and particular interest. Eachnation, in an effort to improve its relative position, takes measures injurious to the absolute

prosperity of its neighbors; and, since its example is not confined to itself, it suffers morefrom similar action by its neighbors than it gains by such action itself. Practically all theremedies popularly advocated to-day are of this internecine character. Competitive wagereductions, competitive tariffs, competitive liquidation of foreign assets, competitive currencydeflations, competitive economy campaigns -- all are of this beggar-my-neighbor description.For one man's expenditure is another man's income. Thus, while we undoubtedly increase ourown margin, we diminish that of someone else; and if the practice is universally followed

everyone will be worse off. An individual may be forced by his private circumstances tocurtail his normal expenditure, and no one can blame him. But let no one suppose that he isperforming a public duty in behaving in such a way. The modern capitalist is a fair-weathersailor. As soon as a storm rises, he abandons the duties of navigation and even sinks the boatswhich might carry him to safety by his haste to push his neighbor off and himself in.

Unfortunately the popular mind has been educated away from the truth, away from commonsense. The average man has been taught to believe what his own common sense, if he reliedon it, would tell him was absurd. Even remedies of a right tendency have become discredited

because of the failure of a timid and vacillating application of them. Now, at last, under theteaching of hard experience, there may be some slight improvement toward wiser counsels.But through lack of foresight, and constructive imagination the financial and politicalauthorities of the world have lacked the courage or the conviction at each stage of the declineto apply the available remedies in sufficiently drastic doses; and by now they have allowedthe collapse to reach a point where the whole system may have lost its resiliency and itscapacity for a rebound.

Meanwhile the problem of reparations and war debts darkens the whole scene. We all knowthat these are now as dead as mutton, and as distasteful as stale mutton. There is no questionof any substantial payments' being made. The problem has ceased to be financial and has

become entirely political and psychological. If in the next six months the French were tomake a very moderate and reasonable proposal in final settlement, I believe that the Germans,in spite of all their present protestations to the contrary, would accept it and would be wise to

accept it. But to all outward appearances the French mind appears to be hardening againstsuch a solution and in favor of forcing a situation in which Germany will default. French

politicians (and in candid moments American politicians may confess to a fellow feeling) areconscious that it will be much easier for them, vis-a-vis the home political front to get rid ofreparations by a German default than to reach by agreement a moderate sum, most of whichmight have to be handed on to the United States. Moreover, this outcome would have whatthey deem to be the advantage of piling up grievances and a legal case against Germany foruse in connection with the other outstanding questions created between the two countries bythe Treaty of Versailles. I cannot, therefore, extract much comfort or prospective hope fromdevelopments in this sphere of international finance.

III


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Well, I have painted the prospect in the blackest colors. What is there to be said on the otherside? What elements of hope can we discern in the surrounding gloom? And what usefulaction does it still lie in our power to take?

The outstanding ground for cheerfulness lies, I think, in this -- that the system has shown

already its capacity to stand an almost inconceivable strain. If anyone had prophesied to us ayear or two ago the actual state of affairs which exists to-day, could we have believed that theworld could continue to maintain even that degree of normality which we actually have? Thisremarkable capacity of the system to take punishment is the best reason for hoping that westill have time to rally the constructive forces of the world.

Moreover, there has been a still recent and, in my judgment, most blessed event of which wehave not yet had time to gain the full benefit. I mean Great Britain's abandonment of the goldstandard. I believe that this event has been charged with beneficent significance over a widefield. If Great Britain had somehow contrived to maintain her gold parity, the position of theworld as a whole to-day would be considerably more desperate than it is, and default more

general.

For Great Britain's action has had two signal consequences. The first has been to stop thedecline of prices, measured in terms of national currencies, over a very considerable

proportion of the world. Consider for a moment what an array of countries are now linked tothe fortunes of sterling rather than gold: Australasia, India, Ceylon, Malaya, East and WestAfrica, Egypt, and Scandinavia; and, in substance, though not so literally, South America,Canada, and Japan. Outside Europe there are no countries in the whole world except SouthAfrica and the United States which now conform to a gold standard. France and the UnitedStates are the only remaining countries of major importance where the gold standard isfunctioning freely.

This means a very great abatement of the deflationary pressure which was existing sixmonths ago. Over wide areas producers are now obtaining prices in terms of their domesticcurrencies which are not so desperately unsatisfactory in relation to their costs of productionand to their debts. These events have been too recent to attract all the attention they deserve.There are several countries of which it could be argued that their economic and financialcondition may have turned the corner in the last six months. It is true, for example, ofAustralia. I think it may be true of Argentina and Brazil. There has been an extraordinaryimprovement in India, where the export of gold previously hoarded, a consequence of thediscount of sterling in terms of gold which no one predicted, has almost solved the financial

problem.

As regards Great Britain herself, the world has a little overlooked, I think, the change sincelast September, which represents, if not an absolute, at least a relative improvement. Thenumber of persons employed to-day exceeds by 200,000 the number employed a year ago --which is true of no other industrial country. This has been achieved in spite of the fact thatthere has been, even during the past year, a further rise in real wages; for, while money wageshave fallen by 2 per cent, the cost of living, in spite of the depreciation of the sterlingexchange, has fallen by 4 per cent. And the explanation is an encouragement for the future.For the explanation lies in the fact that over a wide field of her characteristic activities GreatBritain to-day is once again the cheapest producer in the world. The forces set on foot lastSeptember have by no means had time to work their full effect. Yet even to-day -- though,since popular knowledge of a foreign country is always out of date, it may surprise you that I

should say so -- Great Britain is decidedly the most prosperous country in the world.


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IV

But there is a second major consequence of the partition of the countries of the world intotwo groups, on and off the gold standard respectively. For the two groups roughly correspondto those which have been exercising deflationary pressure on the rest of the world, by having

a net creditor position which causes them to draw gold, and those which have been sufferingthis pressure. Now the departure of the latter group from gold means the beginning of aprocess toward the restoration of economic equilibrium. It means the setting into motion ofnatural forces which are certain in course of time to undermine and eventually destroy thecreditor position of the two leading creditor gold countries. The process will be seen mostrapidly in the case of France, whose creditor position is likely to be completely undermined

before the end of 1932. The cessation of reparation receipts, the loss of tourist traffic, thecompetitive disadvantage of her export trades with non-gold countries, and the importation ofa large proportion of the world's available gold, will, between them, do that work. In the caseof the United States the process may be a slower one, largely because the reduction of touristtraffic, which costs France so dear, means for the United States a large saving. But the

tendency will be the same. A point will surely come when the current release of gold fromIndia and the mines will exceed the favorable balance of the gold countries.

Thus a process has been set moving which may relieve in the end the deflationary pressure.The question is whether this will have time to happen before financial organization and thesystem of international credit break under the strain. If it does, then the way will be clearedfor a concerted policy, probably under the leadership of Great Britain, of capital expansionand price raising throughout the world. For without this the only alternative solution which Ican envisage is one of the general default of debts and the disappearance of the existing creditsystem, followed by rebuilding on quite new foundations.

The following, then, is the chapter of events which might conceivably -- I will not attempt toevaluate the probability of their occurrence -- lead us out of the bog. The financial crisismight wear itself out before a point of catastrophe and general default had been reached. Thisis, perhaps, happening. The greatest dangers may have been surmounted during the past fewmonths. Pari passu with this, the deflationary pressure exerted on the rest of the world by theunbalanced creditor position of France and the United States may be relaxed, through theirlosing their creditor position as a result of the steady operation of the forces which I havealready described. If and when these things are clearly the case, we shall then enter the cheap-money phase. This is the point at which, on the precedent of previous slumps, we might hopefor the beginning of recovery. I am not confident, however, that on this occasion the cheap-money phase will be sufficient by itself to bring about an adequate recovery of newinvestment. It may still be the case that the lender, with his confidence shattered by his

experiences, will continue to ask for new enterprise rates of interest which the borrowercannot expect to earn. Indeed, this was already the case in the moderately-cheap-money

phase which preceded the financial crisis of last autumn.

If this proves to be so, there will be no means of escape from prolonged and perhapsinterminable depression except by direct state intervention to promote and subsidize newinvestment. Formerly there was no expenditure out of the proceeds of borrowing that it wasthought proper for the State to incur except for war. In the past, therefore, we have notinfrequently had to wait for a war to terminate a major depression. I hope that in the futurewe shall not adhere to this purist financial attitude, and that we shall be ready to spend on theenterprises of peace what the financial maxims of the past would only allow us to spend on

the devastations of war. At any rate, I predict with an assured confidence that the only wayout is for us to discover some object which is admitted even by the deadheads to be a


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legitimate excuse for largely increasing the expenditure of someone on something!

V

In all our thoughts and feelings and projects for the betterment of things, we should have it at

the back of our heads that this is not a crisis of poverty, but a crisis of abundance. It is not theharshness and the niggardliness of nature which are oppressing us, but our own incompetenceand wrong-headedness which hinder us from making use of the bountifulness of inventivescience and cause us to be overwhelmed by its generous fruits. The voices which -- in such aconjuncture -- tell us that the path of escape is to be found in strict economy and in refraining,wherever possible, from utilizing the world's potential production are the voices of fools andmadmen. There is a passage from David Hume in which he says: 'Though the ancientsmaintained that, in order to reach the gifts of prophecy, a certain divine fury or madness wasrequisite, one may safely affirm that, in order to deliver such prophecies as these, no more isnecessary than merely to be in one's senses, free from the influence of popular madness anddelusion.'

Obviously it is much more difficult to solve the problem to-day than it would have been ayear ago. But I believe even now, as I believed then, that we could still be, if we would, themasters of our fate. The obstacles to recovery are not material. They reside in the state ofknowledge, judgment, and opinion of those who sit in the seat of authority. Unluckily thetraditional and ingrained beliefs of those who hold responsible positions throughout the worldgrew out of experiences which contained no parallel to the present, and are often the oppositeof what one would wish them to believe to-day. In France the weight of authoritative opinionand public sentiment is genuinely and sincerely opposed to the whole line of thought whichruns through what I have been saying. In the United States it is almost inconceivable whatrubbish a public man has to utter to-day if he is to keep respectable. Serious and sensible

bankers, who as men of common sense are trying to do what they can to stem the tide ofliquidation and to stimulate the forces of expansion, have to go about assuring the world oftheir conviction that there is no serious risk of inflation, when what they really mean is thatthey cannot yet see good enough grounds for daring to hope for it. In Great Britain opinion is

probably more advanced. I believe that the ideas of British bankers are on sounder lines thanthose current elsewhere. What we in London have to fear is timidity and a reluctance to act

boldly.

Nothing could be a greater advantage to the world than that the United States should solveher own domestic problems, and, by solving them, provide the stimulus and the example toother countries. But observing from a distance, -- a nearer view of the prospect might modifymy pessimism, -- I am unable to imagine a course of events which could restore health to

American industry in the near future. I even fancy that, so far from the United States givingthe example, she will herself have to wait for stimulus from outside. I, therefore, dare to hope-- however improbable it may seem in the light of recent experience -- that relief may comefirst of all to Great Britain and the group of overseas countries which look to her for financialleadership. It is a dim hope, I confess. But I discern less light elsewhere.

--------------------------------------------------------------------------------Copyright 1932 by John Maynard Keynes. All rights reserved. 1932


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The Interest Rate Question by Murray N.Rothbard

The Interest Rate Question

The Marxists call it "impressionism": taking social or economic trends of the last few weeksor months and assuming that they will last forever. The problem is not realizing that there areunderlying economic laws at work. Im pressionism has always been rampant; and never moreso than in public discussion of interest rates. For most of 1987, interest rates were inexorablyhigh; for a short while after Black Monday, interest rates fell, and financial opinion turnedaround 180 degrees, and started talking as if interest rates were on a permanent downwardtrend.

No group is more prone to this day-to-day blowin' with the wind than the financial press. This

syndrome comes from lack of understanding of economics and hence being reduced toreacting blindly to rapidly changing events. Sometimes this basic confusion is reflectedwithin the same article. Thus, in the not-so-long ago days of double-digit inflation, the samearticle would predict that interest rates would fall because the Fed was buying securities in [p.43] the open market, and also say that rates would be going up because the market would beexpecting increased inflation.

Nowadays, too, we read that fixed exchange rates are bad because interest rates will have torise to keep foreign capital in the U.S., but also that falling exchange rates are bad becauseinterest rates will have to rise for the same reason. If financial writers are mired in hopelessconfusion, how can we expect the public to make any sense of what is going on?

In truth, interest rates, like any important price, are complex phenomena that are determinedby several factors, each of which can change in varying, or even contradictory, ways. As inthe case of other prices, interest rates move inversely with the supply, but directly with thedemand, for credit. If the Fed enters the open market to buy securities, it thereby increases thesupply of credit, which will tend to lower interest rates; and since this same act will increase

bank reserves by the same extent, the banks will now inflate money and credit out of thin airby a multiple of the initial jolt, nowadays about ten to one. So if the Fed buys $1 billion ofsecurities, bank reserves will rise by the same amount, and bank loans and the money supplywill then increase by $10 billion. The supply of credit has thereby increased further, andinterest rates will fall some more.

But it would be folly to conclude, impressionistically, that interest rates are destined to fallindefinitely. In the first place, the supply and demand for credit are themselves determined bydeeper economic forces, in particular the amount of their income that people in the economywish to save and invest, as opposed to the amount they decide to consume. The more theysave, the lower the interest rate; the more they consume, the higher. Increased bank loans maymimic an increase in genuine savings, yet they are very far from the same thing.

Inflationary bank credit is artificial, created out of thin air; it does not reflect the underlyingsaving or consumption preferences of the public. Some earlier economists referred to this

phenomenon as "forced" savings; more importantly, they are only temporary. As theincreased money supply works its way through the system, prices and all values in moneyterms rise, and interest rates will then bounce back to something like their original level. Only[p. 44] a repeated injection of inflationary bank credit by the Fed will keep interest rates


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artificially low, and thereby keep the artificial and unsound economic boom going; and this isprecisely the hallmark of the boom phase of the boom-bust business cycle.

But something else happens, too. As prices rise, and as people begin to anticipate furtherprice increases, an inflation premium is placed on interest rates. Creditors tack an inflation

premium onto rates because they don't propose to continue being wiped out by a fall in thevalue of the dollar; and debtors will be willing to pay the premium because they too realizethat they have been enjoying a windfall.

And this is why, when the public comes to expect further inflation, Fed increases in reserveswill raise, rather than lower, the rate of interest. And when the acceleration of inflationarycredit finally stops, the higher interest rate puts a sharp end to the boom in the capital markets(stocks and bonds), and an inevitable recession liquidates the unsound investments of theinflationary boom.

An extra twist to the interest rate problem is the international aspect. As a long-run tendency,

capital moves from low-return investments (whether profit rates or interest rates) towardhigh-return investments until rates of return are equal. This is true within every country andalso throughout the world. Internationally, capital will tend to flow from low-interest to high-interest rate countries, raising interest rates in the former and lowering them in the latter.

In the days of the international gold standard, the process was simple. Nowadays, under fiatmoney, the process continues, but results in a series of alleged crises. When governments tryto fix exchange rates (as they did from the Louvre agreement of February 1987 until BlackMonday), then interest rates cannot fall in the United States without losing capital or savingsto foreign countries.

In the current era of a huge balance of trade deficit in the U.S., the U.S. cannot maintain afixed dollar if foreign capital flows outward; the pressure for the dollar to fall would then beenormous. Hence, after Black Monday, the Fed decided to allow the dollar to resume itsmarket tendency to fall, so that the Fed could then inflate credit and lower interest rates. [p.45]

But it should be clear that that interest rate fall could only be ephemeral and strictlytemporary, and indeed interest rates resumed their inexorable upward march. Price inflation isthe consequence of the monetary inflation pumped in by the Federal Reserve for several years

before the spring of 1987, and interest rates were therefore bound to rise as well.

Moreover, the Fed, as in many other matters, is caught in a trap of its own making; for the

long-run trend to equalize interest rates throughout the world is a drive to equalize not simplymoney, or nominal, returns, but real returns corrected for inflation. But if foreign creditorsand investors begin to receive dollars worth less and less in value, they will require highermoney interest rates to compensate--and we will be back again, very shortly, with a redoubledreason for interest rates to rise.

In trying to explain the complexities of interest rates, inflation, money and banking, exchangerates and business cycles to my students, I leave them with this comforting thought: Don't

blame me for all this, blame the government. Without the interference of government, theentire topic would be duck soup.

--------


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The Friedman View -A visit with the most influential

economist since Keynes - By William F Buckley Jr.February 17, 1992.

Milton Friedman will be eighty before the year is out, has a new book coming out in the nextfew months, twice has had heart surgery, and spent last week at Alta, Utah, skiing at altitudesof ten thousand feet, though he will tell you that he has intimations of mortality, now that hisfriend and colleague, the great economic historian George Stigler, is dead. Friedman is almostcertainly the most influential economist since Keynes, and is ready to oblige with a little tourd'horizon of the economic scene. It is to understate the case to say that he is disappointedwith the performance of President Bush.

Why? He cites several reasons. Under President Reagan, the Executive was committed toseveral goals: 1) no increase in taxes, 2) deregulation, and 3) reduced federal spending. The

budget act of 1990 was a gross violation of an understanding Mr. Bush had inherited fromMr. Reagan and had himself reaffirmed with his famous statement about the resolution of hislips.

The tax increase, reasons Mr. Friedman, has the effect of diminishing what Adam Smithcalled the "animal spirits" of entrepreneurs. To plan and to invest, without any certainty thatin the future Congress won't impose new taxes, is to gamble on other than economic successin the marketplace. What tends to happen is "sleepy money," sharply to be distinguished fromthe entrepreneurial zest associated with a vigorous economy.

Friedman would like to see the complete abolition of capital-gains taxes, but more importantis the indexation of capital gains. "As things now stand, you could buy something today for$10,000, sell it ten years from now for $20,000, and be taxed on a $10,000 profit which infact never materialized because the dollar was reduced in value by inflation to fifty cents."But he sharply opposes any attempt at retroactive application of capital-gains relief, on thegrounds that to calculate the taxable rise in value would be impossibly complex.

On the matter of regulation, the Clean Air Act and the Disabilities Act are invitations to anightmare, out of any proportion to benefits presumed. The increasing dependence on action

by the Federal Government augurs difficulties in the days ahead. The size of the federal debtis not an important factor in bringing on a recession - indeed, money spent paying interest onthat debt is probably the "healthiest" government expense going. I.e, it isn't money spent toinaugurate fresh federal enterprises which will soak up energy and depress the private sector


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in the future.

And of course federal spending has increased beyond what was necessary to pay off the S&Ldebt. We are spending over 25 per cent of the GNP, up over two points from the Reaganyears. The Federal Reserve Board has indeed killed substantial inflation. But it

underestimated the amount of money a healthy economy needed, and that is one cause of thecurrent recession. "Has economic science developed to the point of insuring against therecessions associated with the business cycle?" No. It has developed to the point of giving usthe knowledge necessary to forestall deep depressions and runaway inflation. But the

business cycle will be with us always.

What about jump-starting our way out of the current mess? There is one way to do this, andonly one way, he says. It is to print money. The trouble with doing this, of course, is that it ismerely an invitation to inflation in the years ahead. Probably such inflation is in store for usin any event, says Mr. Friedman, given that politics almost inevitably influences the activitiesof the central banks. When debt soars as ours has done, then the great temptation is there:

diminish the debt by diminishing the value of the dollar.

Milton Friedman greatly fears the political attraction of tariffs, and suggests that Reagan'sprimary delinquency was in allowing the tariff creep which now seeks to protect us, butinstead imposes burdens on the American consumer. Do you remember what Henry Georgesaid about tariffs? A country at war with another country attempts to boycott commerce tothat country. A country at peace, when engaged in protectionism, levels identical policiesagainst itself.


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The World Currency Crisis by Murray N.Rothbard

Making Economic Sense

The World Currency Crisis

The world is in permanent monetary crisis, but once in a while, the crisis flares up acutely,

and we noisily shift gears from one flawed monetary system to another. We go back and forthfrom fried paper rates to fluctuating rates, to some inchoate and aborted blend of the two.Each new system, each basic change, is hailed extravagantly by economists, bankers, thefinancial press, politicians, and central banks, as the final and permanent solution to our

persistent monetary woes.

Then, after some years, the inevitable breakdown occurs, and the Establishment trots outanother bauble, another wondrous monetary nostrum for us to admire. Right now, we are onthe edge of another shift.

To stop this shell game, we must first understand it. First, we must realize that there are three

coherent systems of international money, of which only one is sound and non-inflationary.The sound money is the genuine gold standard; "genuine" in the sense that each currency isdefined as a certain unit of weight of gold, and is redeemable at that weight.

Exchange rates between currencies were "fixed" in the sense that each was defined as a givenweight of gold; for example, since the dollar was defined as one-twentieth of a gold ounceand the pound sterling as .24 of a gold ounce, the exchange rate between the two wasnaturally fixed at their proportionate gold weight, i.e., 1 = $4.87.

The other two systems are the Keynesian ideal, where all currencies are fried in terms of aninternational paper unit, and fluctuating independent fiat-paper moneys. Keynes wanted to

call [p. 254] his new world paper unit the bancor while U.S. Treasury official (and secretCommunist) Harry Dexter White wanted to name it the unita. Bancor or unita, these new

paper tickets would ideally be issued by a World Reserve Bank and would form the reservesof the various central banks. Then, the World Reserve Bank could inflate the bancor at will,and the bancor would provide reserves upon which the Fed, the Bank of England, etc. could

pyramid a multiple expansion of their respective national fiat currencies.

The whole world would then be able to inflate together, and therefore not suffer theinconvenience of inflationary countries losing either gold or income to sound-moneycountries. All the countries could inflate in a centrally- coordinated fashion, and we couldsuffer manipulation and inflation by a world government-banking elite without check or

hindrance. At the end of the road would be a horrendous world-wide hyper-inflation, with noway of escaping into sounder or less inflated currencies.


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Fortunately, national rivalries have prevented the Keynesians from achieving their goal, andso they had to settle for "second best," the Bretton Woods system that the U.S. and Britainfoisted on the world in 1944, and which lasted until its collapse in 1971. Instead of the

bancor, the dollar served as the international reserve upon which other currencies could

pyramid their money and credit. The dollar, in turn, was tied to gold in a mockery of agenuine gold standard, at the pre-war par of $35 per ounce. In the first place, dollars were notredeemable in gold coins, as they had been before, but only in large and heavy gold bars,which were worth many thousands of dollars. And second, only foreign governments andcentral banks could redeem their dollars in gold even on this limited basis.

For two decades, the system seemed to work well, as the U.S. issued more and more dollars,and they were then used by foreign central banks as a base for their own inflation. In short,for years the U.S. was able to "export inflation" to foreign countries without suffering theravages itself. Eventually, however, the ever-more inflated dollar became depreciated on thegold market, and the lure of high priced gold they could obtain from the U.S. at the bargain

$35 per ounce led European central banks to cash in dollars for gold. The house of cardscollapsed when President [p. 255] Nixon, in an ignominious declaration of bankruptcy,slammed shut the gold window and went off the last remnants of the gold standard in August1971.

With Bretton Woods gone, the Western powers now tried a system that was not only unstablebut also incoherent: fixing exchange rates without gold or even any international papermoney with which to make payments. The Western powers signed the ill-fated SmithsonianAgreement on December 18, 1971, which was hailed by President Nixon as "the greatestmonetary agreement in the history of the world." But if currencies are purely fiat, with nointernational money, they become goods in themselves, and fixed exchange rates are then

bound to violate the market rates set by supply and demand.

At that time the inflated dollar was heavily overvalued in regard to Western European andJapanese currencies. At the overvalued dollar rate, there were repeated scrambles to buyEuropean and Japanese moneys at bargain rates, and to get rid of dollars. Repeated"shortages" of the harder moneys resulted from this maximum price control of their exchangerates. Finally, panic selling of the dollar broke the Smithsonian system apart in March 1973.With the collapse of Bretton Woods and the far more rapid disintegration of the "greatestmonetary agreement" in world history, both the phony gold standard and the fixed paperexchange rate systems were widely and correctly seen to be inherent failures. The world nowembarked, almost by accident on a new era: a world of fluctuating fiat paper moneys.Friedmanite monetarism was to have its day in the sun.

The Friedmanite monetarists had come into their own, replacing the Keynesians as thefavorites of the financial press and of the international monetary establishment. Governmentsand central banks began to hail the soundness and permanence of fluctuating exchange ratesas fervently as they had once trumpeted the eternal virtues of Bretton Woods. The monetarists

proclaimed the ideal international monetary system to be freely fluctuating exchange ratesbetween different moneys, with no government intervention to try to stabilize or evenmoderate the fluctuations. In that way, exchange rates would reflect, from day to day, thefluctuations of supply and demand, just as prices do on the free market. [p. 256]

Of course, the world had suffered mightily from fluctuating fiat money in the not too distant

past: the 1930s, when every country had gone off gold (a phony gold standard preserved forforeign central banks by the United States). The problem is that each nation-state kept fixing


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its exchange rates, and the result was currency blocs, aggressive devaluations attempting toexpand ex ports and restrict imports, and economic warfare culminating in World War II. Sothe monetarists were insistent that the fluctuations must be absolutely free of all governmentintervention.

But, in the fist place, the Friedmanite plan is politically so naive as to be almost impossible toput into practice. For what the monetarists do, in effect, is to make each currency fiat paperissued by the national government. They give total power over money to that government andits central bank, and then they issue stern admonitions to the wielders of absolute power:"Remember, use your power wisely, don't under any circumstances interfere with exchangerates." But inevitably, governments will find many reasons to interfere: to force exchangerates up or down, or stabilize them, and there is nothing to stop them from exercising theirnatural instincts to control and intervene.

And so what we have had since 1973 is an incoherent blend of "fixed" and fluctuating,unhampered and hampered, foreign currency markets. Even Beryl W. Sprinkel, a dedicated

monetarist who served as Undersecretary of Treasury for Monetary Policy in the first ReaganAdministration, was forced to backtrack on his early achievement of persuading theAdministration to decontrol exchange rates. Even he was compelled to intervene in"emergency" situations, and now the second Reagan Administration moved insistently in thedirection of refixing exchange rates.

The problem with freely fluctuating rates is not only political. One virtue of fixed rates,especially under gold, but even to some extent under paper, is that they keep a check onnational inflation by central banks. The virtue of fluctuating rates--that they prevent suddenmonetary crises due to arbitrarily valued currencies--is a mixed blessing, because at leastthose crises provided a much-needed restraint on domestic inflation. Freely fluctuating ratesmean that the only damper on domestic inflation is that the currency might depreciate. Yetcountries often want their money [p. 257] to depreciate, as we have seen in the recentagitation to soften the dollar and thereby subsidize exports and restrict im-ports--a back-door

protectionism. The current refixers have one sound point: that worldwide inflation onlybecame rampant in the mid and late 1970s, after the last fixed-rate discipline was re moved.

The refixers are on the march. During November 1985, a major, well- publicizedinternational monetary conference took place in Washington, organized by U. S.Representative Jack Kemp and Senator Bill Bradley, and including representatives from theFed, foreign central banks, and Wall Street banks. This liberal-conservative spectrum agreedon the basic objective: refixing exchange rates. But refixing is no solution; it will only bring

bank the arbitrary valuations, and the breakdowns of Bretton Woods and the Smithsonian.

Probably what we will get eventually is a worldwide application of the current "snake," inwhich Western European currencies are tied together so that they can fluctuate but onlywithin a fixed zone. This pointless and inchoate blend of fixed and fluctuating currencies canonly bring us the problems of both systems.

When will we realize that only a genuine gold standard can bring us the virtues of bothsystems and a great deal more: free markets, absence of inflation, and exchange rates that arefixed not arbitrarily by government but as units of weights of a precious market commodity,gold?

--------

Murray N. Rothbard (1926-1995) was professor of economics at the University of Nevada,


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Las Vegas.

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