End the Fed

by Ron Paul

  Mr. Rose asked specifically: “It was too easy?”

  Mr. Geithner went on: “It was too easy, yes. In some ways less so here in the United States, but it was true globally. Real interest rates were very low for a long period of time.” 1

  Rarely do we in Washington hear the real cause of the crisis, stated with full knowledge and without the usual hedging. Most don’t understand the business cycle and its relationship to Federal Reserve policy. What’s more, many of those who do understand how the monetary system operates are not anxious for the general public to find out how it serves the interest of big government, big corporations, and big banks.

  Then there are those, familiar with free-market economics, who are well-informed and understand perfectly how the crisis evolved. Since the predictions made by the free-market Austrian economists have been on-target, and the others completely wrong, it is to them we should be looking for the answer to both the cause and solution.

  Just as Henry Hazlitt and other Austrian economists knew, in 1944, when the Bretton Woods system was established, that it would not last, many others knew from the beginning that the current system started on April 15, 1971, would also fail. The date may not have been known, but its demise was predictable.

  The current crisis, started in 2007 with the break in the housing mortgage market, is now in full swing and signifies the end of the fiat dollar reserve currency system. It is impossible to understand the current crisis without understanding the international monetary system, which has been dominated by our Federal Reserve.

  The core of the contemporary problem dates from 2001 when the Fed attempted to forestall recession through low interest rates. Actual interest rates fell well below historical averages and any monetary rule that the Fed claimed to be following. 2 Greenspan slashed the federal funds target from 6.5 percent in January 2001 down to 1 percent by June 2003. He held the rate at this level for a full year before ratcheting them up again to 5.25 percent in June of 2006, a move that popped the bubble he had earlier created.

  By way of review, when the Fed lowers interest rates below their natural level on a market, it has the effect of expanding investment beyond a sustainable level. Businesses begin investing as if consumers had the savings to back up the signals that the interest rates are sending. But real resources are not in fact available. There is no new wealth available to make good on investments. The lower interest rates are creating no new capital; they are merely distorting the signals borrowers use to assess risk. 3

  We should also consider the political context of the time. The terrorist attacks on American soil had taken place, and the entire country was moving toward war frenzy. The idea then was that we would not let terrorists beat us economically or politically—fine impulses but also conditions that led to stupid short-term decision making. Part of the drive of the Fed to inflate in the year following the attacks was to create an appearance that we as a nation had not been harmed in any way—that our economy was stronger than ever.

  Sadly, Greenspan chose the wrong means to convey this message. It would have been an ideal time to put the economy on a firm foundation, even to the point of risking recession, rather than providing artificial stimulus that would later prove to be illusory. Everyone in those days was consumed by the drive to not let the terrorists win. Well, the Fed assisted in undermining the foundation of the structure of the American economy and, in the long run, did more damage to American economic prosperity than the attacks of 9/11. Greenspan aimed the gun at the terrorists and shot the economy in the foot instead.

  I want to be clear here. The Fed’s policy was dreadfully malformed. It was within Greenspan’s control to have constructed a better policy. He made terrible mistakes. But this does not mean that the answer would have been better policies alone, tighter controls alone, or better managers of the Fed. We’ve been through nearly a hundred years of this same repeating pattern, so it is time that we wise up and learn something. When the printing presses are available to the government and the banking cartel, they will use them rather than do the right thing.

  The problem isn’t with the choices made by central bankers. The problem is that they possess the power to make any choice at all. There is the additional problem that markets are forever having to guess what the Fed is going to do, which creates what historian Robert Higgs calls “regime uncertainty.” 4 He goes so far as to use this notion to explain why markets sometimes take so long to recover from monetary mistakes. Market forces are always working to correct the mistakes made by individuals or government. Since central bank inflation is always disruptive, the market attempts to halt it as quickly as possible. This does not happen on a predictable schedule.

  The post-Bretton Woods system has been challenged numerous times over the past thirty years, but the authorities have been able to reprime the monetary pump, distract the masses, and keep it from deflating and correcting the errors inherent in central bank economic planning.

  Instability was already apparent in 1987, with a sharp stock market correction called a crash. The Fed reinflated and restored confidence in a broken system. No final payment was extracted for the inflation that has gone on since 1971. Dollar imbalances in the world economy kept being papered over. In 1989, the crash of the Japanese market showed that the international imbalances permitted some of our dollar inflation to be exported to Japan rather than do damage at home. More recently, our excessive purchases have come from China, exporting inflated dollars yet again.

  The savings and loan crisis of the 1980s was another effort of the marketplace to rectify the mistakes inherent in the system. Debt, to some degree, was liquidated, but as there were no significant changes in policy the country and the Federal Reserve went back to their old ways, with even more inflation than before.

  Japan’s market has never adequately recovered from its 1990s slump because it prevented liquidation of bad debt held by the banks. Throughout the 1990s in the United States, the market was arguing for liquidation of debt and elimination of gross malinvestment. But our recessions, the Asian crisis, as well as the Russian crisis were papered over with more inflation. Even the failure of Long-Term Capital Management in 1999 was barely a blip on the economic radar screen.

  By the year 2000, the imbalances were more than could be contained. The massive injection of credit for Y2K softened the blow of the 2000 recession, but it was clear by then that the “Big One” was at our doorstep. And I suspect that Greenspan knew it. He energetically contributed to the already very large housing bubble by driving down and holding interest rates very low for several more years. He bought time for himself and the institution he represented.

  The collapse of the stock market in 2000, especially the bursting of the NASDAQ bubble, was the beginning of the current crisis, although many want to date the onset in 2007 when the mortgage crisis became obvious. The bull market in stocks had ended long before. The massive inflation that was directed into housing was designed to make people feel better, and consumers once again were enticed to continue their spending spree by borrowing against their home equities, driven up at least nominally by inflationary expectations. Monetary policy was always hostile to savings. Savers were cheated with lower rates of interest. Greenspan’s answer to my concerns regarding this point was, more or less, “True, but that’s just tough luck.”

  But prosperity can never be achieved by cheap credit. If that were so, no one would have to work for a living. Inflated prices only deceive one into believing that real wealth has been created. But easy come, easy go. It is fun when the bubbles are forming and many can live beyond their means; it’s a different story when they’re forced to live beneath their means in order to pay for their extravagance. Like an individual, a whole nation must accept a decrease in the standard of living if the debt-inflationary system finances an illusion of wealth.

  Although the Fed was primarily responsible for the financial bubbles, the malinvestment, and the excessive debt, other policies significantly contributed to the
distortions that had to be corrected. 5 Artificially low rates of interest orchestrated by the Fed induced investors, savers, borrowers, and consumers to misjudge what was going on. Multiple mistakes were made. The apparent prosperity based on the illusion of such wealth and savings led to misdirected and excessive use of capital. The false information generated by the Federal Reserve policy led to a false confidence that all would be well. This illusion is referred to as moral hazard.

  Anything that is seen as protection against risk causes people to act with less caution. Even if their actions may seem risky, someone else suffers the consequences, and moral hazard will encourage bad economic behavior.

  Knowing that savings were no longer required to get a loan from a bank, since easy credit came from the Federal Reserve, many a banker and borrower were encouraged to “gamble” on business ventures. It is easy to accept this risk, especially in the boom part of the business cycle, with stock, land, and housing assets all going up in nominal value. Beneath the surface, they were buying into a moral hazard, that is, they were being rewarded in the short term for activity that would in the long term prove to be detrimental to everyone. Competitive pressures in the banking industry made it impossible for most to resist the chance for a quick profit.

  Moral hazard, from whatever source, is detrimental because it removes the sense of responsibility for one’s own actions. The more socialized the society, the less the sense of personal responsibility for one’s own behavior; responsibility becomes collective. Interventionism conditions business people to believe they can enjoy the rewards of the market, yet pass on the penalties to others. That’s what’s happening today.

  Although I’m talking here about moral hazard in the financial sense, the whole notion of the safety net permeates a welfare or socialist state, encouraging carelessness and dependency on the government to deal with any problems that come as a consequence of unwise economic or personal behavior. The only way government can fill this role as protector of last resort is through the sacrifice of personal liberty.

  The most serious mistake made by some “progressives,” who are allied with us on restraining the Fed, opposing corporatism, militarism, and the social Machiavellians, is that they make an exception for personal economic decisions. They recognize the right to decide for ourselves what our social and religious values are to be, though they do not understand that it is the same as the right to decide how to spend our money, enter into any voluntary economic contract, and reject any economic association we please.

  It’s bewildering to see some people strongly and correctly wanting to keep the government out of all social, religious, and intellectual decisions, yet also assuming for some reason that the average citizen cannot exist without central economic planning regulating our every move. It’s this inconsistency that allows institutions like the Federal Reserve to gain power over money and credit and, unfortunately, the entire economy.

  Once it’s assumed, as has been the case for decades, that government must protect all citizens against their own actions and compensate for any harm done, the floodgates of preemptive regulations and uncontrolled prior restraint are opened. Although no one proposes that religious or intellectual activities be reviewed by moral engineers in Washington—though some actually try—we are only too happy (or too complacent) to allow the economic planners to review our economic actions, and we expect the government to care for us following any errors we commit or for some unforeseen result of our actions.

  Much has been said about the subprime loans encouraged by government regulations made over the decades before the housing bubble burst, but one could argue that all loans that come from credit created out of thin air have an element of being subprime, making them a less than wise use of capital. This is why the euphoria during the boom is excessive, but only on the bust side is it found to be excessive and devastating. The risky loans were pervasive while the financial structure was being built without a foundation. One need not have been a prophet to have anticipated the collapse; logic and understanding made the collapse a certainty.

  Those who did not see it coming, and still don’t understand why it has occurred, are unaware of how the market works. They are in denial of the shortcomings of the Fed’s monetary policy. The world economy cannot be rescued by the same people, or their philosophy, which brought the havoc upon us.

  Moral hazard breeds dependency, neglect, and sacrifice of liberty, tolerance of false monetary doctrines, and promises of wealth without work. Utopian wishes are dreams destined to turn into nightmares. Paper money advocates make promises to the masses in order to appease them, while they are convinced by their own superiority that they can acquire wealth themselves, control the government for the good of the people, and bring paradise to the world.

  Artificially low interest rates are achieved by inflating the money supply, and they penalize the thrifty and cheat those who save. They promote consumption and borrowing over savings and investing. Manipulating interest rates is an immoral act. It’s economically destructive.

  The market rate of interest provides crucial information for the smooth operation of the economy. A central bank setting interest rates is price-fixing and is a form of central economic planning. Price-fixing is a tool of socialism and destroys production. Central bankers, politicians, and bureaucrats can’t know what the proper rate should be. They lack the knowledge and are deceived by their own aggrandizement.

  Manipulating the money supply and interest rates rejects all the principles of the free market, and so it cannot be said that too free a market caused this mess. The market was not free at all. It was manipulated and distorted. Ironically, free markets and sound money generate low rates, but unlike the artificially low rates orchestrated by the Fed, the information conveyed is beneficial to investors and savers. Only the Federal Reserve can inflate the currency, creating new money and credit out of thin air, in secrecy, without oversight or supervision. Inflation facilitates deficits, needless wars, and excessive welfare spending.

  When you think about it, debasing a currency is counterfeiting. It steals value from every dollar earned or saved. It robs the people and makes them poorer. It is the absolute enemy of the workingman. Inflation is the most vicious and regressive of all forms of taxation. It transfers wealth from the middle class to the privileged rich. The economic chaos that results from a policy of central bank inflation inevitably leads to political instability and violence. It’s an ancient tool of all authoritarians.

  Inflating is never a benefit to freedom-loving people. It destroys prosperity and feeds the fires of war. It is responsible for recessions and depressions. It’s deceptive, addictive, and causes delusions of grandeur with regards to wealth and knowledge. Wealth cannot be achieved by creating money by fiat, which instead destroys wealth and rewards the special interests, but more importantly, simply is not real.

  Depending on monetary fraud for national prosperity or a reversal of our downward spiral is riskier than depending on the lottery.

  Inflation has been used to pay for all wars and empires as far back as ancient Rome. And they all end badly. Inflationism and corporatism engender protectionism and trade wars. They prompt scapegoating: blaming foreigners, illegal immigrants, ethnic minorities, and too often freedom itself for the predictable events and suffering that result.

  The Congress, the bureaucrats, and the courts took an unsound monetary system destined to wreak havoc on our economy and made it much worse. Various programs, many started in the 1930s, encouraged and sometimes forced lenders to make subprime loans. The market, though not perfect, minimizes unsound lending practices. Both borrowers and lenders are much more cautious when the risk is borne by the two parties involved rather than protected by the proverbial safety net.

  In a structured social welfare–interventionist state, no one becomes solely responsible for his or her own actions. The penalty is diluted and hidden from the victims. Benefits are seen, costs are delayed and difficult to identify. Politicians thr
ive with arrangements like this, at least until the truth is revealed in the painful period of a correction.

  If individuals aren’t responsible for their actions as the bubble forms, the responsibility falls on others and to a future generation. Taxpayers, eventually, must foot the bill. High prices, a consequence of inflationary policies, act as a tax on everyone, but hurt the poor and the middle class the most. All bailouts are dependent on the Fed to create new credit out of nothing, the very policy that caused the mess in the first place.

  The Community Reinvestment Act of 1977, as well as the Equal Credit Opportunity Act of 1974, contributed in large measure to the excesses in the subprime market by forcing lending agencies to specifically make loans they otherwise would have avoided. The flawed concept of economic equality through force, a socialist notion, prompted legislation like the Community Reinvestment Act, which was really a way of institutionalizing affirmative action in the financial sector, since the borrowers who temporarily benefited (or were exploited) were disproportionately minorities. The very most one might concede is that affirmative action in making loans is based on the good intentions of many who support the programs. But as with all government actions, unintended consequences and new problems result.

  The problem is that, in the early stages, government economic planning and affirmative action lending look appealing. More homes are built and more people purchase homes that they otherwise would not have qualified for. Home prices soar and borrowing against the inflated prices is something the government and regulations encourage. The homeowners live beyond their means on borrowed money. None of this would have occurred in a free market with sound money. But the climactic end to this illusion of wealth and home ownership for everyone is logically predicted. The poor are being foreclosed upon. Many will be out on the street. More inflation and government handouts won’t solve the problem. The government is broke, and any effort to bail out everyone further prevents the return to sound economic policies. The agony compounds as the system unwinds, just as the euphoria expands on the upswing. Reality has now set in. The con game is over. Proper analysis is crucial, or we stand to lose a lot more.