The Revolution

by Ron Paul

  The Constitution is clear about the monetary powers of the federal government. Congress has a constitutional responsibility to maintain the value of the dollar by making only gold and silver legal tender and not to "emit bills of credit." The records from the Founders make perfectly clear that that was their intention. The power to regulate the value of money does not mean the federal government can debase the currency; the Framers would never have given the federal government such a power. It is nothing more than a power to codify an already existing definition of the dollar (which antedated the Constitution) in terms of gold; it also refers to the government's power to declare the ratio between gold and silver, or gold and any other metal, based on the market values of those metals.

  This responsibility was carried out relatively well in the nineteenth century, despite the abuse the dollar suffered during the Civil War and despite repeated efforts to form a central bank. This policy served to maintain relatively stable prices, and problems arose only when the rules of the gold standard were ignored or abused. (Superficial economic histories of the nineteenth century blame economic hard times, absurdly enough, on the gold standard; a good antidote is Murray N. Rothbard's A History of Money and Banking in the United States: The Colonial Era to World War II.)

  The Founding Fathers had had plenty of experience with paper money, and it turned the great majority of them firmly against it. The Revolutionary War was financed in part by the government-issued Continental currency, which was not backed by gold, which people were forced to use, and which the government issued in greater and greater abundance until its value was completely destroyed. Little wonder that most American statesmen opposed the issuance of paper money by the government, and the Constitution they drafted nowhere granted the federal government such a power.

  For that reason, James Madison once wrote that the constitutional prohibition of bills of credit (what we would understand as paper money) should

  give pleasure to every citizen in proportion to his love of justice and his knowledge of the true springs of public prosperity. The loss which America has sustained since the peace, from the pestilent effects of paper money on the necessary confidence between man and man, on the necessary confidence in the public councils, on the industry and morals of the people, and on the character of republican government, constitutes an enormous debt against the States chargeable with this unadvised measure.

  Throughout most of American history the dollar has been defined as a specific weight in gold. Until 1933, in fact, 20 dollars could be redeemed for one ounce of gold. But that year, the U.S. government went off the gold standard, and henceforth American currency would be redeemable into nothing. The government actually confiscated Americans' holdings of monetary gold, nullified even private contracts that called for payment for a good or service in gold, and declared the dollar no longer redeemable into gold by American citizens--but made allowances for redemption by foreign central banks at 35 dollars an ounce, a devaluation of the dollar from its previous ratio of $20.67 an ounce. And even this tenuous link to gold was severed in 1971, when Richard Nixon declared that within a year, at the $35 exchange rate, we would not have an ounce of gold remaining. Other governments had begun to realize that the dollar, which was being massively inflated, was losing its value, and more and more were demanding gold in exchange for dollars. At that point Nixon officially closed the gold window, so that not even foreign central banks could get gold for dollars. In so doing, he cut the dollar's last lingering tie to gold.

  Now let's consider at least a few of the nuts and bolts of how the Federal Reserve System typically operates. When we read that the Federal Reserve chairman is cutting interest rates, what does that mean? Analysts are referring to something called the federal funds rate, the rate that banks charge when they borrow from each other. The banks are required to keep a specific fraction of their deposits on reserve, as opposed to lent out, to be available for customer withdrawal. Banks can find themselves below the reserve requirement set by the Fed if they have made a lot of loans or if an unusually large number of people have withdrawn funds. Banks borrow from each other when they need additional cash reserves to meet the reserve requirement.

  The federal funds rate rises when there is too much demand from banks looking to borrow and too little supply from banks willing to lend. For reasons we shall see in a moment, the Fed often wants to prevent the federal funds rate from rising. Although it cannot directly set the rate, it can intervene in the economy in such a way as to push it upward or downward. The way it pushes the rate down is by buying bonds from the banks. That gives the banks more money and therefore more reserves on hand to lend to banks that need it. Funds available to be lent to other banks are now less scarce, and a correspondingly lower federal funds rate reflects this.

  Where does the Fed get the money to buy the bonds? It creates it out of thin air, simply writing checks on itself and giving them to banks. If that sounds fishy, then you understand it just fine.

  Here, finally, is how the Fed's activity leads to lower interest rates offered by banks. Thanks to Fed purchases of bonds from the banks, the banks now have excess reserves they can lend (either to other banks or to individuals or corporations). In order to attract additional borrowers, though, they must lower their interest rates, reduce their lending standards, or both.

  When the Fed intervenes like this, increasing the money supply with money and credit it creates out of thin air, it causes all kinds of economic problems. It decreases the value of the dollar, thereby making people poorer. And in the long run even the apparent stimulus to the economy that comes from all the additional borrowing and spending turns out to be harmful as well, for this phony prosperity actually sows the seeds for hard times and recession down the road.

  First, consider the effects of inflation, by which we mean the Fed's increase in the supply of money, on the value of the dollar. By increasing the supply of money, the Federal Reserve lowers the value of every dollar that already exists. If the supply of Mickey Mantle baseball cards were suddenly to increase a millionfold, each individual card would become almost valueless. The same principle applies to money: the more the Fed creates, the less value each individual monetary unit possesses. When the money supply is increased, prices rise--with each dollar now worth less than before, it can purchase fewer goods than it could in the past. Or imagine an art auction in which bidders are each given an additional million dollars. Would we not expect bids to go up? The market works the same way, except in a free market there are numerous sellers instead of the one seller in an auction.

  All right, some may say, prices may indeed rise, but so do wages and salaries, and therefore inflation causes no real problems on net. This misconception overlooks one of the most insidious and immoral effects of inflation: its redistribution of wealth from the poor and middle class to the politically well connected. The price increases that take place as a result of inflation do not occur all at once and to the same degree. Those who receive the new money first receive it before prices have yet risen. They enjoy a windfall. Meanwhile, as they spend the new money, and the next wave of recipients spend it, and so on, prices begin to rise throughout the economy--well before the new money has trickled down to most people. The average person is now paying higher prices while still earning his old income, which has not yet been adjusted to account for the higher money supply. By the time the new money has made its way throughout the economy, average people have all this time been paying higher prices, and only now can begin to break even. The enrichment of the politically well connected--in other words, those who get the newly created money first: government contractors, big banks, and the like--comes at the direct expense of everyone else. These are known as the distribution effects, or Cantillon effects, of inflation, after economist Richard Cantillon. The average person is silently robbed through this invisible means and usually doesn't understand what exactly is happening to him. And almost no one in the political establishment has an incentive to tell him.r />
  I have already discussed health care, but it's important to understand that rising health care costs cannot be understood apart from the money question. With government so heavily involved in medicine, that is where so much of the new money is directed. Thus health costs tend to rise faster than other costs because of the distribution effects of inflation: wherever government spends its new money, that is where higher prices will be most immediate and evident.

  When the value of Americans' savings is deliberately eroded through inflation, that is a tax, albeit a hidden one. I call it the inflation tax, a tax that is all the more insidious for being so underhanded: most Americans have no idea what causes it or why their standard of living is going down. Meanwhile, government and its favored constituencies receive their ill-gotten loot. The racket is safe as long as no one figures out what is going on.

  Incidentally, wise Americans from our nation's past understood the damage that unbacked paper money could do to society's most vulnerable. "The rise of prices that follows an expansion of [paper money]," wrote William Gouge, Andrew Jackson's Treasury adviser, "does not affect all descriptions of labor and commodities, at the same time, to an equal degree. . . . Wages appear to be among the last things that are raised. . . . The working man finds all the articles he uses in his family rising in price, while the money rate of his own wages remains the same." Jackson himself warned that an inflationary monetary policy by means of "spurious paper currency" is "always attended by a loss to the laboring classes." Likewise, Senator Daniel Webster maintained that "of all the contrivances for cheating the laboring classes of mankind, none has been found more effectual than that which deludes them with paper money."

  Moreover, the "inflation rate" itself, which is tracked using the Consumer Price Index (CPI), tends to be measured in a misleading way. Ask the average American if he thinks prices are going up by only a few percent per year, as the official figures would have it. So-called core inflation figures do not include food or energy, whose prices have been rising rapidly.

  But there is another, more significant way in which these kinds of measurements of "inflation" are designed to obscure rather than reveal. Ludwig von Mises used to say that governments will always try to get people to focus on prices when thinking about inflation. But rising prices are a result of inflation, not inflation itself. Inflation is the increase in the money supply. If we understood inflation that way, we would instantly know how to cure it: simply demand that the Federal Reserve cease increasing the money supply. By focusing our attention on prices instead, we are liable to misdiagnose the problem, and we are more apt to accept bogus government "solutions" like wage and price controls, as in the 1970s.

  Let's now consider what really happens when the Fed lowers interest rates. We often hear calls for the Fed to do just that, as if forcing rates down were a costless way to bring about permanent prosperity. The alleged prosperity it brings about is neither costless nor permanent. When the Fed artificially lowers rates, it misrepresents economic conditions and misleads people into making unsound investments. Investments that would not have been profitable beforehand suddenly seem attractive in light of the lower interest rates. These are malinvestments, which would not have been undertaken if the business world had been able to view the economy clearly instead of being misled by the Fed's false signals.

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

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

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

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

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

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

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

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

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

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

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

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