by Steve Forbes
In 1970, under Bretton Woods, European governments had balanced budgets. By the end of the decade they were all running deficits.
Pre-Copernican Monetary Policy in the Twenty-First Century
The Keynesian and monetarist bureaucrats who today set the monetary policies of the Fed and other central banks are like pre-Copernican astronomers who subscribed to the notion that the sun revolved around the earth. They are convinced that government can successfully direct the economy by raising and lowering the value of money.
After Janet Yellen, the new Federal Reserve chair, made some statements shortly after she took office, more than one news outlet wrote with characteristic awe that the Fed’s newest mandarin “signaled” that she would continue the taper, the scaling back of QE that began in the final days under Ben Bernanke. She left open the option of changing course if the economy did not continue to improve, telling the House Financial Services Committee, “Too many people are unemployed.”
This declaration reflects the prevailing Keynesian belief in the Phillips curve, a graph that purports to show that higher inflation increases employment. But, as we discuss later in Chapter 4 on inflation, this idea was long ago discredited by a succession of economists. Yet like so many other Keynesian assumptions, it is rarely if ever questioned.
The notion that a healthy economy requires a positive “balance of trade”—exports that bring in money from overseas—is absurd. And perhaps the most senseless and paradoxical idea is that the way to increase wealth creation is through policies that lower the value of people’s money.
These dangerous beliefs have done global economies immense harm. When you think about them, they make little intuitive sense. There is no way that monetary bureaucrats all over the world can possibly guide the activities of billions of people who engage in tens of billions of transactions every week.
The great periods of job creation and growth throughout history were not responses to changes in currency values. They were the work of entrepreneurs responding to real-world needs by coming up with innovations, from the invention of the steam engine to the creation of the personal computer. Indeed, as we will discuss later, one of the most creative periods of technological innovation, the late nineteenth century, occurred during a rare interlude of stable money and unimpeded capital creation, the era of the classical gold standard.
There has not been one instance in history where active monetary management has advanced an economy. The only time central bank intervention has produced truly positive benefits is when it cleaned up a mess created by its own policies. The outstanding example is when the Federal Reserve under then chair Paul Volcker tightened money in the early 1980s to break the back of the 1970s’ inflation, which the Fed’s prior policies had created in the first place.
Four Decades of Money Mismanagement
Since the decimation of the Bretton Woods system, the dollar has been on a four-decade downward slide, with only periodic interruptions.
One interlude of relative stability was “the great moderation” during the Reagan administration under Paul Volcker. Successor Alan Greenspan’s strengthening of the dollar in the late 1990s produced mild deflation, but the Fed then reverted to form: the weak dollar policy that led to the crisis of 2008–2009.
Greenspan was followed by Bernanke and his policy of quantitative easing. At its height, the Fed was expanding the monetary base by buying about $85 billion in bonds a month. To put that in perspective, in 1971 the entire monetary base was $85 billion. Today it is well past $4 trillion and climbing.
Over the last decade the United States has led the way in what has been a global monetary expansion. The European Central Bank increased its balance sheet to record levels in 2012, though not as much as the Fed. Even Japan, which has traditionally gone in the opposite direction with monetary policies based on tight money, has lately talked about weakening the yen.
The overall global expansion has slowed and the economy has improved somewhat thanks to the taper. But, given past history, the scaling back of QE is more likely to be a short-lived pause than a turn toward saner policy—unless the public awakens to the need for stable money.
The 1970s Redux?
There were such pauses in the inflationary 1970s after Richard Nixon ended the gold standard system. Keen observers like Nathan Lewis and others have pointed out that the malaise that began in the middle part of the last decade looks a lot like the 1970s, another period of global monetary expansion and instability.
There are some differences: unlike the 1970s, the past 10 years have not seen an enormous rise in consumer prices. Both periods, however, have experienced ferocious market swings, soaring energy and commodity prices, unrest in the Middle East, and high unemployment. As with the 1970s, gold prices soared, peaking at $1,896.50 in 2011. GDP growth, which as of 2014 is around 2%, is not much better than the average rate of growth from 1968 to 1982.
All of this should be no surprise. Today’s disasters are the products of the same Keynesian thinking that gave us the stagflation of the 1970s. Those ideas were wrong then. They are wrong now.
Lifting the Veil off the Fed’s Mystique
All of this raises the question: Why has there been so little discussion of these policy failures and of money? One explanation is that for many people, including those in the media, conversations about monetary policy can seem dry and somewhat forbidding—a surefire way to discourage unwanted conversations on airplanes. The mystique that surrounds the Federal Reserve is sufficient to have inspired William Greider to title his classic book about the Fed Secrets of the Temple.
The dense, bureaucratic lingo of central bankers has long elicited eye-rolling among journalists who have dubbed it “Fed-speak.” Its most famous practitioner, former Federal Reserve chairman Alan Greenspan, famously quipped, “Since I’ve become a central banker, I’ve learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.” As one former official put it, Fedspeak is “a language in which it is possible to speak without ever saying anything.” Insiders insist that Fedspeak is needed to avoid strong statements that can jar markets. But the opaque jargon also discourages scrutiny.
Further inhibiting debate are the Keynesians and monetarists who dominate the media and policy establishment. Keynesians believe in the welfare state and fear that a return to fixed exchange rates will mean less spending and smaller government. That isn’t true. The Germans under Otto von Bismarck invented the welfare state in the 1880s, and they were better able to afford it because they maintained sound money. Stable money, as well as continuous tax cutting, allowed the German economy after World War II not only to recover but actually to surpass the rest of Europe and Great Britain.
The misguided Keynesian perceptions about money have produced one disaster after the next. A better awareness of the origins and fallacies of today’s thinking are crucial for turning things around.
More people must recognize that the seemingly dry pronouncements of monetary bureaucrats have serious and often destructive consequences. As this book will show, they play out not only on the financial pages but also in the lives of each and every individual in the world.
THE NUGGET
An unstable currency means an unstable economy and less prosperity.
CHAPTER 2
What Is Money?
Money is the foundation stone in the political framework of a civilized community. . . . But stable community requires a stable currency.
—LEWIS E. LEHRMAN, Money, Gold, and History
WHAT IS MONEY?
Millions of words have been written attempting to answer this question. Most of them have decreased, rather than increased, understanding. The answer is simple. Money has three roles in an economy:
1. It is a measure of value.
2. It is an instrument of trust that permits transactions to take place between strangers.
3. It provides a system of communication throughout a society.
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bsp; Measurement. Trust. Communication. In order to function in these roles, money, above all, must be stable. When it isn’t, it becomes impaired and an economy suffers. In the worst instances, when money stops working altogether, a society can be destroyed.
Money is a tool that facilitates transactions. It does not create them. And money, in and of itself, is not wealth—nor does increasing the supply of money by the whims of central bankers mean that wealth will be created. In fact, the opposite is the case.
This chapter discusses how money functions as a standard of measurement, a facilitator of trust, and a system of communication. Disasters wrought by bad monetary policy have all occurred because of a failure to grasp these three fundamental principles.
Money Is a Unit of Measurement
Money is a standard of measurement, like a ruler or a clock, but instead of measuring inches or time, it measures what something is worth.
Imagine what the world would be like if the number of minutes in an hour changed each day or if the number of inches in a foot kept changing. Life would become infinitely more difficult. How could a music teacher know what to charge for an hour-long music lesson if one hour was composed of 60 minutes one week and 70 minutes the next? How could an architect design a house if a foot consisted of 12 inches on a given day but a short time later it was 15 inches? Imagine how tricky it would be to bake a cake if the recipe called for 45 minutes in the oven, and you had to figure out if those were nominal minutes or inflation-adjusted minutes.
Just as we need to be sure of the number of inches in a foot or the minutes in an hour, people in the economy must be certain that their money is an accurate measure of worth. When the value of money fluctuates, as it so often does today, it produces uncertainty in addition to unnatural and often destructive marketplace behavior—artificial booms and busts that breed malignant economic and social consequences. Graphic examples include Germany after World War I and the United States during the 1970s, as well as in the past decade.
People, Not Government, Invented Money
People accustomed to Uncle Sam’s ubiquitous dollar and other national currencies rarely recognize that government did not invent money. Money originated in the marketplace as a solution to a problem. It arose spontaneously, like the spoon or the personal computer, in response to a need. In this case, the need was for a stable unit of value to facilitate trade.
The earliest coins were invented in ancient times in response to the challenges of barter. In order for a successful exchange to take place, there had to be what economists have called a “double coincidence of wants.” Each side had to want the precise item offered.
For example, if Forbes magazine had sold an advertisement before the advent of money, we might have been paid with a herd of goats. For the sake of illustration, let’s say iPads existed in those days and we wanted to buy them for our writers. We’d take our herd of goats to an Apple Store. But the proprietor informs us that he wants sheep instead of goats. So now we have to figure out how to swap goats for sheep. In the process we would have to hire a shepherd to make sure wolves didn’t eat the sheep. The shepherd wants to be paid in wine. We have red wine, but he wants white wine. You can readily see how utterly inefficient and cumbersome barter is for getting things done.
In economics class we all learn that money is a medium of exchange, that it has certain physical characteristics. It should be fungible. One unit, like a gold bar or coin, should be interchangeable with another, and it should be portable and easy to store for use later. (That’s why, as some have observed, chocolate coins in gold wrappers would not work as money, especially in hot weather.)
First and foremost, money must be stable.
The Virtues of Stable Money
Stability is best achieved by a link to a commodity. Over the centuries, precious metals, such as silver and especially gold, most often have served this purpose. But other commodities, such as seashells, fur, fish, corn, rice, and tobacco, have also worked as currencies. Tobacco notes were used as money during colonial times. Prisoners of war used cigarettes as money during World War II, as did the Germans for several years after the war.
Milton Friedman’s classic book Money Mischief tells the famous story of South Pacific Islanders who traded with giant stone coins known as fei. Because the islanders believed this money had great intrinsic value, the fei was extremely reliable as an indicator of worth. But the currency failed miserably when it came to portability. According to an eyewitness, it “[consisted] of large, solid, thick, stone wheels, ranging in diameter from a foot to twelve feet.” Islanders had to insert a pole in the center of one of these giant coins to roll it around.
One couldn’t ask for a less convenient currency. But the giant stones worked as currency because the islanders believed that they were a reliable measure of value. The Pacific Islanders did not fear that their tribal council would suddenly decree that there should be twice the number of fei—and their money would be worth less.
When Money Doesn’t Work
Having a track record for soundness also helps fortify a currency. That’s one reason why money has generally little value in communist nations racked by shortages of consumer goods. How can you know that your money is an accurate measure of worth if there’s very little to buy? The Cuban government, for example, knows the Cuban peso is nearly worthless. That’s why it demands that tourists buy pesos with dollars at a grossly inflated price far above black market rates.
In the Soviet Union, consumers were always hungering for decent meats, fruits, and vegetables. But even if you had a fistful of rubles, your money usually couldn’t buy these scarce staples unless you were politically connected and had access to special stores used by the party elites.
All the East German ostmarks in the world could not have bought a Trabant, the government-manufactured automobile. The infamous clunker was harder to get than a BMW, not because it was desirable but because the Trabant was virtually the only vehicle East Germans were allowed to get, and Trabants were strictly rationed.
Little wonder that both the ostmark and the ruble were perceived as nearly worthless. Communist currencies all sold in black markets at a fraction of their official exchange rates. The country’s communist governments may have maintained the charade of a sound and stable currency, but the reality of the marketplace said something different: you never knew the purchasing power of your money because you couldn’t be sure what goods would be available from day to day.
In the Soviet Union, the situation was summed up by the commonly heard expression “we pretend to work, and they pretend to pay us.” Not surprising that productivity and the quality of products was notoriously poor.
The communist currencies and the fei also illustrate the second critical characteristic of money: it’s about trust.
In Money We Trust—or Not
Money facilitates trade by creating trust between both sides in a transaction. In the days of barter if you exchanged, say, eggs for a loaf of bread, you could not be certain whether you would be getting fresh bread or day-old bread. But if you exchanged your eggs for money, you could trust in the value of what you were getting.
The media like to portray money as a fomenter of conflict. In fact, throughout history, money has promoted cooperation, bringing together buyers and sellers who are total strangers but who agree upon a standard measure of value. The historian Jack Weatherford and others have described how money has transformed society by making traditional kinship and social relationships less important. For this reason money creates a meritocracy, empowering smaller players to challenge the established order.
The power of money to create meritocracy was why Alexander Hamilton, the first secretary of the treasury under George Washington, proposed a new U.S. Mint that would produce coins as small as copper cents and half-cent pieces in order to make possible prices that were affordable for the poor. Born in the West Indies to a single mother, Hamilton had a unique appreciation of the ability of money to promote a culture
of opportunity that enabled outsiders to rise. In the words of biographer Forrest McDonald, Hamilton keenly understood that “money is oblivious to class, status, color and inherited social position; money is the ultimate, neutral, impersonal arbiter.” Hamilton built a financial system based on money and markets because he wanted America to be, in McDonald’s words, a “society fluid and open to merit.”
Money must be trusted for an economy, and also a society, to function. The value of money has less to do with whether it is made of metal or paper and more to do with perceptions.
People can lose faith in money as a result of a cataclysmic event—for example, a war. But more often this loss of faith happens when governments, for whatever reason—such as building bloated welfare states or financing costly military conflicts—print too much money or seem likely to do so in the future.
A profound and far-reaching loss of faith can produce a disastrous, self-fulfilling scenario: a massive sell-off of a currency on the foreign exchange market. At its worst, this kind of attack can bring on a death spiral and collapse in monetary value. This can accelerate inflation at home and cause a government to sharply raise interest rates, throwing an economy into severe recession. It can set off a panic that can spread to other nations.
In 2013 when the Federal Reserve indicated that its promiscuous bond buying would taper off and thereby lead to higher U.S. interest rates, emerging countries such as Brazil, India, Turkey, and Indonesia saw the value of their currencies weaken in anticipation that banks and companies would pull money out of those nations to take advantage of rising interest rates in the United States.
