Money Bawl
From the February 20, 2012, issue of NR

Ron Paul campaigns in Golden Valley, Minn., February 7, 2012.


Ramesh Ponnuru

Monetary expansion is also, for Paul, a key enabler of what he takes to be our imperialist foreign policy: The creation of money out of thin air allows the government to finance wars, as well as the welfare state. Central banking is a form of central planning, on his theory, and as such “incompatible” with freedom. Paul allows that “not every supporter of the Fed is somehow a participant in a conspiracy to control the world.” The rest of them, judging from comments repeatedly made in the book, have fallen for the delusion that expanding the money supply is a “magic means to generate prosperity.” Paul finds it baffling that anyone could hold this absurd view, but attributes it to Chairman Bernanke, among others.

Almost all of the criticisms Paul makes of central banking, when stated in the axiomatic form he prefers, are false. To put it more charitably, he assumes that the negative features that monetary expansion can have in some circumstances are its necessary properties. Consider, for example, a world in which the Federal Reserve conducts monetary policy so that the price level rises steadily at 2 percent a year. Savers, knowing this, will demand a higher interest rate to compensate them for the lost value of their money. If the Fed generates more inflation than they expected, as it did in the 1970s, then savers will suffer and borrowers benefit. If it undershoots expectations, as it has over the last few years, the reverse will happen. The anti-saver redistribution Paul decries is thus not a consequence of monetary expansion per se, but a consequence of an unpredictedly large expansion. For the same reason, monetary expansion does not necessarily lead to less saving. There is no reason to believe that the real burden of home loans would be any larger in a world with 2 percent inflation than in one with 1 percent inflation.

Nor is the wage earner necessarily defrauded. Continuing with our scenario of a steady 2 percent increase in the price level, the prices he pays after ten years are higher but, on average, so are his wages. There is no reason to expect a larger money supply over the long run to affect relative prices — to change the ratio of the cost of a week’s supply of vegetables to a week’s wages, for example. That’s why central banking isn’t central planning: It never attempts to fix the relative prices or quantities of all the goods an economy produces, and it cannot cause the total amount of goods an economy produces to hit any particular target.

Paul is right that more money does not magically produce more goods in circulation over the long run. (So right, that nobody believes otherwise.) It’s because he’s right that we ought not to regard all of the prosperity of the last few decades as an illusion. Productivity growth was real and we don’t have to roll it all back and start over with a better monetary regime.

Paul’s contention that the Fed has continuously abetted the expansion of the state — its wars, its welfare, its attacks on civil liberties — is also false. The federal government uses its monopoly over the currency to finance very little of its spending. It gets almost all of its money through taxing and borrowing, and the borrowed funds come from people who are well aware of the need to charge a premium to cover the risks of inflation.

The doctor’s prescription is as mistaken as his diagnosis. The drawbacks to a gold standard are well known. If industrial demand for gold rises anywhere in the world, the real price of gold must rise — which means that the price of everything else must drop if it is measured in terms of gold. Because workers resist wage cuts, this kind of deflation is typically accompanied by a spike in unemployment and a drop in output: in other words, by a recession or depression. If the resulting economic strain leads people to fear that the government may go off the gold standard, they will respond by hoarding gold, which makes the deflation worse.

If another country’s government begins hoarding gold, the same thing happens. This is not a theoretical concern: It’s what France did in the early years of the Great Depression. Countries were forced off the gold standard, and recovered in the order they left it. Representative Paul’s strategy for dealing with the theoretical and historical arguments against the gold standard in End the Fed is to ignore all of them. All he says is that problems arose in the 1930s because of the “misuse of the gold standard.” But note that the great advantage of the gold standard is supposed to be that governments cannot manipulate it. Concede that they can and the argument is half lost.

People who see through Paul’s illogic, misapprehensions, and paranoia typically dismiss everything he has to say about money. But buried beneath all of that are some reasonable points. The Fed doesn’t have a great track record, and keeping it in its present form may not serve us well. In a recent study for the Cato Institute, three academic specialists in monetary policy noted that the Fed, in its first decades, generated a severe inflation and a severe depression; that it does not seem to have stabilized the economy; and that it has extinguished the kind of benign, productivity-driven deflation that the country sometimes experienced before the Fed’s creation.

The purpose of money, as Paul rightly describes it, is to facilitate exchange and thus the coordination of economic plans. A governmental institution with discretionary control over the money supply — which is a good working definition of a central bank — undermines that goal because no clear rule constrains it, forces it to behave predictably, and thus enables economic actors to make and coordinate their plans against a background of monetary stability. Central banking is not central planning, but it does reflect an unwarranted confidence in the ability of government officials to engineer beneficial economic outcomes.