More On: Central Banks
The twentieth century was a century of absolute conflict. Limitations on the scope of war, which had been built up over many years, began to crumble in the nineteenth century, but were completely erased in the twentieth.
And, of course, the sheer amount of resources that centralized regimes could bring to bear in conflict, as well as the horrifying new killing technology that were accessible to them, made the twentieth century a century of nearly inconceivable terror.
It's not often that people analyze the evolution of total war with the evolution of contemporary central banking, which, while precursors existed long earlier, likewise came into its own in the twentieth century. It's no surprise that Ron Paul, the guy in public life who has done more than anybody to push the boundaries of what's acceptable to say in polite society on both of these issues, has also been so clear that the twin phenomena of war and central banking are related. "It is no accident that the century of total war coincided with the century of central banking," Dr. Paul added.
He continued, saying:
If every American taxpayer had to submit an extra five or ten thousand dollars to the IRS this April to pay for the war, I'm quite certain it would end very quickly. The problem is that government finances war by borrowing and printing money, rather than presenting a bill directly in the form of higher taxes. When the costs are obscured, the question of whether any war is worth it becomes distorted.
For the sake of my remarks today I take it as given that Murray Rothbard's analysis of the true functions of central banking is correct. Rothbard's books The History of Money and Banking: The Colonial Era Through World War II, The Case Against the Fed, The Mystery of Banking, and What Has Government Done to Our Money? provide the logical case and the empirical evidence for this view, and I refer you to those sources for additional details.
For the time being, I believe it is unarguable that central banks serve three important responsibilities for the financial system and the government. First, they operate as lenders of last resort, which translates into bailouts for large financial institutions. Second, they coordinate money supply inflation by creating a standard pace at which banks inflate, making the fractional-reserve banking system less volatile and more consistently lucrative than it would be in the absence of a central bank (which, by the way, is why the banks themselves always clamor for a central bank). Finally, they enable governments to fund their activities significantly more cheaply and covertly than they could otherwise.
The Fed, as a facilitator of inflation, is ipso facto an enabler of war. In 1919, Ludwig von Mises reflected on World War I and stated, "It is hardly an exaggeration to suggest that inflation is a necessary tool for militarism. Without it, the effects of war on welfare become apparent much more immediately and deeply; battle fatigue would set in much sooner."
No government has ever stated, "We must renounce central banking because we want to go to war," or "We must forsake inflation and the fiat money system because we want to go to war." "We must leave the gold standard because we want to go to war," governments constantly claim. That alone demonstrates the constraints that real money imposes on governments. Precious metals cannot be generated out of thin air, which is why governments oppose precious metal-based monetary systems.
Governments may generate funds in three ways. Taxation is the most apparent method of doing so, and it ultimately encounters public opposition. They may borrow the funds they need, but their borrowing is apparent to the public in the shape of increased interest rates – as the federal government competes for a limited quantity of accessible credit, credit becomes scarcer for other borrowers.
The third method, creating money out of thin air, is preferred by governments because the mechanism by which the political elite siphons resources from society through inflation is significantly less direct and visible than in the situations of taxes and borrowing. In the past, rulers cut the coins, saved the shavings, and then re-circulated the coins with the same nominal value. Governments carefully defend their authority once they acquire it. Mises once said that if King Charles I had had access to the Bank of England during the English Civil War in the 1640s, he might have defeated the parliamentary forces arrayed against him, and English history would have been quite different.
Juan de Mariana, a Spanish Jesuit who wrote in the 16th and early 17th centuries, is best known in political philosophy for having defended regicide in his 1599 work De Rege. Casual students often assume that it must have been for this provocative claim that the Spanish government confined him for a time. But in fact it was his Treatise on the Alteration of Money, which condemned monetary inflation as a moral evil, that got him in trouble.
Consider that. It was one thing to say the monarch may be assassinated. But taking direct aim at the regime's lifeblood, inflation? That was pushing it a little too far.
In those days, if a war was to be partially supported by monetary debasement, the technique was simple and straightforward. Today's events are more complicated, but, as I previously stated, not fundamentally different. Today, the government does not need to pay for a war, falls short, and just creates money to make up the difference. The procedure isn't nearly as crude. But, upon closer inspection, it turns out to be basically the same thing.
The establishment of central banks by the world's governments allows such governments to spend more than they earn in taxes. Borrowing enabled them to spend more than they earned in taxes, but government borrowing resulted in increased interest rates, which may irritate the public in unfavorable ways. When central banks print money and inject it into the banking system, they serve the interests of governments by lowering interest rates and thereby masking the impacts of government borrowing.
However, central banking accomplishes much more than this. It effectively prints money and gives it to the government, but not as directly or overtly.
First, the federal government is able to sell its bonds at falsely high prices (and so at artificially low interest rates) because purchasers of its debt know they may sell to the Federal Reserve. True, the federal government must pay interest on the securities owned by the Federal Reserve, but at the end of the year, the Fed returns that money to the Treasury, minus its minor operating expenditures. That takes care of the issue of interest. And, contrary to popular belief, the federal government is not required to pay at least the principal. When the government's current debt matures, it may roll it over by issuing a new bond to pay down the principal of the previous one.
The federal government is able to perform the equivalent of generating money and spending it via this intricate procedure – a mechanism that, ironically, the ordinary population is unlikely to be aware of or comprehend. While everyone else must acquire resources by spending money earned in a productive business — in other words, they must first generate something for society before they can consume – the government may obtain resources without first producing anything. Money production via government monopoly therefore becomes another vehicle for perpetuating the exploitative connection between government and the citizenry.
Because the central bank enables the government to disguise the cost of everything it does, it offers an incentive for governments to increase expenditure in areas other than war. However, since war is so costly, and the sacrifices that accompany it throw such a burden on the people, any government would appreciate the central bank's aid with wartime costs.
The Federal Reserve System, which was founded in late 1913 and opened its doors the following year, was put to the test for the first time during World War I. Unlike several other nations, the US did not forsake the gold standard throughout the war, although it was not functioning on a pure 100 percent gold standard in any event. The Fed had the ability and did engage in credit expansion. On Mises.org we feature an article by John Paul Koning that takes the reader through the exact process by which the Fed carried out its monetary inflation in those early years. In brief, the Fed essentially created money and used it to add war bonds to its balance sheet. Benjamin Anderson, the Austrian-sympathetic economist, observed at the time, "The growth in virtually all the items of the balance sheet of the Federal Reserve System since the United States entered the war has been very great indeed."
The Fed's accommodating role was not confined to wartime itself. In America's Money Machine, Elgin Groseclose wrote,
Although the war was over in 1918, in a fighting sense, it was not over in a financial sense. The Treasury still had enormous obligations to meet, which were eventually covered by a Victory loan. The main support in the market again was the Federal Reserve.
During the Vietnam War, monetary growth was very beneficial to the US government. Lyndon Johnson could have both his Great Society programs and his foreign war, and the pressure on the public was maintained within tolerable bounds – at least at initially.
By 1970, Arthur Okun, one of the decade's top presidential economic advisors, was saying in a published retrospective that good economic management seemed to have done away with the business cycle. However, reality could not be avoided indefinitely, and the ostensibly booming military economy of the 1960s gave way to the stagnation of the 1970s.
There is a universal rule that states that if the public is assured that the boom-bust economic cycle has been abolished for good, a bust is only around the corner. The recession occurred one month after Okun's cheery book was released.
Americans paid a high price for the 1960s inflation. The most cruel and horrible of these expenses was the loss of life as a consequence of the war itself, but the economic damage cannot be overlooked. As many of us recall, the US economy was beset by years of unemployment and rising inflation. Even worse, the stock market performed poorly. Mark Thornton observes that
in May 1970, a portfolio consisting of one share of every stock listed on the Big Board was worth just about half of what it would have been worth at the start of 1969. The high flyers that had led the market of 1967 and 1968 — conglomerates, computer leasers, far-out electronics companies, franchisers — were precipitously down from their peaks. Nor were they down 25 percent, like the Dow, but 80, 90, or 95 percent.
… The Dow index shows that stocks tended to trade in a wide channel for much of the period between 1965 and 1984. However, if you adjust the value of stocks by price inflation as measured by the Consumer Price Index, a clearer and more disturbing picture emerges. The inflation-adjusted or real purchasing power measure of the Dow indicates that it lost nearly 80% of its peak value.
And, for all the bluster about the Fed's claimed independence, it's difficult to picture the Fed sustaining a tight-money policy when the dictatorship wants stimulus or when soldiers are deployed. During the so-called War on Terror, it has been more than accommodating. Consider the amount of debt acquired by the Fed each year and compare it to that year's military spending to get a sense of the Fed's enabling role.
While it is true that a gold standard constrains governments, it is also true that governments have minimal problem creating pretexts to quit the gold standard, war being one of them. As a result, the gold standard is insufficient to curb the government's aspirations both at home and abroad.
As we look to the future, we must abandon all hesitancy in our monetary reform plans. We are not looking for a gold-exchange standard like the one that existed under the Bretton Woods regime. We do not intend to utilize the gold price as a calibration instrument to aid the monetary authorities in determining how much money to generate. We do not even desire the reinstatement of the traditional gold standard, as valuable as it is.
The wonderful term "separation of bank and state" was invented in the 1830s by hard-money Jacksonian monetary theorists. That'd be a start.
Today, we need the separation of money and state.
Money is distinct from other products in several respects. For one thing, money is valued not for its own sake, but for its ability to be exchanged. For another, money is passed from one person to the next rather than consumed. And the prices of all other products in the economy are stated in terms of this item.
But nothing about money — or anything else, for that matter — should lead us to believe that its manufacture must be carried out by the government or its chosen monopoly grantee. Money accounts for one-half of all non-barter market transactions. People who believe in the market economy yet are willing to give over custodianship of this most important good to the state should reconsider.
Interventionists may argue that a certain product is just too vital to be left to the market. The usual free-market response flips this argument: the more vital a commodity is, the more crucial it is for the government not to create it and instead leave it to the market.
This is especially true in the case of money. The history of money, as Ludwig von Mises famously stated, is the history of government attempts to eliminate money. Government control of money has resulted in monetary debasement, social impoverishment relative to the state, devastating business cycles, financial bubbles, capital consumption (due to falsified profit-and-loss accounting), moral hazard, and — most pertinent to my topic today — public expropriation in ways they are unlikely to understand. It is this quiet expropriation that has enabled some of the state's most heinous acts, including wars, and it is the sum of all of these misdeeds that constitutes a strong public case against the existing system and in support of a market solution.
In short, the war machine and the money machine are inextricably intertwined. It is pointless to condemn the moral grotesqueries of the US empire without also criticizing the crucial backing that makes it all possible. If we want to resist the state and all of its expressions — its imperial excursions, domestic subsidies, uncontrollable spending and debt buildup — we must point to its source, the central bank, the mechanism that the state and its cloistered media and economists will defend to the death.
The state has convinced the people that its interests are the same as theirs. It aims to improve their well-being. Its wars are its conflicts. It is the great benefactor, and the people must be satisfied with their position as its contented subjects.
We have a different point of view. The state's relationship with the people is not one of benign giver and grateful receiver. It is an exploitative relationship in which a slew of self-perpetuating fiefdoms that generate nothing survive at the cost of the laboring masses. Its wars do not safeguard the people; rather, they exploit it. Its subsidies do not advance the ostensibly public good; rather, they destroy it. Why should we anticipate its monetary generation to be an exception to this general rule?
As F.A. Hayek put it, it is illogical to believe that the state is interested in providing us with "good money." What the state wants is to create the money or to have a privileged position in relation to the source of the money so that it may distribute largesse to its preferred constituency. We should not be concerned with accommodating it.
The state makes no concessions, and neither should we. Few will challenge the state and the common wisdom it wants us to accept in the war for liberty against power. Fewer yet will oppose the state and its programs in their entirety. As we strive toward a future in which we are the many, we must be those few.
This is our objective today, as it has been the Mises Institute's mission for the previous 30 years. With your help, we will continue to produce books and journals, fund research and teaching in Austrian economics, publicize the Austrian School, and prepare tomorrow's advocates of the economics of liberty.
[Originally published under the title "Twin Demons."]