The United States and most of the rest of the world are, once again, in the midst of an inflationary crisis. Prices in general are rising at annualized rates not experienced by, especially, the industrialized countries of North America and Europe for well over 40 years. More than 50 percent of the U.S. population is under 40 years of age, meaning that half of the people in the country have never experienced in their life time a period of rising prices such as is now occurring.
It is not surprising, therefore, the shock that it has had for so many. There was a period of time in the late 1970s when price inflation, as measured by the Consumer Price Index (CPI), was going up at an annualized rate of nearly 15 percent. That was the highest since during the American Civil War, more than a hundred years earlier. So, the nearly 9 percent price inflation in the summer of 2022 was something totally new for the average American family.
Prices Do Not All Rise By the Same Amount at the Same Time
It is worth keeping in mind that the headline CPI number is only a statistical averaging of a selected group of individual prices chosen to reflect the representative purchases of an “average” urban American family in terms of the goods purchased and their relative amounts in a hypothetical “basket” of items. Break that down into the subcategories of different goods and services, and many of these subgroups of goods have been registered as rising much more or noticeably less than the general CPI number. For instance, in August of 2022, fuel oil prices were almost 69 percent higher than a year earlier, while food prices in general were between 11 and 13 percent above where they were in August of 2021. Housing prices were “only” 6 percent above 12 months earlier.
But any way that it is looked at, this is a new experience for most Americans used to an average rise in prices of only 2 to 3 percent a year for much of the last four decades. It is one thing to be a bit irritated because something that cost, say, $100 last year costs $102 today. But it is another matter entirely when what cost $100 last year may now cost $133 or even $169. When that is happening not to just one or two or three significant items in a basket of purchased goods but to many or most of what is regularly being bought, “inflation” becomes a budgetary crisis for many families across the country.
Rising Prices Are the Effect of An Earlier Monetary Action
What is missed in all of this is that the general rise in prices is a symptom and not the cause of the problem. We all know that if we take someone’s temperature, the number registered on the thermometer indicating a fever is not the cause of that fever; it is merely telling us that person’s body temperature is above what is considered “normal.” It does not explain or answer what is behind the “read” on the thermometer.
Suppose that someone has a regular income of $1,000 and that he spends, say, $500 on commodity “x,” $250 on commodity “y,” and $250 on commodity “z.” If this is all the money at his disposal and he wants to increase his spending on commodity “y” to $300, then he must reduce his purchases by $50 on either commodity “x” or commodity “z,” or some reduced combination of the two. He might draw down previously accumulated cash holdings or borrow the $50 from someone else. But in the former case, there will be a point at which he has drawn down all his available cash, and he must therefore restrict his overall purchases to his regular $1,000 income. If he borrows the money, it means that the lender must reduce a loan to another borrower by $50.
Whether it’s an individual or a community of individuals, the total sum of money available to that person or group of individuals sets the maximum of dollars offered in exchange for desired goods and services, as a whole. Only if the number of dollars in the hands of that individual or community increases can the demand for and prices of one or more goods rise without some complementary decline in money demand for some other good(s). Overall “price inflation” cannot occur over any sustained period of time without a preceding or contemporaneous increase in the total amount of money in the economic community of buyers and sellers.
The Gold Standard Served as a “Check” on Inflation
The type of gold standard that prevailed before the First World War provided a natural check on any increases in the supply of money in any country. Paper currencies (“bank notes”) issued by the central banks or commercial banks of the time were not the actual “monies.” They were claims to quantities of gold deposited by bank customers, serving as convenient money substitutes to the gold for facilitating everyday market transactions. In principle, bank depositors could redeem those notes for a fixed sum of gold during ordinary business hours. In practice, governments could and did “intervene” and influence the money supply at various times, but in general, this was the exception and not the rule, and only within relatively narrow limits.
If the number of bank notes were to increase in general, this required a net inflow of gold into the banking system as a whole. For instance, if there was an increase in the demand for gold as money, its value would rise, setting in motion the profitability of gold prospecting, mining, and extracting, leading to an increase in the minting of additional gold in the form of coins or bullion. If deposited in a banking institution, notes representing the additional gold left in depositors’ accounts were issued as the rightful claims to it. Likewise, if there were a net withdrawal of gold from the banking system, the total quantity for bank notes in circulation would decrease.
What has just been explained is, no doubt, a simplification that in reality was never perfectly matched or followed. Nonetheless, it did reflect the general monetary “rules of the game” under the then-prevailing gold standard, which kept politically influenced increases in the money supply within narrow bands, both within countries and between them.
World War I Broke the Golden Chains Limiting Inflation
But all this changed with the coming of the First World War in 1914. All the belligerent powers in Europe rapidly took their respective countries “off the gold standard,” that is, prohibited the redemption of bank notes for gold, or the exportation of gold without government permission. The respective central banks were ordered to provide the needed and necessary monetary sums to financially cover large portions of the costs of war; usually, the procedure was for the nation’s government to issue war bonds and for the central bank to buy them up and print paper money to purchase them, with that paper money passing into the coffers of the government to spend as needed for the war.
The United States entered the war on the Allied side only in April 1917, a bit more than a year and a half before the war ended in November 1918. The United States did not go off the gold standard in the same manner the other combatant governments did. Still, the recently established American central bank, the Federal Reserve System, ended up printing money equal to about 40 percent of the Woodrow Wilson administration’s war expenditures.
Price inflations were experienced in all the countries at war, but their full effects were suppressed from view through systems of wartime wage and price controls. When the war ended, catastrophic hyperinflations were experienced in countries like Germany and Austria. There were half-hearted attempts to “return” to gold standards in both victorious and defeated nations in the 1920s, but they were nothing like the monetary systems that prevailed before 1914. Within a short period of time following the beginning of the Great Depression in 1929–1930, all the major countries of the world had, either de jure or de facto, left the gold standard to give governments the discretionary ability to fund growing budget deficits to “fight” the depression.
Keynesian Economics Rationalized Unending Deficit Spending
In America after 1933, Franklin D. Roosevelt’s New Deal policies included the confiscation of the citizenry’s gold, with depreciating paper Federal Reserve Notes given in exchange to make it easier to fund FDR’s budget deficits. “The Fed” then created even larger quantities of money to cover U.S. government spending in the Second World War. In addition, by the end of the war in 1945, Keynesian economics held a near monopoly hold on monetary and fiscal policy thinking in America and most of Europe.
In Democracy in Deficit (1977), James M. Buchanan (1919–2013) and Richard E. Wagner argued that in the nineteenth century, the fiscal policy norm was a balanced budget. When occasional national emergences arose (usually wars), government borrowing might be necessary to fund unexpected war costs, but when the crisis passed, it was expected that the government would run budget surpluses to pay off any accumulated debt. The annual balanced budget rule assured political transparency to government spending; those proposing new or enlarged government programs would have to explain how much it would cost and how the tax money would be raised to pay for it and, therefore, upon whom would the “tax incidence” would fall. The tax costs of whatever government did were closely linked to the presumed “benefits” of what the politicians wanted to do with “other people’s money.”
But John Maynard Keynes, in The General Theory of Employment, Interest, and Money (1936), threw this overboard. He argued that it should be the responsibility of the government to “macro”-manage the economy to ensure targeted levels of aggregate employment, output, and the general price level. Those in government needed the discretion over monetary and fiscal policy to make the necessary twists and turns needed to keep the economy on an even keel. Government budgets should be balanced not on a rigid annual basis but over the phases of the business cycle, with deficits in recessionary “bad years” and surpluses in the inflationary “good years.”
The practical problem is that once the institutional restraints of both the gold standard and the balanced budget rule were set aside, the political incentives and interests of both politicians wanting to be elected or reelected and special interest groups wanting goodies from the government by offering politicians campaign contributions and election-day votes opened the floodgates to never-ending deficit spending, year after year, regardless of their being “good times” or “bad times.” The “benefits” of government spending could be extended far and wide with borrowed money that hid the real price tag of it all, and the Federal Reserve could make it a lot easier and cheaper for the government by “monetizing” the debt through monetary expansion.
Central Bankers as Monetary Central Planners
At the same time, Keynesian economics and related policy perspectives cultivated the social-engineering mentality that it is within the knowledge, wisdom, and ability of the “experts” in government to plan the direction and shape of an entire economy through the right monetary and fiscal tools in the hands of those presumed to be qualified to turn the monetary dials and pull the fiscal levers. Those who oversee the Federal Reserve are, in fact, monetary central planners.
The Board of Governors of the Fed and all those who work with them at America’s central bank do not view money, credit, and interest rates as market-originating and market-based aspects of the competitive order, within a financial system that is meant to be the intermediary institution for coordinating the plans and actions of savers and investors. No, they are considered to be activist policy “instruments” to be used and manipulated as part of that plan to direct and shape the economy as a whole. And like all forms of central planning, it has, time and again, been a disastrous failure.
At the beginning of the twenty-first century, the Federal Reserve Board of Governors feared that the country might be facing a “dangerous” period of—oh, no!—price deflation. So the monetary spigot was opened wide between 2003 and 2008, with a 50-percent increase in the money supply (M-2) that pushed real interest rates into the negative range (when adjusted for price inflation), which fostered an investment boom and facilitated an unsustainable housing bubble that all came crashing down in 2008–2010.
This was followed for the next 10 years with a new era of “quantitative easing,” a fancy term for the Federal Reserve buying even more government debt instruments, along with shaky home mortgages and a variety of other financial assets; the result was that the money supply tripled in size over that decade, from 2010 to 2020. Then when the coronavirus crisis caused political panic in early 2020 and governments around the world followed the Communist Chinese model of commanding production and retail shutdowns and lockdowns, with restrictions on consumer spending and orders for people to stay at home, the economies of the world crashed with varying degrees of severity.
Monetary Madness During COVID and Beyond
Just between 2020 and 2022, the money supply has, again, dramatically increased by 50 percent over that 24-month period, enabling the federal government to spend even more trillions of borrowed dollars to “save” the economy from the massive social and economic upheaval that its own coronavirus policies created. Now, when, finally, its own monetary policies finally bring forth the recent rise in prices in the economy, the Federal Reserve central planners are “shocked, shocked,” to be faced with a price inflation that they had been saying would not occur or would be merely “transitory” for a few months.
At the same time, what is their answer to the new “inflationary crisis?” Don’t worry, they tell us, they know just the right amount by which to manipulate interest rates in an upward direction to ease the rising prices by curbing spending and borrowing and, miraculously, without pushing the economy into a recession. When they likely fail in this, their almost inevitable response will be: “Don’t worry, we’ve learned new and important lessons; you can trust us to get it right—next time.”
The fundamental problem is that there cannot be any successful “next time.” One reason is that as long as there is a central bank, it will be susceptible to direct and indirect political pressures. Somehow the now $1 trillion-a-year budget deficits must be financed; somehow, it must ensure that the interest rates government has to pay for its borrowed money are kept at the lowest possible manipulated levels; somehow, someone has to make sure that the economy does not crash into another Great Depression, with all the resulting political spillover effects on those holding high public office.
The “somehow” is the Federal Reserve and the “someone” are its board of Governors. Let us not forget that those board members are nominated by the president and confirmed by the Senate, just like an ambassador to a foreign country. Those nominated and approved will always be those who can be trusted to do the “right” thing politically. When not too long ago a known proponent of the gold standard was proposed for a seat on the Fed board, that person was soon ridiculed and condemned in Congress and in the media as someone unqualified for such an important position; after all, they might have tried to turn off the monetary spigot!
Government Control of Money Undermines a Free Economy
While in exile in America during the Second World War, the German free-market economist Gustav Stolper (1888–1947) published a book analyzing This Age of Fable (1942). He pointed out:
Hardly do the advocates of free capitalism realize how utterly their ideal was frustrated at the moment the state assumed control of the monetary system. There is today only one prominent liberal theorist consistent enough to advocate free, uncontrolled competition among banks in the creation of money, [Ludwig von] Mises…Yet, without it the ideal of a state-free economy collapses. A “free” capitalism with governmental responsibility for money and credit has lost its innocence. From that point on it is no longer a matter of principle but one of expediency how far one wishes or permits governmental interference to go. Money control is the supreme and most comprehensive of all government controls short of expropriation. (p. 59)
The boom-bust cycles of inflations and recession and the political use of money-creation to serve the deficit spending needs of governments will never be effectively and permanently ended until central banking has been ended. Monetary matters must be fully returned to the market process of competitive supply and demand. “The market”—which means all of as a multitude of individuals interactively buying and selling, producing, and consuming in society—should decide what commodities or other substances seem most useful and effective as a medium (or media) of exchange.
Government should have nothing to do with what is used as money, and the legal system should recognize and enforce all freely and honestly entered into contracts, including those concerning the money in terms of which exchanges are agreed to be made. No currency, such as Federal Reserve Notes, should be given any special status, as they are under legal-tender laws.
Money, after all, was not originally a creation of the state. It emerged “spontaneously” out of the discovered uses and benefits by market participants of some valued and convenient commodity as a medium of exchange to overcome the barriers to successful trade under conditions of barter (the direct exchange of one commodity for another). From ancient times on, those in political authority have found it advantageous to assert control over the monetary system, because whatever commodity comes to be used as money is the commodity by which everything else desired by consumers is purchased. How much better to debase coins or print paper money to gain access to all the goods available on the market without having to arouse the resentment and resistance of those who otherwise would have to be more directly taxed for the government to have access to the funds it wants to spend.
Central Banking and the Business Cycle
Central banking also is the institutional conduit through which the booms and busts of the business cycle are created. After the federal government has issued debt instruments to fund its borrowing in the financial markets, the Federal Reserve then buys them up in what is called the “secondary market.” They create money to purchase them “out of thin air,” through the click of the mouse on the computer screen. This money now enters the banking system, and the banks receiving this newly created money as deposits find themselves with “excess reserves” available for lending purposes. Additional borrowers are attracted by the lower interest rates at which these new loanable sums may be acquired for investment and other uses.
From this “injection” point, the new money is spent first by those who have taken up additional loans; the new money now passes to another group of hands in the economy, those who have sold goods and services to those borrowers. From this second set of hands, the money is now spent and passes to a third group of hands. Like a pebble dropped into a pond, from the epicenter point at which the money enters the economy, waves of demand are created, first for one set of wanted goods, and then another, and then another in a patterned sequence.
In the process of bringing about a general rise in prices, the structure of relative prices and wages is distorted, with supplies and demands misdirected and resources, including labor, misallocated. The interest rate manipulation brings about a potential mismatch between actual and available savings in the economy and investments undertaken; this brings about unsustainable investment, housing, and stock market booms. When the downturn finally comes, all the resulting malinvestments and misdirection of resources, capital, and labor become evident. The recession is really the recovery process stage of the business cycle, when prices, supply and demand, and resource and labor use are readjusted and rebalanced to restore the market conditions for a healthy return to real and sustainable employment, investment, and longer-term economic growth.
Monetary Freedom and Competitive Free Banking
There is no way of knowing what market interest rates should be in terms of effectively coordinating and balancing actual savings with borrowing demands other than letting market competition in financial markets find out what the appropriate “equilibrium” rates of interest are, and how they should change in always changing market circumstances.
There is no way of knowing what commodities should be the used as money other than allowing market participants to choose the monies most advantageous in market transactions of various and sundry sorts. There is no way of fully knowing how financial institutions should function in terms of individual bank currencies, or the cash reserves banks might find it appropriate and judicious to hold against outstanding bank liabilities other than discovering these things through allowing a free, unregulated, and competitive banking sector no longer under government regulatory control or political influence.
Monetary central planning is no more desirable or workable than any other form of government central planning. The institutional goal, in other words, should be an end to monetary policy through the abolition of central banking. The ideal, therefore, is monetary freedom. Without it, the long-run possibility and sustainability of a truly free market society may not be fully possible.
This article was originally featured at the Future of Freedom Foundation and is republished with permission.