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In Praise of Price Gouging – Article by Ron Paul

In Praise of Price Gouging – Article by Ron Paul

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The New Renaissance Hat
Ron Paul
November 12, 2012
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As the northeastern United States continues to recover from Hurricane Sandy, we hear the usual outcry against individuals and companies who dare to charge market prices for goods such as gasoline. The normal market response of rising prices in the wake of a natural disaster and resulting supply disruptions is redefined as “price gouging.” The federal government and some state governments on the East Coast claim that price gouging is the charging of ruinous or exploitative prices for goods in short supply in the wake of a disaster and is a heinous crime  But does this reflect economic reality, or merely political posturing to capitalize on raw emotions?

In the wake of Hurricane Sandy, the supply of gasoline was greatly disrupted. Many gas stations were unable to pump gas due to a lack of electricity, thus greatly reducing the supply.  At the same time demand for gasoline spiked due to the widespread use of generators. Because gas stations were forbidden from raising their prices to meet the increased demand, miles-long lines developed and stations were forced to start limiting the amount of gasoline that individuals could purchase. New Jersey gas stations began to look like Soviet grocery stores.

Had gas stations been allowed to raise their prices to reflect the increased demand for gasoline, only those most in need of gasoline would have purchased gas, while everyone would have economized on their existing supply. But because prices remained lower than they should have been, no one sought to conserve gas.  Low prices signaled that gas was in abundant supply, while reality was exactly the opposite, and only those fortunate enough to be at the front of gas lines were able to purchase gas before it sold out.  Not surprisingly, a thriving black market developed, with gas offered for up to $20 per gallon.

With price controls in effect, supply shortages were exacerbated.  If prices had been allowed to increase to market levels, the profit opportunity would have brought in new supplies from outside the region.  As supplies increased, prices gradually would have decreased as supply and demand returned to equilibrium. But with price controls in effect, what company would want to deal with the hassle of shipping gas to a disaster-stricken area with downed power lines and flooded highways when the same profit could be made elsewhere?  So instead of gas shipments flooding into the disaster zones, what little gas supply is left is rapidly sold and consumed.

Many governments fail to understand that prices are not just random numbers. Prices perform an important role in providing information, coordinating supply and demand, and enabling economic calculation. When government interferes with the price mechanism, economic calamity ensues. Price controls on gasoline led to the infamous gas lines of the 1970s, yet politicians today repeat those same failed mistakes. Instituting price caps at a below-market price will always lead to shortages. No act of any legislature can reverse the laws of supply and demand.

History shows us that the quickest path to economic recovery is to abolish all price controls. If governments really want to aid recovery, they would abolish their “price-gouging” legislation and allow the free market to function.

Representative Ron Paul (R – TX), MD, was a three-time Republican candidate for U. S. President. See his Congressional webpage and his official campaign website. 

This article has been released by Dr. Paul into the public domain and may be republished by anyone in any manner.

Gold is Good Money – Article by Ron Paul

Gold is Good Money – Article by Ron Paul

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The New Renaissance Hat
Ron Paul
October 1, 2012
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Last year the Chairman of the Federal Reserve told me that gold is not money, a position which central banks, national governments, and mainstream economists have claimed is the consensus for decades.  But lately there have been some high-profile defections from that consensus.  As Forbes recently reported, the president of the Bundesbank (Germany’s central bank) and two highly respected analysts at Deutsche Bank have praised gold as good money.

Why is gold good money?  Because it possesses all the monetary properties that the market demands: it is divisible, portable, recognizable and, most importantly, scarce – making it a stable store of value. It is all things the market needs good money to be and has been recognized as such throughout history.  Gold rose to nearly $1800 an ounce after the Fed’s most recent round of quantitative easing because the people know that gold is money when fiat money fails.

Central bankers recognize this too, even if they officially deny it.  Some analysts have speculated that the International Monetary Fund’s real clout is due to its large holdings of gold.  And central banks around the world have increased their gold holdings over the last year, especially in emerging market economies trying to protect themselves from the collapse of Western fiat currencies.

Fiat money is not good money because it can be issued without limit and therefore cannot act as a stable store of value. A fiat monetary system gives complete discretion to those who run the printing press, allowing national governments to spend money without having to suffer the political consequences of raising taxes.  Fiat money benefits those who create it and receive it first, enriching national governments and their cronies.  And the negative effects of fiat money are disguised so that people do not realize that money the Fed creates today is the reason for the busts, rising prices and unemployment, and diminished standard of living tomorrow.

This is why it is so important to allow people the freedom to choose stable money.  Earlier this Congress I introduced the Free Competition in Currency Act (H.R. 1098) to permit people to use gold as money again. By eliminating taxes on gold and other precious metals and repealing legal tender laws, people are given the option between using good money or fiat money. If the federal government persists in debasing the dollar – as money monopolists have always done – then the people would be able to protect themselves by using alternatives such as gold that are both sound and stable.

As the fiat money pyramid crumbles, gold retains its luster.  Rather than being the barbarous relic Keynesians have tried to lead us to believe it is, gold is, as the Bundesbank president put it, “a timeless classic.”  The defamation of gold wrought by central banks and national governments is because gold exposes the devaluation of fiat currencies and the flawed policies of the national government.  National governments hate gold because the people cannot be fooled by it.

Representative Ron Paul (R – TX), MD, was a three-time Republican candidate for U. S. President. See his Congressional webpage and his official campaign website. 

This article has been released by Dr. Paul into the public domain and may be republished by anyone in any manner.

Interest Rates Are Prices – Article by Ron Paul

Interest Rates Are Prices – Article by Ron Paul

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The New Renaissance Hat
Ron Paul
September 28, 2012
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One of the most enduring myths in the United States is that this country has a free market, when in reality, the market is merely the structural shell of formerly free institutions.  The federal government pulls the strings behind the scenes.  No better illustration of this can be found than in the Federal Reserve’s manipulation of interest rates.

The Fed has interfered with the proper function of interest rates for decades, but perhaps never as boldly as it has in the past few years through its policies of quantitative easing.  In Chairman Bernanke’s most recent press conference he stated that the Fed wishes not only to drive down rates on Treasury debt, but also rates on mortgages, corporate bonds, and other important interest rates.  Markets greeted this statement enthusiastically, as this means trillions more newly-created dollars flowing directly to Wall Street.

Because the interest rate is the price of money, manipulation of interest rates has the same effect in the market for loanable funds as price controls have in markets for goods and services. Since demand for funds has increased, but the supply is not being increased, the only way to match the shortfall is to continue to create new credit. But this process cannot continue indefinitely. At some point the capital projects funded by the new credit are completed. Houses must be sold, mines must begin to produce ore, factories must begin to operate and produce consumer goods.

But because consumption patterns have either remained unchanged or have become more present-oriented, by the time these new capital projects are finished and begin to produce, the producers find no market for their goods. Because the coordination between savings and consumption was severed through the artificial lowering of the interest rate, both savers and borrowers have been signaled into unsustainable patterns of economic activity. Resources that would have been used in productive endeavors under a regime of market-determined interest rates are instead shuttled into endeavors that only after the fact are determined to be unprofitable.  In order to return to a functioning economy, those resources which have been malinvested need to be liquidated and shifted into sectors in which they can be put to productive use.

Another effect of the injections of credit into the system is that prices rise.  More money chasing the same amount of goods results in a rise in prices.  Wall Street and the banking system gain the use of the new credit before prices rise.  Main Street, however, sees the prices rise before they are able to take advantage of the newly-created credit. The purchasing power of the dollar is eroded and the standard of living of the American people drops.

We live today not in a free market economic system but in a “mixed economy”, marked by an uneasy mixture of corporatism; vestiges of free-market capitalism; and outright central planning in some sectors.  Each infusion of credit by the Fed distorts the structure of the economy, damages the important role that interest rates play in the market, and erodes the purchasing power of the dollar.  Fed policymakers view themselves as wise gurus managing the economy, yet every action they take results in economic distortion and devastation.

Unless Congress gets serious about reining in the Federal Reserve and putting an end to its manipulation, the economic distortions the Fed has caused will not be liquidated; they will become more entrenched, keeping true economic recovery out of our grasp and sowing the seeds for future crisis.

Representative Ron Paul (R – TX), MD, was a three-time Republican candidate for U. S. President. See his Congressional webpage and his official campaign website. 

This article has been released by Dr. Paul into the public domain and may be republished by anyone in any manner.

Droughts, Famines, and Markets – Article by Steven Horwitz

Droughts, Famines, and Markets – Article by Steven Horwitz

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Steven Horwitz
August 28, 2012
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As I write, many high school students all over the United States, my daughter included, are reading John Steinbeck’s The Grapes of Wrath, with its portrayal of the 1930s Dust Bowl, in preparation for literature courses in the fall.  Steinbeck’s fictional account vividly captures the suffering endured by many Americans due to the severe drought, poor farming techniques, and ensuing dust storms in Texas, Oklahoma, and other states.

With the U.S. Midwest stricken by drought this summer, it’s worth considering why the crop failures there have not led to food shortages and other serious problems.

It’s also worth considering why famines, which occurred with regularity for most of human history, have all but disappeared in the last 100 years or so.

The answer is: the market and globalization.  This combination, for reasons I explore below, enables humanity to be far less at the mercy of the weather and provides us with ways to ensure that food gets to where it needs to go.

Markets help us avoid famines in two ways.  First, the innovation made possible by the search for profit and the relative freedom of markets in the western world have increased agricultural productivity by an order of magnitude.  We feed a planet of almost 7 billion reasonably well–although not as well as we might like–and we do it with a decreasing number of people and acres of land.  The United States can feed its own population and still export grain to the rest of the world–even as farmers are forced to divert corn to boondoggles like ethanol.  We are at less risk for famines simply because we can produce more food with fewer resources, and even if one large crop fails, we have more large crops elsewhere to make up the loss.

Signals

The second way markets help is that price and profit signals inform producers where foodstuffs are in short supply and simultaneously provide incentives to get the food there.  Prices are an incentive wrapped in knowledge, enabling them to serve as traffic signals to ensure that no one goes without. True, food may be more expensive during a drought, but that is far better than no food at all, as was often the case in human history.

We see these processes at work right now.  The drought in the middle of America destroyed a good deal of the corn crop in Indiana and Iowa.  Meanwhile, farmers in places like Washington state and Virginia have largely escaped unscathed.  The short supply in the Midwest drives up prices and signals to producers elsewhere that profit opportunities exist in those places; the incentive associated with that signal leads farmers to get their crops to where the demand is.  Yes, the higher prices mean that folks will be a little worse off, but corn is in fact more scarce, so those higher prices are not the result of farmers exploiting the drought, but rather a reflection of genuinely shorter supply.

The price signals might also cause corn producers to divert some corn from other uses to food for humans. Such substitution is only possible because market prices provide the needed knowledge and incentives. In a world without markets, producers could not get information so easily and effectively; nor would they have the incentive to respond appropriately. More famines would result.

Globalization

Finally, globalization has nearly eradicated famines.  All the market processes I have identified are even more effective when the area of trade expands.  When commodity markets are global, countries facing droughts and bad harvests have a whole world from which they can attract new supplies.  The United States is not limited to tapping farmers in Washington and Virginia. It can attract corn from around the world.  In fact, Canadian farmers have had a much better year and are already seeing higher prices for their exports to the United States.  Canadians will pay a bit more for their grains as a result, but prices in the United States will be significantly lower than they would be without the Canadian imports.

As Pierre Desrochers and Hiroko Shimizu point out in their wonderful new book, The Locavore’s Dilemma, the belief that making food production and distribution more local and less global will increase “food security” has it exactly backward.  The most important thing we can do to ensure a secure food supply in the face of droughts and other threats to the harvest is to allow markets to work freely and extend that freedom globally.

We cannot control the weather, so the threat of drought is always present. But we can unleash the market and further globalize food production to avoid the human disaster of famines when harvests go bad.  The conquering of famine is one of the great human accomplishments of the last century.  That no one is starving because of the drought this summer is evidence of that victory.  Let’s not let the forces of locavorism reverse those gains.

Steven Horwitz is the Charles A. Dana Professor of Economics at St. Lawrence University and the author of Microfoundations and Macroeconomics: An Austrian Perspective, now in paperback.

This article was published by The Foundation for Economic Education and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

Why the Deflationists Are Wrong – Article by Gary North

Why the Deflationists Are Wrong – Article by Gary North

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Gary North
August 23, 2012
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An inflationist is someone who believes that price inflation is the result of two things: (1) monetary inflation and (2) central-bank policy.

A deflationist is someone who believes that deflation is inevitable, despite (1) monetary inflation and (2) central -bank policy.

No inflationist says that price inflation is inevitable. Every deflationist says that price deflation is inevitable.

Deflationists have been wrong ever since 1933.

Milton Friedman is most famous for his book A Monetary History of the United States (1963), which relies on facts collected by Anna Schwartz, who died recently.

It is for one argument: the Federal Reserve caused the Great Depression because it refused to inflate.

This argument, as quoted by mainstream economists, is factually wrong.

I often cite a study, where you can see that the monetary base grew under the Federal Reserve, 1931 to 1932. This graph is from a speech given by the vice president of the Federal Reserve Bank of St. Louis. You can access it here.

Figure 1
I posted this first in early 2010.

We can see that there was monetary deflation of the money supply, beginning in 1930. This continued in 1931 and 1932, despite a deliberate policy of inflation by the Fed, beginning in the second half of 1931 and continuing through 1932.

Depositors kept pulling currency out of banks and hoarding it. They did not redeposit it in other banks. This imploded the fractional-reserve-banking process for the banking system as a whole. M1 declined: monetary deflation.

The Fed could not control M1. It could only control the monetary base.

The argument of Friedman and Schwartz was picked up by mainstream economists. It is his most famous and widely accepted position. Bernanke praised him for it on Friedman’s 90th birthday in 2002.

Why was the argument wrong, as applied to 1931–33? I must tell the story one more time. Four letters tell it: FDIC. Well, nine: FDIC + FSLIC. They did not exist.

Franklin Roosevelt froze all bank deposits in early March 1933, immediately after his inauguration. This calmed the public when the banks reopened a few days later. He verbally promised people that the banks were now safe.

The US government created federal bank-depositor insurance in 1933. The Wikipedia article describes the Banking Act of 1933, which was signed into law in June:

  • Established the FDIC as a temporary government corporation
  • Gave the FDIC authority to provide deposit insurance to banks
  • Gave the FDIC the authority to regulate and supervise state non-member banks
  • Funded the FDIC with initial loans of $289 million through the U.S. Treasury

That stopped the bank runs. The money supply reversed. It went ballistic. So did the monetary base.

The key event was therefore the Banking Act of 1933. After that, the money supply never fell again. After that, prices never fell again by more than 1 percent. That was in 1955.

All it took for prices to reverse and rise was this: an expansion of the monetary base coupled with bank lending.

Yet deflationists ever since 1933 have predicted falling prices. They die predicting this. Then their successors die predicting this.

They never learn.

They do not understand monetary theory. They do not understand monetary history. They therefore do not learn. They do not correct their bad predictions, year after year, decade after decade, generation after generation.

They still find people who believe them, people who also do not understand monetary theory or monetary history.

I have personally been arguing against them for four decades.

Price deflation has nothing to do with the fall in the price of stocks.

There can be monetary deflation as a result of excess reserves held at the Fed by commercial banks. But this is Fed policy. The Fed pays banks interest on the deposits. Even if it didn’t, there would still be excess reserves. But by imposing a fee on excess reserves, the Fed could eliminate excess reserves overnight. Then the money multiplier would go positive, price inflation would reappear, and the Fed would get blamed. So, it maintains a policy of restricting the M1 multiplier.

Every inflationist says that monetary inflation will produce hyperinflation unless reversed by the central bank. There will be a return to low prices after what Ludwig von Mises called the crack-up boom. The classic example is Germany in 1934. That was a matter of policy. The central bank substituted a new currency and stopped inflating.

John Exter — an old friend of mine — argued in the 1970s and 1980s that monetary deflation has to come, despite Fed policy. There will be a collapse of prices through deleveraging.

He was wrong. Why? Because it is not possible for depositors to take sufficient money in paper-currency notes out of banks and keep these notes out, thereby reversing the fractional-reserve process, thereby deflating the money supply. That was what happened in the United States from 1930 to 1933. If hoarders spend the notes, businesses will redeposit them in their banks. Only if they deal exclusively with other hoarders can they keep money out of banks. But the vast majority of all money transactions are based on digital money, not paper currency.

Today, large depositors can pull digital money out of bank A, but only by transferring it to bank B. Digits must be in a bank account at all times. There can be no decrease in the money supply for as long as money is digital. Hence, there can be no decrease in prices unless it is Fed policy to decrease prices. This was not true, 1930 to 1933.

Deflationists never respond to this argument by invoking either monetary theory or monetary history. You can and should ignore them until one of them does answer this, and all the others publicly say, “Yes. That’s it! We have waited since 1933 for this argument! I was blind, but now I see! I’m on board! I will sink or swim with this.”

Let me know when this happens. Until then, ignore the deflationists. All of them. (There are not many still standing.)

The fact that a new deflationist shows up is irrelevant. Anyone can predict inevitable price deflation. They keep doing this. Look for the refutation of the inflationists’ position. Look for a theory.

If you do not understand the case I have just made, you will not understand any refutation. In this case, just pay no attention to either side. If you cannot follow economic theory, the debate will confuse you. It’s not worth your time.

For background, see my book Mises on Money.

See also Murray Rothbard’s book What Has Government done to Our Money?

Gary North is the author of Mises on Money and Honest Money: The Biblical Blueprint for Money and Banking. He is also the author of a free 20-volume series, An Economic Commentary on the Bible. Visit his website: GaryNorth.com. Send him mail. See Gary North’s article archives.

This article originally appeared on GaryNorth.com.

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Copyright © 2012 by the Ludwig von Mises Institute. Permission to reprint in whole or in part is hereby granted, provided full credit is given.

Audit the Fed Moves Forward! – Article by Ron Paul

Audit the Fed Moves Forward! – Article by Ron Paul

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The New Renaissance Hat
Ron Paul
July 31, 2012
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Last week the House of Representatives overwhelmingly passed my legislation calling for a full and effective audit of the Federal Reserve.  Well over 300 of my Congressional colleagues supported the bill, each casting a landmark vote that marks the culmination of decades of work.  We have taken a big step toward bringing transparency to the most destructive financial institution in the world.

But in many ways our work is only beginning.  Despite the Senate Majority Leader’s past support for similar legislation, no vote has been scheduled on my bill this year in the Senate.  And only 29 Senators have cosponsored Senator Rand Paul’s version of my bill in the other body.  If your Senator is not listed at the link above, please contact them and ask for their support.  We need to push Senate leadership to hold a vote this year.

Understand that last week’s historic vote never would have taken place without the efforts of millions of Americans like you, ordinary citizens concerned about liberty and the integrity of our currency.  Political elites respond to political pressure, pure and simple.  They follow rather than lead.  If all 100 Senators feel enough grassroots pressure, they will respond and force Senate leadership to hold what will be a very popular vote.

In fact, “Audit the Fed” is so popular that 75% of all Americans support it according to this Rasmussen poll.  We are making progress.

Of course Fed apologists– including Mr. Bernanke– frequently insist that the Fed already is audited.  But this is true only in the sense that it produces annual financial statements.  It provides the public with its balance sheet as a fait accompli: we see only the net results of its financial transactions from the previous fiscal year in broad categories, and only after the fact.

We’re also told that the Dodd-Frank bill passed in 2010 mandates an audit.  But it provides for only a limited audit of certain Fed credit facilities surrounding the crisis period of 2008.  It is backward looking, which frankly is of limited benefit.

The Fed also claims it wants to be “independent” from Congress so that politics don’t interfere with monetary policy.  This is absurd for two reasons.

First, the Fed already is inherently and unavoidably political.  It made a political decision when it chose not to rescue Lehman Brothers in 2008, just as it made a political decision to provide liquidity for AIG in the same time period. These are just two obvious examples.  Also Fed member banks and the Treasury Department are full of former– and future– Goldman Sachs officials.  Are we really to believe that the interests of Goldman Sachs have absolutely no effect on Fed decisions? Clearly it’s naïve to think the Fed somehow is above political or financial influence.

Second, it’s important to remember that Congress created the Fed by statute.  Congress therefore has the full, inherent authority to regulate the Fed in any way– up to and including abolishing it altogether.

My bill provides for an ongoing, thorough audit of what the Fed really does in secret, which is make decisions about the money supply, interest rates, and bailouts of favored banks, financial firms, and companies.  In other words, I want the Government Accountability Office to examine the Fed’s actual monetary policy operations and make them public.

It is precisely this information that must be made public because it so profoundly affects everyone who holds, saves, or uses US dollars.

Representative Ron Paul (R – TX), MD, is a Republican candidate for U. S. President. See his Congressional webpage and his official campaign website. 

This article has been released by Dr. Paul into the public domain and may be republished by anyone in any manner.

Let Unsound Money Wither Away – Article by Joseph T. Salerno

Let Unsound Money Wither Away – Article by Joseph T. Salerno

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Joseph T. Salerno
July 29, 2012
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[This is a revised version of written testimony submitted to the the Subcommittee on Domestic Monetary Policy and Technology of the Committee on Financial Services, US House of Representatives “Fractional Reserve Banking and Central Banking as Sources of Economic Instability: The Sound Money Alternative,” June 28, 2012.]
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Chairman Paul and members of the subcommittee, I am deeply honored to appear before you to testify on the topic of fractional-reserve banking. Thank you for your invitation and attention.

In the short time I have, I will give a brief description of fractional reserve-banking, identify the problems it presents in the current institutional setting, and suggest a potential solution.

A bank is simply a business firm that issues claims to a fixed sum of money in receipt for a deposit of cash. These claims are payable on demand and without cost to the depositor. In today’s world these claims may take the form of checkable deposits, so called because they can be transferred to a third party by writing out a check payable to the party named on the check. They may also take the form of so-called “savings” deposits with limited or no checking privileges and that require withdrawal in person at one of the bank’s branches or at an ATM. In the United States, the cash for which the claim is redeemable are Federal Reserve notes — the “dollar bills” that we are all familiar with.

Fractional-reserve banking occurs when the bank lends or invests some of its depositors’ funds and retains only a fraction of the deposits in cash. This cash is the bank’s reserves. Hence the name fractional-reserve banking. All commercial banks and thrift institutions in the United States today engage in fractional–reserve banking.

Let me illustrate how fractional-reserve banking works with a simple example. Assume that a bank with deposits of $1 million makes $900,000 of loans and investments. If we ignore for simplicity the capital paid in by its owners, this bank is holding a cash reserve of 10 percent against its deposit liabilities. The deposits constitute the bank’s liabilities because the bank is contractually obligated to redeem them on demand. The assets of the bank are its reserves, loans, and investments. Bank reserves consist of the dollar bills in its vaults and ATMs and the bank’s deposits at the Federal Reserve, which can be cashed on demand for dollar bills printed by the Bureau of Engraving and Printing at the order of the Fed. The bank’s loans and securities are noncash assets that are titles to sums of cash payable only in the near or distant future. These assets include short-term business loans, credit-card loans, mortgage loans, and the securities issued by the US Treasury and foreign financial authorities.

Now the key to understanding the nature of fractional-reserve banking and the problems it creates is to recognize that a bank deposit is not itself money. It is rather a “money substitute,” that is, a claim to standard money — dollar bills — universally regarded as perfectly secure.

Bank deposits transferred by check or debit card will be routinely paid and received in exchange in lieu of money only as long as the public does not have the slightest doubt that the bank that creates these deposits is able and willing to redeem them without delay or expense.

Under these circumstances, bank deposits are eagerly accepted and held by businesses and households and regarded as indistinguishable from cash itself. They are therefore properly included as part of the money supply, that is, the total supply of dollars in the economy.

The very nature of fractional-reserve banking, however, presents an immediate problem. On the one hand, all of a bank’s deposit liabilities mature on a daily basis, because it has promised to cash them in on demand. On the other, only a small fraction of its assets is available at any given moment to meet these liabilities. For example, during normal times, US banks effectively hold much less than 10 percent of deposits in cash reserves. The rest of a bank’s liabilities will only mature after a number of months, years, or, in the case of mortgage loans, even decades. In the jargon of economics, fractional-reserve banking always involves “term-structure risk,” which arises from the mismatching of the maturity profile of its liabilities with that of its assets.

In layman’s terms, banks “borrow short and lend long.” The problem is revealed when demands for withdrawal of deposits exceeds a bank’s existing cash reserves. The bank is then compelled to hastily sell off some of its longer-term assets, many of which are not readily saleable. It will thus incur big losses. This will cause a panic among the rest of its depositors who will scramble to withdraw their deposits before they become worthless. A classic bank run will ensue. At this point the value of the bank’s remaining assets will no longer be sufficient to pay off all its fixed-dollar deposit liabilities and the bank will fail.

A fractional-reserve bank, therefore, can only remain solvent for as long as public confidence exists that its deposits really are riskless claims on cash. If for any reason — real or imagined — the faintest suspicion arises among its clients that a bank’s deposits are no longer payable on demand, the bank’s reputation as an issuer of money substitutes vanishes overnight. The bank’s brand of money substitutes is then instantly extinguished and people rush to withdraw their deposits in cash — cash that no fractional-reserve bank can provide on demand in sufficient quantity. Thus the threat of brand extinction and insolvency is always looming over fractional-reserve banks.

In other words, a fractional-reserve bank must develop what Ludwig von Mises called a “special kind of good will” in order to create a clientele who treats their deposits as money substitutes. On a free market this kind of good will is very difficult and costly to acquire and maintain. This reputational asset is what induces a bank’s clients to forebear from immediately cashing in their deposit claims and driving the bank into instant insolvency. Of course to remain profitable the bank must also build up conventional business good will, which depends upon convenient geographical location, outstanding customer service, attractive facilities, the reputation of its management team and so on. But unlike the common form of good will essential to all successful business ventures, the good will that is necessary for a particular bank’s brand of deposits to circulate as money substitutes is indivisible. In almost all other industries, customer good will can be gained or lost in marginal units and does not typically vanish all at once, destroying its product brand and plunging the firm into immediate insolvency.

Ludwig von Mises described the loss of confidence in a bank’s solvency and the related phenomenon of brand extinction in the following terms:

The confidence which a bank and the money-substitutes it has issued enjoy is indivisible. It is either present with all its clients or it vanishes entirely. If some of the clients lose confidence the rest of them lose it too.… One must not forget that every bank issuing fiduciary media is in a rather precarious position. Its most valuable asset is its reputation. It must go bankrupt as soon as doubts arise concerning its perfect trustworthiness and solvency. [1]

The issuing of deposits not fully backed by cash is therefore always a precarious business on the free market. The slightest doubt about the bank’s solvency among even some of its clients will instantly destroy the character of its deposits as money substitutes. Furthermore, the loss of confidence that causes this phenomenon of “brand extinction” is the cause and not the result of a run on the bank and cannot be deterred by a high ratio of reserves to deposits. For under fractional-reserve banking, by definition, reserves are always insufficient to pay off all the demand liabilities that the bank has incurred. In fact the level of cash reserves is not directly relevant to the stability of a bank. It is simply one of several factors that a bank’s clients take into account in forming their subjective judgment concerning whether a bank’s brand of notes and deposits are or are not money substitutes. For example in the 19th century the ratio of gold reserves to notes and deposits of the Bank of England are reported to have been as low as 3 percent, yet it was generally regarded as one of the most stable financial institutions in the world.

The peculiar and overriding importance of public confidence in sustaining fractional-reserve banking was particularly emphasized by Murray N. Rothbard:

But in what sense is a bank “sound” when one whisper of doom, one faltering of public confidence, should quickly bring the bank down? In what other industry does a mere rumor or hint of doubt bring down a mighty and seemingly solid firm? What is it about banking that public confidence should play such a decisive and overwhelmingly important role? The answer lies in the nature of our banking system, in the fact that both commercial banks and thrift banks have been systematically engaging in fractional-reserve banking: that is, they have far less cash on hand than there are demand claims to cash outstanding.[2]

Rothbard’s point about the extreme fragility of public confidence in issuers of fractionally-backed money substitutes is well illustrated by the stunning collapse of Washington Mutual (WaMu) in September 2008, the largest bank failure in United States history. WaMu had been in existence for 119 years and was the sixth-largest bank in the United States with assets of $307 billion. It had branches throughout the country and billed itself as the Walmart of banking. It was one of the top performers on Wall Street until shortly before its failure. Its depositors clearly had enormous confidence in its solidity, especially given that its deposits were insured by the federal government reinforced by the existence of the Fed’s “too-big-to-fail” policy. And yet, almost overnight the special good will that gave its deposits the quality of money substitutes vanished as panic-stricken depositors rushed to withdraw their funds. The unlikely event that triggered the sudden loss of confidence and subsequent brand extinction was the failure of Lehman Brothers, a venerable investment house. A week after Lehman failed, mighty WaMu was no more.

The highly publicized Lehman Brothers failure had shaken public confidence in the solvency not only of WaMu but of the entire banking system. Had the Fed and Treasury not acted aggressively to bail out the largest banks in the fall of 2008, there is no doubt that the entire system would have collapsed in short order. Indeed on a single day in December, the combined emergency lending by the Fed and the US Treasury had risen to a peak of $1.2 trillion. The recipients of these billions included some of the most trusted and reputable brand names in banking: Citibank, Bank of America, Morgan Stanley, as well as European banks like the Royal Bank of Scotland and UBS AG. Without this unprecedented bailout, these discredited brand names would have been relegated to the dustbin of business history

The ever-present threat of insolvency is a relatively minor problem with fractional-reserve banks, however. Its effects are restricted to the bank’s stockholders, creditors, and depositors who voluntarily assume the peculiar risks involved in this business.

The major problems with fractional-reserve banking are its harmful effects on the overall economy caused by the related phenomena of inflation and business cycles.

First, fractional-reserve banking is inherently inflationary. When a bank lends out its clients’ deposits, it inevitably expands the money supply. For example, when people deposit an additional $100,000 of cash in the bank, depositors now have an additional $100,000 in their checking accounts while the bank accumulates an additional $100,000 of cash (dollar bills) in its vaults. The total money supply, which includes both dollar bills in circulation among the public and dollar balances in bank deposits, has not changed. The depositors have reduced the amount of cash in circulation by $100,000, which is now stored in the bank’s vaults, but they have increased the total deposit balance that they may draw on by check or debit card by the exact same amount. Suppose now the loan officers of the bank lend out $90,000 of this added cash to businesses and consumers and maintain the remaining $10,000 on reserve against the $100,000 of new deposits. These loans increase the money supply by $90,000 because, while the original depositors have the extra $100,000 still available on deposit, the borrowers now have an extra $90,000 of the cash they did not have before.

The expansion of the money supply does not stop here however, for when the borrowers spend the borrowed cash to buy goods or to pay wages, the recipients of these dollars redeposit some or all of these dollars in their own banks, which in turn lend out a proportion of these new deposits. Through this process, bank-deposit dollars are created and multiplied far beyond the amount of the initial cash deposits. (Given the institutional conditions in the United States today, each dollar of currency deposited in a bank can increase the US money supply by a maximum of $10.00.) As the additional deposit dollars are spent, prices in the economy progressively rise, and the inevitable result is inflation, with all its associated deleterious effects on the economy.

Fractional-reserve banking inflicts another great harm on the economy. In order to induce businesses and consumers to borrow the additional dollars created, banks must reduce interest rates below the market-equilibrium level determined by the amount of voluntary savings in the economy. Businesses are misled by the artificially low interest rates into borrowing to expand their facilities or undertake new long-term investment projects of various kinds. But the prospective profitability of these undertakings depends on expectations that bank credit will remain cheap more or less indefinitely. Consumers, too, are deceived by the lower interest rates and rush to purchase larger residences or vacation homes. They take out second mortgages on their homes to buy big-ticket luxury items. A false economic boom begins that is doomed to turn into a bust as soon as interest rates begin to rise again.

As the inflationary boom progresses and prices rise, the demand for credit becomes more intense at the same time that more cash is withdrawn from bank deposits to finance the purchase of everyday goods. The banks react to these developments by sharply raising interest rates and contracting loans and deposits, causing a decline in the money supply. Indeed the money supply may very well collapse, as it did in the early 1930s, because the public loses confidence in the banks and demands it deposits back in cash. In this case, a series of bank runs ensue that pushes many fractional-reserve banks into insolvency and instantly extinguishes their money substitutes, which had previously circulated as part of the money supply. Recession and deflation results and the binge of bad investments and overconsumption is starkly revealed in the abandoned construction projects, empty commercial buildings, and foreclosed homes that litter the economic landscape. At the end of the recession it turns out that almost all households and business firms are made poorer by fractional-reserve bank-credit expansion, even those who may have initially gained from the inflation.

Inflation and the boom-bust cycles generated by fractional-reserve banking are enormously intensified by Federal Reserve and US-government interference with the banking industry. Indeed, this interference is justified by economists and policymaker precisely because of the instability of the fractional-reserve system. The most dangerous forms of such interference are the power of the Federal Reserve to create bank reserves out of thin air via open market operations, its use of these phony reserves to bail out failing banks in its role as a lender of last resort, and federal insurance of bank deposits. In the presence of such polices, the deposits of all banks are perceived and trusted by the public as one homogeneous brand of money substitute fully guaranteed by the Federal government and backed up by the Fed’s power to print up bank reserves at will and bail out insolvent banks. Under the current monetary regime, there is thus absolutely no check on the natural propensity of fractional-reserve banks to mismatch the maturity profiles of their assets and liabilities, to expand credit and deposits, and to artificially depress interest rates. Without fundamental change in the US monetary system, the growth of bubbles in various sectors of the economy and subsequent financial crises will continue unabated.

The solution is to treat banking as any other business and permit it to operate on the free market — a market completely free of government guarantees of bank deposits and of the possibility of Fed bailouts. In order to achieve the latter, federal deposit insurance must be phased out and the Fed would have to be permanently and credibly deprived of its legal power to create bank reserves out of nothing. The best way to do this is to establish a genuine gold standard in which gold coins would circulate as cash and serve as bank reserves; at the same time the Fed must be stripped of its authority to issue notes and conduct open-market operations. Also, banks would once again be legally enabled to issue their own brands of notes, as they were in the 19th and early 20th century.

Once this mighty rollback of government intervention in banking is accomplished, each fractional-reserve bank would be rigidly constrained by public confidence when issuing money substitutes. One false step — one questionable loan, one imprudent emission of unbacked notes and deposits — would cause instant brand extinction of its money substitutes, a bank run, and insolvency.

In fact on the banking market as I have described it, I foresee the ever-present threat of insolvency compelling banks to refrain from further lending of their deposits payable on demand. This means that if a bank wished to make loans of shorter or longer maturity, they would do so by issuing credit instruments whose maturities matched the loans. Thus for short-term business lending they would issue certificates of deposits with maturities of three or six months. To finance car loans they might issue three-year or four-year short bonds. Mortgage lending would be financed by five- or ten-year bonds. Without government institutions like Fannie Mae and Freddie Mac — backed by the Fed’s money-creating power — implicitly guaranteeing mortgages, mortgage loans would probably be transformed into shorter five- or ten-year balloon loans, as they were until the 1930s. The bank may retain an option to roll over a mortgage loan when it comes due pending a reevaluation of the mortgagor’s current financial situation and recent credit history as well as the general economic environment. In short, on a free market, fractional-reserve banking with all its inherent problems would slowly wither away.

Notes

[1] Ludwig von Mises, Human Action: A Treatise on Economics. Scholar’s Ed. (Auburn, AL: Ludwig von Mises Institute, 1998), pp. 442, 444.

[2] Murray N. Rothbard, Making Economic Sense, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2006), p. 326.

Joseph Salerno is academic vice president of the Mises Institute, professor of economics at Pace University, and editor of the Quarterly Journal of Austrian Economics. He has been interviewed in the Austrian Economics Newsletter and on Mises.org. Send him mail. See Joseph T. Salerno’s article archives.

This is a revised version of written testimony submitted to the the Subcommittee on Domestic Monetary Policy and Technology of the Committee on Financial Services, US House of Representatives “Fractional Reserve Banking and Central Banking as Sources of Economic Instability: The Sound Money Alternative,” June 28, 2012.

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Copyright © 2012 by the Ludwig von Mises Institute. Permission to reprint in whole or in part is hereby granted, provided full credit is given.

Inflation is a Monetary Phenomenon – Article by Ron Paul

Inflation is a Monetary Phenomenon – Article by Ron Paul

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The New Renaissance Hat
Ron Paul
July 18, 2012
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Later this month Congress will have an unprecedented opportunity to force the Federal Reserve to provide meaningful transparency to lawmakers and taxpayers. HR 459, my bill known as “Audit the Fed,” is scheduled for a vote before the full Congress in July. More than 270 of my colleagues cosponsored the bill, and it has the support of congressional leadership. But its passage in the House of Representatives is only the beginning of the battle, as many Senators and the President still don’t see the critical need to have a national discussion about monetary policy.

The American public now senses that the Fed’s actions, especially since 2008, are enormously inflationary and will cause great harm to the American economy in the long run. They are beginning to understand what so many economists still don’t understand, which is that inflation is a monetary phenomenon, and rising prices are merely a symptom of that phenomenon.  Prices eventually rise when the supply of US dollars (paper or electronic) grows faster than the available goods and services being chased by those dollars.

This fundamental truth has been thoroughly explained by Milton Friedman and many others, so today’s Keynesian economists have no excuse for their claims that “inflation is under control.”  Ordinary Americans don’t need a PhD simply to look at the Fed’s balance sheet and understand the staggering amount of money creation that has occurred in recent years. They know it will have harmful consequences for all of us eventually.

I’ve spoken at length about inflation, and how Fed money creation is effectively a tax. Every dollar created out of thin air dilutes the value of the dollars in your pocket and your savings in the bank. But the truth is that we are only beginning to see the results of the Fed’s dramatic increase in the money supply. As former Fed Chair Alan Greenspan himself explained last week to Larry Kudlow, most of the dollar deposits created by the Fed via successive rounds of “quantitative easing” remain on the balance sheet of Fed member banks. Because of very rational economic fears, banks are not lending, businesses are not expanding, and individuals are shedding debt. So, the trillions of dollars created by the Fed since 2008 remained largely undeployed. When those dollars eventually make their way into the world economy, prices across all sectors of the economy are likely to rise dramatically.

The true evil of inflation is that newly created money benefits politically favored financial interests, especially banks, on the front end. Over time, however, the net result of monetary inflation is always the devaluation of savings and purchasing power. This devaluation discourages saving, which is the key to capital accumulation and investment in a healthy economy. Inflation also tends to hurt seniors and those living on fixed incomes the most.

For decades the Fed has operated without any meaningful oversight whatsoever, resulting in the loss of savings, loss of purchasing power, and loss of quality of life for all Americans. It causes individuals and businesses to make bad decisions, misallocating their capital because market signals have been distorted. It causes financial ruin by engineering the inevitable boom and bust cycles that so many erroneously blame on capitalism. And it does all this in secrecy, to the benefit of the financial and political classes. It is time to Audit the Fed, as a first step toward ending its unchecked power over our money and economic fortunes.

Representative Ron Paul (R – TX), MD, is a Republican candidate for U. S. President. See his Congressional webpage and his official campaign website. 

This article has been released by Dr. Paul into the public domain and may be republished by anyone in any manner.

Not Enough Inflation? – Article by Tyler Watts

Not Enough Inflation? – Article by Tyler Watts

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The New Renaissance Hat
Tyler Watts
July 15, 2012
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Two wrongs may not make a right, but a second dose of poison might just cure the first dose. That’s at least what Paul Krugman, America’s most prominent left-wing economic pundit, is saying about an untapped remedy for our economic woes. In his April 5 New York Times column, “Not Enough Inflation,” Krugman repeated his claim that “a bit more inflation would be a good thing, not a bad thing.”

If you’re wondering how progressively higher prices for everyday goods could help any household get ahead economically, let alone contribute to overall economic recovery, you’re in good company. As all econ-principles students know, inflation is caused by an increase in the supply of money relative to money demand. The increase in consumer goods prices—that’s how the layman defines and experiences inflation—is really just a symptom of the reduced purchasing power of money caused by the increase in its quantity. The higher prices for all goods in turn mean lower real incomes for consumers—which is all of us—not to mention that inflation is also typically symptomatic of the boom-bust business cycle and can cause significant widespread economic damage. In its most severe forms, inflation can wipe out people’s monetary wealth and bring commerce to a halt.

But smart guys like Professor Krugman aren’t mere monetary cranks. They know that high inflation is economically dangerous. What they’re asking for is just a small, temporary dose of fresh money to inject some new life into the economy. There is a kernel of truth to this inflationary prescription. As the Scottish philosopher David Hume explained in his 1752 essay Of Money, prices for different kinds of goods react differently to new money entering the economy. Generally speaking, commodities or consumer goods prices will rise faster than wages. So for a manufacturing entrepreneur, for instance, who employs many workers, inflation will cause output prices (revenue) to increase relative to wages (costs), bringing an increase in profits that will induce an increase in output. Therefore, in Hume’s terms, an increase of money “must first quicken the diligence of every [entrepreneur], before it increase the price of labor.”

This “sticky wages” effect is what economists like Hume, John Maynard Keynes, and Krugman have in mind when advocating inflationary stimulus. Krugman also notes that “parts of the private sector continue to be crippled by the overhang of debt accumulated during the bubble years,” and that “modest inflation . . . by eroding the real value of that debt . . . [would] help promote the private-sector recovery.” So higher inflation not only increases the demand for labor, but can also help clean up companies’ and individuals’ balance sheets, giving them the ability to ramp up their hiring and spending. What’s not to love about this miracle elixir?

There are two big problems with inflationary stimulus. The first involves the process dynamics of the market economy. The inflationists tend to omit the rest of the story, which involves the long-run effects of new money. New money will eventually increase all prices—even wages—meaning the stimulus effect can only be temporary. For if entrepreneurs read the price increases not as mere inflation, but higher demand for their products (as the inflationists hope), they are liable to make investments to expand their production capacity. Once the inflation effect peters out, once rising wages eventually push profits back down, they find that extra production is no longer profitable. The expansion can’t be sustained without more inflationary stimulus.

In a rising inflation environment, moreover, people will eventually come to anticipate further price increases. Workers demand upward wage adjustments in advance, and entrepreneurs anticipate rising costs and thus scale back their expansion plans. Once people catch on to inflationary stimulus in this fashion, larger and larger money injections (that is, higher inflation rates) are needed to merely maintain output levels. At some point, the high, rising, and volatile inflation rate itself becomes a drag on the economy. Miscalculation of next year’s, or even next month’s, inflation rate could spell disaster for entrepreneur and worker alike. As inflation heats up, it can actually drag investment down, as people seek to shelter their wealth in “sterile” assets like gold. Inflation, instead of a stimulus factor, becomes a source of economic confusion and frustration. Iconic images of people hauling wheelbarrow loads of money to buy a loaf of bread in post-World War I Germany remind us of the potential economic turmoil of unchecked inflation. This of course is not what Krugman has in mind, but we should not forget that the mightiest river begins as a trickle.

The second big problem with inflation is a moral one. Along with causing economic confusion, inflation redistributes wealth. The key fact here, again, is that not all prices rise immediately when new money enters circulation. People who are first to receive the new money get to spend it before prices go up. Those last in line see prices go up before their own incomes do. Inflation also redistributes wealth from lenders to borrowers, as Krugman indicated, by reducing the real value of debt. But Krugman conveniently ignores the corresponding fact that, whenever a borrower’s real debt burden is eased, a lender’s asset value is eroded. Thus to use inflation as a partial bailout for borrowers is to harm lenders and investors. This is happening already—even at “mild” inflation rates that are too low for Krugman’s tastes, real returns on investments like bank CDs are driven into negative territory.

Through these redistributions of purchasing power, inflation acts like a tax: a tax on savers, on investors, on those at the very end of the monetary policy food chain. Ironically for Progressives like Krugman, this inflation tax arguably hits the poor and uneducated hardest. Educated, economically sophisticated people know the warning signs of inflation and know how to shelter their assets—as attested by the flurry of gold bullion dealers’ ads on cable news and AM radio. The poor are much more likely to be wage earners whose incomes tend to lag inflation, or pensioners who, even with annual cost-of-living adjustments, can still see consistent reductions in their purchasing power.

Nonetheless, Krugman and the inflation party don’t understand the free-market camp’s arguments against inflation. He accuses us of “obsessing” over inflation, while he thinks the Fed should focus on curing unemployment. Even conceding that inflation can provide a temporary, halting employment stimulus, the objection remains strong. It comes down to the fact that inflation is a big lie—or, should we say, a million little lies, because inflation distorts all prices and thereby hinders their crucial function of giving entrepreneurs and workers the correct information and incentives on which to make the best economic decisions. Inflation’s promises of faster growth and greater wealth are illusory. Like alcohol or drug abuse, every high begets a crash that demands larger and larger doses to maintain the effect. Inflation is a dangerous medicine that stands to do the patient more harm than good.

Tyler Watts is an assistant professor of economics at Ball State University and the winner of the 2012 Beth A. Hoffman Memorial Prize for Economic Writing.

This article was published by The Foundation for Economic Education and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

The Fed: Mend It or End It? – Article by Ron Paul

The Fed: Mend It or End It? – Article by Ron Paul

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The New Renaissance Hat
Ron Paul
June 3, 2012
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In early May 2012, I held a hearing to examine the various proposals that have been put forth both to mend and to end the Fed.  The purpose was to spur a vigorous and long-lasting discussion about the Fed’s problems, hopefully leading to concrete actions to rein in the Fed.

First, it is important to understand the Federal Reserve System.  Some people claim it is a secret cabal of elite bankers, while others claim it is part of the federal government.  In reality it is a bit of both.  The Federal Reserve System is the collusion of big government and big business to profit at the expense of taxpayers.  The Fed’s bailout of large banks during the financial crisis propped up poorly-run corporations that should have gone under, giving them a market-distorting advantage that no business in the United States should receive.  The recent news about JP Morgan is a case in point.  JP Morgan, a recipient of $25 billion in bailout money, recently announced it lost another $2 billion.  If a corporation shows itself to be a bottomless money pit of “errors, sloppiness and bad judgment,” the Fed shouldn’t have expected $25 billion in free money to change that or teach anyone a lesson in fiscal discipline.  But it determined that this form of deliberate capital destruction was preferable to one business suffering bankruptcy.  Clearly, some changes need to be made.

Several reforms for the Fed were discussed at the hearing.  One was a call for the full-employment mandate to be repealed, in order to allow the Fed to focus solely on stable prices.

Another reform calls for changes to the composition of the Federal Open Market Committee.  Still another proposal was for outright nationalization of the Fed or of its functions.  But if what the Fed does now is bad and inflationary, allowing the Treasury to print and issue money at-will would be even worse, and could possibly lead to a Weimar-like hyperinflation.

The problems and advantages of the gold standard were discussed at the hearing.  The era of the classical gold standard was undoubtedly one of the greatest eras in human history.  For a period of several decades in the late 19th century, the West made enormous advances.  However, the gold standard was still run by government.  The temptation to suspend gold redemption reared its head again with the outbreak of World War I.  Once the tie to gold was severed and fiscal restraint thrown to the wind, undoing the damage would have required great fiscal austerity.  Instead, the Western world proceeded to set up a gold-exchange standard which lasted not even a decade before easy money led to the Great Depression.

While returning to the gold standard would certainly be far better than maintaining the current fiat paper system, as long as the government retains the power to go off gold we may end up repeating the same mistakes.

The only viable solution is to get government out of the money business permanently.  The way to bring this about is through currency competition: allow parallel currencies to circulate without receiving any special recognition or favor from the government.  Fiat paper monetary standards throughout history have always collapsed due to their inflationary nature, and our current fiat paper standard will be no different.

It is imperative that the American people be educated on the dangers of the Fed and the importance of restoring sound money.  The laying of the groundwork must begin today, so that the American people will be prepared for the day when the mirage the Fed has created evaporates completely.  The full hearing footage is available on my website, and I would encourage every American to take a look.

Representative Ron Paul (R – TX), MD, is a Republican candidate for U. S. President. See his Congressional webpage and his official campaign website. 

This article has been released by Dr. Paul into the public domain and may be republished by anyone in any manner.