What's Wrong With the Markets?

Exclusive to STR

March 5, 2008

'The Federal Reserve, the central bank of the United States , provides the nation with a safe, flexible, and stable monetary and financial system.' ~ Board of Governors of the Federal Reserve System [4]

'WAR IS PEACE FREEDOM IS SLAVERY IGNORANCE IS STRENGTH' ~ 1984 quote hidden in Apple's February keyboard update [5]

Like an interminable soap opera, pundits continue to bring forth scenarios of impending economic disaster. Financial Times columnist Martin Wolf [6], for instance, discusses in detail Professor Nouriel Roubini's Twelve Steps to Financial Disaster [7], of how we have reached unsustainable levels of debt, and that bankruptcies, defaults, a collapse of stock prices, and 'a drying-up of liquidity' are heading straight at us. Wolf adds that the Bernanke Fed, finally waking to the dangers, has lowered interest rates by two percentage points this year, as 'insurance against a financial meltdown.' Because we're a debtor nation, the government 'must keep the trust of foreigners. Should it fail to do so the inflationary solution becomes probable. This is quite enough to explain why gold costs $920 an ounce [as of Feb. 19].'

Wolf sums up by saying:

The connection between the bursting of the housing bubble and the fragility of the financial system has created huge dangers, for the US and the rest of the world. The US public sector is now coming to the rescue, led by the Fed. In the end, they will succeed. But the journey is likely to be wretchedly uncomfortable.

Isn't it strange how inflation becomes the probable solution to inflation?

But history is on his side, especially since World War I. Economists have adopted the position that if some money is nice, more money is nicer, and enough to flood the Great Basin [8] is close to ideal -- never mind that any increase in the money supply confers no broad social benefits, as Rothbard has argued [9] [p. 766]. What to do when prices reach the stratosphere and the money is so depreciated it becomes cheaper to burn than firewood [10]? Switch to a new currency and begin debasing that one, which is how the state funds prosperity.

The classic example of a country turning to the 'inflationary solution' is Germany following World War I, which made the 'journey' for German citizens 'wretchedly uncomfortable.'

Why did the German authorities rev up the engines on their printing presses? The answer shouldn't surprise us.

The 'Mystery' of German Hyperinflation

The post-war inflation at first stimulated production, notes Professor Costantino Bresciani-Turroni [11], who witnessed the monetary breakdown first-hand, but later it

exercised an increasingly disadvantageous influence, disorganizing and limiting production. It annihilated thrift; . . . It destroyed incalculable moral and intellectual values; . . . millions of individuals were thrown into poverty. It was a distressing preoccupation and constant torment of innumerable families; it poisoned the German people by spreading among all classes the spirit of speculation and by diverting them from proper and regular work, and it was the cause of incessant political and moral disturbance . . . The record of the sad years 1919-1923 always weighs like a nightmare on the German people. [p. 404]

Prior to the war, he said, 'there were, perhaps, no examples of great fortunes amassed exclusively by speculation . . . The accumulation of great fortunes had not, in the past, meant the transfer of wealth from one to another.' But after the war, the 'new men were for the most part very clever speculators . . . above all, their successes were intimately connected with the inflation.' [p. 291]

'Clever speculators' thus joined 'vengeful victors' as the scapegoats of the post-war nightmare. But neither was in charge of the money supply.

Before the war Germany 's central bank, the Reichsbank, was gently destroying its currency at a rate of only one to two percent. When war broke out in August, 1914, Germany , like all the belligerent governments, suspended gold redemption so it could help finance the war with inflation and thus avoid the unpopularity of huge tax increases. To this end, the government issued 'obligations' that the central bank bought with money created with its printing presses.

When the war was over, as Hans Sennholz recounts in an excerpt [12] from his Age of Inflation [13], 'the amount of money in circulation had risen fourfold and prices some 140 percent. Yet the German mark had suffered no more than the British pound, was somewhat weaker than the American dollar but stronger than the French franc.'

When the Armistice was declared at 11 a.m. on November 11, 1918 , the mark was still worth about 60 percent of its pre-war value in terms of gold. The socialists who came to power that month, however, lacked the political strength needed to mulct the rich enough to pay for their programs, so they ran the printing presses harder, creating for smart speculators new and substantial opportunities for profit. [Bresciani-Turroni [11], p. 288] By February, 1920 the mark had depreciated to roughly nine percent of its gold parity and served as a strong stimulus to exports, and while real wages remained low, the unemployed rapidly found work. [Ibid, p. 257]

It became obvious that even with the war over the mark would continue to deteriorate, though the public, swallowing official explanations, exculpated the government and the Reichsbank. Politically correct commentators, including eminent economists as well as politicians, claimed there was neither monetary nor credit inflation in Germany [Sennholz [12]]. While admitting there was indeed an enormous amount of paper money in circulation, officials said it bore little relation to prices. Some argued that the Reichsbank's gold reserves covered the currency at a higher ratio than before the war, while others insisted that, as great as the number of new issues was, Germany actually suffered from a shortage of paper currency. Nevertheless, the public, realizing they were without a 'store of value,' turned to stock market speculation in an attempt to supplement their income.

By December 1923, Sennholz writes, 'the Reichsbank had issued 496.5 quintillion [496.5 x 1018] marks, each of which had fallen to one-trillionth of its 1914 gold value.' One penny was the equivalent of 42 billion marks, a dollar was quoted at 4.2 trillion marks.

It was the political class in Germany -- not foreigners or speculators -- that created this nightmare. As Sennholz makes clear:

Every mark was printed by Germans and issued by a central bank that was governed by Germans under a government that was purely German. It was German political parties, such as the Socialists, the Catholic Centre Party, and the Democrats, forming various coalition governments, that were solely responsible for the policies they conducted.

In the last stages of the debacle the public ceased using the legal money, replacing it gradually with foreign money, specie that had been hoarded, or new money created by private firms. [Bresciani-Turroni [11], p. 341]

Introducing a Currency of 'Stable Value'

As Mises observed in Human Action [14]:

If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last forever. [p. 425]

The chaos in monetary affairs took a positive turn on November 16, 1923 when the government issued an emergency currency, the rentenmark, with something resembling gold cover that by decree was to be issued in limited quantity. One rentenmark equaled one gold mark, which was equivalent at the time to one trillion paper marks. Holders of rentenmarks could exchange 500 rentenmarks for a bond having a nominal value of 500 gold marks. [Bresciani-Turroni [11], p. 340] The gold backing went no further than words on paper, but desperate Germans, seeking deliverance from their monetary nightmare, were willing to accept it.

Meanwhile, the Reichsbank continued to issue paper marks, which remained the only legal tender until October 11, 1924 , at which time they bowed out to the reichsmark, also defined as one trillion paper marks. The paper mark was withdrawn from circulation and ceased to be legal tender on June 5, 1925 . Very importantly, after November 16, 1923 , the Reichsbank ceased issuing paper marks for the discounting of Treasury bills -- a crucial factor in slowing the monetary depreciation. [Bresciani-Turroni [11], p. 337] Thereafter, it issued marks for 'commercial purposes' only.

Although the reichsmark was defined in terms of gold, the government suspended convertibility of the notes but guaranteed an exchange rate of one reichsmark equal to 4.2 dollars on the foreign exchange. In April 1930, the Reichsbank, at its discretion, began converting reichsmarks into German gold coins, gold ingots, or foreign exchange. [Ibid, p. 354]

These features -- a new currency of 'stable value,' mandated to be issued in limited quantities, and tied to gold, even if tenuously -- established a significant degree of public confidence in the monetary reforms. With a stabilized exchange rate, tax receipts increased in November and December, 1923, and by January, government receipts and expenditures were balanced for the first time since the war began. [Ibid, p. 356] But balanced budgets never last long in a welfare state; the government returned to deficit spending in 1925 and continued spending more than it received until the end of the decade, at which point a new crisis arrived.

Since the war to 'end all wars,' Germany was only one of 30 countries [10] that turned to the 'inflationary solution' and ended up reaching an inflation rate of 50 percent or greater -- usually far greater. The 'inflationary solution,' always administered by a public authority that compels its citizens to accept inconvertible paper for money, made life miserable for people in Angola, Argentina, Austria, Belarus, Bolivia, Bosnia, Brazil, Chile, China, Danzig, Georgia, Germany, Greece, Hungary, Israel, Krajina, Madagascar, Mexico, Nicaragua, Peru, Poland, Republika Srpska, Romania, Russia (twice), Taiwan, Turkey, Ukraine, Yugoslavia, Zaire, and now Zimbabwe, where its new $10 million note is not enough to buy a hamburger [15].

Exactly what the 'inflationary solution' would entail for us is anyone's guess, but Johns Hopkins economics professor Steve Hanke [16] perhaps gives us some idea with his description of the Milosevic inflation in Yugoslavia . Milosevic's 'solution' peaked in January 1994, when prices increased 313 million percent (313,000,000%). What would that mean if Bernanke did the same to us? '[I]magine the value of your bank accounts in dollars and then move the decimal point 22 places to the left,' Hanke says. 'Then try to buy something.'

And we're supposed to believe the gold standard is a barbarous relic [17].

The solution

What's wrong with the markets? The answer should be obvious -- nothing. Nothing is wrong with the markets. This is the way they're supposed to work -- inflation, euphoria, crisis, followed by more inflation, euphoria, crisis. It continues like this until the legal tender becomes so worthless the public rejects it and begins using a different money, at which point the state intervenes and gives them a new fiat issue substantiated with hollow promises about keeping it stable. Then the process begins anew, but with most people believing only good times lie ahead because central bankers have learned how to manage a fiat currency, as Alan Greenspan once assured us [18] and Ben Bernanke has affirmed [19].

But central bankers have always known how to manage a fiat currency. That's never been the problem. If their goal was to keep the currency sound and avoid market swings, they would keep the money supply constant. But that's not what central banks were designed to do.

Central banks exist for the purpose of inflating the money supply in such a manner that the penalty is not borne by the major commercial lenders. Instead, the inflation is passed on to the public, who pay for it in higher prices, lost savings, and tax-funded bailouts. They also pay in less direct ways, such as unnecessary wars, lost liberty, and moral deterioration.

Chronic inflation is not an inherent curse of unfettered markets. It is Fed policy. It is a policy that has the full support of government. Inflation is equivalent in its effects to counterfeiting, as Rothbard (here [20] and here [21], for example) and other Austrians have frequently pointed out. But no one outside the Austrian community talks about the Federal Open Market Committee [22] as a legal counterfeiting authority.

Inflation is a joint venture of bankers and politicians that has proved highly successful in amassing profit and power because most people accept the definition of inflation as a rise in prices. They therefore reject outright any suggestion that inflation is Fed policy. How could it be? The Fed doesn't increase prices. Business does.

The only person active in building a better economic foundation is Ron Paul, who wants to slash government spending, abolish the Fed, repeal the income tax, and establish a sound monetary standard independent of government. In calling for such a radical overhaul, he claims he's only doing his job, i.e., defending the Constitution. Anarchists don't defend any state's constitution, but Dr. Paul might be onto something. What anarchist wouldn't take heart at this happening at the University of Michigan [23] last October?

• You might have thought you were at a normal campaign rally if you stopped by the Diag to watch Republican presidential candidate Ron Paul speak last night.
• Then someone in the crowd lit a few dollar bills on fire and held them aloft. . .
• The burning of the dollar bills came as Paul called for a return to the gold standard for backing printed currency.

If all Ron Paul supporters set fire to Federal Reserve notes and mailed the burnt remains to Ben Bernanke, it would at the very least register their protest against a system of depreciating currency that is causing economic havoc, eating our wealth, and funding illegal wars.