Federal Reserve Independence and Democracy
I can imagine arguments against institutional independence for central banks, but I think the whole idea that Fed independence is “undemocratic” in a problematic way is, itself, pretty problematic. After all, Ben Bernanke’s not a dictator. He was appointed by the President of the United States and confirmed by the United States Senate, just like a lot of other officials. It’s true that the president can’t just fire him unilaterally. But it’s not clear that George W. Bush’s ability to fire US Attorneys for failing to pervert the criminal justice system for partisan ends served the cause of democracy. Nor do I think it makes much sense to say that the United States is undemocratic for requiring the president to listen to the military advice of professional officers rather than political appointees.
Meanwhile, we have lots of countermajoritarian political institutions in the United States, ranging from the apportionment of the Senate to the filibuster to the workings of the committee system to the electoral college to bicameralism in our legislatures. But we’re still “a democracy” just like Canada and France and India and Japan are all democracies despite having very different political institutions. And given the rest of the political institutions in the United States, it’s not clear what alternative to independence would be more democratic.
We could just let the President set interest rates and conduct monetary policy, but that would be making Fed functions less responsive to congress than the current setup is. Or we could say that monetary policy actions require an act of congress. But congress is countermajoritarian itself and has an enormous status quo bias. Maybe we could have the Fed chair stand for election independently? But to make a long story short, I don’t really see a huge problem here in terms of democracy once you put the Fed in the context of the rest of the American institutional framework.
38 Responses to “Federal Reserve Independence and Democracy”
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April 14th, 2009 at 3:31 pm
The Fed is independent within the government, not of the government.
like Supreme Court Justices, the Fed reads election returns.
April 14th, 2009 at 3:42 pm
The issue is that the Fed is not audited, so we don’t really know what it does, and so we can’t evaluate certain fundamental aspects of our economy.
April 14th, 2009 at 3:48 pm
On the other hand, why can’t we point out that this is a situation in which “democracy,” narrowly defined, isn’t exactly a preferable scenario. That is, if the authority responsible for conducting monetary policy were directly “accountable” to the political landscape, it’s highly likely that raising interest rates would be unduly difficult, even when raises were necessary or prudent.
God bless America and all that, but I don’t understand the inclination to reflexively fetishize expansive democracy in every imagineable form, especially considering we’ve got a living example of the sort of policy that leads to in California.
April 14th, 2009 at 3:55 pm
Brien Jackson– The Federal Reserve can be independent without being completely politically unaccountable. Wouldn’t it be nice to know how much money there is, for example. They don’t tell us. Wouldn’t it be nice to know what kinds of dealings the Fed has with banks, when its handing over trillions of dollars? We don’t have a right to ask, under existing law.
Democracy is important because it prevents corruption and abuse of power. Think corruption and abuse of power might be a problem for an institution that can print money whenever it wants and doesn’t have to disclose it’s transactions? Nahhh…..
April 14th, 2009 at 3:56 pm
It is wrong to assume that the Fed is, de facto, independent of the political process.
http://www.nationalreview.com/nrof_bartlett/bartlett200404280812.asp
April 14th, 2009 at 4:08 pm
You won’t have a problem with his independence until he does something you don’t like. Then the ink will flow in rivers, stating that the Federal Reserve, unlike so many other American institutions, has no connection to popular will.
April 14th, 2009 at 4:09 pm
But it’s not clear that George W. Bush’s ability to fire US Attorneys for failing to pervert the criminal justice system for partisan ends served the cause of democracy.
It’s not clear that having Alan Greenspan weighing in on policy debates under cover of being ostensibly ‘non-partisan’ or trying to affect election results serves the ends of democray either.
Question: if parliamentary democracy is good enough in your view for the US, why would having the Fed be subject to the same effects be bad?
max
['That's aside from the fact that the Fed is essentially a conservative partisan institution.']
April 14th, 2009 at 4:15 pm
Matt’s response was great. Megan’s was even worse than her normal postings. WTF?
April 14th, 2009 at 4:16 pm
Matt asks the wrong question. The real issue is whether the Fed is independent of the banks over which it is supposed to exercise an oversight role. The record says no. The Fed made no attempt to curb the risky practices by the big banks while the they were making huge profits. Apparently saying “no” to Wall Street while the $$$ were rolling in wasn’t something the Fed found the courage to do.
April 14th, 2009 at 4:25 pm
I tip my tin-foil hat to you on this fine post, but it ignores the secrets of GOLD!!
April 14th, 2009 at 4:28 pm
This is effectively what occurred in ‘03 and ‘04, as Greenspan was greasing the skids for Bush’s re-election.
April 14th, 2009 at 4:31 pm
Our political system is democratic, but our government is not a democracy. We’re not even a representitive democracy, like parliamentary systems. I don’t think there is an easy label for our governmental system, a Montesquieuian Republic perhaps?
April 14th, 2009 at 4:33 pm
This whole thing is ludicrous. The Europeans have decided to give the ECB even greater independence. The Bundesbank, the best managed central bank in the history of the world, was fiercely independent and resentful of populist pressures. To somehow subject the Fed to populist, partisan vagaries is just mind-baffling.
If anything, the Fed should have more independence, not less. The whole argument about democracy does not fly when it comes to highly technical and touchy subjects like interest rate policy. To subject it to direct democracy is suicidal.
In fact, those who want to do so should perhaps check out the hyperinflation in Zimbabwe. And the ridiculous double-digit inflation in Venezuela, which is actually an oil state.
April 14th, 2009 at 4:34 pm
Paulite you are clearly no follower of DR. PAUL. Mr. Yglesias does not UNDERSTAND the CONSTITUTION. Megan’s post shows she is only BEGINNING to UNDERSTAND the CONSTITUTION! THE OBVIOUS DEMOCRATIC THING TO DO IS MOVE TO A GOLD STANDARD!
April 14th, 2009 at 4:35 pm
parliamentary democracy is good enough in your view for the US, why would having the Fed be subject to the same effects be bad?
In European parliamentary democracies (and in Canada), the central bank is more insulated from electoral pressures, not less.
April 14th, 2009 at 4:36 pm
As a matter of principle, people who are liable to buckle to populist pressures of mob rule, i.e. politicians, should not have any say over the conduct of monetary policy.
April 14th, 2009 at 4:42 pm
I would note that democratic pressures only apply to lower interest rates; it never apply to raise interest rates. And a working monetary mechanism must do both. Thus, democracy within the framework of monetary policy is deficient, inappropriate, and bad.
April 14th, 2009 at 4:46 pm
Myles SG– So you think Greenspan was being “independent” when he told everyone to go out and get themselves an adjustable rate mortgage?
The Fed’s independence is a charade. If it’s independent of politics, its dependent on something else–in this case, the interests of the financial community.
If we can’t audit the Fed, we can’t know what they’re doing. That makes abuse likely. No one is curious where all these trillions of dollars of printed money are going?
April 14th, 2009 at 4:50 pm
A completely independent Fed would be nice. We should really try that someday.
April 14th, 2009 at 4:52 pm
Brien Jackson– The Federal Reserve can be independent without being completely politically unaccountable. Wouldn’t it be nice to know how much money there is, for example. They don’t tell us.
The problem is, if you make the Fed transparent, you make its investment choices subject to political pressure. Presidential administrations will push the Fed to reward campaign contributors and punish supporters of the opposing party.
Keep it secret, and the Fed can conduct its open market operations and focus on attaining sustained growth and low inflation.
April 14th, 2009 at 4:55 pm
The problem was not the level of independence. It was Greenspan and his worldview. With someone like Bernanke, independence is crucial. With someone like Greenspan, it doesn’t matter.
April 14th, 2009 at 4:57 pm
Kafka is right – the Fed doesn’t just do monetary policy, its also an important bank and financial services regulator. Given that, the role of member banks in the Fed’s governance structure is very problematic. Its not at all implausible that the failure of Fed supervisors to insist that banks step back from the risky practices the supervisors identified has something to do with the governance structure. Moreover, as far as monetary policy goes, James Galbraith has done a pretty rigorous -if ignored- analysis of the political bias in Fed policy: during election years when the incumbent is a Republican the Fed deviates from its Taylor rule toward looser policy. This could help to explain Larry Bartel’s finding that while all income groups do better under Democrats than Republicans over the course of full presidential terms, during election years, all income groups do better under the GOP.
April 14th, 2009 at 4:58 pm
Dilan Esper– You can have transparency without the Fed’s decisions being dictated by politicians. Have a long term for the chairman and the board so they aren’t accountable to political pressure. Just make sure we know what they’re doing so they can’t rob the American people and give money away to their friends in finance.
April 14th, 2009 at 5:02 pm
I’m not sure what “democratic” is supposed to mean. Does it mean the selection process? Or does it mean accountability? If the latter, then certainly the least democratic part of our system is a second-term President. Although I think that a lame duck President is still “accountable” even though he won’t face the voters again.
April 14th, 2009 at 5:14 pm
Dilan Esper– You can have transparency without the Fed’s decisions being dictated by politicians. Have a long term for the chairman and the board so they aren’t accountable to political pressure. Just make sure we know what they’re doing so they can’t rob the American people and give money away to their friends in finance.
The reality is that it is precisely the lack of transparency that avoids this. You have a governmental agency that invests all sorts of money into private businesses in the economy. Make them transparent and suddenly these decisions will be politicized in a manner they are not now.
April 14th, 2009 at 5:22 pm
God bless America and all that, but I don’t understand the inclination to reflexively fetishize expansive democracy in every imagineable form, especially considering we’ve got a living example of the sort of policy that leads to in California.
I don’t understand why liberals are so down on democracy. Is it because of the Bush-hate regnant in some of their brains? Bush talked up democracy in the Middle East, so now it’s a bad thing because of guilt by association?
Max:
“It’s not clear that having Alan Greenspan weighing in on policy debates under cover of being ostensibly ‘non-partisan’ or trying to affect election results serves the ends of democray either.”
“Independence” and being full of shit are not mutually exclusive as Greenspan demonstrated (”too much surplus is bad so we must cut taxes”, etc.) although I have to give him credit for admitting he was wrong all along in the face of overwhelming evidence.
April 14th, 2009 at 5:30 pm
Dilan Esper– No, read Kafka and Rich C above. The lack of oversight of the Fed means that it may be governed by the interests of the financial community, which (clearly) are not synonymous with the national interest. There are always risks of excessive political meddling, but I’ll take an overzealous committee chairman over secret backroom deals with financiers any day.
April 14th, 2009 at 5:47 pm
No, read Kafka and Rich C above. The lack of oversight of the Fed means that it may be governed by the interests of the financial community, which (clearly) are not synonymous with the national interest.
That may be true when it comes to financial REGULATION, but it is clearly false when it comes to the Fed’s Open Market Operations. Nobody has ever credibly accused the Fed of picking and choosing open market operations to favor particular interests in the economy. And the only reason to have transparency in the Fed would be to expose that sort of corruption, which isn’t happening.
Meanwhile, if we DID have such transparency, we WOULD almost immediately have a rent-seeking problem.
April 14th, 2009 at 5:57 pm
Dilan– You’re right, giving trillions of dollars to Bankers doesn’t favor any particular interest in the economy…except Bankers.
It’s hard to make a credible allegation when you don’t have access to any of the relevant information.
April 14th, 2009 at 5:58 pm
Matt:
Try to see if you can avoid using the word “prolematic” for an entire week.
April 14th, 2009 at 5:59 pm
Well, try to see if you can avoid using the word “problematic” for an entire day.
April 14th, 2009 at 6:05 pm
Dilan– You’re right, giving trillions of dollars to Bankers doesn’t favor any particular interest in the economy…except Bankers.
You are referring to the current bailout and emergency stimulus measures, which actually are somewhat transparent and subject to congressional oversight.
Federal Open Market Operations, the non-transparent part of the Fed’s business, consist of purchasing and selling securities on the open market. If you don’t keep it secret, there would be huge pressure on the Fed to favor particular businesses rather than having a neutral stimulus.
But these two things are totally separate programs, and they don’t have anything to do with each other.
April 14th, 2009 at 6:08 pm
I am not exactly sure why your ideals of “democracy” and the Democratic idea of “good government” exactly square. I mean let’s examine that in the context of the Federal Reserve and the Humphrey-Hawkins act. In order to promote low-skilled employment, I suppose you wouldn’t have issue with Federal Reserve fueling relatively large inflation, since the monolithic wealthy suffer more from their depreciated assets than poor who largely subsist.
OK. But we can at least pretend we face trade-offs here? Right now the convenient spectre of Keynesian “deflation” allows you to pretend that this choice doesn’t have to exist – not only are resources “idle”, but money velocity is falling, so we can both commit to GDP growth AND full employment using our favored fiscal and monetary strategies. If we weren’t in such a convenient position, at what’s YOUR APPROPRIATE MARGIN at which the Fed should commit to signaling to investors that the forward economic situation will be fundamentally sound, while keeping pre-existing jobs?
April 14th, 2009 at 9:36 pm
I’m sure that if the Fed was more “democratic”, they would have been even more liberal in their lending practices and taken even bigger risks to suit the desires of the people. Who wouldn’t the banks to get lending flowing cheaply and freely for themselves? How many people bought into the housing bubble?
Everyone is to blame for the current circumstance, not just a few “Big Bankers”. No one forced people to take on gigantic loans for things they could not afford. How else do you explain the popularity of HGTV, Flip That House, etc, etc. Yes, we will deal with the banks and bankers, but everyone needs to take responsibility for our collective actions.
April 14th, 2009 at 10:20 pm
The thing about the Fed is that it is ultimately accountable to the popular will, and should be, but it is kind of shielded from it on a day in and day out basis. Most people think that this doesn’t work perfectly but does work rather well, considering the alternatives. The interesting thing about this isn’t about the Fed per se, but about the Presidency and to a lesser extent, the Senate, which were by the original design, supposed to be similar to the way the Fed now is, with all the ‘edge’ that the Fed has to pursue good govt, in spite of little d democratic tendencies (democracy was rule of the mob and a very bad thing in the Founder’s day) to stupid govt.
Per above, the Fed system is not suited to it’s present day purpose because it wasn’t set up to control monetary policy. The Fed was originally set up to do functionally what the FDIC does now but in a different fashion, it was supposed to aggressively lend to sound but illiquid banks during panics. It was established in 1914, JP Morgan died in 1913, and I don’t think the timing was an accident. It botched this up so bad in 1929-1932 that it was replaced by the FDIC, which was institutionally very different, but since just not having any sort of real function or role to play won’t kill a govt dept, they eventually found something elseto do, which is want they do now.
Per Rich C and election years, that is very true, that last time it was really blatant was in 1992, but Greenspan’s candidate still lost though.
April 14th, 2009 at 10:33 pm
But we’re still “a democracy” just like Canada and France and India and Japan are all democracies despite having very different political institutions.
You are so naive, Matt.
April 16th, 2009 at 11:12 am
April 14th, 2009 at 4:52 pm
Brien Jackson– “The Federal Reserve can be independent without being completely politically unaccountable. Wouldn’t it be nice to know how much money there is, for example. They don’t tell us.”
Dilan Esper Says: “The problem is, if you make the Fed transparent, you make its investment choices subject to political pressure. Presidential administrations will push the Fed to reward campaign contributors and punish supporters of the opposing party.
Keep it secret, and the Fed can conduct its open market operations and focus on attaining sustained growth and low inflation.”
This only holds under a (IMHO, very bad) assumption that elite interests don’t have sources within the Fed, to give them a heads-up. Such sources would *start* with Greenspan himself, and work down through the many layers. Being the person who gave, uh, ‘guidance’ to a firm for a mult-billion dollar transaction would be well-rewarded.
April 16th, 2009 at 8:04 pm
Not a bailout, but a pure give-away of hard earned taxpayer dollars to the elite criminals that run a fiat, for profit, FED and their crony elitist CFR, TriLat & BB shareholders who are the world’s largest foreign and domestic bank’s owners.
American’s NEVER were allowed to buy shares of the FED at it’s inception or ever – just Rothschild’s handmaidens Morgan, Rockefeller, Kuhn Loeb, etc.
The FED created this entire mess with 1% rates for over a year and counterfeiting fresh DEBT FRN scrip to beat the band. And their cronies killed Glass-Steigal to foist it. Of course the self “regulators” of one of the many govt sanctioned cartels ignored every tip at the people’s expense.
Why does Sir Alan write a book to cover his arse when indeed he has before spoken the truth about our crooked FED’s nearly invisible inflation tax that most naive Americans haven’t the first clue about?
GOLD AND ECONOMIC FREEDOM by Alan Greenspan
An almost hysterical antagonism toward the gold standard is one issue which unites statists of all persuasions. They seem to sense-perhaps more clearly and subtly than many consistent defenders of laissez-faire — that gold and economic freedom are inseparable, that the gold standard is an instrument of laissez-faire and that each implies and requires the other.
In order to understand the source of their antagonism, it is necessary first to understand the specific role of gold in a free society.
Money is the common denominator of all economic transactions. It is that commodity which serves as a medium of exchange, is universally acceptable to all participants in an exchange economy as payment for their goods or services, and can, therefore, be used as a standard of market value and as a store of value, i.e., as a means of saving.
The existence of such a commodity is a precondition of a division of labor economy. If men did not have some commodity of objective value which was generally acceptable as money, they would have to resort to primitive barter or be forced to live on self-sufficient farms and forgo the inestimable advantages of specialization. If men had no means to store value, i.e., to save, neither long-range planning nor exchange would be possible.
What medium of exchange will be acceptable to all participants in an economy is not determined arbitrarily. First, the medium of exchange should be durable. In a primitive society of meager wealth, wheat might be sufficiently durable to serve as a medium, since all exchanges would occur only during and immediately after the harvest, leaving no value-surplus to store. But where store-of-value considerations are important, as they are in richer, more civilized societies, the medium of exchange must be a durable commodity, usually a metal. A metal is generally chosen because it is homogeneous and divisible: every unit is the same as every other and it can be blended or formed in any quantity. Precious jewels, for example, are neither homogeneous nor divisible. More important, the commodity chosen as a medium must be a luxury. Human desires for luxuries are unlimited and, therefore, luxury goods are always in demand and will always be acceptable. Wheat is a luxury in underfed civilizations, but not in a prosperous society. Cigarettes ordinarily would not serve as money, but they did in post-World War II Europe where they were considered a luxury. The term “luxury good” implies scarcity and high unit value. Having a high unit value, such a good is easily portable; for instance, an ounce of gold is worth a half-ton of pig iron.
In the early stages of a developing money economy, several media of exchange might be used, since a wide variety of commodities would fulfill the foregoing conditions. However, one of the commodities will gradually displace all others, by being more widely acceptable. Preferences on what to hold as a store of value, will shift to the most widely acceptable commodity, which, in turn, will make it still more acceptable. The shift is progressive until that commodity becomes the sole medium of exchange. The use of a single medium is highly advantageous for the same reasons that a money economy is superior to a barter economy: it makes exchanges possible on an incalculably wider scale.
Whether the single medium is gold, silver, seashells, cattle, or tobacco is optional, depending on the context and development of a given economy. In fact, all have been employed, at various times, as media of exchange. Even in the present century, two major commodities, gold and silver, have been used as international media of exchange, with gold becoming the predominant one. Gold, having both artistic and functional uses and being relatively scarce, has significant advantages over all other media of exchange. Since the beginning of World War I, it has been virtually the sole international standard of exchange. If all goods and services were to be paid for in gold, large payments would be difficult to execute and this would tend to limit the extent of a society’s divisions of labor and specialization. Thus a logical extension of the creation of a medium of exchange is the development of a banking system and credit instruments (bank notes and deposits) which act as a substitute for, but are convertible into, gold.
A free banking system based on gold is able to extend credit and thus to create bank notes (currency) and deposits, according to the production requirements of the economy. Individual owners of gold are induced, by payments of interest, to deposit their gold in a bank (against which they can draw checks). But since it is rarely the case that all depositors want to withdraw all their gold at the same time, the banker need keep only a fraction of his total deposits in gold as reserves. This enables the banker to loan out more than the amount of his gold deposits (which means that he holds claims to gold rather than gold as security of his deposits). But the amount of loans which he can afford to make is not arbitrary: he has to gauge it in relation to his reserves and to the status of his investments.
When banks loan money to finance productive and profitable endeavors, the loans are paid off rapidly and bank credit continues to be generally available. But when the business ventures financed by bank credit are less profitable and slow to pay off, bankers soon find that their loans outstanding are excessive relative to their gold reserves, and they begin to curtail new lending, usually by charging higher interest rates. This tends to restrict the financing of new ventures and requires the existing borrowers to improve their profitability before they can obtain credit for further expansion. Thus, under the gold standard, a free banking system stands as the protector of an economy’s stability and balanced growth.
When gold is accepted as the medium of exchange by most or all nations, an unhampered free international gold standard serves to foster a world-wide division of labor and the broadest international trade. Even though the units of exchange (the dollar, the pound, the franc, etc.) differ from country to country, when all are defined in terms of gold the economies of the different countries act as one — so long as there are no restraints on trade or on the movement of capital. Credit, interest rates, and prices tend to follow similar patterns in all countries. For example, if banks in one country extend credit too liberally, interest rates in that country will tend to fall, inducing depositors to shift their gold to higher-interest paying banks in other countries. This will immediately cause a shortage of bank reserves in the “easy money” country, inducing tighter credit standards and a return to competitively higher interest rates again.
A fully free banking system and fully consistent gold standard have not as yet been achieved. But prior to World War I, the banking system in the United States (and in most of the world) was based on gold and even though governments intervened occasionally, banking was more free than controlled. Periodically, as a result of overly rapid credit expansion, banks became loaned up to the limit of their gold reserves, interest rates rose sharply, new credit was cut off, and the economy went into a sharp, but short-lived recession. (Compared with the depressions of 1920 and 1932, the pre-World War I business declines were mild indeed.) It was limited gold reserves that stopped the unbalanced expansions of business activity, before they could develop into the post-World War I type of disaster. The readjustment periods were short and the economies quickly reestablished a sound basis to resume expansion.
But the process of cure was misdiagnosed as the disease: if shortage of bank reserves was causing a business decline-argued economic interventionists — why not find a way of supplying increased reserves to the banks so they never need be short! If banks can continue to loan money indefinitely — it was claimed — there need never be any slumps in business. And so the Federal Reserve System was organized in 1913. It consisted of twelve regional Federal Reserve banks nominally owned by private bankers, but in fact government sponsored, controlled, and supported. Credit extended by these banks is in practice (though not legally) backed by the taxing power of the federal government. Technically, we remained on the gold standard; individuals were still free to own gold, and gold continued to be used as bank reserves. But now, in addition to gold, credit extended by the Federal Reserve banks (”paper reserves”) could serve as legal tender to pay depositors.
When business in the United States underwent a mild contraction in 1927, the Federal Reserve created more paper reserves in the hope of forestalling any possible bank reserve shortage. More disastrous, however, was the Federal Reserve’s attempt to assist Great Britain who had been losing gold to us because the Bank of England refused to allow interest rates to rise when market forces dictated (it was politically unpalatable). The reasoning of the authorities involved was as follows: if the Federal Reserve pumped excessive paper reserves into American banks, interest rates in the United States would fall to a level comparable with those in Great Britain; this would act to stop Britain’s gold loss and avoid the political embarrassment of having to raise interest rates.
The “Fed” succeeded; it stopped the gold loss, but it nearly destroyed the economies of the world in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market — triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed. Great Britain fared even worse, and rather than absorb the full consequences of her previous folly, she abandoned the gold standard completely in 1931, tearing asunder what remained of the fabric of confidence and inducing a world-wide series of bank failures. The world economies plunged into the Great Depression of the 1930’s.
With a logic reminiscent of a generation earlier, statists argued that the gold standard was largely to blame for the credit debacle which led to the Great Depression. If the gold standard had not existed, they argued, Britain’s abandonment of gold payments in 1931 would not have caused the failure of banks all over the world. (The irony was that since 1913, we had been, not on a gold standard, but on what may be termed “a mixed gold standard”; yet it is gold that took the blame.) But the opposition to the gold standard in any form — from a growing number of welfare-state advocates — was prompted by a much subtler insight: the realization that the gold standard is incompatible with chronic deficit spending (the hallmark of the welfare state). Stripped of its academic jargon, the welfare state is nothing more than a mechanism by which governments confiscate the wealth of the productive members of a society to support a wide variety of welfare schemes. A substantial part of the confiscation is effected by taxation. But the welfare statists were quick to recognize that if they wished to retain political power, the amount of taxation had to be limited and they had to resort to programs of massive deficit spending, i.e., they had to borrow money, by issuing government bonds, to finance welfare expenditures on a large scale.
Under a gold standard, the amount of credit that an economy can support is determined by the economy’s tangible assets, since every credit instrument is ultimately a claim on some tangible asset. But government bonds are not backed by tangible wealth, only by the government’s promise to pay out of future tax revenues, and cannot easily be absorbed by the financial markets. A large volume of new government bonds can be sold to the public only at progressively higher interest rates. Thus, government deficit spending under a gold standard is severely limited. The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means to an unlimited expansion of credit. They have created paper reserves in the form of government bonds which — through a complex series of steps — the banks accept in place of tangible assets and treat as if they were an actual deposit, i.e., as the equivalent of what was formerly a deposit of gold. The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets. The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise. Thus the earnings saved by the productive members of the society lose value in terms of goods. When the economy’s books are finally balanced, one finds that this loss in value represents the goods purchased by the government for welfare or other purposes with the money proceeds of the government bonds financed by bank credit expansion.
In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.
This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard.
Comment by marxbites — April 16, 2009 @ 4:03 pm