A Centrally-Managed Fiat Currency has Serious Side Effects

Fed Chairman Bernanke’s decision to use the tools of printing money through directly monetizing government debt and mortgages rests upon decades of academic theory, and in particular on work that blames the gold standard for the depth and length of the Great Depression.

Although there is ample evidence that government intervention was injurious because it retarded the private sector’s actions to save and reduce debt, Treasury Secretary Geithner has stated that economic recovery in the 1930s did not occur chiefly because the government failed to act in a large enough way.

Bernanke, Geithner, and other monetary theorists who are in charge of the financial system rely upon academic work that argues the operation of a currency system that each year prints money (historically an average of 7 percent for M3) and elicits a percent or two of consumer price inflation is inherently stable. This work also finds that a system, such as gold, that limits monetary growth would result in deflation, instability, and sub-optimal economic growth.

We have a centrally managed fiat currency by choice. It ensures a small, manageable amount of inflation, and isolates control of the quantity of money in the hands of a benevolent few who possess the highest degree of understanding of its operation.

But there is a side effect: It presents an enticing one-way bet to profit from the use of debt. Known to all students of finance is the Capital Asset Pricing Model ([TICKER] CAPM [/TICKER]), which states there is an optimal mixture of equity and debt in investment decisions. Although as a theory it holds appeal, in practice the lure of leverage, which exists even in monetary systems that are not established by fiat or lack central control, is powerful.

The record shows that neither is there long-term correlation between interest rates and inflation, nor between interest rates and money supply growth. These are tremendously counterintuitive conclusions, but they are nonetheless true.

Instead, real growth is optimized when credit expands moderately, which historically occurred more often than not over a gold-reserved monetary base. Extremely low or high monetary growth is associated with an interventionist, centralized system, and it has shortchanged mankind with periods of low real economic expansion.


Bill Baker,
for The Daily Reckoning

[Editor’s note: This passage is reprinted from William W. Baker’s book, Endless Money: The Moral Hazards of Socialism, with the permission of John Wiley & Sons, Inc (©2010). You can get your own copy here.]

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