Are Free Markets Free?

Speech for the Conservative Leadership Conference (New York City, January 22, 2010)

How many of you are in favor of free markets? In my book Endless Money: The Moral Hazards of Socialism, I make the case that free markets and capitalism are threatened by our monetary system. Our central bank operates by the decree of government. It administers the U.S. dollar, which it has printed with abandon. This makes government spending uncontrollable, and it can, once enough credit has been extended, imperil businesses, the wealth of our citizens, and alter our nation’s political landscape.

If you studied economics in college, your professors taught you that a baseless currency was a given, even a good thing, which ceded maximal control to beneficent and highly trained central planners who could turn the dials, and voila, they could cause a recession to go away. Who could be against that? Although an economics education probably won’t help you figure out what’s wrong with this, a history major might. Opinions such as mine were in the mainstream from the founding of this nation through about the Civil War, although many disagreed then, too.

Our banks manufacture money out of thin air in astonishing quantities over time. Surely you are thinking: Not in America; maybe Argentina, or Zimbabwe. But amazingly, over 95% of the U.S. dollars held in banks, money funds, or as currency have been created since 1971, when Nixon stopped redeeming dollars with gold.

Or rather you might be saying to yourself, “I haven’t been hurt. There has been a lot of economic growth, and inflation has been under control. We had a problem back in 2008, but Bernanke repaired it, and we’re in a recovery. The system isn’t broken; all we need to do is regulate it better.”

So am I a crank? Why are economics professors who would propose dumping our current monetary system as rare as snowflakes in Bagdad? Well, they need to get research papers published in the “right” periodicals. They have to get consulting gigs on Wall Street. And they get grants to do research from the Fed. Here is what Nobel Prize winner Milton Friedman said in a 2006 interview:

“The difficulty of having people understand monetary theory is very simple–the central banks are good at press relations. The central banks hire people and the central banks employ a large fraction of all economists so there is a bias to tell the case–the story–in a way that is favorable to the central banks.” (Friedman, Milton, An Interview with Milton Friedman, EconTalk, September 4, 2006)

Let me repeat that. Central banks employ “a large fraction of all economists.” You see, the smart people at the Fed have done a magnificent job at casting their peculiar central planning agency as a defender of capitalism, free markets, and best of all as a dragon slayer protecting us from inflation and recessions. Monetary policy is hard to understand if you think, in the twisted logic of Fed economists, that it is very desirable to maintain a low inflation rate. No, that is not a mistake. “Low” inflation is like beating your wife once a week. Yes, it is better than every day, but this supposedly desirable state of affairs has unintended consequences.

Unintended consequences. Sound familiar? When Ronald Reagan was rising through the political ranks, he would quote the nineteenth century economist, Frederic Bastiat, who was famous for telling the parable of the broken window, warning that from economic policy there is always an “unseen” outcome along with that which is “seen.” Thomas Sowell, a conservative Stanford economist, reminds us of the fallacy of composition. If everyone stands up at the baseball stadium, none of us can see the action better than if we were seated.

So, I ask you, knowing this, are we all richer if the banking system manufactures more money? I also ask you this: Do you know where the printing press is? Is it hidden in the basement of the Fed? Is it inside its computer? The answer is no.

Money is created through a process that makes the layman’s eyes glaze over. Described by that daunting phrase: fractional reserve lending, it is really nothing more complicated than taking your deposit of one dollar, literally giving it to someone else, and pretending that both that deposit and the money lent out are now two dollars, and so on, forever and ever, like a germ that divides continuously. And like an infectious disease, unless stopped, it can make its host very, very sick.

Do you still disbelieve me? Would you still say to me: But look, the unseen peril of which you warn us does not exist, because it is unseen? After all, Ben Bernanke is Time magazine’s “Man of the Year,” and the economy, though a little punch-drunk, is getting up off the mat.

Yes, this is true. But here is where the history major can help the confused student of economics. Before about 1800, fractional reserve lending was seen as fraud, Ponzi, counterfeiting. So after its legalization, new banks sprouted up everywhere, and as early as 1814 money substitutes, that is the recirculation of loans into fresh deposits, stretched banks so thinly, they could not repay depositors. And it would happen over and over, in the 1830s, the 1870s, and the 1890s. Remember, none of the deposits, not even the original one, stayed inside the four walls of the bank. Like ghosts they vanished through the walls, spooking asset prices, mostly for land, to jump out of their skin. And when, not if, citizens decided to run the movie in reverse, to exchange their real estate for cash, it was like trying to put popped corn back into its kernel. Deflation and default was the only path back.

The idea behind the Fed was that the rampant manufacturing of money substitutes by banks, if administered centrally, could be slowed down so as to avert the nineteenth century bubbles, and sped up in times of panic. In 1913, most banks had fortress-like balance sheets, but a few spoiled the party by manufacturing too great a quantity of money substitutes, that is by lending deposits too thinly and enticing new account holders with unsustainably high interest rates, a hallmark of the Ponzi method.

Last week a college economics teacher asked me what to say to a student who wrote that the 2008 panic was just like the last great panic of the pre-regulation era, 1907. I told him that the epicenter of that crisis, the Knickerbocker Trust, would look like Fort Knox compared to the most “safe” banks today. That bank paid off its depositors without government assistance in full within three years. Just imagine Countrywide doing that!

The leverage in the system today is twice the level of 1929, and the disaster from purging it has only been forestalled. We are not experiencing inflation, and we probably won’t see it unless the Fed helicopters drop far more money than they have to date, and the bank’s governors announce boldly and publicly that its exit plan is impossible. But the problem with deliberate inflation such as this, is that it breeds more of the same. Soon we would be deluged with unstable credit markets once again, because any fool would know borrowing to buy rising assets is very profitable and a sure thing.

But the nineteenth century is different, you say. Well, Keynesianism wasn’t invented in the 1930s. In fact, in the 1800s politicians asked for and spent massive amounts on stimulus for canals, roads, and railroads. States authorized new “inconvertible paper currencies” directly or through designated banks to try to inflate away their credit crises. These solutions worked when implemented for moments in time, but they ended horrifically. These are the topics of papers I have authored for the Ludwig von Mises Institute and also for my website, You can “tweet” me at my moniker “goldeconomist.”

What? Gold? Did I hear a murmur that the panics prior to the founding of the Fed were caused by using gold for money, and not by the institution of fractional lending? Don’t I know that there have been dozens of academic papers written by the most esteemed economists in the world proving gold was what caused the 1930s depression to be called “Great” in retrospect? Ben Bernanke is the most famed of these academics. That is the mythology the central bankers want you to believe, but in my book I take specific aim at these papers in a chapter called “Flat-Earth Economics.”

I asked you at the beginning of this speech if you were in favor of free markets, and I know nearly all of you are. Well then, along with finance, can you think of any one industry so impacted by government largesse as real estate? Well over half of every bank deposit gets lent to buy real estate. If we did not have a monetary system that encouraged a one-way bet on asset price inflation, wouldn’t our wealth have been directed elsewhere? The incentive is further heightened by having the government cosign just about every mortgage through Fannie Mae and Freddie Mac, reducing interest rates. Then the IRS reduces the rate through a homeowners’ deduction.

For too long, the Republican Party has ignored the distortion of centrally administering a baseless currency. Consequently, despite the obvious thumbprint of the Democrats on affordable housing and the flameout of Fannie and Freddie, concepts also heartily embraced by George Bush, the public thinks Republicans support Wall Street over Main Street.

It creates an uphill battle for the populist wing of the Republicans, led by Sarah Palin. Ask yourself this. Tax rates haven’t changed too radically since the mid-1980s, yet the tea party movement has caught fire. Why? I would tell you it is because of the unintended consequences of fiat currency are beginning to be felt, and the effects will intensify.

If you truly think you stand for a free citizenry, but you nonetheless accept being ruled by elite technocrats, especially those at the helm of the Fed and the Treasury, your political future will be as desolate as that of the Republicans of the 1930s. Frustration with credit cuts across all voting blocks. If you can preempt this issue before the clock runs out, you may just get your chance to do something good for your nation, and win the support of what will be a new entrenched majority of voters.