Ben Bernanke's Paper Dollar Embodies Systemic Risk
The paper dollar is now the single most important source of systemic risk to the financial system, the world economy, and the security of the American people.
That is the lesson of the past 100 years that Federal Reserve Chairman Ben Bernanke did not teach during his four lectures at George Washington University’s Graduate School of Business. Instead, he celebrated the importance of the extraordinary powers he and his fellow governors have to manipulate interest rates and the value of the dollar in the name of economic growth and stability.
In so doing, he ignored completely that the ever growing need for heroic interventions by the Fed is itself being created by the paper dollar system he celebrates.
This failure is all the more telling because Mr. Bernanke states up front that central banks perform two critical functions: The first is to “achieve macroeconomic stability.” By that, he generally means “stable growth in the economy, avoiding big swings, recessions and the like, and keeping inflation low and stable.” The second is to provide “financial stability” by either trying to prevent or mitigate financial panics or financial crises.
On both counts, the paper dollar system in effect since the final link between the dollar and gold was broken in 1971 has failed and failed miserably when compared to the results produced under the gold standard.
Let’s begin by stipulating that we agree with Chairman Bernanke’s point that the gold standard is not a perfect monetary system. What is?
The more important question is which system, the gold standard or the paper dollar, provides more macroeconomic stability and fewer financial crises.
To answer this question, let’s examine the historic record beginning with the most difficult example, the Great Depression, which supporters of the paper dollar invoke to discredit the gold standard and thereby avoid defending the abysmal record of the paper dollar.
As Professor Brian Domitrovic pointed out in his recent Forbes.com column, the officials running the Federal Reserve in the critical period between 1928 and 1933 chose to ignore the rules of the gold standard, which would have forced them to increase the money supply in response to inflows of gold. Instead, the Fed exercised discretion and tightened, thereby making the deflation of the early 1930s worse than it otherwise would have been. Explains Domitrovic:
“Rather, as (Richard H.) Timberlake has shown, we know what guided Fed thinking in this period, and this was the doctrine that the Fed would refrain from issuing money unless it clearly would go to financing end-point economic transactions, as opposed to things like stock-market speculation and even investment. Whatever you want to say about this doctrine, it has zip to do with the gold standard. And it was at the root of the Fed’s weird decision-making 1928-33 where it presided over a radical narrowing of the money supply.”
What about the claim that, while the gold standard maintains a stable price level over longer periods of time, in the words of Chairman Bernanke: “over shorter periods, maybe 5 or 10 years, you can actually have a lot of inflation, rising prices, or deflation, falling prices.”
After the largest gold discovery of modern times set off the 1849 California gold rush the price level in the US rose 12.4% over the next 8 years. Under the paper dollar, that 8 year cumulative increase was exceeded in 1974, 1979 and 1980 alone. Moreover, an 8 year increase of 12.4% is equivalent to an average increase of 1.5% a year. By contrast, current Fed policy calls for inflation to average 2% a year which equates to a 17% increase in the price level over the next 8 years.
Since abandoning the last vestiges of the gold standard in 1971, inflation has averaged 4.4% a year. Nevertheless, various sectors of the economy have suffered Great Depression like deflations. For example, between 1980 and 1986, the price of oil fell 60%, and the price of agricultural commodities and farm land fell by double digits. Those deflations led to the major bank failures of the mid and late 1980s. And, of course, the most recent financial crisis was triggered by a 30% decline in home prices, a disaster for American families, banks and investors alike that ranks right up there with the hardships experienced during the Great Depression.
The net result is that without the guidance of the gold standard, the Fed and the paper dollar have become the leading sources of economic and financial instability. Since 1971, when President Nixon freed the Federal Reserve from the strictures of the gold standard, recessions have become more frequent, longer and deeper. From 1971 through 2010 (under the paper standard) unemployment averaged 6.3%, much worse than the 1947-67 (gold standard) average of 4.7%. We have since experienced the three worst recessions since the end of World War II, with the unemployment rate averaging 8.5% in 1975, 9.7% in 1982, and now above 8% for three years and counting.
Under the post-World War II gold standard, there were no financial crises that presented a systemic risk to the US economy. Since 1971, we have experienced the:
- 1973 oil shock and international monetary crisis
- 1979 oil shock and dollar crisis
- 1982 Latin American debt crisis
- 1984 banking crisis and effective nationalization of Continental Illinois Bank
- 1987 stock market crash
- 1989-91 S&L crisis and bailout
- 1990 Japanese bubble collapse and banking crisis
- 1994 Mexican peso crisis
- 1998 Asian currency crisis
- 2001 dot com crash
- 2007-09 Housing collapse and international financial crisis
- 2010-2012 European sovereign debt crisis
In addition, the massive increase in the Fed’s and other major central bank balance sheets since the first quantitative easing in 2009 has coincided with the slowest recovery ever — even worse than the recoveries experienced during the 1930s — and the fear of yet another break out in inflation.
Under Chairman Bernanke’s leadership, the extraordinary steps taken to contain the financial panic in late 2008 and early 2009 by fulfilling its “lender of last resort” role to banks and, under emergency powers granted to it by the Federal Reserve Act, to non-bank institutions, may well have avoided a complete collapse of the world’s financial system.
But to use that success as justification for a discretionary monetary policy and a defense of the Fed’s ability to manipulate interest rates and the value of the dollar is to miss the greater point. The growing instability of the macro economy and the financial system is itself a product of the paper dollar system.
The most important thing the Fed could do now to fulfill its two fundamental roles of providing for a stable economy and preventing financial crises would be to begin an orderly transition back to a dollar whose value was once again defined by a unit weight of gold — that is to make the dollar once again as good as gold. To do otherwise is to leave in place the fundamental source of systemic risk that no amount of increased regulation or oversight can correct — the inherent instability of today’s monetary system based on a paper dollar whose future value is unknown and unknowable.