Bernanke and the Holy Grail

Exclusive to STR

March 20, 2008

In times of financial crisis, people want nuts and bolts advice on how to survive, or even better, how to profit from the calamity. 'Tell us how to get out of this, not how we got in it,' is the prevailing attitude -- which is ironic, since most investors are calling for more cheap credit, the policy that brought us to disaster's door in the first place.

The Fed and the government -- the public sector -- will 'do what it takes to maintain the stability of our financial system,' according to Treasury Secretary Henry Paulson, and that is precisely why we can expect more of the same -- bailouts, inflation, jittery investors, false euphoria, the continued destruction of the dollar -- not just now but for as long as the government controls the money supply. History tells us so, and theory backs it up.

In his book, Essays on the Great Depression, published in 2000, Ben Bernanke says,

To understand the Great Depression is the Holy Grail of macroeconomics.

The experience of the 1930s continues to influence macroeconomists' beliefs, policy recommendations, and research agendas. [p. 5]

He says we don't yet 'have our hands on the Grail by any means,' but we're getting there. According to Bernanke, we've made 'substantial progress' in the last 15 years.

Bernanke will never find the Holy Grail. To paraphrase an old song, he's looking for it in all the wrong places. This would hardly be worth mentioning if it weren't for the job he holds. As such, he's dragging us and every other prisoner of central banking along on his misguided search.

Where has Bernanke gone wrong? In the area of fundamental economics. Bernanke does not understand what money is. He and his countless watchers in the financial press talk about 'liquidity,' not money. Bernanke can create all the 'liquidity' he wants, but he will not create one cent of real money. He can't because real money emerges on the market, not from FOMC policy decisions.

To be sure, what comes out of the Fed's powwows is something that functions like money, and therein lies a big error. For at least the last three centuries, economists have had ample evidence that fiat money -- another name for the paper government orders us to use in exchange for real goods and services -- has a short lifespan. It exists because it's easy to create, and when money is easy to create, it gets created -- for the benefit of some at the expense of the rest of us. But even those it seems to favor pay a price. Cheap credit produces an atmosphere of euphoria while leading investors astray.

And when the tide goes out and certain firms are seen swimming naked, we hit the bust phase of the trade cycle. The Fed runs its printing presses harder and passes out suits to the naked swimmers, if they're deemed important enough. It happens every time. In what sense is this 'substantial progress'?

The other economic fundamental that Bernanke fails to understand is the effect of government intervention. The state intervened to create the Fed in 1913. The Fed inflated the money supply during the 1920s, per its mandate and Morgan's connections in Britain. The Fed retrenched then started inflating again, but by then the Crash had come. Hoover was in the White House and began aggressive intervention. The recession fell into a depression. Banks were failing as people discovered the banks had loaned out their money to others. Rather than hold the banks responsible, Hoover's successor blamed gold and declared it would no longer be money, at least domestically. The new president called his interventions a New Deal. It started to show promise only after the Court struck down eight of his programs in 1935-1936, including his National Recovery Act (NRA) and the Agricultural Adjustment Act (AAA), both centerpieces of New Deal legislation. The president then went after the Court to get it to think more like him. He also stepped up his attack on business. The short-lived recovery ended in 1938.

The recovery faltered because investors and businessmen didn't trust Roosevelt. Why should they? He was Mr. Intervention. He was calling them 'economic royalists.' And he had strong popular support.

We operate today with the same ideas that ran the economy into the ground during the 1930s. But Bernanke excuses himself on that point, saying in his book he prefers to focus on 'broad economic issues rather than historical details.' [p. 6] For his history of the interwar period, Bernanke draws heavily on the work of economist Barry Eichengreen, who blames the gold standard for 'sharp unintended declines in national money supplies,' which he says were 'strongly associated with falling prices, output and employment.'

With gold out of the way, we've arrived at the financial landscape we see today. The central bank has flooded the world with liquidity, creating the housing bust with record levels of foreclosures, raising the prices of consumer goods, and fostering multibillion-dollar bailouts. Instead of taking a close look at what the Fed does, most commentators never bother to question its existence. In good times and bad, they clamor for more Fed liquidity. When problems linger, they call on government to take 'bold action' -- a Bush New Deal, perhaps -- and get the economy running again. That interventionism has always failed is irrelevant. That we pay a heavy price in lost liberty is never mentioned.

In the days before the Fed, recessions were allowed to self-correct and consequently didn't last long. They could've been avoided altogether if government had enforced property rights and defended depositors who had been robbed through fractional reserve banking. Instead, government gave us the Fed, a cartel in which fractional reserve banking has been enshrined as sound policy.

To quote Ron Paul from Gold, Peace, and Prosperity:

The central bank never set out to protect the integrity of our money. In fact, the Fed set out to destroy it by institutionalizing inflation. The gold coin standard was doomed and today's inflation made inevitable the day the Federal Reserve was created. [p. 46]

If we want real prosperity, we need real money. We need to switch to a 100 percent reserve gold standard. We need to free money from the grip of government, permanently and completely.

Your rating: None
George F. Smith's picture
Columns on STR: 71

George F. Smith is the author of The Flight of The Barbarous Relic, a novel about a renegade Fed chairman.  Visit his website.