Ron Paul and the Federal Reserve, Part Two


By Nick Li


 Although Ron Paul may have been right on some points (see previous post), there is also room for criticism. Here follows a critique of some of Ron Paul’s positions relating to his plan to abolish the Federal Reserve and restore America to the gold standard. The following five positions will be commented on:

(a) The Federal Reserve causes boom and bust cycles, while the Gold Standard would stabilize the economy.

(b) The Federal Reserve and fiat money cause inflation that erodes the value of money. This causes disincentives to save.

(c) The Federal Reserve causes financial crises and asset bubbles by intervening in markets – markets are self-regulating, so the gold standard, which is hands-off, would lead to an end of financial crises.

(d) By lowering interest rates when the government increases spending, the Federal Reserve accommodates the government actions and allows it to continue to borrow beyond its means. With a Gold Standard, the government would be forced into fiscal discipline.

(e) The Federal Reserve policy harms the average American and benefits those in a position to take advantage of the cycles in monetary policy. The main beneficiaries are those who receive access to artificially inflated money and/or credit before the inflationary effects of the policy impact the entire economy. The conspiracy theories about the Fed are easily dismissed – see the excellent article by Edward Flaherty. But Ron Paul’s criticisms are more substantial and require some economic analysis and examination of the historical record, so let me address them in turn:

(a) The Federal Reserve causes boom and bust cycles, while the Gold Standard would stabilize the economy.

This claim is complete nonsense and requires total ignorance of the historical record. The National Bureau for Economic Research provides the following dates for business cycles . There were more frequent business cycles under the classical gold standard. These recessions often began as seasonal liquidity shortfalls related to agriculture that developed into banking panics. They were also related to major gold discoveries. The U.S. economy has never been less volatile than since 1982 – while economists have different theories for this (from changes in business inventory management, demographics and labor force participation, or simple good luck through less supply/oil shocks) most would acknowledge that some of the credit should go to the Federal Reserve and the Volcker/Greenspan/Bernanke regimes.

(b) The Federal Reserve and fiat money cause inflation that erodes the value of money. This causes disincentives to save.

While high inflation does decrease the incentive to save, this is not necessarily a bad thing. Higher inflation creates incentives to spend now or invest now (since keeping dollars under your mattress in a zero interest chequing account leads to a loss of value over time) – this stimulates the economy. Deflation, where prices are expected to fall, makes people delay purchases and hold off on spending, and also makes it more attractive to hold on to money instead of spending it or investing it in risky projects (since the value of money will increase automatically). This can be a very bad thing – this was one of the major problems during the Great Depression which contributed to the slump in consumer spending. Sure, some saving is good, but too much saving and the economy grinds to a halt. Japan is the only country to experience serious deflation in recent times, beginning in the 1990s. Economists there have been trying to figure out how to kick start consumer spending, and part of the challenge is getting people to believe that there will be higher inflation in the future, which will spur them to spend and invest aggressively now. Economists have other reasons for liking some inflation – the mainstream view now is that zero inflation is too low, and that a low and stable rate – 1-3% per year – is better. One of the reasons for this is precisely that inflation acts like a hidden tax. People believe very strongly that nominal wages (the figure you see on your paycheck) should never go down. A positive rate of inflation allows the real value of wages to decrease when the economy is slowing down, which means firms are less likely to lay off workers (they get higher prices but lower wages). Without any inflation, it is very politically difficult to lower the wages of workers during an economic downturn to stimulate production and employment. America’s saving problem has nothing to do with fiat money or the Federal Reserve. It is the flipside of high savings and balance of payment surpluses by many other countries with central banks and fiat money. It has deeper institutional causes, related to easy access to credit, distortions in the tax system, Federal government policies, and the patience of American consumers relative to Europeans and Japanese.

(c) The Federal Reserve causes financial crises and asset bubbles by intervening in markets – markets are self-regulating, so the gold standard, which is hands-off, would lead to an end of financial crises.

The current thinking of the Federal Reserve, and part of its original mandate, is to act as a lender of last resort. This means extending loans to banks that are short of liquidity. The purpose of this is to prevent bank runs and banking panics from destroying banks that are fundamentally sound but lacking in short term liquidity. The opposite point of view, sometimes called the "real bills" doctrine was prevalent even within the Federal Reserve in the 1920s, and holds that there are "bad apples" – banks that take too many risks and make stupid decisions – and that these banks should be allowed to fail. A related issue is whether periods of low interest rates lead to speculative bubbles that have disastrous economic consequences when they burst, and whether we would be better off with a hands-off Fed, where the free market would discipline the speculators. The truth is that bailouts can happen regardless of whether there was paper money or the Federal Reserve – bailouts happened all the time under the classical gold standard. In fact, it was only loans between the governments and banks of gold standard countries that kept the gold standard working at all. There were some famous bailouts – the Baring crisis of 1890, for example – where central banks stepped in to save the ass of investors and prevent wider panics and collapses. Whether or not banks should be extended loans or bailed out in a time of crisis is a difficult question with no simple answer, and depends much on the particular context – if every bank was bailed out there would be no incentive to be cautious and banks would be too risky, but if no banks were ever bailed out than simple bad luck along with a herd mentality could cause significant real losses as banking panics lead to the failure of otherwise sound banks and the intermediation services they provide are lost. The Great Depression and the East Asian crisis stand out as two examples of where the "real bills"/"bad apples" doctrines had some substantial negative effects. During the Great Depression, the real bills doctrine was quite popular in the early stages, particularly in certain regional Fed banks. Others, like the Atlanta Fed, provided lots of help to banks struggling with liquidity crises. It turns out that states governed by the Atlanta Fed did a lot better than states governed by the St. Louis Fed – there were less bank failures, and a smaller decline in economic activity. If the Fed contributed to the severity of the Great Depression, it was partly by not doing enough to support banks that were fundamentally sound, but short on liquidity due to panics and bank-runs. During the East Asian crisis, the IMF adhered to the "real bills" doctrine in the sense that it felt that all failing banks were "unsound" and should be allowed to fail – let free market discipline reign. Joseph Stiglitz has criticized this view, claiming that part of the reason Indonesia was hit much harder than the other countries affected by the crisis is that the failure of some banks prompted bank-runs and panics, leading to the loss of many sound banks. The result was a severe blow to the economy, as the collapse in banks led to the collapse of investment and lending to firms, and the valuable intermediation service of banks (based on local knowledge and personal relationships) was lost forever. Ben Bernanke has argued that something similar happened during the Great Depression. One should never underestimate the psychological component of financial crises and banking panics. The belief that if the government left it alone, the free market would rationally price all risk and prevent any economic cycles or crises, lacks any empirical basis and ignores the fundamental reality that human beings do have herding behavior and are systematically overconfident (just look at the fascinating zero-sum gain of currency speculation, for example, and think about how such a market could exist in a fully rational world). There were plenty of speculative bubbles – including the famous Dutch "tulip-mania" – under the classical gold standard, and they will always be with us. The appropriate role of the Federal Reserve is not to pop speculative bubbles – something Greenspan is much criticized for – but to maintain low and stable inflation. The best way to prevent the "bad apples" is not by punishing the financial sector during economic downturns when it is most vulnerable and most crucial to economic recovery, but by prudential regulation that prevents banks from taking too many risks in the first place. This was the other recommendation of the IMF for the East Asian countries, something they have taken to heart, but it would never be acceptable to Ron Paul or other libertarians who believe that any regulation is harmful.

(d) By lowering interest rates when the government increases spending, the Federal Reserve accommodates the government actions and allows it to continue to borrow beyond its means. With a Gold Standard, the government would be forced into fiscal discipline.

This is true to some extent. Under a Gold Standard, governments are forced to maintain external balance – they must do everything possible to make sure too much gold does not enter or leave a country. Thus domestic economic policy is held hostage by the need to maintain fixed exchange rates – in this case, exchange rates are fixed to the price of gold. Under fiat money, gold is just one more commodity, so even though some countries are fixed to the dollar, the dollar itself varies in its gold value. Pursuit of external balance means domestic policy – through interest rates and fiscal policy – must be completely subjugated to the demands of meeting the Gold Standard. Contrary to the view of Ron Paulites, this was a very popular policy with Bankers under the classical Gold Standard. They could have full confidence in the value of the currency, knowing that governments would endure any kind of unemployment or domestic misery in order to maintain the gold value of their currency. The forces militating against the gold standard were the popular classes – farmers and organized labour. This is because they were suffering from deflation – falling prices for agricultural goods (see an interesting interpretation of the Wizard of Oz here). The popular classes are usually less concerned with the value of their assets – they have few – and are more concerned about unemployment, the quantity of exports, and industrial production. Thus they tend to favour lower interest rates in during economic downturns and also favour stimulative fiscal policies. In "Golden Fetters" Barry Eichengreen argues that part of the reason for the failure of the post-WWI gold-standard is that labor and populist parties were much stronger, and there was enormous pressure for governments to intervene to stimulate the economy and promote full employment – this meant that the Gold Standard could not be maintained. Part of the illusion of the Gold Standard is that it was self-regulating. This was clearly not the case – the Gold Standard existed as long as governments were

(1) willing to help each other out by shoring up gold reserves of countries whose supplies were running low; (2) willing to tolerate deflation, high unemployment, and extremely high interest rates to defend their currency; (3) willing to enforce severe fiscal discpline and never attempt counter-cyclical fiscal policy that interfered with maintaining the Gold Standard.

The underlying problem, then, is that these conditions no longer hold because the world is much more democratic than it used to be, and the pressures of governments to do something and use their power to stabilize the economy and give it a boost during economic downturns is just too strong. Ron Paul is from the same school of fiscal policy that says that during a recession, we should raise taxes and cut spending (to balance the budget) – two propositions that most people, on the left or the right, would find simply ludicrous today. There is nothing intrinsically great or moral about running a balanced budget over the entire business cycle (any more than there is in running a balanced budget at every point in one’s lifecycle), but that is where the logic of Ron Paul leads. Ultimately, of course, Ron Paul would probably prefer to do away with all government except for maybe the military, police and firefighters. As John Maynard Keynes noted when England became the first country to go off the Gold Standard in 1931 (and not coincidentally the first to recover), ‘There are few Englishmen. who do not rejoice at the breaking of our golden fetters.’

(e) The Federal Reserve policy harms the average American and benefits those in a position to take advantage of the cycles in monetary policy. The main beneficiaries are those who receive access to artificially inflated money and/or credit before the inflationary effects of the policy impact the entire economy.

It is true that the minimum wage, U.S. manufacturing wages, and some fixed incomes have not kept pace with inflation in the last few decades resulting in lower real purchasing power. But is that the fault of the Federal Reserve and fiat money? Let us not forget the Gilded Age of the 1920s, when the gold standard prevailed in the United States and inflation was kept low but inequality reached some of its highest levels ever, or the fact that real wages for many other classes of workers – white collar workers and professionals for example – have increased. Could it really be that inflation hurts steel workers in Michigan but somehow those well-connected IT professionals, Professional Athletes, Musicians, and Entertainers, and lawyers and doctors get access to that sweet "artificially inflated money" and credit? Could it really be that a 2% a year tax on wealth (not on income, since wages also rise, even if at a slower rate than prices) which gets rebated to the U.S. treasury (i.e. the printing of more money) is responsible for, say, the rising divergence in wages between workers with and without college degrees, instead of, say, the rise of competition with cheap labor exporting giants like China, decades of right-wing economic policies, the decline in the strength of American unions, and the rise of skill-biased technologies like computers? Could it really be that the average person benefits when the Fed does not bail out a bank and there is a widespread banking panic that wipes the savings of thousands? How about other countries with fiat money (oh, like, every other country in the world) that have seen rising real wages over the same period? On this topic, Ron Paul is completely wrong. And it is particularly galling to hear THIS as a reason for opposing fiat money and the Federal reserve from the same person who is against any form of government redistribution and would prefer to have no publicly provided education or healthcare. It is telling that in the Youtube segments from the links above, Ron Paul cites the German hyperinflation of the 1920s as the reason why fiat money is dangerous while nodding approvingly at how Argentina solved its inflation problem by fixing to the U.S. dollar (we all know how that turned out). Yes, there were some major disasters with fiat money in the early years, as there is with any new economic institution. But governments have learned their lessons – part of the reason central banks are independent and insulated from popular pressures is to prevent that kind of politically motivated debt monetization and to ensure that price stability is the main objective of monetary policy. Central Banks today understand that their primary role is to stabilize domestic prices, not micromanage economic growth and unemployment or preserve fixed exchange rates. Ron Paul’s claim that over the centuries, the only kind of money that endured was based on precious metals is just silly in this respect (as if I had claimed that what always was must always be) and shows him up to be squarely stuck in the era of William Taft (his idol), a classic throwback conservative who thinks we have learned nothing of value about economics since the turn of the century and no government intervention can ever be good for the economy. It is thus unsurprising to find him advocating economic doctrines that were put to rest around the time he was born in 1935. I think part of the reason Ron Paul and some other conservatives, especially of the libertarian persuasion, tend to like the Gold Standard is that they feel very unsure about what gives paper money its value. It feels like monopoly money to them, while gold is tangible, it looks nice and is shiny. In the end, there is no particular reason to like gold money to anything else – historically, silver was more valuable in China and there was a very profitable gold/silver arbitrage between China and the West for a long time. In various times and places, other forms of currency have been used – cowrie shells on some Pacific islands, copper coins, cigarettes in prison, etc. What makes paper money have value is the same thing that gives all of these other things value as a medium of exchange – social convention. Every US bill notes that "This note is legal tender for all debts, public and private." Why is this significant? The U.S. dollar has value, in part, because it is accepted as a means to repay debts to the Federal government. Every year, we all have debts to the Federal government – taxes. Why do we pay taxes? Because otherwise the government, using its monopoly on the use of force and coercion, will seize our assets and eventually throw us in jail. Thus paper money does have real value, but it is value based on the current conventions and alignments of force that govern our society. Libertarians just can’t stand the idea of "socialization" and "social conventions" being important forces, and are even more distressed by the idea that governments could tell us what to do. But they can, and do, so until the apocalypse comes and we return to a barter economy (and trust me, gold will probably not be the most valuable commodity when people are struggling to survive) paper money is as legitimate as anything else. – Nick

5 thoughts on “Ron Paul and the Federal Reserve, Part Two

  1. I wonder if you would care to comment on the legitimacy of fractional reserve banking which is the basis of this pyramid scam?

    Why is it legal and legitimate for banks to counterfeit money through fractional reserve, when the gain generated by this action benefit private bankers and harm the public through devaluation of their savings?

    It is essentially a taxing mechanism on the public that benefits private interests. This is excluding the obvious immoral act of requiring the repayment of a principal amount 90% of which hadn’t previously existed prior to being loaned.

    The reason that there is a Federal Reserve bank in the first place is to perpetuate this scam. There is no legitimate reason to allow private individuals through their banks to counterfeit money in this manner.

    You overly long and drawn out explanations are typical of those tactics used to confuse the public on a subject which is rudimentary.

    Thanks for the reply Tim. I’ll keep it short and pithy then. First, fractional reserve banking long pre-dates the Fed and existed under the gold standard. Second, there is no direct evidence that having banks as financial intermediaries is either harmful or helpful, as fractional reserve banking exists in all societies everywhere today – there is no comparison group. However,in a capitalist economy there is nothing to stop someone from setting up a full-reserve bank, which would basically be a safety deposit box. The fact that no one does that should you give you some pause. Note that this would be the case even under a gold standard with trend inflation of zero.

  2. Nick,

    You provide the standard Keynesian analysis on the Gold standard here that rose in the 1930s. In that period the French, Swiss and Dutch governments have held longest on the Gold standard and got serious deflation indeed. There is however a point to make, that this does not apply today.
    The 1920s and 1930s were the period with a large scale increase of industrial output (mass production) due to the introduction of Henry Ford style production techniques. The proper analysis than is that the economies of scale that were accelerating strongly forces deflation in countries who sticked with the Gold standard. The amount of Gold would not increase as fast as the volume of goods people could consume with it.
    One measure than is to ditch the Gold standard, keep salaries stable, while increasing the money supply in line with the massive output and productivity growth. If one sticked to the Gold standard, only aggressive price cuts could provide additional sales. Those industries that did not enjoy productivity improvement would gradually be forced to cut salaries, causing shrinking demand and further deflation.
    The point here is that sticking to the Gold standard would keep savings value (vis-a-vis Gold) but effectively raise it’s value when observing the amount of goods one could buy. The Gold standard thus benefits liquid asset owners, which was why Queen Wilhelmina was in favor as was Colijn. It’s a shift from the labour classes to the asset owner classes.
    Today reintroducing the Gold standard however deserves new analysis. It would, on a global scale, imply that the strong actual deflation in industrial goods costs, due to the massive output growth in China, shows up as a rapid fall in prices for these goods, while the spending in service economies and in particular intellectual property and information goods, where productivity growth is hardly measurable, would benefit from it. Anyone who would look at this issue will agree that a peg of the dollar to Gold, together with a policy of withdrawal of American troops from around the world (the main item a president like Ron Paul can influence without long fights with congress) would terminate American global lending, stabilise confidence in the Dollar, but effectively would force China to reasses its policies, as they will be forced into deflation when they stick with pegging their coin to the dollar.

    Today, the USA is not quite able to convince the Chinese government to raise the exchange rate of the Yan to the Dollar. Pegging towards a gold standard in conjunction with serious budget cuts by reducing ‘Empire Spending’ on non-productive items like military equipment and salaries for mercenaries causes an unilateral turning of the tables.
    The prime point of the Austrian critique on Fiat money is that in the long-run it benefits mainly those who are the first in the money supply, e.g. governments as money printers and bankers as distributors, while inflationary effects are only visible after a few years. I think that analysis is a bit incomplete without mentioning the effects on price vs goods output. We are however today in a service economy where capital intensive services (e.g. flying aeroplanes, telecommunications etc.) and the jobs to operate them are dominating society and not outputs in industrial goods. As you take that in account, you start to grasp that Keynes’ analysis might not apply anymore. Most modern day jobs are more related to productive capital goods then labour, a large group of the population in western countries therefore could benefit and a rapid changeover to a real service economy could occur, while a gold standard would force a dramatic decrease in the cost of the fast growing information output and discipline the financial service industry far more than an inflation driven system. Also, we are close to the retirement years of the Babyboomers, a Gold standard would benefit countries with large scale retirement savings (e.g. the Anglo-Saxon world, Scandinavia, the Netherlands and Switzerland).

    Interesting argument Hank. I think US current account deficits with China and fiat money vs. gold standard are two separate issues though there is some relation. First, I think you have seen deflation (or at last near zero inflation) of industrial goods prices to some extent due to trade with China. This seems to happen precisely because China doesn’t revalue (upwards) the Reminbi-dollar exchange rate, which would make the Chinese goods more expensive here and depress their exports, decreasing the US trade deficit with China. Whether adopting a gold standard would force China to revalue its currency is hard to say – they are fixing to the US dollar, and there is no reason they can’t fix to a US dollar that is fixed to a commodity like gold. Whether they can do this while maintaining local price stability and open capital markets is unclear as it potentially violates the “trilemma” of international economics.

    On your second point, I agree that a major decrease in US spending, through military cuts or other means, would help fix the global imbalances, as would an increase in spending by China. As long as China funds US twin current account and budget deficits with its surplus, and wants to accumulate US dollar denominated assets, we’ll have these global imbalances. The most the US can do is cut back its private and government consumption, which to some extent it is doing already and which it will continue to do in the next few decades. The Gold Standard is historically associated with balanced budgets, but you need the political will first, otherwise the gold standard is not credible (see Barry Eichengreen’s work). And if you have the political will to balance budgets, you don’t really need the gold standard.

  3. A very balanced look at the issue. There’s not a lot of info out there to directly rebut anti-fed statements. Thanks for posting.

  4. Hi Liz, you ask a good question. Some of this comes down to psychology, since throughout the 20th century real wages have been rising (whatever you do for a living, odds are your salary buys a lot more than it would have in 1900). Now for this to happen, despite the fact that prices are way higher now than in 1900, your wage has to be much higher as well. Thus although prices have been going up every year, so have wages, and by a greater amount over the whole century. Granted, the tedency since the 1970s is for wages to rise slower than prices for manufacturing workers, and the minimum wage has also not kept pace with inflation (but this is just politics – one of the focusses of the “living wage” movement, in part, is to recognize that since things get more expensive every year, the minimum wage also has to rise every year- it should be indexed to inflation). Now, why would it be good to have a wage increase by 3% every year while prices increase by 2% every year, instead of having wages go up by 1% but prices stay the same? Rationally, there is no difference, but psychologically, people like getting a bigger raise. People, when asked in surveys, seem to prefer to see their wages go up – psychologically, that is better than having a constant wage and prices falling, which is exactly what can happen when you have deflation (the reverse of inflation).

    Now, inflation hurts you if you keep dollars stuffed under your mattress. Inflation creates an incentive for you to save your money in a bank, or invest it in your own business or buy real estate, etc. In my opinion this is a good thing, though not everyone will agree.

    As for your scenario where suddenly your wealth is reduced to zero, I think it is important to note that this could only be avoided if you kept all of your savings in concrete assets like gold, diamonds, artwork, property and even then a government could always seize it [think about the Jews in World War II.] If you kept all your money in the form of gold in a bank, or in your government social security check or pension plan (Enron or otherwise), a catastrophic event of the kind you suggest would leave you just as vulnerable. That is why some people don’t like to keep their money in banks either – look at what happened in Argentina.

    Also, what you propose goes a bit further than Ron Paul. Ron Paul wants 1:1 backing of dollars with gold – we would still use paper money, only the value of a dollar would be fixed to gold, so you could redeem your paper for gold by giving it to the Federal Government. Note that in this scenario, the government could one day decide to alter the amount of gold it gives you for a dollar, just as surely as it could print more paper money. What you propose is more like a gold coin standard -we only use valuable precious metals for exchange – which also makes fractional reserve banking (where banks can lend out more than they keep as assets) impossible.
    This is rather extreme, and we have not had a system like that for a long time…

  5. I really wish I understood all the fiscal workings so I could comment. I can only say that 1 – 3% inflation is good for whom? Certainly it’s not good for me. Why should I pay more? Common sense seems to indicate that a piece of money backed by something of value is sure worth a WHOLE lot more then that piece of paper in my wallet that’s backed by NOTHING. It changes value constantly and today it is worth FAR LESS both on the global scene and in purchasing power now then ever before. If all of a sudden we decided to change monetary systems, that piece of paper’s worth zip, zilch, nada because it’s backed by nothing. I’m certainly no expert and these are just my rambling opinions but I think the “experts” on these things their way with these things too long. Look where it’s gotten us overall.

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