Writers of all ages are invited to address the following:
“Should the Federal Reserve be abolished? What monetary system should replace it?”

Deadline: Midnight, Dec. 31, 2011
Length: 2,000 words. No footnotes or endnotes.
Email Word file to: essaycontest@fee.org
(One entry only.)

The winner will be awarded $2,000 and have his or her essay published in The Freeman.

Eligibility: The Eugene S. Thorpe Writing Competition is open to writers from around the world, including students, freelance writers, teachers and professors, and business professionals. There is no minimum or maximum age for entrants. FEE employees (and their immediate family members), trustees, and Freeman editors and columnists are not eligible.

Eugene Stephenson Thorpe (1913–2001) was born in Elroy, Wisconsin, and graduated from Cornell University with a degree in civil engineering. An early critic of FDR and the changes his policies made in the fabric of American life, Mr. Thorpe’s core beliefs included hard work, free trade, small government, and self-reliance.  He was a longtime supporter of the Foundation for Economic Education and a devoted reader of The Freeman. His children have fittingly established the Eugene S. Thorpe Award as a tribute to his life and ideas.

Although no serious discussion is occurring in the nation about the desirability of shifting economic power from individual decision-makers to the national government, that shift is a basic characteristic of virtually every policy proposal being debated in the Congress.

Take tax policy.  A 131-page document (pdf) issued by the Treasury goes way beyond recommending the extension of some of the expiring Bush administration tax cuts.  For example, the fine print contains over a dozen ways of discouraging American firms from doing business and investing overseas.  Supposedly minor technical changes also would have a severe impact.

For example, eliminating LIFO (last in-first out) inventory accounting will raise business taxes over $60 billion in one decade.  The Treasury also wants to revive four corporate environmental taxes that were eliminated in 1969.  These four arbitrary taxes have no relation between the tax burden imposed on a company and the pollution that it generates.  This bears an uneasy resemblance to Willie Sutton, who robbed banks because that was where the money was. Inevitably a variety of technical tax provisions will increase the paperwork burden on business.  The penalties for failing to file information returns (such as Form 1099) promptly and accurately are raised in a very complicated fashion involving three tiers of penalties.

On the expenditure side, the typical stimulus project increases the power of government in private business decision-making.  The bailout of the automobile industry is really an inefficient method of financing union pension and health plans.  The stockholders are zapped and the bondholders poorly treated.  The taxpayers are left holding the bag, especially considering the restrictions on General Motors importing the really fuel-efficient cars they produce overseas.  Apparently, the new General Motors factory for building compact cars was chosen on the basis of “carbon footprint” and “community impact.”

It is hard to keep a straight face when analyzing the new “cash for clunkers” program.  For example, owners of the biggest old clunkers get a $3,500 credit for trading in the old vehicles for a new one with an improvement of just one mile per gallon.  Surely, it would save energy if the Treasury just mailed the $3,500 checks directly to Detroit!

Of course, the Obama administration is making some reductions in federal spending.  It is reportedly imposing a 9 percent reduction in the budget for the division in the Labor Department that polices fraud and other illegalities on the part of labor unions.  As noted below, a simultaneous expansion of business-oriented antitrust enforcement is taking place.

Turning to regulation, one of Ralph Nader’s biggest disappointments during his heyday as a consumer advocate was the failure of his proposal for a new Consumer Protection Agency.  However, the administration’s financial regulatory plan creates a powerful new Consumer Financial Protection Agency (CFPA).

This new free-wheeling agency takes authority now divided between the Securities and Exchange Commission (SEC) and the Federal Reserve System.  In a change guaranteed to cause confusion, the CFPA will share authority with the Federal Trade Commission.  The new regulatory agency will also have a mandate to give consumers more economic education.  Educators find that especially scary.

Moreover, the agency will have its own money pot, independent of the normal congressional appropriations process.  It will be financed directly by fees assessed on “entities and transactions” across the financial sector.

The Treasury’s financial plan contains many other expansions of government power over business.  The Federal Reserve System is given new authority to oversee any large financial entity whose failure the Fed thinks could generate “systemic risk.”  The Treasury heads a new Financial Services Oversight Council to “resolve” the inevitable jurisdictional disputes among federal agencies.  A new Office of National Insurance is to be established in the Treasury to monitor “all aspects of the insurance industry,” a sector of the economy traditionally under the province of state governments.

The SEC will require the registration of all advisers to hedge funds and other private pools of capital with assets over a given threshold.  It also will have the power to inspect the books of the advisers and to ensure compliance by their clients.  In addition, the power of the SEC will be expanded by legislative proposals to give it a more active role in guiding the compensation committees of all public companies.

The Federal Deposit Insurance Corporation will have new authority to take over and shut down financial institutions (not just banks) whose failure is deemed to pose “systemic risk.”

Viewed in their totality, these technical financial changes would represent a historic expansion of government.  Sadly, there is little comfort in the Treasury’s warning in its 88 pages of detailed proposals:  “More can and should be done in the future.”  Comparisons with the New Deal of the 1930s are too timid.  Shades of Alexander Hamilton!

The complicated climate change bill that recently passed the House of Representatives is a dramatic example of expanding government power over the economy.  Again, the fine print deserves far more attention than it has received.  For example, buried in the 1,201 pages of detail is a provision authorizing the Department of Transportation to require automotive manufacturers to produce vehicles that can run on methanol (wood alcohol), a fuel not widely available.

Other provisions, as expected, have little to do with the subject of global warming.  For example, contractors on some energy projects must pay employees at least the locally “prevailing wage.”  It is well known that, in practice, that means paying higher union wage scales.

Many federal departments are trying to climb aboard the economic stimulus bandwagon.  The Department of Justice wants to help out by showing that antitrust should be a “frontline issue” in the response to the problems facing the economy.  Apparently, business is not getting sued often enough.  Incredibly, one new assistant attorney general views antitrust enforcers as “key members of the government’s economic recovery team.”

When we step back and try to add up all the tax, spending, and regulatory actions and proposals of the new Obama administration, the result is clear: a cumulative squeeze on private decision-making and a more slowly growing economy in the years ahead.

In the process, private businesses will be discouraged by a host of government policies from making major new investments, especially those of a long-term nature with payoffs far in the future.  Key negative factors are the likelihood of higher taxes and greater inflation resulting from the huge budget deficits that are likely to arise in the next several decades, abetted by lax monetary policies.

The American public is likely to have a long wait until the national unemployment rate gets back down to the 7.6 percent that was reported when President Obama took office in January 2009.

One fundamental point deserves to be stressed.  In the inevitable tension in public policymaking between economic prosperity and income redistribution, for the next several years the American people can expect that income equalization will get the government’s priority over improvements in people’s living standards.  The average American, at best, will receive a more equal slice of an income pie that will be far smaller than the public expects.

Articles

• Toward Radical Monetary Reform by Lawrence W. Reed
• Gold versus Fractional Reserves by Henry Hazlitt
• Central Banks, Gold, and the Decline of the Dollar by Robert Batemarco
• How Gold Was Money- How Gold Could be Money Again by Richard H. Timberlake
• Gold Standard by Ludwig von Mises
• The Gold Standard and Fractional Reserve Banking by Joe Cobb
• Back to Gold? by Henry Hazlitt
• Money and Gold in the 1920s and 1930s by Joseph T. Salerno
• No Shortage of Gold by Hans F. Sennholz
• How to Return to Gold by Henry Hazlitt
• The Solution by Murray N. Rothbard
• A Golden Comeback, Part 1 by Mark Skousen
• A Golden Comeback, Part 2 by Mark Skousen
• A Golden Comeback, Part 3 by Mark Skousen
• The Value of Money by Hans F. Sennholz
• A Closer Look at Gold by Charles E. Weber
• Hazlitt on Gold by Jude Blanchette
• How Much Money? by Percy L. Greaves Jr.
• The Future of the Dollar by Henry Hazlitt
• Gold Policy in the 1930s by Richard H. Timberlake

Audio

• Peace and Gold by Steve Horwitz
• Is the Gold Standard a Viable Policy Option? by Lawrence White

The Federal Reserve has been pumping hundreds of billions of newly created dollars into “the economy.” Much of that money has been sent to Wall Street to bailout large, struggling firms. But that’s just the beginning. President-elect Obama says that since he needs to “stimulate the economy” we can look forward to trillion-dollar budget deficits for years to come. Even before the financial turmoil began, the deficit had approached $500 billion. (Not to worry, though–Obama says deficit spending will impose “fiscal discipline” in the future.)

Of course, when the federal government spends more than it taxes, it has to get the extra money somewhere. Therein lies the treachery. The government’s vendors and other beneficiaries demand to be paid on time. So it borrows from the credit markets by selling Treasury securities to investors. The Federal Reserve in turn monetizes the debt by buying Treasury securities in the marketplace. It pays for those securities by creating bank reserves–money–from nothing, or as John Maynard Keynes suggested, by performing the “miracle … of turning stone into bread.”

Since we, like the rest of the world, have long lived with a fiat-money system–that is, a system in which the paper money is not backed by anything–there is nothing remarkable about this for most people (if they are aware of the procedure at all). But before long, they will pay a steep price whether or not they know who the culprit is.

The central bank’s expansion of money and credit used to be called inflation. Today that word is used mostly for one of the consequences of monetary expansion: generally rising prices. That’s unfortunate because that definition papers over the most important effects of deficit spending and monetary inflation.

To think of inflation as generally rising prices is to miss the real point. If an increase in the money simply raised the “price level” uniformly, it would be little more than an inconvenience. Prices might outrun wages at first, reducing real incomes, but soon wages would catch up and, in real terms, we’d be back where we started. The dollar values would larger, but without real consequence.

That’s not how  it works, though. Ludwig von Mises explained the process in a lecture he gave in Paris in 1938 and again in New York in 1945. It was later published under the title “The Non-Neutrality of Money.” (It appears in Money, Method, and the Market Process: Essays by Ludwig von Mises, edited by Richard M. Ebeling.)

Barter Economy

In this lecture Mises was determined to disabuse his listeners of their belief in the neutrality of money–that is, the idea that changes in the money supply leave real factors undisturbed. He understood why economists have held this erroneous belief. They began thinking of exchange in the admittedly simplified terms of a barter economy in which goods exchange for other goods. When they added money to this unrealistic picture, they assumed nothing of importance changed. As Mises put it, they believed “The functioning of the market mechanism as demonstrated by the concept of pure barter was not affected by monetary factors.”

These economists acknowledged that money prices can vary, but “they believed–and this is exactly the essence of the fallacy of money’s neutrality–that these changes in purchasing power were brought about simultaneously in the whole market and that they affected all commodities to the same extent.” Thus according to this view, the price level changes, but relative prices do not.

Here’s the problem. There really is no price level, except for ones constructed by averaging the prices of an arbitrary basket of goods and services. What really exist–and therefore what really count–are millions of prices for goods and services that are constantly subject to change in relation to one another. These prices emerge from the decisions of potential buyers and sellers who pursue their ends according to their subjective priorities.

You’d hardly know this by reading mainstream economics, but economic phenomena happen on the ground–where human action and interaction take place–and not at the level of statistical aggregates and averages that no real person ever encounters..

“Monetary problems are economic problems and have to be dealt with in the same way as all other economic problems,” Mises continued. He meant that when analyzing inflation and other monetary issues, our focus should not be “the economy” holistically conceived. As he put it, “Changes in the quantity of money and in the demand for money for cash holding do not occur in the economic system as a whole if they do not occur in the households of individuals. These changes in the households of individuals never occur for all individuals at the same time and to the same degree and they therefore never affect their judgments of value to the same extent and at the same time.”

In the economists’ lingo, macroeconomics is, or should be, rooted in microeconomics.

Inflation and Its Consequences

Take inflation. When the government expands the supply of money, it does not do so by dropping Federal Reserve notes evenly across the land from the proverbial helicopter. In the old days government would print money or filch precious metals to make coins, then spend the money as it liked. A few select people received the money first, and they could then enter the market and buy what they liked at prices still unaffected by the inflation. the late receivers were the losers.

These days the process is more complicated. The Treasury borrows money from private lenders by selling securities. With that cash it pays contractors and welfare-state beneficiaries. Meanwhile, the Federal Reserve creates money in the form of bank reserves by buying government securities. It’s called monetizing the debt. Banks then pyramid loans on these new reserves, expanding the money supply and lowering interest rates. Among the consequences is the depreciation of the monetary unit (rising prices) and the boom-bust trade cycle described by Mises and F.A. Hayek. (Hayek won his Nobel Prize in 1974 partly for his work on the trade cycle.).

Whichever method is used, the point is that the newly created money enters the economy at specific points rather than blanketing society evenly. The result is a diversion of the economy from the path it would have taken in the absence of the disturbance. A new pattern emerges the details of which cannot be predicted. Why not? Because people are people not robots. If your cash balance doubled tomorrow you wouldn’t mechanically double the quantities of everything you buy now . Instead, you would change the proportions–buy more of this and less of that–and even buy things you don’t buy today. You yourself can’t predict exactly what you would do in these circumstances.

“The additional quantity of money does not find its way at first into the pockets of all individuals; not every individual of those benefited first gets the same amount and not every individual reacts to the same additional quantity in the same way…,” Mises summed up. “The additional amount of money offered by them on the market makes prices and wages go up. But not all the prices and wages rise, and those which do rise do not rise to the same degree.”

Income Distribution

Now things get interesting. We begin to see that inflation is a form of government distribution of income. (I don’t say “redistribution” because in a true market economy income is not distributed but rather acquired through exchange.)

“If [for instance] the additional money is spent for military purposes,” Mises wrote, “the prices of some commodities only and the wages of only some kinds of labor rise, others remain unchanged or may even temporarily fall. They may fall because there are now on the market some groups of men whose incomes have not risen but who nevertheless are obliged to pay more for some commodities, namely for those asked by the men first benefited by the inflation. Thus, price changes which are the result of the inflation start with some commodities and services only, and are diffused more or less slowly from one group to the others. It takes time till the additional quantity of money has exhausted all its price changing possibilities.”

Make no mistake about it. This is a government-engineered transfer of resources, that is, a violation of property rights. And by the way, the distribution is not from rich to poor. If anything, the distribution is upwards.

As Mises explained, “But even in the end the different commodities are not affected to the same extent. The process of progressive depreciation has changed the income and the wealth of the different social groups. As long as this depreciation is still going on, as long as the additional quantity of money has not yet exhausted all its possibilities of influencing prices, as long as there are still prices left unchanged at all or not yet changed to the extent that they will be, there are in the community some groups favored and some at a disadvantage…. As long as the inflation is in progress, there is a perpetual shift in income and wealth from some social group, to other social groups.”

We have seen that government expansion of the money supply rearranges resources in society and interferes with the market’s natural tendency to serve consumers according to their own priorities. Thus inflation would be objectionable even if it did not cause malinvestment and seed the ground for a subsequent depression, that is, even if it did not spawn the trade cycle.

It is incumbent on the inflationists–specifically, the incoming government officials–to explain why income distribution is a proper function of government.