A time to praise central banking?
This is truly an awful op ed from today's WSJ. I am hoping that a bunch of us can write Letters to the Editor, so maybe one of ours will get published. The writer claims that our periodic banking panics are the fault of Thomas Jefferson, because he didn't understand commerce and hated rich people, and thus killed (through his disciples) a strong central bank that could prevent crises. Oh, the writer also explains Jefferson got these weird views because he grew up on the backs of slaves.
Comments (22)
This letter went out today:
John Steele Gordon seems to be under the misimpression that private banks fail because they are too small, too numerous, and not uniformly regulated and that a Hamiltonian-style Central Bank's "most important job is to...act as a lender of last resort...in times of financial distress." But Gordon never acknowledges that it is the Central Bank itself, by dramatically inflating the money supply and lowering interest rates, that causes the "financial distress" in the first place, and that private banks will never be safe and secure absent 100% reserves against demand deposits. Systemic malinvestment and financial collapse on the scale currently witnessed demonstrate the truth of the Mises/Hayek argument that fiat central banking (and not under-regulation) is the proximate cause of the boom/bust business cycle.
Dominick T. Armentano
Published: October 10, 2008 9:21 PM
Mr. Gordon is a fine court historian, but as is so often the case, the court historians have very little grasp of the truth behind their state aggrandizing viewpoint. Mr. Gordon blames the small scale and scope of individual banks for causing all of the panics up until the creation of the Federal Reserve, and he excuses the Federal Reserve of any complicity in the Great Depression. How convenient when your goal is to defend the Federal Reserve and encourage greater centralization. The real truth of the matter is that banks have historically played fast and loose with their depositors money, creating fiduciary media and loans not backed by reserves and savings of equal amount. The fact is that once a bank creates money ex nihilo, it is by definition insolvent, and the slightest rumor can precipitate a bank run which exposes the fraud of the bank. Adding a central bank to the mix only encourages this risky and immoral behavior on the part of the banks and compounds the problem by setting minimum reserve ratios much lower than even the formerly risky individual bankers would attempt on their own.
In the run up to the Great Depression, the Federal Reserve increased the money supply at a fantastic rate and kept interest rates at a level that encouraged entrepreneurs to invest in projects which would not have been feasible at the natural market interest rate. Once the shoeshine boys started giving out stock tips, the boom turned into a bust as the malinvestments built up during the roaring twenties could no longer be hidden and the resources needed to be allocated to their next best uses. The Federal Reserve working with both the Hoover and Roosevelt administrations attempted to keep prices up and fight against the natural tendency of the market to liquidate bad investments. This succeeded in putting the country into a 16 year long financial doldrum.
The panics of the 19th century, and even 1907 were quick and sharp, correcting the fraudulent excesses of the banks and hitting those who assumed the greatest risk the hardest. The central bank breaks these important market feedback mechanisms. It allows the scope of financial disaster to reach truly epic proportions in a manner which is not understood by the population at large. It provides implicit backstops and encourages risky behavior on the part of the banks. Its fundamental nature is to create and increase in magnitude the business cycle. Perhaps the most pernicious feature of the central bank is that it enables the state to grow to the Leviathan that exists today. If we are to have stable and free markets and a limited government with a rational foreign policy, we must insist on sound banking and eliminate the Federal Reserve.
Published: October 10, 2008 10:18 PM
This is a constant source of discussion in my firm (Economics consultancy). I refuse to let it go, why do people who favour free markets so often jump on the socialist banking bandwagon without even so much as a thought? I don't understand it.
Published: October 11, 2008 2:06 AM
Wow, this little stooge has some great clanging brass balls to praise his masters NOW! Stunning.
Published: October 11, 2008 3:12 AM
I'm not fully sure, I am used to central banks. Our experiences in Germany after the second world war were encouraging. Howerver I've never thought what'll happen without a central bank. There are few things I never have seen and it's implications. What about a country without army, what about a country without police what about a country without firemen.
I could live with a country without army and probably would like it. But I'm not sure about other things. Howerver this blog makes me think. I've not idea if that' s good or bad ;-)
Published: October 11, 2008 4:54 AM
When banks 'create' money it does have backing in the form of trust - faith in the borrower to repay. The trust comes with a degree of risk expressed in the form of interest rate which is the natural arbitrator for the 'leap of faith'. Riskier ventures require higher interest rates to prevent abuse of the system of trust. Fundamental to the crisis is the realisation that risk was not priced in correctly and that cheap money encourages - even necessitates - riskier investment.
Cheap money RIP - and good riddance.
Now, if the above is true, why are interest rates falling instead of rising?
Published: October 11, 2008 7:03 AM
Its bad enough that Gordon has pretended to be an historian for so long, but pretending to be an economist is just insulting.
We had to read this guy's book for my American Economic History class, and he doesn't just drink the Kool-aid, he pisses it.
Published: October 11, 2008 10:26 AM
What an odd time to be writing an article about the wonders of central banking. Odd indeed.
Published: October 11, 2008 3:14 PM
On his radio program this morning, Larry Kudlow praised this article and referred it to his listeners.
While I appreciate Kudlow's good nature and (often cockeyed) optimism, I find it curious how someone ostensibly so devoted to free market principles is utterly incapable of making the intellectual leap to apply these principles to money and banking.
Published: October 11, 2008 4:13 PM
Friedrich, you speak of services that economists argue can be provided on the market. Yet central banking is not like that. It's a rip off, and certainly no service, so it's very much unlike being without policemen. It's like being without a robber.
Published: October 11, 2008 6:12 PM
Hey guys,
First time posting here, hopefully I can get your opinion. I don't know where to post but I thought this is somewhat related.
I run an equity options market making company in Chicago and I am one of the people trying to make markets and provide liquidity in financial stocks.
I read today that the government is going to start making equity investments in banks. I imagine they will start to totally distort the prices of the banks to the upside, and this could cause a sharp rally as people are providing very little liquidity to buy or sell.
Do you think the government can indefinitely prop up the stock prices of banks? Or do you think that there will be a huge rally and eventual bust? I am not sure when or how much they intend to start investing, but it sounds scary.
Published: October 11, 2008 6:28 PM
AJ,
Your guess is probably as right as any. The government has been propping up the banking industry for several months now and needs to take ever more drastic steps to maintain that price floor. The steps that it has taken most recently by lending directly to banks and large bank customers is not the classical form of the boom stage of the business cycle, but I think that it's effect is similar enough that we can use the business cycle theory to analyze what is likely to happen. Propping up the banks and enabling them to provide a return greater than any others in the market will drive an upward spiral in their stock prices, but it will also allow them to make loans to entrepreneurs who then malinvest the money into undesired projects and products. Just like the classical business cycle, a contraction in credit and the discovery of the malinvestment will lead to a reallocation and liquidation of the poor investments. I see this as just another attempt at price fixing that will eventually create a new bubble and start the next business cycle. I am not a speculator, but it may be worth a couple of shares to see if you can guess the next peak.
Published: October 11, 2008 9:12 PM
To Aj you wrote:
"Do you think the government can indefinitely prop up the stock prices of banks? Or do you think that there will be a huge rally and eventual bust? I am not sure when or how much they intend to start investing, but it sounds scary."
To the first question: No, there will always be a limit.
To 2: maybe but maybe not, if people can get out and do not believe in "recovery" then they can spend money as hell till the own that company after that they will get crushed by probably way too much debt
Scary? Well I guess it depends on the outlook. The current crash is quite abrupt, maybe they can delay it a bit but if they run out of money, then the following downturn may be much harsher.
Published: October 12, 2008 1:03 AM
It looks like the Mises crowd turned out in mass to reply to this article over at the WSJ. I could not figure out how to post over there unfortunately, but it looks like most of my points were made by others.
One subject I would like to elaborate on: The financial panics of the 19th century rarely, if ever, had a significant effect on the REAL economy - employment and real incomes (just look at the statistics). The effects were borne by those who caused the problems. In contrast, the Great Depression showed what a Central Bank and a large interventionist government can do - spread the pain to the real economy and spread it out over years or decades. This may be the most fundamental things missed by 20th century progressives and statist revisionists trying to justify our massive, bloated government.
The original "great depression" in the late 1800's was actually a time of dynamic economic growth and productivity, not unemployment and falling real incomes like the 1930's version. Real productivity gains were manifest in mild, beneficial deflation that made most of the staples of life decrease in price, freeing income to be spent on other products and services that the common man could never before have dreamed of. This is how an economy is supposed to work free of the cancerous influence of unlimited money creation. No question there were winners and losers in the short run, but the benefit to mankind was enormous.
We are currently living in Hamilton's world with all of the problems that Jefferson warned about coming to a head. Neither 20th century political party or dominant political philosophy can lay claim to Jefferson's legacy. The New Deal, with the exception of the populist rhetoric used to win votes, was pure Hamilton. The fact that FDR used his name and built monuments to him surely had Jefferson spinning in his grave.
Published: October 12, 2008 9:08 AM
This is just like the fascists from the Weekly Standard (e.g., Bill Crystal) singing the praises of the bailout and Alexander Hamilton as the savior of the free market. My only consolation was to hear my 19 year old daughter remark "Are you kidding? He's citing Hamilton?".
Published: October 12, 2008 3:44 PM
As an amateur observer, the Austrian theory of the business cycle, at the very least, has the advantages of being both logical and comprehensible. But there are still some questions about it that I haven't figured.
If a central bank runs a cheap money policy, why can't it do so forever? What causes 'the tipping point' when they have to 'take their foot off the accelerator' with resulting consequences of forced liquidation of malinvestments?
Published: October 13, 2008 1:19 AM
Terry K: “If a central bank runs a cheap money policy, why can't it do so forever? What causes 'the tipping point' when they have to 'take their foot off the accelerator' with resulting consequences of forced liquidation of malinvestments?”
The Fed stops pumping money into the economy when they see price inflation start up. Monetary pumping will eventually cause prices to rise after the resources left from the previous depression are used up. Keep in mind that creating money does not create any new goods or services. It only causes the prices of existing goods and services to rise. Those rising profits cause accounting profits to rise (until costs catch up), but not real profits. Only the production of more goods can cause real profits to rise.
As ignorant as they are of economics, Fed bankers remember the hyperinflation in Germany, the stagflation in the US, and the current hyperinflation in Zimbabwe. They don’t want hyperinflation. They just want mild, steady inflation, being ignorant of the damage it causes.
Published: October 13, 2008 8:31 AM
IN a similar discussion elsewhere, a friend of mine made an analogy that explains graphically why people fear a free market in general, and a free banking sector in particular:
An animal born in the wild has no need of assistance to thrive in its natural environment. But it is very difficult to successfully introduce one born in captivity to the wild.
Published: October 13, 2008 8:54 AM
Friedrich: “I'm not fully sure, I am used to central banks.”
People always feel more comfortable with what they have known. But consider this: the sole purpose of a central bank is to prevent other banks, mainly the big ones from failing. How would that work with other industries? For example, what if we set up a government organization whose sole purpose was to make sure that no car maker ever failed? If the car maker earned profits, he could keep them. But if he lost enough money to risk collapse, the government agency would bail him out. Do you think car makers might be a tad bit less careful about their business practices? Now you know why this financial crisis has taken place.
AJ: “Do you think the government can indefinitely prop up the stock prices of banks? Or do you think that there will be a huge rally and eventual bust?”
There will be a rally because most people have enormous faith in the state’s omnipotence. But stock prices can ignore economic fundamentals only in the short run. The problem today is that money has disappeared along with some wealth. Money and wealth are not the same thing. Wealth consists of goods and services. Money is a claim on those. Goods and services increase only with hard work and time. Paper money can increase rapidly and disappear just as rapidly. The money supply grew far faster than the real economy of goods and services, causing prices to rise and accounting profits to rise as well. Credit expansion caused the money supply to grow so fast. As Warren Buffet said recently, everyone became highly leveraged and now they are trying to deleverage at the same time. As lot of that leverage showed up in the stock market.
But as with all artificial, money-caused, booms of the past 400 years, it just takes a few companies defaulting on their loans to make the entire credit structure snap back like a giant rubber band. Everyone starts deleveraging and the money that the banks created during the boom vanishes like mist in the sun. When that money disappears, prices fall. Falling prices mean accounting losses and bankruptcies.
The Feds can stand on deck and blow at the sails (pump more money into the economy) to keep the ship running a little farther, but the longer they do so, the worse will be the depression when it finally hits. Not only has the money disappeared, but real wealth has been wasted, too. It takes time to recover.
The Feds can pump money into banks all they want, but for the economy to turn around, businessmen must be willing to borrow and banks must be willing to lend. Banks will have much tighter credit policies than before even if they have low interest rates. And businessmen must regain confidence before they will borrow. But as Hayek points out, the main thing that must happen is for wages to rise to a high enough level (in other words, prices of consumer goods fall) that businessmen see profit potential in purchasing labor-saving equipment. Then the capital goods industries will start growing again.
Published: October 13, 2008 9:01 AM
thanks 'fundamentalist' !
Published: October 14, 2008 3:59 AM
Boy!
Am I sorry I missed this exchange back in October.
I totally agree with Robert Murphy and his respondents. Most especially with DS and his post of Oct. 12 at 9:08 AM.
What silliness on the part of John Steele Gordon. Mr. Gordon would be well-advised to read the opinion piece from another WSJ contributor, Holman W. Jenkins, Jr. at http://online.wsj.com/article/SB123007755316531663.html
"A Short Banking History of the United States"?
Try "A Short Fable About The ‘Success’ of American Central Banking --- Why our FED-operated system is so prone to creating panics" instead.
Talk about a 'quintessential intellectual'.
Gordon's confusion explains why the FED survives in its present form. It explains the confusion in the public mind. It explains why the 'adoring' overseers in Congress continually fail to rein the FED in. They just don't get it. Except for Ron Paul.
Gordon is so confused about his reading of history, that his thesis completely contradicts his first statement:
"We are now in the midst of a major financial panic".
Gordon follows up with another gem:
“How could the richest and most productive economy the world has ever known have a financial system so prone to periodic and catastrophic break down?”
No kidding. And HOW did that happen with the FED on the watch? Did Thomas Jefferson come back from the grave to 'take his revenge'? Both now and in the 1930-s?
Please. Gordon's article is so monumentally flawed that I think we need a new Mount Rushmore to showcase Human Illogicality.
I have said it before --- the only "pedagogically useful” --- though ultimately tragically experienced --- thing to come out of our upcoming depression-recession is that we might finally see how all the 'years of experience' are manifested in all the wrong decisions made, by this FED and its front-men policy-makers at the Treasury, desperately trying to alleviate this particular ‘panic’.
We may just get the ‘quintessential’ demonstration of how the FED and its cohorts can destroy an economy (maybe even the world economy).
Of course the FED did the same thing in the 1920-s and then bungled the recovery in the 1930-s --- the 1930-s part even FED chair Bernanke agrees with.
But will the FED and the mistaken policies really be blamed? Don’t hold your breath. If the ‘historians’ have their way, the FED will be praised to high heaven for “shortening” this debacle. This is group-think in its most pernicious form.
"Guard the Money Supply"? Ha-Ha-Ha-Ha-Ha-Ha-Ha-Ha-Ha-Ha-Ha-Ha-Ha-Ha-Ha-Ha-Ha-Ha-Ha-Ha... This is TOO much. “--- regulating the economy thereby”. Please, you’re killing me (literally) already.
Let me give you my own take of History directed as a reply to Mr. John Steele Gordon taken from my post on September 28, 2005 from
http://www.businessweek.com/the_thread/hotproperty/archives/2005/07/past_housing_bu.html under “Hans”:
“I agree with those that see the [Housing] bubble and not with those who cannot.
Time will tell who has the clearer vision.
However, the ultimate causes of this housing bubble are not clear.
While human psychology is clearly a main player, it is a player that acts to facilitate the bubble and not to directly create it.
The ultimate cause is the FED and, as quaint as it might sound, the lack of any foundation for our money system.
Of course, we all swim in the same pool, and there are other derivative players as well (pun intended). The whole world is now playing in a Ponzi sandbox of unknown size. We are so far out of the envelope that we have gone nutty.
We have a money system that is no longer self-limiting and self-governing.
The FED (and other Central Banks around the world) have no restraints, nor does the rest of the financial community, when it comes to their behaviour in the creation and use of money, nor do they, nor any of us, have any useful, timely feedback to indicate when we are in harm’s way. There is a hurricane bearing down on us, but all of our eyes in the sky are blind.
We used to have limits, before we decided to trust in paper money, which is backed by nothing, except the printing press. We are so used to this approach in our daily lives, that we take it for granted, as if nothing could ever go wrong with this system. It has gone wrong, terribly wrong. But we are not yet aware of how wrong. The storm is still off shore.
There may never be a perfect system for money, but the one we have today is most likely the riskiest and the most open to abuse and mismanagement of any we could possibly have invented (other than possibly having counterfeiters and loan sharks running the show).
Isn't it time to consider abolishing Central Banks, or at least changing the directives that they operate under? Can a Command Economy approach ever work? It hasn’t yet (and the Communists gave us a pretty good history lesson on that topic). How can it be expected to work from a Central Bank perspective?
The FED's bad judgment has manifested in terrible decisions that have destroyed countless people's lives since 1913. If it wasn't for bad judgment, the FED seemingly wouldn't have any at all. Perhaps it is just a function of the mandate they are asked to fulfill? Central Planning... need I say more?
Sadly, the FED (and other central banks around the world) will not soon leave the stage, nor will the extreme damage they cause soon be alleviated. Their raison d'être is supposedly to "smooth" the business cycle and diminish the pain. Ha! There is no greater instigator of instability in the business cycle, than is the proverbial Central Bank. It creates the pain and keeps itself in business by promising to mitigate that pain. What a fraud! What extortion!
The FED created (or, if you are generous, it exacerbated) the boom of the 1920's, which led inescapably to a depression, which the FED then managed to aggravate into the GREAT Depression. Most recently, the boom of the 1990's and then bust of the 2000's. And now the latest act of infamy: the housing boom. It would be funny if it did not kill. ‘NUF said.”
More takeouts from Mr. Gordon’s essay:
“Without a central bank there was no way to inject liquidity into the banking system to stem a panic. As a result, the panics of the 19th century were far worse here than in Europe and precipitated longer and deeper depressions.”
Please provide proof --- as DS indicated, you are on weak ground here.
“The system was stable in the prosperous postwar years, but when inflation took off in the late 1960s, it began to break down.”
Where did the (price) inflation come from? Space Aliens?
“But Congress's attempt to force banks to make home loans to people who had limited creditworthiness, while encouraging Fannie Mae and Freddie Mac to take these dubious loans off their hands so that the banks could make still more of them, created another crisis in the banking system that is now playing out.”
Right, blame the other guy. (Not that they don’t deserve some blame IMO.)
“While it will be painful, the present crisis will at least provide another opportunity to give this country, finally, a unified banking system of large, diversified, well-capitalized banking institutions that are under the control of a unified and coherent regulatory system free of undue political influence.”
“Finally”? How more “final” chances does the FED need?
No political influence? You obviously don’t know what kind of a delicious (and insidious) dessert “Washington Schmooze” is.
Maybe that is our tragedy. That the Hamiltonians have won out over the Jeffersonians in America in more ways than one.
Bankers in the fractional reserve banking system believe in that system. So do most of the rest of us, because most times, it seems to work. It would contradict our experience to suggest that it, and the world money system, are faulty at their core.
Bankers cannot see the contradictions within such a system, levered as it is by phony money. They cannot see it, because to acknowledge that contradiction would require repudiating what they do, what they believe in, who they are --- it would require believing that something needs fixing.
And yet, Mr. Gordon uses Alexander Hamilton, the banker --- not a person who was a ‘landed aristocrat who lived off the labor of slaves’ --- as his prodigy of whom to follow in matters of Central Banking.
How many more crises and circuses are you going to need, Mr. Gordon, before the Central Banks get it right?
Published: December 25, 2008 2:17 PM
Mr. Gordon has a weird take on the history of Central Banking.
The first Central Banker of our era can probably be considered to be John Law, who messed things up in the 1720-s in France.
This was a sorry example of a Central Banker. There have been many who have have played at Central Banker since.
Many have made a far worse mess of things than what existed before they made their entrance.
It would be advisable for Mr. Gordon to read "Money, Bank Credit, and Economic Cycles" by Jesús Huerta de Soto, professor of economics at the Universidad Rey Juan Carlos, Madrid.
Please see
http://www.mises.org/store/product.aspx?ProductId=290
and
https://mises.org/story/1690
and
http://mises.org/story/3161
and
http://www.henryckliu.com/page19.html
From Henry C. K. Liu: "central bankers believe in sound money, but not too sound please, lest the economy should falter. Their mantra is borrowed from the Confessions of St Augustine: 'God, give me chastity and continence - but not just now.'" Please see http://www.henryckliu.com/page14.html
Mr. Gordon has somehow disturbed the view of history he sees through his particular prism and thus cannot see it clearly IMO.
Philosopher George Santayana: "Those who cannot remember the past are condemned to repeat it."
John Maynard Keynes: "Lenin was right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency..."
There was John Law in France 1717-1720 leading to economic chaos.
There was France in 1790-1796 with its issuing of Assignats leading to The Terror and Napoleon and tragedy for Europe.
There was Weimar Germany's 1920-1923 hyperinflation leading to Hitler/World tragedy.
Now we have the FED exporting inflation to the world. Of course, many nations willingly import that inflation, so as to artificially stimulate their own economies, and provide 'vendor-financing' to America. We saw how that scheme ended with the Nortels of the world in the dot-com bust in 2000.
What revolutions will occur as people cannot buy food?
Edmund Burke believed "the rise of prices...would render it unprofitable for farmers to take crops to market. They would stay home and produce only for themselves or for barter with their neighbors. The government would then send troops into the countryside to confiscate grain and other foodstuffs. It happened exactly as he foretold."
Mr. Gordon seems to share his view of Central Banking with Chris Farrell of BusinessWeek:
http://www.businessweek.com/investor/content/jun2008/pi20080611_987593.htm
Published: December 26, 2008 8:31 PM