A few weeks ago, I happened upon his new book End the Fed while I was perusing the shelves of a local Borders. Given my lack of a clear position on his thinking, I decided that I’d read it and sort out the legitimate arguments from the anarchist paranoia for myself. What follows is my earnest attempt to give Paul’s economic philosophy a fair and balanced analysis – something it gets from neither his foes on the left nor from his teabag-waving, money-burning supporters on the libertarian right.
I must admit that End the Fed is incredibly persuasive. Aside from the fact that over half of its references are either to materials printed by the sympathetic Ludwig von Mises Institute in Auburn, Alabama (which promotes the teaching of the Austrian School of classical liberalism) or to things written by Ayn Rand, its scholarship is extensive and solid, and its argumentation sound and intellectual. It even includes a recommended reading list divided into categories based on level of familiarity with economics.
My overall impression of the book is that it correctly and incisively exposes the flaws that have become virtually inherent in the conduct of American monetary and fiscal policy and the ways in which irresponsible decision-making by our political leaders has exacerbated the wild fluctuations of the business cycle. It concludes from this, however, that the only workable alternative is an ideology that strictly prohibits the government from getting involved in the economy at all. The need for substantial reform is duly noted, and this reform may even have to consist of significantly crippling the powers of the Federal Reserve. It certainly does not mean that government should have no role in the economy, or that a return to the gold standard (the second main argument of the book) is necessary or desirable.
The Gold Standard
I’ll address this latter issue first, since it consumes a good part of End the Fed’s 210 pages. Paul repeatedly calls for a return to “sound money,” and indeed this is a worthy goal. Wealth is only truly safe from the “inflation tax” when it can be secured in a form that is not subject to changing political tides. Though he claims that he has no bias for gold in particular, and that any “system that would permit markets to once again choose the most suitable money, whatever that turns out to be”, would be acceptable, he also argues that “gold has all the qualities that we associate most with good money: divisibility, portability, high value per unit of weight, durability, and uniform quality” (pg. 71). He further claims that there is no need to ever change the size of the money supply, since “any quantity of money will do, so long as the money is sound. … New quantities of money injected into society confer no social benefit.” (pg. 203) In principle, this is true. Since wealth is created by the act of production, the physical supply of money (or even the nonphysical supply, as determined by a metric like M3) is secondary, a mere representation of something more abstract.
But the problem is that Paul attempts to conclude from this that there would be no inflation in an economy where manipulation of the money supply is not an option, since “inflation is always and everywhere a monetary phenomenon.” This assertion, originally stated by Milton Friedman and reiterated by Paul and others like him, is largely incorrect. Though inflation certainly can be precipitated by monetary policy (extreme examples are Weimar Germany and Zimbabwe prior to dollarization), the more common forms are due to changes in aggregate demand (“demand-pull inflation”) and changes in aggregate supply as a result of fluctuating factor prices or exogenous cost shocks (“cost-push” or “wage-push inflation”). Inflationary expectations can easily make either of these chronic and unstoppable, necessitating intervention. Even if inflation did disappear in Paul’s Fed-less America, growth with a fixed money supply would likely cause significant deflation, which entails its own very real costs.
End the Fed includes a partial transcript of a congressional hearing from July of 2005, in which Alan Greenspan replies to a question fielded by Ron Paul about the possibility of returning the U.S. to the gold standard:
Would there be any advantage, at this particular stage, in going back to the gold standard? And the answer is: I don’t think so, because we’re acting as though we were there. (pg. 91)
In other words, the “soundness” of money has nothing to do with what that money is, or even how it’s backed, but rather with how the supply of it is manipulated by governments (or by gold miners – a fact that seems lost on Paul). True, commodity money whose value is managed by markets rather than by central banks is less susceptible to such manipulation, but it is by no means safe from the threat of becoming unsound for other reasons. Greenspan rightly points out that the blame for chronic boom-bust cycles rests not with fiat money as such, but with the people who print it.
Paul: The Patron Saint of Economic Morality?
Before I address Paul’s specific criticisms of the Fed, I want to touch upon his free-market ideology. Though he provides numerous examples of inefficient government interference in the economy (e.g. wage and price controls during World War II and the 1970’s), it is also true that markets do not always achieve the most efficient outcome, a phenomenon known as market failure. There are certainly government failures as well, in which government action does not achieve the most efficient outcome, but the existence of one does not negate the existence of the other. The Austrians would have you believe that market failures never happen – because they’ve defined markets as mechanisms that are incapable of any meaningful kind of failure. This is clearly disingenuous. The Austrians are guilty of intellectual dishonesty, for this and for the fact that they claim economics cannot be empirically studied (which conveniently renders their critics unable to prove them incorrect).
In the context of American politics, even strict constitutionalists and limited government-ers like Paul, whether knowingly or not, concede the need for some government involvement in the economy. I submit that the Constitution not only mentions but actually grants the federal government the right to address various types of market failure. Article I, Section 8 lists among the enumerated powers of Congress the power to “establish Post Offices and Post Roads” (provide nonexcludable public goods), “fix the Standard of Weights and Measures” (impose standards for the sake of efficiency in markets that do not automatically converge to their own), and to “promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries” (manipulate the ability of firms to acquire market power). The bottom line is that Paul’s ideology is deeply inconsistent, and his criticisms of the Fed should be approached with caution.
Where Paul Gets It Right (But Then Very Wrong)
Nevertheless, I would like to deal with one criticism in particular, namely that the Federal Reserve sets the stage for recessions and depressions by distorting market signals. I’ll briefly deal with this argument before explaining why the Fed is ultimately necessary and how we can learn from Ron Paul’s whistleblowing and make the system better.
Paul, on regulation:
The idea that we can depend on the [regulators] to protect us significantly contributes to moral hazard. More risks are taken believing the government will protect us, and our guard against evil is diminished. Easy credit by the Fed sets the stage for excesses… The entire system… is like a super Ponzi scheme (if we can’t pay it back, let’s just create more!)… (pg. 187)
In other words, the mere existence of the Fed can encourage irresponsible behavior – even by the Fed itself. By setting interest rates lower than the market would on its own, it gives entrepreneurs and investors the impression that more financial capital is available than actually is, and the construction of a house of cards begins. There are other problems too. As Paul points out, a central bank with money-printing powers can strongly tempt politicians to abandon a sense of fiscal discipline, and, he alleges, may even do much worse (“[If the Fed were ended, no longer would presidents be in a position to lean on the central bank to artificially boost the economy before elections…” (pg. 8)).
He also attempts to argue that a banking system akin to the kind that existed for most of the 1800’s would be more desirable than the status quo:
But would this be “wildcat banking” of the sort that is frequently condemned from the nineteenth century? No more so than we have “wildcat restaurants” or “wildcat shoe companies.” Markets are self-regulating, responding to the wishes of consumers. It would be the same in banking. (pg. 190)
Not quite. Paul cites research that claims that the panics of the 1800’s were healthy for the system in that they destroyed banks that performed badly, and indeed Friedman argues elsewhere that attempts to stop banks from failing at the start of the Great Depression prolonged pain that would otherwise have been relatively self-limited. For all its merits, the problem with this thinking is twofold.
For one, banks and financial institutions today are remarkably interconnected in ways that could not have been dreamt of 150 years ago, and information about institutional instability is spread much more quickly. No longer is there a sense that a bank failure 100 miles away is not my problem. Secondly, the psychological impact of a bank failure is radically different from that of the failure of any other type of firm. Despite Paul’s assertion that “bank failures are no more to be regretted than any other business failures” (pg. 27), banks are not just “any other business.” They protect personal savings and the financial capital that is essential for future growth. The failure of a bank does not just cause people to decide that that bank was poorly run; it sows doubt as to whether any and all other banks are suffering from similar internal problems. The market may very well not self-correct. The economy could be paralyzed by systemic fear. The only way out is for an unshakable central bank to restore public confidence in a consistent and predictable way that minimizes the threat of moral hazard (Bear Stearns was allowed to fail, so why not Bank of America too?).
“The Way Out”
As he explains in the last chapter of the book, entitled “The Way Out,” Paul’s first step toward abolition of the Fed is to bring its activities under greater Congressional scrutiny by allowing the Government Accountability Office (GAO) to audit any and all of its decisions and transactions. In fact, an amendment he introduced to do just that passed the House on 19 November 2009, and will presumably be considered by the Senate after Obama’s healthcare saga comes to an end. The Fed was intended to be a completely apolitical entity, and while this is probably an unrealistic vision, bringing more of the Fed’s powers under the purview of Congress only worsens the problem. An audit is called for, but it would be better to have it done by a private sector firm than by another government agency. As for how to reconcile the need for a central bank with the need to keep it as politically detached as possible, I would propose a system under which monetary policy is run by a pool of academic economists. This group of experts (the bigger, the better) could be polled on whether or not to approve certain actions, with only a random subset of those votes actually counting. This would help to limit the amount of political pressure that could be exerted on the system by keeping it decentralized and partly anonymous.
Saith Paul, in the dramatic conclusion of his book: “We have a natural, God-given right to our lives, our liberties, and the fruits of our labor.” (pg. 210) I couldn’t agree more. But to paraphrase Galileo, a God who would give us the faculty of reason would not also encourage us to abandon its use. The science of economics has taught us much about how to better our lives, and while “liberty” is an appealing virtue, it is not the kind of nuanced answer required by the complex problems that face our society.
Moral of the Story
End the Fed is well worth the read, but like me, you might consider waiting until you can buy it for 50% off. Or until you have a giftcard, in which case somebody else is paying for it.
I wrote roughly 80% of this note before I happened upon a similar commentary from a Time column called “The Curious Capitalist," which raises many of the arguments I've explicated and more.