The True Gold Standard (Second Edition)
Key Writings: Lehrman on the Gold Standard
To evaluate the history of the Federal Reserve System, we cannot help but wonder, whither the Fed? and to consider wherefore its reform—even what and how to do it. But first let us remember whence we came one century ago.
The End of the Classical Gold Standard
No one knew better than Jacques Rueff, a soldier of France and a famous central banker, that World War I had brought to an end the preeminence of the classical European states system and its monetary regime—the classical gold standard. World War I had decimated the flower of European youth; it had destroyed the European continent’s industrial primacy. No less ominously, the historic monetary standard of commercial civilization had collapsed into the ruins occasioned by the Great War. The international gold standard—the gyroscope of the Industrial Revolution, the common currency of the world trading system, the guarantor of more than 100 years of a stable monetary system, the balance wheel of unprecedented economic growth—was brushed aside by the belligerents. Into the breach marched unrestrained central bank credit expansion, the express government purpose of which was to finance the colossal budget deficits occasioned by war and its aftermath.
The Rise of Discretionary Central Banking
With the benefit of hindsight we can see that quantitative easing (QE) was actually inaugurated with World War I. We can see also that discretionary central banking in the United States coincided with the founding of the Federal Reserve System. After the banking panic of 1907, the Federal Reserve Act of 1913 was designed to provide “an elastic currency” but also to reinforce the international gold standard. Thus, Federal Reserve sponsorship of floating exchange rates in 1971 would become one of the great ironies of American monetary history.
To interpret the financial events associated with the Great War and their effect on the ensuing 100 years, my colleague John Mueller and I have highlighted two crucial events of 1913. First, of course, was the establishment of the Federal Reserve System, and second, the publication by the young John Maynard Keynes of his book, Indian Currency and Finance. The inauguration of the Federal Reserve and the intellectual foundation provided by the monetary ideas of Keynes, taken together, soon gave rise to a perfect intellectual and financial storm—a storm which would last a century.
Lately we have been engulfed by headlines reporting financial turmoil on every continent, in almost every nation, large and small. The commissars of central planning who so marred the history of the 20th century have been replaced by central banks in the 21st. In Cyprus, the new leadership now dares to confiscate citizens’ wealth with a one-time tax of up to 60 percent on bank deposits above 100,000 euros. Self-interested prime ministers blame continental monetary policies for instigating the currency wars that they themselves surreptitiously carry on.
Central banks worldwide, led by the U.S. Federal Reserve, mint new money ceaselessly to bail out insolvent governments, insolvent banks, and insolvent but politically powerful corporations and labor unions. This new money goes first to insiders in the financial sector, who exchange the cheap credit for commodities, stocks, and real estate at ever-rising prices. This is the so-called carry-trade, monopolized by a financial class that uses free money from the Fed to front-run the authorities for insider profits.
From the beginning of the American republic until not long ago, dollars could be exchanged for gold at a parity established by congressional statute (1792–1971, but from 1934–1973 convertible by foreigners alone). Currency convertibility to gold, enforced by law, established a finite limit to the money supply. Inflation—caused by the issue of excess money and credit—would lead citizens to promptly cash out for gold, thus reducing the money supply and ending the rise in prices. In a sense, the system was self-regulating.
With an unlimited money supply, the insolvency of national banking institutions has become an endemic global problem. Depositors are at risk of loss or arbitrary confiscation by panicked political authorities, as in Cyprus. Taxpayers are involuntarily dragooned in to bail out the banking system, as at the start of America’s recession. And if the central bank credit bubble collapses, systemic deflation will be the profound and destructive consequence.
A winning agenda for a political party must simultaneously satisfy the requirements of economic effectiveness and political success. Ronald Reagan had such an agenda in the 1980s. Subsequent Republican presidential candidates have not. The opportunity now is great. Far from having a free hand after reelection, President Obama is constrained by the same economic and political realities as everyone else. This is why his first act of 2013 was to sign into law a tax code in which the top rate on labor income is about twice the rate on property income, disappointing the dominant faction of his own party.
The four basic principles of successful American political economy may be summarized simply:
1. Current peacetime government consumption of goods and services should be funded by current taxation, not money creation—thus limiting peacetime government borrowing to an amount equal to government-owned investments of the same or lesser duration. This principle was first enunciated and implemented under President George Washington.
2. Current consumption of true public goods (such as national defense and administration of justice) should be funded with an income tax levied about equally on labor and property income. This principle was first implemented under Abraham Lincoln.
3. More narrowly targeted “quasi-public” goods, which benefit many but not all citizens, should have dedicated funding. Social benefits for specified individuals (Social Security, Medicare, and Medicaid, primarily) should be financed by payroll taxes on individuals, not by income or property taxes. This principle was first applied under Franklin D. Roosevelt at the insistence of his Treasury secretary, Henry Morgenthau.
The counterpart to this policy is that subsidies to property owners (e.g., tax-advantaged savings accounts and product, corporate, and banking subsidies) should be financed by taxes on property income (such as interest, dividends, rents, or capital gains), not payroll or income taxes.
4. Government’s size and methods should be strictly limited in order not to displace private jobs, or cause general unemployment or disinvestment in people and property. This was attempted by Ronald Reagan (with its success limited by factors we will describe).
President Obama chose to deliver his State of the Union address this year on the 204th anniversary of the birth of Abraham Lincoln. It was a good selection of a significant date. As Steven Spielberg makes clear in his epic film "Lincoln," Americans of all backgrounds and political persuasions can learn much from the character and presidency of the 16th president.
With regard to human rights and economic liberty, Lincoln adhered to two fundamental principles. First, that every person was entitled to the fruits of his or her labors, and no one had an unrequited claim (i.e., slavery) to the fruits of the labors of others. What so troubled Lincoln about slavery was that it was theft—pure and simple. Lincoln ran for president on a platform to stop slavery's spread. As president and commander in chief, he struck against slavery in the rebellious states through the Emancipation Proclamation. Then he pressed for slavery's permanent abolition by constitutional amendment—in both rebellious and loyal border states—because no man may steal the fruits of the labor of others.
The second principle that guided the Republican president was that every person, regardless of the circumstances of his birth, should be able to climb as far up the economic ladder as his talents may take him. Historian Richard Hofstadter called Lincoln the "greatest dramatist" for upward mobility the nation ever produced, and for good reason.
Under Lincoln's watchful eye and skillful leadership, the 37th Congress enacted more economically significant legislation than had any of its predecessors. The underlying theme of Lincoln's economic initiatives was that by providing ordinary people with incentives to use their own skills and labor, the entire nation would prosper. Very little of what Lincoln signed into law could be declared, in the present-day idiom, "entitlements" or "redistribution."
Who caused the financial collapse? Just about everyone.
To appreciate this landmark work it is necessary to know a bit about the author’s background.
John Allison is not only a banker-entrepreneur; he is also a recognized intellectual leader of American business. Moreover, Allison’s financial expertise is a product of his personal biography: In a mere two decades, he built BB&T (Branch Banking & Trust Co.), a comparatively small Southern bank of $4.5 billion in assets, into a $152-billion financial enterprise, making it one of America’s largest and most profitable banks. But unlike many overpaid, underperforming CEOs, Allison focused his leader-manager skills—at modest compensation—on behalf of his employees, customers, and shareholders.
Briefly stated, Allison’s core principles begin with an unapologetic dedication to customer-oriented banking and carefully managed risk-taking as sound and effective means to long-term profitability and high returns on capital. BB&T deploys an uncommon means to sustain the bank’s dedicated corporate culture: continuous, serious, systemic employee education aimed at the formation of leaders, executives, and well-trained employees at every level. A core goal of every employee must be to focus on making every client profitable and successful on a risk-adjusted financial basis—that is, through conservative banking. False financial products were neither fabricated nor widely distributed during the bubble years (such products having been an important cause of the financial crisis). Monthly employee readings in philosophy and economics are mobilized to reinforce the core principles.
At the center of this banking philosophy is the development of the full potential of each employee, and each client, of the bank: This strategy, Allison argues, is the optimum path to shareholder, customer, and employee enrichment. Many firms pretend to such a strategy; Allison earned a national reputation because he actually carried it out, and successfully, in a banking system engaged during the bubble years in a “race to the bottom.”
In a free-market society, it is hard to exaggerate the importance of such a corporate culture. And in business, the individual conscience, dedicated to long-term rational self-interest, is the indispensable condition of a minimally regulated free market. It is striking that Allison’s strategy was vindicated by good returns on capital; it is equally striking that BB&T’s corporate culture was proven right in the financial crisis and Great Recession, as BB&T experienced not a single quarterly loss during the financial earthquake of 2007-2009.
It is necessary to know all this in order to understand the importance of The Financial Crisis and the Free Market Cure. As the head of a major American bank, Allison was witness to the decisions of government, Federal Reserve leaders, and banking CEOs that led to a huge speculative bubble and the collapse of the financial system, including Fannie Mae, Freddie Mac, virtually the entire cartel of big banks and brokers, and major companies. Allison guides us, with a gimlet eye, through taxpayer-subsidized bailouts of these wards of the state, focusing on a reckless, insolvent, privileged financial oligarchy—subsidized by a feckless Fed, a dilatory Treasury, and a politicized FDIC. The coercive power of the federal government, and the moral hazard of excessive regulation, is dissected and debunked.
By Lewis E. Lehrman: