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 The commissars of central planning who so marred the history of the 20th century have been replaced by central banks in the 21st.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.
EVERY DAY WE WAKE UP hoping for good economic news: lower unemployment numbers, more jobs created, stronger growth. But we miss the forest for the trees. Our markets, for the past 100 years, have been engulfed in perennial financial crises.
Many of these crises have been associated with major Federal Reserve credit expansions and contractions. Upon examination, these volatile market episodes almost always lead to major moves in non-durable commodities, primarily oil and food.
But first, some historical background.
How do we mark the onset of the age of financial disorder, or, if you will, the Age of Inflation? The starting point was the volcanic eruption in 1914 at the epicenter of the Western world. World War I brought to an end the preeminence of the classical European states system; it decimated the flower of European youth; it destroyed the European continent’s industrial primacy, making Europe a debtor and America a creditor. The classical gold standard was suspended everywhere by the belligerents. The monetary gyroscope of the Industrial Revolution collapsed along with the world trading system into the anarchy of total war.
To interpret the financial events associated with the Great War —and their effect on the ensuing hundred years—let us highlight two crucial occasions of 1913: the establishment of the Federal Reserve system and the publication by the young John Maynard Keynes of his book Indian Currency and Finance. Neither event by itself would probably have created a barrier to resumption of the long period of monetary stability and economic growth under the prewar classical gold standard. But the inauguration of the Federal Reserve and the monetary ideas of Keynes, taken together, created the perfect storm.
As originally conceived, the Federal Reserve system, a government-dominated central bank, was designed to strengthen American participation in the classical international gold standard, even while making the U.S. currency and banking system more “elastic,” so it would be able to deal with crises like the panic of 1907. As the lender of last resort, the Fed was also tasked with issuing Federal Reserve notes and commercial bank deposits against collateral convertible on demand into gold. (By collateral here, we mean things such as the liquid, short-term, high-quality commercial paper of solvent firms used to finance goods in the process of production.)
Statement and Testimony of Lewis E. Lehrman Chairman, The Lehrman Institute Prepared for September 21, 2012 Hearing
... Now we are able to formulate an authentic, bipartisan program to restore 4 percent American economic growth over the long term. Tax rate reductions with an enlarged tax base, government spending restraint aimed at a balanced budget, simplification of business regulation designed to empower entrepreneurial innovation -- these reforms can be made effective for America and the world by a modernized gold standard and stable exchange rates. This is the very same platform which uplifted 13 impoverished colonies by the sea in 1789 to leadership of the world in little more than a century.
Gold, a fundamental, metallic element of the earth’s constitution, exhibits unique properties that enabled it, during two millennia of market testing, to emerge as a universally accepted store of value and medium of exchange, not least because it could sustain purchasing power over the long run against a standard assortment of goods and services. Rarely considered in monetary debates, these natural properties of gold caused it to prevail as a stable monetary standard, the most marketable means by which trading peoples worldwide could make trustworthy direct and indirect exchanges for all other articles of wealth.
The preference of tribal cultures, as well as ancient and modern civilizations, to use gold as money was no mere accident of history. Nor has this natural, historical, and global preference for gold as a store of value and standard of measure been easily purged by academic theory and government fiat.
Gold, by its intrinsic nature, is durable, homogenous, fungible, imperishable, indestructible, and malleable. It has a relatively low melting point, facilitating coined money. It is portable and can be readily transported from place to place. Gold money can be safely stored at very low cost, and then exchanged for monetary certificates, bank deposits, and notes—convertible bills of exchange that efficiently extended the gold standard worldwide.
Like paper money, gold is almost infinitely divisible into smaller denominations. But paper money has a marginal production cost near zero. Producing gold money, like other articles of wealth, requires real labor and capital.
In the absence of government prohibitions and restrictions in favor of inconvertible paper and credit money, history shows that gold—or paper and credit money convertible to gold—was preferred and accepted in trade and exchange from time immemorial. Until recent times the gold standard also underwrote, indeed required, the trade rebalancing and equilibrium mechanisms of the international economy. In the absence of prompt balance-of-payments settlements in gold, the undisciplined official reserve currency systems have immobilized the international adjustment mechanism with the result being increasing trade imbalances, debt and credit leverage at home and abroad. For example, under the world dollar standard, other nations gain desired dollar reserves only as the United States becomes an increasingly leveraged debtor through balance-of-payments deficits; whereas under the gold standard, the global economy may actually attain balance-of-payments surplus as a whole vis-à-vis worldwide gold producers.
The true gold standard—without official reserve currencies—is the sole, rule-based monetary order which reliably and systematically rebalances worldwide trade and exchange among all participating nations.
In 2012, inflation proceeds gradually in the United States because of unemployed resources. At full employment, inflation accelerates. But then, as the Fed and the banking system reduce the growth rate of credit, the threat of deflation will reappear (as in 2006-07 and 2012). Because the reserve currency system generally leads to a rapid increase in global purchasing power without a commensurate increase in the supply of goods and services, the systemic tendency of the reserve currency system is inflation—generally in the prices of investment assets, commodities, and speculative vehicles like art and antiques. Yet the process can dangerously work in reverse, causing deflation, especially when the Fed tightens, or there is panic out of foreign currencies into the dollar (the Asian Crisis, 1996-2002, and the Euro Crisis—2012). Illiquidity abroad causes foreign official dollar reserves to be resold or liquidated in very large quantities, reducing the global monetary base—as occurred in 1929-33 and recently in 2007-09.
By Lewis E. Lehrman: