From the February 20, 2012, issue of NR

When the Federal Reserve decided to loosen monetary policy in September 2007, not many people criticized it. The vote was unanimous. Few congressmen said anything about the move. Three years later, inflation was lower and unemployment higher than in 2007. But the Fed’s move to loosen money in mid-2010 aroused fierce opposition from conservative politicians, economists, and journalists. Sarah Palin complained that “printing money out of thin air” would “erode the value of our incomes and our savings.”


Republicans and conservatives have started to take a much harder line against inflation and a Federal Reserve they consider too inclined toward monetary expansion. In the early 1980s, supply-siders would sometimes criticize Paul Volcker’s Fed for fighting inflation too vigorously. Few on the right say anything similar today.

This rapid shift in positions has several causes. The view that overly loose Fed policy contributed to the housing bubble of the last decade became the conventional wisdom. The massive expansion of the money supply in the wake of the financial crisis alarmed many observers. But the shift in position was also a testament to Representative Ron Paul’s dogged campaign against the Fed and its allegedly inflationary ways, and for a gold standard. If not for the Texas Republican — who has long been the congressman most interested in monetary policy, and now chairs the subcommittee with jurisdiction over it — it is hard to imagine that Newt Gingrich would have proposed a new commission to examine the gold standard, or accused Fed chairman Ben Bernanke of being “the most inflationary, dangerous, and power-centered chairman of the Fed in the history of the Fed.”

Many Republicans tell pollsters that they will not vote for Paul because of his foreign-policy views. Nobody says that his monetary views are a deal breaker; no pollster even bothers to ask. There is no organized opposition to Paulite views on money within the Republican party or conservative movement, and the people who hold those views hold them intensely. Thus the progress of those views.


Yet Paul’s views are a long way from dominance. The next Republican president’s appointees to the Fed will not insist that the money supply never increase. Most of the economists in his administration will not be supporters of the gold standard, or opponents of the Fed’s existence. What Paul has accomplished is to set a tone for the economic-policy debate on the right.


In End the Fed, his 2009 book, Paul writes that a rotten monetary system underlies “the most vexing problems of politics.” In his view, any expansion of the money supply counts as inflation, whether or not prices rise. (That’s also the definition Gingrich is using, since Bernanke can’t be convicted of record inflation defined as price increases.) If prices stay flat after an expansion, it means that they would have fallen without it. The expansion is thus a form of theft from people who must now pay higher prices than they would otherwise pay, and especially from savers, whose money becomes less valuable than it would otherwise be. Expanding the money supply thus discourages saving and encourages consumption. Paul goes so far as to say that it is the Fed that has led to people’s being “enslaved to their high credit card debt, the college loans, their car and home loans.” This “personal fiduciary bondage . . . simply could not be part of a free society with sound money.”

Paul follows the Austrian school of economics, which holds that the expansion of the money supply (or, in some variants, the overexpansion of it) is the reason we suffer through business cycles. Loose money artificially lowers interest rates and misleads businesses about the demand for capital goods, causing them to invest in the wrong lines of production. Eventually the “false” or “illusory” prosperity of the boom gives way to a bust in which these malinvestments have to be painfully liquidated. Efforts to mitigate the pain merely prolong the necessary process. In End the Fed, Paul treats the entire period from 1982 through 2009 as “one giant financial bubble” blown up by the central bank. (At one point he dates its beginning to 1971.) Absent his preferred reforms, “we should be prepared for hyperinflation and a great deal of poverty with a depression and possibly street violence as well.”


Monetary expansion is also, for Paul, a key enabler of what he takes to be our imperialist foreign policy: The creation of money out of thin air allows the government to finance wars, as well as the welfare state. Central banking is a form of central planning, on his theory, and as such “incompatible” with freedom. Paul allows that “not every supporter of the Fed is somehow a participant in a conspiracy to control the world.” The rest of them, judging from comments repeatedly made in the book, have fallen for the delusion that expanding the money supply is a “magic means to generate prosperity.” Paul finds it baffling that anyone could hold this absurd view, but attributes it to Chairman Bernanke, among others.


Almost all of the criticisms Paul makes of central banking, when stated in the axiomatic form he prefers, are false. To put it more charitably, he assumes that the negative features that monetary expansion can have in some circumstances are its necessary properties. Consider, for example, a world in which the Federal Reserve conducts monetary policy so that the price level rises steadily at 2 percent a year. Savers, knowing this, will demand a higher interest rate to compensate them for the lost value of their money. If the Fed generates more inflation than they expected, as it did in the 1970s, then savers will suffer and borrowers benefit. If it undershoots expectations, as it has over the last few years, the reverse will happen. The anti-saver redistribution Paul decries is thus not a consequence of monetary expansion per se, but a consequence of an unpredictedly large expansion. For the same reason, monetary expansion does not necessarily lead to less saving. There is no reason to believe that the real burden of home loans would be any larger in a world with 2 percent inflation than in one with 1 percent inflation.


Nor is the wage earner necessarily defrauded. Continuing with our scenario of a steady 2 percent increase in the price level, the prices he pays after ten years are higher but, on average, so are his wages. There is no reason to expect a larger money supply over the long run to affect relative prices — to change the ratio of the cost of a week’s supply of vegetables to a week’s wages, for example. That’s why central banking isn’t central planning: It never attempts to fix the relative prices or quantities of all the goods an economy produces, and it cannot cause the total amount of goods an economy produces to hit any particular target.

Paul is right that more money does not magically produce more goods in circulation over the long run. (So right, that nobody believes otherwise.) It’s because he’s right that we ought not to regard all of the prosperity of the last few decades as an illusion. Productivity growth was real and we don’t have to roll it all back and start over with a better monetary regime.

Paul’s contention that the Fed has continuously abetted the expansion of the state — its wars, its welfare, its attacks on civil liberties — is also false. The federal government uses its monopoly over the currency to finance very little of its spending. It gets almost all of its money through taxing and borrowing, and the borrowed funds come from people who are well aware of the need to charge a premium to cover the risks of inflation.


The doctor’s prescription is as mistaken as his diagnosis. The drawbacks to a gold standard are well known. If industrial demand for gold rises anywhere in the world, the real price of gold must rise — which means that the price of everything else must drop if it is measured in terms of gold. Because workers resist wage cuts, this kind of deflation is typically accompanied by a spike in unemployment and a drop in output: in other words, by a recession or depression. If the resulting economic strain leads people to fear that the government may go off the gold standard, they will respond by hoarding gold, which makes the deflation worse.

If another country’s government begins hoarding gold, the same thing happens. This is not a theoretical concern: It’s what France did in the early years of the Great Depression. Countries were forced off the gold standard, and recovered in the order they left it. Representative Paul’s strategy for dealing with the theoretical and historical arguments against the gold standard in End the Fed is to ignore all of them. All he says is that problems arose in the 1930s because of the “misuse of the gold standard.” But note that the great advantage of the gold standard is supposed to be that governments cannot manipulate it. Concede that they can and the argument is half lost.

People who see through Paul’s illogic, misapprehensions, and paranoia typically dismiss everything he has to say about money. But buried beneath all of that are some reasonable points. The Fed doesn’t have a great track record, and keeping it in its present form may not serve us well. In a recent study for the Cato Institute, three academic specialists in monetary policy noted that the Fed, in its first decades, generated a severe inflation and a severe depression; that it does not seem to have stabilized the economy; and that it has extinguished the kind of benign, productivity-driven deflation that the country sometimes experienced before the Fed’s creation.


The purpose of money, as Paul rightly describes it, is to facilitate exchange and thus the coordination of economic plans. A governmental institution with discretionary control over the money supply — which is a good working definition of a central bank — undermines that goal because no clear rule constrains it, forces it to behave predictably, and thus enables economic actors to make and coordinate their plans against a background of monetary stability. Central banking is not central planning, but it does reflect an unwarranted confidence in the ability of government officials to engineer beneficial economic outcomes.

Replacing discretion with a sound rule would thus be a major step forward. One possible rule would force the Federal Reserve to freeze the money supply, as Paul recommends. But this rule would require prices and output to fall any time people increased their demand for money balances. Another rule would instruct the Fed to keep the price level constant from year to year. But under that rule the Fed would have to compound the blow from any negative supply shock (a disruption of the oil market, for example) by reducing the money supply. A sudden move to that rule could also cause serious economic dislocation if people were used to a higher inflation rate and had, for example, factored it into long-term debt contracts.

Considerations such as these have led some monetary economists to favor a rule that would commit the monetary authorities to stabilizing the growth of spending. Inflation would be allowed to go up or down in response to productivity shocks, and the money supply would be allowed to go up or down in response to changes in the demand for money balances. Theorists of free banking have generally agreed that if banks were allowed to issue currencies in competition with one another, something like this rule would emerge as a market equilibrium. So a government pursuing this policy would in a sense be mimicking a free-market outcome (although the choice of growth rate and starting point would admittedly have an element of arbitrariness). Scott Sumner, a professor of economics at Bentley University, has made an ingenious proposal to use futures markets to estimate the future course of nominal spending, further reducing the discretion and improving the accuracy of the monetary authority.

We have already had something of a test of this policy. Between 1982 and 2007, the Fed’s conduct of monetary policy led to a fairly consistent 5 percent annual increase in nominal spending even though it was not legally bound to produce one. This period was not the nightmare that Paul portrays but a time of relatively stable growth and low inflation. (Over the last twelve years of the period, inflation averaged 2.6 percent.) In the closing years of the period the Fed allowed nominal-spending growth to rise a bit above the trendline, which may have expanded some asset bubbles. The Fed could have corrected for this excess and then gradually reduced the growth rate of nominal spending to eliminate all long-term inflation.

Instead, starting in mid-2008, it allowed nominal spending to drop at the fastest rate since the depression within a depression of 1937–38. It even discouraged the circulation of money by paying banks interest on their reserves. The consequences of these decisions have been many and horrible. Among them are booming book sales and credibility for a congressman who does not deserve them.

— Ramesh Ponnuru is a senior editor of National Review. This article appears in the February 20, 2012, issue of National Review.