Cobden Centre Seminar at the Bank of England – Detlev’s Speech

Speech – Bank of England

July 11, 2017

From Gold Standard to PhD Standard – The last 100 Years of Money and Central Banking as seen from an ‘Austrian’ Perspective

Detlev S. Schlichter

To integrate money fully into a model of the economy has been a perennial challenge for economists. Most of 19^th century Classical Economics simply viewed money as a veil that lays over the real economy and that does not interfere with any of the ‘real’ economic procedures underneath. The fact that money is a medium of exchange, and that ultimately people exchange goods and services for other goods and services, with money simply an intermediary, provided an excuse to ignore money itself as a factor.

One social scientist who attempted to break this mould was the Austrian economist Ludwig von Mises, who, in the early 20^th century, was the first to apply the then new approach of marginal-value theory to the analysis of money. His book, “Theory of Money and Credit”  – published in 1912, second edition 1924 – became the seminal text on the topic within the Austrian School. It defines what I understand to be the “Austrian” perspective.

Mises explained that with any expansion of the money supply, there is necessarily always a point of entry, where the new money is injected into the economy, and from where it then spreads by a chain of transactions. This means that some prices rise earlier than others. An expansion in the money supply can never lift all prices simultaneously or by the same degree.

Any expansion of the supply of money changes the wealth of specific individuals or groups of individuals. The early recipients of the new money can spend it before it has spread to the wider economy and thus before many prices have been lifted. Therefore, the earlier recipients benefit at the expense of later recipients, whom the money reaches only at the end of a number of transactions, and after it has lost some of its original purchasing power.

Every money injection must change relative prices, wealth and income distribution, and change the direction and structure of economic activity. In short, money can never be neutral. After any expansion of money, the economy is not the same as before, just with a higher price level and a larger GDP. It is, in many ways, a changed economy.

I would like to emphasize the difference with current debates on monetary policy, which often give the impression that a direct link exists between money and the macro-aggregates GDP and the price level, with everything in-between being unaffected. This has led to the unfortunate notion that a policy of ‘easy money’ lifts all boats simultaneously and equally. That this is a dangerous simplification is a key tenet of the Austrian argument. By the way, the now so popular price indices mask these more granular effects, and they are therefore poor measures of the full range of consequences of any changes in the money supply.

In a modern economy most money is created by banks, and it is here that Mises developed the Austrian Theory of the Business Cycle.

The characteristic feature of banks is that they can extend credit by issuing claims against themselves that then circulate in the wider economy as a form of money. If banks are willing to lower their reserve ratios they can extend loans by simultaneously crediting the accounts of the borrowers with new deposit money. Thus, banks discharge new money as a by-product of their lending activity.

The effects of this process are that interest rates fall and the amounts available on the loan market increase. This in turn encourages extra investment. These effects are the same as if the amount of available saving had increased. But crucially, no additional saving has occurred. Consumers have not freed up any resources from their employment in the fulfilment of present consumption needs, and have not voluntarily made them available for investment.

Artificially depressed interest rates are therefore wrong signals that fool entrepreneurs into extending the capital structure beyond what voluntary savings by the public would sustain in the long run. As Roger Garrison put it: Investment funded by saving leads to stable growth; investment funded by money creation leads to boom and bust.

It is important to recognize the function of a recession in the Austrian interpretation. Rather than seeing the recession as an accident or aberration, in Austrian theory the recession is a necessary if painful process by which the economy gets back into balance. Through the recession the economy cleanses itself of the accumulated misallocations of capital that always occur in the credit-driven boom. If you do not want to have a recession you have to avoid the artificial easy-money boom that precedes it. Once you have allowed an artificial credit-driven boom to occur, the correction will be unavoidable.

The policy implications are straightforward: You either put limits on the banks’ ability to extend credit via money creation –as was indeed done in Britain in 1844 via the Peel Act – or, if this is deemed too Draconian, then at least do not encourage or subsidize it. Do not socialize its risks and consequences.

I will now try to show that, over the past 100 years and up to today, developments have gone almost consistently in the opposite direction. Our financial infrastructure has moved towards ever more elastic currencies, the systematic subsidization of banking, and the progressive cartelization of banks under the control of a central bank. This did not happen because the Austrian School was proven wrong (it wasn’t), or because the people in power found Keynesianism or Monetarism more convincing (believe me, they didn’t).

The driving force behind the evolution of our monetary system has simply been the age-old hope that prosperity could somehow be boosted by simply printing more money and by artificially depressing interest rates.

My quick historical run-through will focus on the US, but surely you will not struggle to see the international parallels.

Prior to 1914 the United States did have a gold standard and did not have a central bank. Two previous attempts to establish a Bank of the United States had failed. But in 1914 the Federal Reserve System was launched, supposedly as a government-sponsored safety net against bank runs. As Milton Friedman and Anna Schwartz write in their famous monetary history of America:

“The Federal Reserve System was created by men whose outlook on the goals of central banking was shaped by their experience of money panics during the national banking era. The basic monetary problem seemed to them to be banking crises produced by or resulting in an attempted shift by the public from deposits to currency.”

The Fed was supposed to add an element of elasticity to the otherwise rigid gold standard, and this was intended to lessen the risk of bank runs. Of course, we can expect two consequences: 1) the credit boom can now last longer, because it will not be terminated as readily by the limited supply of gold reserves at banks; and 2) the banks, now knowing that a government-sponsored lender-of-last-resort has their backs, will expand their balance sheets more and create more money.

Critics of the Federal Reserve Act – and yes, there were a few –  saw this clearly. Here is Senator Elihu Root, one of the opponents:

“With the exhaustless reservoir of the Government of the United States furnishing easy money, the sales increase, the businesses enlarge, more new enterprises are started, the spirit of optimism pervades the community…All the world moves along upon a growing tide of optimism.”

Indeed, from 1914 to 1920 more than 1,700 new banks began operations in eleven states, and total farm mortgages grew by more than 9 percent per annum between 1910 and 1920. The US economy looked, of course, rather different 100 years ago. The main beneficiary of easy money was not yet residential housing but agriculture.

Mission creep set in early at the Fed. The Federal Reserve Act had stipulated that the Federal Reserve Banks “furnish an elastic currency to afford means of rediscounting commercial paper […]” but by 1917 the Fed began to provide facilities for lending against the government’s issuance of war bonds.

Between 1922 and 1928, the Federal Reserve presided over a doubling of domestic bank credit.

Sponsorship from the government does not make credit booms harmless, of course. According to Austrian theory, the accumulated imbalances from a prolonged cycle would now ultimately be larger. The boom could last longer; the eventual bust would therefore only be more severe.

The boom did end, of course, as it simply had to, and for the US and a number of other countries it ended in a severe economic depression.

As the Austrian theory explained, the recession was now an important process of getting the economy back into balance. According to Austrian analysis there was no rational alternative available to allowing prices to adjust and malinvestment to get liquidated. This has nothing to do with “moral hazard”. It has nothing to do with punishment for previous excesses. It is also wrong to suggest that the Austrian theory prescribes deflation. The Austrian School simply maintains that the credit-driven boom had necessarily introduced distortions in prices and in capital allocation. These were the ultimate root causes of the recession. The economy can logically only adjust and get back to equilibrium if prices are allowed to reflect the new reality. What government should do under no circumstances is obstruct market forces. The faster the economy is allowed to adjust, the shorter the correction will be.

Of course, obstruct market forces is precisely what the Roosevelt administration did, like most administrations ever since, The government introduced market interventions on a previously unprecedented scale, with many of the policies targeted at keeping prices, including wages, at high levels or boosting them further. Almost all anti-crisis interventions to this day are conservative in nature. They aim to sustain established price structures and established resource allocation, even though these are distorted from the preceding boom. They thus hinder liquidation and economic rebalancing, and therefore tend to prolong the painful recession. Austrians do not deny that such policies can engineer temporary recoveries. But usually those don’t last. The US economy bounced back in 1933, only to be back in deep recession by 1937. The verdict is clear from an Austrian perspective: it was the New Deal that put the ‘Great’ in Great Depression.

Importantly, the institutional setting for bank credit creation had now been loosened further. Banks had been allowed to default on their promises to their depositors of redeeming deposits in gold, and were still allowed to continue as going concerns. Indeed, per executive order Roosevelt confiscated all privately held gold in the US in 1933 and banned US citizens from owning the precious metal, a prohibition that lasted till 1974. Having already been hollowed out by the policies of the previous two decades, the gold standard had finally been terminated, at least domestically.

Internationally, however, a form of gold anchor was still deemed essential for monetary stability. After World War II a return to the classical gold standard was rejected. Instead a sort-of gold standard light was put in place, the Bretton Woods system. Like all previous gold standards or quasi-gold standards, it too collided with the perennial wish for lower interest rates, cheaper credit and larger deficits. In the 1960s the habit of running persistent budget deficits had taken hold in the US, and soon began to undermine confidence in the US’s willingness to maintain a gold-parity for the dollar on international markets. On August 15, 1971, another de-facto default occurred, as the US single-handled reneged on its international gold commitments, thereby terminating Bretton Woods.

It is worth stressing that the new system – or rather non-system – that was born at that moment, did not reflect some carefully thought-out theory about a sustainable monetary order; it had not been extensively deliberated by academic economists. Nixon in 1971, just like Roosevelt in 1933, acted on the spurt of the moment, and in response to what they perceived to be national emergencies.

Since August 1971, pretty much the entire world has been, for the first time in history, on an entirely unconstrained paper standard. Nowhere today is the production of money limited by a link to a commodity of limited supply. Thus the final step towards a fully elastic monetary system had been taken: From gold standard to gold-exchange standard to unconstrained fiat money system.

What consequences should we expect from such arrangement on the basis of Austrian theory? – The booms can now be extended further. Of course, imbalances and capital misallocations must still accumulate, making occasional cleansing recessions still necessary and inevitable. But, crucially, central banks now face no meaningful restriction to easing monetary conditions further, and to doing so in particular in and during the downturn. They may therefore just about be able to shorten the correction, to short-circuit the process of cleansing, and even start a new boom, before the recession has fully liquidated the distortions from the previous boom. It therefore seems reasonable to assume that over time imbalances – such as, for example, over-extended bank balance sheets and high debt levels – will pile up. As a result, monetary policy will have to run ever faster, so to speak, it will have to become ever more aggressively accommodative to stem itself against the forces of liquidation, and it will be ever harder to generate the next artificial boom. Ironically, as policy gets ever more flamboyantly accommodative, it also becomes less effective.

Let’s take a look at some of the things that happened since 1971, and start with the question, has the world become more stable? – The evidence suggests, no. In their popular study This Times is Different from 2011 Carmen Reinhard and Kenneth Rogoff – hardly two Austrian School economists, I may suggest – showed that since 1971 the number and intensity of banking crises around the world has increased. We had the Latin American debt crisis of the 1980s, the Mexican crisis of 1994, and the Asian debt crisis of 1997. The Scandinavian countries suffered a major banking crisis in the early 1990s.

Most famously, of course, Japan experienced phenomenal growth in its banking industry in the 1980s, fuelling a massive boom in real estate and equity markets. By 1987 the ten largest banks in the world measured by volume of deposits were all Japanese. Since that boom turned into a bust in the early 1990s, Japan has struggled to regain meaningful economic growth ever since, and the country has basically become a giant test case for Keynesian and Monetarist policy prescriptions. Decades of systematic suppression of interest rates and persistently large budget deficit – all in the name of reflation and ‘stimulating aggregate demand’ – have left Japan with the largest public sector debt of any country on the planet but still in search of a satisfying recovery. I have marvelled for 30 years at the persistence with which economists of the Keynesian and Monetarist persuasion seem to tell the Japanese that their policies are absolutely the right ones, that they will ultimately work – the Japanese authorities simply have to keep increasing the dosage. From an Austrian perspective, these policies are counterproductive.

Has the population in the US benefitted from the shift to fully elastic money? – I don’t think so. In the US the personal savings rate peaked at 13.3 percent in 1971. Real hourly wages—that is, wage rates adjusted for inflation—peaked in 1972; since then, the average hourly wage has essentially been flat. (These figures do not include the value of benefits, which has increased.)

Of course, as Mises explained 100 years ago, early recipients benefit from newly injected money at the expense of later recipients. So some people have benefitted. As new money gets channelled through the banking system and the financial markets first, those who own financial assets or real estate, or work in related industries can reasonably be expected to have done well. It pays to stay close to the money tap.

What about the assumption that the system deteriorates progressively, and central banks have to become ever more aggressively interventionist to achieve their goals? – The evidence may be anecdotal but I think it is everywhere to see.

When the Asian debt crisis and the Russia default triggered the collapse of hedge fund LTCM in 1998, all it took the Fed was a few intra-meeting rate cuts (at a time when the Fed officially had a tightening bias), to avert the threat of deleveraging. Quickly, stock markets and credit markets were off to the races again – and the so-called “Greenspan put” was born. Investors and traders learnt that the central bank had their backs. Increasingly, the central bank could not afford not to.

After the NASDAQ bubble burst in 2000 and around the time Enron and Worldcom went bankrupt in 2002, the Fed adopted a 1-percent Fed Funds rate, and left rates that low for more than three years to support the economy. The Fed’s ultra-easy policy during those years was, of course, instrumental in blowing the gigantic housing bubble that burst in 2007 and kicked-off the 2008 global financial crisis. After three rounds of quantitative easing and more than 7 years of zero interest rates, the Fed has now begun a most glacial process of policy “normalization”. Remarkably, at a conference here in London only two weeks ago Janet Yellen said that she does not believe we will see another financial crisis in our lifetime. I wish Chairwoman Yellen a long and healthy life, of course, but personally I strongly take the other side of that bet. Of both bets in fact.

I do believe we will see more crises in the not too distant future and I do believe that meaningful ‘normalization’ will not occur. If ‘easy money’ has indeed underwritten the recovery, as was the intention of the central bankers, then it will have done so by introducing new dislocations into the economy and thereby sowing the seeds of the next recession. This is what the Austrian Theory tells us, and it ties in nicely with what we have seen in markets over the past 30 years. The system has become ever more dependent on policy support, and any removal of that support has led to progressively worse withdrawal symptoms.

Sadly, we have moved progressively away from free market principles in the field of money. 100 years ago, under a gold standard, bankers faced a more pressing risk of bank runs, but banks were still capitalist enterprises. Bankers had to weigh the profit from balance sheet extension against the risk of losing the trust of their depositors. Importantly, bankers were still answerable to their depositors. 100 years later, after extensive bank regulation and government-run deposit insurance, and now with the support of a central bank that uses banks as a conduit for its macro-economic policies, banks have largely become indistinguishable to the consumer, and bankers are now predominately answerable to their regulators and the central bank (which are now, frequently, the same).

The central bank has also changed dramatically. Remember, the Fed was founded to “furnish an elastic currency to afford means of rediscounting commercial paper….” but has since become the largest buyer and owner of US government bonds and a massive investor in mortgage-backed securities. In the 1950s, the Fed still concentrated its open-market operations on the front end of the curve, so not to influence bond prices for longer maturities. With Operation Twist in 2011, the Fed has taken it upon itself to guide the shape of the yield curve. Other central banks have taken the next steps: the ECB and the Bank of England buy corporate bonds with an aim to manage credit spreads; the Bank of Japan and the Swiss National Bank buy equities and real-estate investment trusts. And last year, the Bank of Japan was the first central bank, to my knowledge, to announce a specific target for 10-year yields on government debt. (Why not announce target levels for the stock market?) James Grant has called this system the Phd-standard. Rather than being based on a framework of hard rules, the system puts all its trust in the skill of the economists who now run the big central banks, and the theories they presently subscribe too.

From an Austrian perspective, these developments are unlikely to lead to stability and sustainable growth. But all we can do, representing the minority opinion, is to encourage a fundamental rethink about what the proper role of central banking should be in a modern economy.

Detlev S. Schlichter is a portfolio manager and author. His has more than 20 years experience as a trader and professional investment manager, with stints at J. P. Morgan, Merrill Lynch, Western Asset Management and Rogge Global Partners. He wrote the award-winning book Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown (Wiley 2011, 2014).