David Jensen is the Principal of Jensen Strategic a Vancouver-based strategic planning and business advisory services company.
Central Banks and Their "Elastic" Currency
The founding fathers, being aware of the withering effect of monetary inflation which had occurred with the unbacked "Continentals" during the revolution forbade the use of a currency that was not gold or silver backed. Specifically Article 1, Section 10 of the Constitution stipulates : "No State shall... ...coin Money, emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; ...". Despite clear and express opposition of those who wrote the Constitution to un-redeemable fiat money as Legal Tender, through a series of hand-wringing decisions, U.S. courts in 1878 finally ruled paper money constitutional allowing the future removal of gold and silver from any disciplinary role in the issuance of US currency.31
There are many who have voiced concerns about the creation of the Federal Reserve and the elastic money it created including Warren Buffett's father32 (Congressman 1943-49, 1951-53) as well as Alan Greenspan himself in a previous manifestation.33
From 1914 and on in the U.S. and in Canada we have the current age of Central Bank fiat currency, where the Central Bank in each country modulated the amount (stock) of money and its cost (the interest rate) in an effort to control the economy. Freed by the suspension of the fixed convertibility of money into gold, Canada and the U.S. were able to finance their war activities with an "elastic" (expandable) money stock.
Since the creation of the Federal Reserve, the U.S. has had three major price inflations corresponding with an increase in the money supply: 1914 to 1920, 1939 to 1948, and 1967 to 198034 - coincidentally corresponding to WW I, WW II and the Vietnam War, respectively.
The Federal Reserve Bank, while permitted to operate U.S. monetary policy by the U.S. government, are not Federal at all and they have no hard reserve backing the Federal Reserve notes. Instead, the Fed's shares are fully owned by a combination of national banks (who must own shares in the Fed) and state banks (who may own shares in the Fed). Thus the U.S. monetary system (interest rates, money stock growth, etc.) is controlled by an institution (the Federal Reserve), that, while approved to operate by the Federal Government, is a private institution owned by banks operating in the U.S.
In conjunction with the Fed, the U.S. Treasury prints Federal Reserve Notes (today's paper dollar currency) at the directive of the Federal Reserve. The Secretary of the Treasury is the principle economic advisor to the President and thus works with the Fed although he does not have authority over the US money stock - only the Fed Board of Governors and the Fed's FOMC has that control and operates independently.
The interest rate setting FOMC is composed of the 7 Fed Governors plus the president of the New York Fed plus 4 other presidents selected from the remaining 11 Fed Regional Banks.
The Fed has grown in its powers over time. Initially limited to controlling the money supply under the directive of the Secretary of the Treasury, the Fed's powers have been increased both by Congressional action and by the Fed's own edict. As an example of the latter, the Fed states that in order to maintain its "independence" the Fed of its own volition in 1962 began to intervene in foreign currency markets35 that had been the strict purview of the U.S. Treasury. This raises the question how an independent, non-government body can expand its own powers giving it the ability to act in contravention to the Department of the Treasury which is overseen by the President and the executive branch of government.
In Canada, monetary policy is set by the Bank of Canada. Established in 1934 as a privately held bank, the Bank of Canada was nationalized in 1938.36 Since Confederation, Canada's dollar had been redeemable at a fixed quantity for gold. Due initially to World War I, from 1914 to 1926, and forward from 1931 (de facto) and officially (by Cabinet Order) in 1933, Canada's currency was removed from the fixed gold standard.
The Age of Monetarism - Already Looking for a Place to Happen
In 1911, the famed economist, Irving Fisher published his "quantity of money" theory in his work "The Purchasing Power of Money" where he postulated that the level of economic activity was somehow related to the amount of money in an economy.
What Fisher did not show with his theory was causality - that the government could effect greater sustained and real economic activity by increasing the money stock. This was not an issue as the Central Banks in 1914 did not rely on Fisher's economic theory as justification for their massive increases in the money stock. A war was on and money needed to be created and spent in relation to the war effort - they now had the elastic money stock needed.
That there was immediately a price inflation in 1914 in both the U.S. and Canada followed by the stock market mania and crash of the 1920's tells us the machine was not quite perfected.
A tangible sigh of relief must have swept through central bank and government circles with the publishing of John Maynard Keynes' "General Theory" in 1936 which put forth that during economic slow-downs, falling prices were evidence of "insufficient" money in the economy and not only could the money stock affect the level of economic activity, the government and central banks should intervene with government spending and Central Bank injections to the money supply to counter this "insufficiency" made evident by falling price levels - this theory is accepted even today by government and Central Bank economists. Keynes' theory relied on humans acting neatly and predictably as aggregates who, no matter what the money stock levels, could and should be steered by government and central bank intervention using their mathematical models.
Not all embraced Keynes. As noted by economist Henry Hazlitt:
"I have been unable to find in [Keynes' General Theory] a single important doctrine that is both true and original. What is original in the book is not true; and what is true is not original. In fact, even much that is fallacious in the book is not original, but can be found in a score of previous writers." 37
However, the ball was already rolling and Governments and Central Banks now had the ammunition backing the monetary and government expansionist policy they had already been using - creating money to allow activity beyond their means.
"In the long run we are all dead." - Keynes
Keynes trite argument for not waiting and rather intervening to spur on the economy should give us pause for our current monetary intervention in the economy.
Before monetarism and Keynes' belated theory to justify Central Bank expansion of the money stock and government spending to boost the economy, there was what is now referred to as the Austrian School. Starting in the late 1800's the name 'Austrian' was applied as a derisory term by German economists to attempt to portray this group as not being part of the mainstream Prussian-German body of economists.
In the Austrian school started by Carl Menger in the 1870's and extended most famously by Ludwig von Mises (1881 - 1973) in the 20th century, the central tenet of this school was that analysis of economic phenomena and then attempted explanation by various mathematical models was not possible - humans are complex and cannot be predicted by aggregating their "average" behavior according to neat mathematician's curves.
The nub of von Mises' theory was as follows: the complexity of human behavior required that you could only develop a rational and objective economic theory based upon fundamental logical principles (deduction) of human action as opposed to the monetarists' and Keynesians' selected observation followed by attempted mathematical modeling (induction). (The latter method being the source of endless frustration of those who rely on economist's predictions as mathematical forecasting models have shown their failure. To wit: President Lyndon Johnson's exclamation "Will someone get me a one-armed economist!" after tiring of hearing "On one-hand.... Yet on the other hand...." from his economists with their insufficient models and need to hedge their predictions.). von Mises correctly identified that all individuals are independent actors and the effect of addition of money to the money supply would see individuals using it in different ways that could not be predicted - only observed after the fact.
von Mises identified that the pool of funding (loan availability from savings) in a gold standard economy is set by organic growth of the economy through productive enterprise and consequent savings. As a medium of exchange, the money stock in the economy and the associated bank interest rate of money transfers critical information about the state of the economy, self-adjusted economic activity and were thus not to be manipulated.
The Austrian / von Mises model works as follows: in a system with a given money stock, the availability of money through savings in bank accounts sets interest rates according to the laws of market supply and demand. With high consumer spending, bank accounts would be drawn-down and interest rates set by market forces would increase to attract savings so that banks could still provide loans. These higher interest rates would focus industry on activities which would give short-term financial return on the loans by satisfying current consumer and industry demand. As consumer/industry needs were met, demand for goods would slow somewhat and savings would increase thereby lowering interest rates as more money was available for lending. Less costly loans at lower interest rates allow industry to undertake longer-term project which give a return over a longer period.
"When a central bank expands the money stock, it does not enlarge the (real) pool of funds. It gives rise to the consumption of goods, which is not preceded by production (and savings). It leads to less means of sustenance. As long as the pool of funding continues to expand, loose monetary policies give the impression that economic activity is being boosted. That this is not the case becomes apparent as soon as the pool of funding begins to stagnate or shrink. Once this happens, the economy begins its downwards plunge. The most aggressive loosening of money will not reverse the plunge..." 38
Frank Shostak
Under a gold standard monetary system, the availability and cost of money, as the signaling mechanism for self-adjustment of the economy, is continually adjusted by economic activity as a consequence of the decisions of consumers. Because there is no central bank intervention into interest rates and the money supply, the continual self-adjustment of the interest rate and industry and consumer response to these movements results in interest rates tending to be stable and varying little over time. As a result of this continual market driven adjustment of interest rates, economic growth and recessions also tends to be more steady under the gold standard. From 1850 to 1910, the U.S. average economic growth of 1.3% per worker39 per annum which speaks to the relative strength of the economy during this period of industrialization and social upheaval. Compared to the contraction of GDP by nearly 50% during the Great Depression, the gold standard performed in a far superior manner compared to the Federal Reserve's elastic money era which quite literally started with a bang (and will likely end thus).
As a result of this stability, under the gold standard there is little variability between various bond maturities be they 1-year, 2-year, 5-year, or 10-year bonds; because interest rates vary little, bond market speculation over in...