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The Fed's Schizophrenic Monetary Economists

Economics / Economic Theory Oct 07, 2009 - 02:24 AM GMT

By: Gary_North


Diamond Rated - Best Financial Markets Analysis ArticleIf monetary theory is accurate, it is a subset of general economic theory, which must also be accurate. Monetary theory is not an independent theory of human action that is divorced analytically from a general theory of human action.

Only the Austrian School of economics believes this and adheres to it in practice. All other systems of economic thought segregate monetary theory from general economic theory.

There is a reason for this. Bankers for five centuries have benefited from a grant of privilege from the state: a legal privilege. Banks are allowed to write contracts that are prohibited to all other profit-seeking agencies. They are allowed to promise depositors immediate payment, yet they lend the depositors' money to borrowers.

The most detailed study of this grant of legal privilege is Prof. J. H. DeSoto's 900-page masterpiece, Money, Bank Credit, and Economic Cycles. It is easy to read and comprehend; you just have to stick with it. He shows how this violation of contract law has led to inflation, the boom-bust business cycle, and depression. You can download the book for free.

Non-Austrian School free market economists do not challenge this legal arrangement, either in the name of economics (counterfeiting) or law (special privilege). They accept it. They do more than accept it. The applaud it, but in a value-free, totally neutral academic way. They are apologists for this grant of privilege.

They pay an intellectual price for their cheerleading. They cannot conceptually integrate this grant of privilege into their general theory of economic causation, which rests on a concept of private ownership and enforceable contracts. They make no attempt to square the analytical circle. They remain silent about this anomaly. They pretend that their various rival theories of economic causation are coherent. They aren't.


A decentralized free market enables an individual to decide what are the best options for the assets he possesses. This decentralized market transfers responsibility to the individual who owns the assets.

The assumption here is an individual is more careful about allocating the assets he owns than a distant bureaucrat is. This system is sometimes called "consumer sovereignty." I prefer to call it "customer's authority." The customer has money, which is the most marketable commodity. He therefore has economic authority – not legal authority – over the seller of a specialized good or service. The person who has money can spend it almost anywhere. The person who is trying to sell a specialized commodity faces a narrow, limited market. In order to preserve customer's authority, the legal structure should make individuals responsible for setting prices, not distant committees.

In such a private-planning system there is no monopoly. The government does not grant special privilege to anybody in the society. This includes bankers. The same rule of law that applies to the individual must also apply to bankers.

An individual is not allowed to pretend that he owns assets, writing contracts in terms of assets that he does not own. Neither should bankers allowed to do this. But under fractional reserve banking, bankers are allowed to lend money to individuals at a rate of interest. They get money to lend from depositors. Yet the depositors cannot come down the same time and take their money out of the bank. The funds are gone – lent out. The bank is borrowed short and lent long.

This is a violation of contract rights. This is defrauding the depositors. It places extra risk on the depositors, despite the fact that the bankers made a promise that there is no such risk. An individual is not allowed to do this, but a licensed bank is.


Non-Austrian systems of economic thought treat central banks as necessarily autonomous agencies that are necessary to preserve economic growth, price stability, and predictable free markets. Economists promote the idea that a group of bureaucrats, who cannot be fired and who do not own the assets they invest, are the best sources of policy-making regarding the money supply. Economists also promote the idea that a central bank, using information that is not available to individual economic actors, is capable of running an economy so that it will be stable, free, and productive.

The Austrian School denies this outlook. Austrian economic theory rests on a defense of individual responsibility and personal decision-making within the framework of a private property social order. Its members argue that a property-owning decision-maker must be made legally responsible for his actions. This decision-maker is best able to understand what he wants to do with his assets. He has an economic incentive to make wise decisions: profit rather than loss. He also has better information about the conditions facing him locally. He, not some distant committee, is the agent who has the greatest self-interest in seeing to it that he does not waste his assets.

Austrian economic theory defends a system of the private ownership of the means of production. Why? Because this allows acting individuals the legal right to follow their own goals. The concept of private ownership includes the private ownership of money: the most marketable commodity. Austrian economic theory defends a full gold coin standard, because this legal arrangement lodges authority over property in the hands of the individual owner: his coins.

This economic theory insists that the best monetary policy is that policy which results from individual decision-making, based on the pursuit of personal self-interest and legal responsibility. Monetary policy should be set by individual owners of private property, not by a distant bureaucratic committee that has no legal liability for the outcome of its corporate decisions.

Monetary theory should therefore reflect the presuppositions, logic, and evidence that undergird general economic theory. Any attempt to segregate monetary theory from general economic theory is an admission of the failure of the general economic theory. This general theory is not general, because it does not apply to monetary theory.

What is true of monetary theory is also true of monetary policy. Any institutional arrangement that interferes with the individual in his allocation of his assets is an attempt to undermine the freedom of the individual. It also is an attempt to undermine the productivity that is the direct result of personal responsibility and the pursuit of individual self-interest.

This outlook is basic to all free-market economic theory, yet with only the exception of the Austrian School, all schools of economic thought refuse to apply this theory to money and banking. All other schools argue that banks should not be subject to the same laws of private property and contract that prevail in every other area of the free-market economy.

All these systems of economic thought argue for a King's X for bankers. The enforcer of this King's X is the nation's central bank, which in turn has been granted by the national government a monopoly license of authority to control the monetary policy of commercial banks.

Nowhere in introductory economics textbooks do we find an analysis of central banking that is consistent with the chapter on economic cartels. No textbook in money and banking begins with an analysis of the banking system in terms of the economic analysis that applies to a cartel. Yet modern banking is unquestionably a cartel.

When money is controlled by a cartel that uses political power to keep out entrants into the industry, we can be sure that the members of this cartel are acting in their own economic self-interest. They are not acting on the basis of concern for the general public. They are not public-spirited individuals; they are self-interested individuals, just like everybody else.

Here is an example. When members of the school of economic thought called "public choice theory" analyze any government-protected cartel except central banking, they begin by showing how government protection of the cartel leads to higher prices, reduced productivity, and actions in opposition to the public interest. Yet when public choice economists write a chapter on central banking, they abandon their entire system of economic analysis. They speak of central bankers as public-spirited individuals who must be protected from interference by self-interested politicians, because banking is too important to be left to politicians. What banks need is legal independence, they say. What they need is immunity from democracy.

They seem completely oblivious to the fact that they are totally schizophrenic, analytically speaking. This goes on, decade after decade, yet other economists do not point to this inconsistency, precisely because they hold the same position.


Another example of the economists' conceptual schizophrenia is their discussion of falling prices. They accept this for individual goods and services. They reject it for all goods and services.

A standard criticism of a full gold coin standard is that the money supply is constant, or close to it. The critics say that most prices will fall under such an economic regime. The critics are correct. When increasing productivity leads to more goods and services being offered for sale, customers find that producers must compete against each other in order to make a sale. This leads to lower prices, or better economic terms, for whatever it is that is being offered for sale. This is not regarded as a liability by members of the Austrian school of economics.

In all other areas of the economy, free-market economists declare that this is an advantage to customers. But, when applied to the entire economy, what is good for individual customers is seen as being a liability for society in general. Falling prices are now perceived as a liability, not an advantage. While falling prices of individual services and products are hailed as a triumph of consumer sovereignty, falling prices in general are decried as a terrible outcome of a full gold coin standard.

Prices are a way of sending information to buyers and producers. Falling prices convey accurate information regarding recent economic conditions. They tell buyers and sellers that new conditions exist which may require even lower prices to clear the markets. When producers factor in falling future prices, they must discover ways of buying producer goods at today's prices in such a way that they can sell the output of the producer goods at lower prices.

This is what Henry Ford did with the Model T. He constantly lowered the price of the Model T, and in doing so, he increased demand. This increase in demand let him adopt new techniques of mass production. He was then able to purchase raw materials, transportation services, and other factors of production at ever-lower prices. The one thing he did not cut was wages. In 1914, he increased wages in order to gain a steady labor force. Immediately, absenteeism disappeared. Nobody wanted to lose his job at the Ford Motor Company, so everybody showed up at work on time. Nobody quit if he didn't have to. He wanted to keep his job. So, for a system of mass production, Ford cut the cost of production per unit, lowered the price of the model T, and raised the income of workers who showed up on time.

Henry Ford did with his firm what every producer should attempt to do in his own firm. When he does this, greater productivity will result in lower retail prices, and it will also result in lower costs of production. It will produce rising real wages. Workers are the most scarce factor of production. Workers can quit in search of a better job. Employers have to find ways to offer good terms to workers.

This concept of the free market is supposedly hailed by every economist who believes in the free market. Yet, when it comes to monetary theory, they abandon this view of market competition. Only the Austrians are consistent in their defense of falling general prices. Only Austrians see a falling price level as an advantage to individuals and to society in general. Falling prices indicate that things are getting less expensive, which is another way of saying that the economic order is steadily overcoming the effects of scarcity.

Non-Austrian economists insist that the central bank must increase the money supply in order to counteract falling prices. They debate about how much the central bank should inflate, and under what rules. They all deny that the central bank should be closed, the government should not control money, and fractional reserve banking should be made illegal because it is a violation of contract law and therefore fraudulent.


There is a constant criticism of a full gold coin standard that insists that there is not enough gold to run the economy. This outlook is the implication of the outlook that I have previously described. It is an outlook which is hostile to the idea of steadily declining prices as a result of steadily increasing productivity and a relatively fixed money supply. It is an outlook that says prices should be stable, despite the fact that there is an increase in the number of goods and services in the society.

This is a view of economic life that says price stability is a legitimate goal of civil government. This view is conceptually incorrect if individuals are to be allowed authority over their property, including coins. Price stability is no more a special goal of government than price increases or price declines. Prices should rise or fall in terms of two principles: (1) supply and demand; (2) high bid wins.

A rising price level is unlikely under a full gold coin standard. I know of no case in which such a standard has prevailed in which prices generally rose. Of course, the last time such a system was fully in operation was in the Byzantine Empire, from the fourth century to the 15th century. Fractional reserve banking has always reared its ugly inflationary head to compromise a full gold coin standard. But the reality of the West's international gold standard, from 1815 to 1914, was price stability in wholesale and retail goods. In some cases, such as the United States after 1875, prices fell. Yet output continued to increase. This was one of the most productive periods in the history of man, and yet retail prices fell in the United States.


Politicians want to be perceived as providing more money to their constituents. This means more fiat money. They oppose price deflation.

Here is an example. Falling prices tend to produce lower interest rates. If someone lends money at 5% per annum, and the rate of inflation increases to 5% per annum, he has lost money. He will have to pay income taxes on his profits, yet the money that he gets back is worth no more than the money he lent in the first place.

When prices are relatively stable, and he lends at 3%, he makes money on the transaction. He pays income taxes on his 3% return.

When prices are falling by 2% per annum, he can lend money at 1% per annum and come out ahead. He pays taxes only on the 1% return.

Politicians are hostile to the idea of a currency unit that is appreciating in value: falling prices. Because recipients of government money receive more real income from the government than before, the government must steadily cut nominal benefits. This looks as though the government is cutting back on its promised benefits. The public does not understand that this is not really a cut-back in terms of purchasing power.

In the United States, Social Security retirement benefits have a built-in cost-of-living adjustment (COLA). Beneficiaries receive more income next year if prices rise this year, i.e., if the dollar depreciates. But the law does not allow for reduced benefits if prices fall. That would be politically suicidal. So there is no cost-of-living adjustment on the downside. Politicians know how their bread is buttered. It is not buttered by price deflation.

This is why governments will do almost anything to make certain that the price level does not fall. Most governments prefer that the price level rise at 2% to 3% per annum. When this is true, interest rates rise, and they collect more nominal revenues from people who lend money at interest. Politicians want those increased revenues, which they will spend with loud fanfare in the districts back home. So, they want a depreciating currency unit. This is what they get. This is why governments, decade after decade, fail to demand that the central bank bring price increases under control. This is because politicians have no intention of bringing price increases under control. They have a deliberate and self-conscious preference for rising prices, which lead to increased nominal tax revenues and rising nominal payments to voters. "Your government is on your side. Blame higher prices on greedy capitalists."


If wealth is marked by your ability to buy more today than you could buy a decade ago, what does it matter whether you have more money, when prices have fallen in comparison to a decade ago? Your real income has increased. You can buy more goods and services.

To put it more generally, you have an increased number of options for the amount of money that you possess. The amount of money you possess is irrelevant; it is the increase in the options available to you that is important. This is the best definition of increased wealth. You want to be able to increase the number of options that you can make with your assets. If you can increase the number of options available, you have become richer.

The government should not promote higher prices, lower prices, or stable prices. To imagine that the government should pursue a specific goal regarding prices is to imagine that governments should interfere with private decisions of acting individuals. It is the idea that a group of government officials is better able to determine what prices should be than the general public – sellers versus sellers, buyers versus buyers – can produce as a result of their competition.

Once again, we see the idea that a group of government bureaucrats, who possess monopolistic power, are more reliable in setting economic goals for society than are the property owning members of the society. Once again, we see a breakdown of economic analysis. The free market economist tells us that it is good for consumers to be left free to pursue their self-interest. Then they tell us that, in the case of pricing, a government committee, or committee of a central bank that has been licensed by the government, is the proper locus of authority for setting prices in general.

Nobody sets prices in general; prices in general are a statistical phenomenon. Individual prices are set by individual competition.

When a government committee or a central bank committee interferes with pricing, this necessarily mandates a reduction of personal responsibility on the part of property owners. Such interference is promoted by every school economic opinion except the Austrian school. Every other system of economics promotes the idea that a committee in charge of money has the best information available, and therefore has not only the legal right but the responsibility to interfere with individual transactions, so as to affect the general price level.

The means by which the committee is to do this is by increasing or decreasing the monetary base of the central bank: the balance sheet of the central bank. The central bankers buy assets, generally government debt, or sell assets in order to achieve a particular statistical outcome of a statistical phenomenon known as the price level.


When central banks are granted this degree of authority by the government, the result is predictable: rising prices. Central banks are inherently inflationary. This is because fractional reserve banking is inherently inflationary.

A fractional reserve banking system grants a special right or privilege to licensed banks. They can lawfully expand the money supply. Let us say that the central bank buys a million dollars of government bonds. The Treasury deposits this million dollars in its account. Then it writes a check to some agency or business. The recipient bank then lends $900,000 and sends $100,000 to the regional Federal Reserve bank as its legal reserve. Next, the borrower's bank does the same thing. Through the banking system, if there is a 10% legal reserve requirement, $9 million in new money will be generated throughout the banking system. (But not if banks keep excess reserves at the FED.)

This is leveraged counterfeiting. The central bank creates money out of nothing to buy the original asset, and the fractional reserve banking system continues the process of counterfeiting until all of the reserves are exhausted.

The enormous profitability of bank capital comes as a result of the legal authorization of commercial banks to counterfeit money. They lend counterfeit money at interest, and so their profits on capital are higher than any other industry. Their profits are higher because they are counterfeiters.

This is been known in theory since the early 19th century, but no modern society has ever imposed 100% reserve requirements on the banking system. A system of 100% reserves did prevail at one central bank for over a century, that was the central bank of the Netherlands in the 16th and 17th centuries. That bank had 100% reserves. But that model was abandoned with the coming of the Bank of England in 1694. Fractional reserve banking, which is protected by a central bank that has been granted monopoly power by the civil government. This is the model by which all societies are governed today.


Monetary policy today is set by banks that are not governed by the same theory of contracts that binds individuals.

This has led economists to operate in terms of two theories of economic causation: one for banks and another for individuals. Non-Austrian free-market economists offer a theory of economic causation for the market in general; then they abandon this theory when they get to fractional reserve banking and central banking. They offer no developed theory of economic causation regarding money and banking. They do not explain why this methodological schizophrenia does not undermine their general theory, their monetary theory or both.

The great exception was Murray Rothbard, whose textbook on money and banking, The Mystery of Banking, attacks fractional reserve banking as a violation of the laws of property. That book immediately went out of print. I know. My Institute for Christian Economics got the publishing rights from Rothbard. I failed to publish it. So, years later, I gave the rights to the Mises Institute. You can download it for free.

    Gary North [send him mail ] is the author of Mises on Money . Visit . He is also the author of a free 20-volume series, An Economic Commentary on the Bible .

    © 2009 Copyright Gary North / - All Rights Reserved
    Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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