Copyright 2004 - Robert K. Landis


Fiat's Reprieve: Saving the System, 1979-1987

by Bob Landis


Agent K: “Did he say anything to you?”
Officer Edwards: “Yeah, he said the world was coming to an end.”
Agent K: “Did he say when?”
Men in Black (2001)


Reading the pro-gold submissions incorporated in the Report of the U.S. Gold Commission twenty-some years ago is a humbling exercise. A lot of those old commentaries could have been written today. They say just what gold bugs say now: our monetary system is doomed, and its end will be marked by a major monetary crisis. The concluding chapter of the Minority Report (Volume II, Annex A) put it thus:[1]

Should Congress not adopt the recommendations outlined above, we can expect core inflation rates to rise over the next decade, and at an accelerated rate – so that in ten years from now we can expect cheering in the media when the inflation rate falls below 50%. As inflation deepens and accelerates, inflationary expectations will intensify, and prices will begin to spurt ahead faster than the money supply. / It will be at that point that a fateful decision will be made – the same that was made by Rudolf Havenstein and the German Reichsbank in the early 1920’s: whether to stop or greatly slow down the inflation, or to yield to public outcries of a “shortage of money” or a “liquidity crunch” (as business called it in the mini-recession of 1966). / In the latter case, the central bank will promise business or the public that it will issue enough money to enable the money supply to “catch up” with prices. When that fateful event occurs, as it did in Germany in the early 1920’s, prices and money could spiral upward to infinity and it could cost $10 billion to buy a loaf of bread. America could experience the veritable holocaust of runaway inflation, a cataclysm which would make the Depression of the 1930’s – let alone an ordinary recession – seem like a tea party.

Ahem. To state the obvious, the gold bugs of a generation ago got it wrong. Congress did not adopt their sound money recommendations, and yet the sky did not fall, the paper-based system muddled through famously, and in fact it was gold that entered into a 20 year bear market in dollar terms.

Left unaddressed, this bad call makes it easy to dismiss the balance of the Minority Report as similarly flawed or at best irrelevant. Moreover, it implicitly impeaches the credibility of all sound money advocates even today. After all, why should anyone pay attention to a bunch of Chicken Littles who’ve been demonstrably wrong for a generation? So it behooves us to address this question, and examine why we didn’t slip into terminal monetary crisis, as predicted, back in the 1980’s.

Our inquiry will take us through jargon-infested waters, so we will take pains to define our terms. We write as gold bugs, but we will also be guided by the teachings of the great Austrian economists, principally Ludwig von Mises and Murray N. Rothbard.

Anatomy of a Hoax

For the naïve mind there is something miraculous in the issuance of fiat money. A magic word spoken by the government creates out of nothing a thing which can be exchanged against any merchandise a man would like to get. How pale is the art of sorcerers, witches, and conjurors when compared with that of the government’s Treasury Department![2]

To understand how our monetary system was rescued, we first need to get clear on what that system is.[3] This is not as easy as it should be. That’s because in substance it’s just a government printing press, of the type reflected in the foregoing quote from Mises. But in form it’s a holdover from an earlier time when we had a “fractional reserve” banking system with gold as the reserve asset. The structure and terminology of our current system only make sense in their original context, where, for all the many problems associated with fractional reserve banking, there was at least something real at the heart of it. Given the disconnect between form and substance in our current system, the enormous confusion that now attends the subject, even on the part of knowledgeable people, is perfectly understandable. But it makes a brief review of Fed 101 essential to making sense of what happened in the 1980’s.

The creation of our fiat money, that is, money issued by decree, or “fiat”, occurs in two phases. Phase I is controlled by the Fed, which does two things. First, it sets the level of non interest-bearing “reserves” that banks are required to hold, expressed as a percentage of their checking deposit base. That percentage is known as the “reserve ratio”. Adjusting this ratio up or down has a massive contractionary or expansionary impact on the money supply, given the multiplier effect described below, and for that reason it has been left alone for years at a marginal rate of 10%. Banks must maintain these reserves either in the form of Federal Reserve Notes kept on hand (“vault cash”), or in the form of balances held in an account at a Federal Reserve Bank (“reserve balances”).

Second, the Fed creates the reserves, and injects them into the banking system. This is where the gulf between form and substance is most telling, causing reasonable people to marvel at the brazenness of it all. The Fed creates reserves out of thin air, in the form of fresh paper notes (“Federal Reserve Notes” or “dollars”) that it prints up, or in the form of checks written on itself. It can inject reserves into the banking system in two ways. One way is to lend them to specific banks, at a rate of interest known as the “discount rate.” Reserves borrowed in this fashion are called, logically enough, “borrowed reserves.” This used to be an important tool of monetary policy, but is rarely used today.

The other way is to buy things, and pay for them with cash or credit. This is the primary tool today. Whatever the Fed buys, or “monetizes”, goes on its balance sheet as an asset. Whatever it spends, goes on the Fed’s balance sheet as a liability, but becomes a reserve asset on the books of the vendor, or on the books of the vendor’s bank, if the vendor itself is not a bank. These transactions occur either through outright purchases and sales, which have a relatively long-term impact on the level of reserves in the system, or, more commonly, through temporary arrangements known as repurchase agreements, most of which unwind quickly. The Fed buys things only from a select group of friendly finance contractors, now 22 in number, known collectively as “primary dealers.”[4] Some of these primary dealers are banks themselves; the rest operate through other member banks. Reserves created by means of these purchase and sale transactions are known as “non-borrowed reserves.”

Once the Fed has bought something and paid for it with “reserves” thus created out of thin air, Phase II kicks in. Phase II is controlled by the banks and the banks’ customers in what remains in form, despite the ethereal quality of it all, a fractional reserve banking system. The new reserve asset, which the vendor bank received in payment from the Fed, gives the bank the power to begin a process of creating more new money. The aggregate amount of new money that can be created is a multiple of the new reserve asset, equal to the reciprocal of the marginal reserve ratio, today, 10.

To illustrate this process, Rothbard walks us through it, step by step.[5] Say the Fed buys an asset for $10 from Big Bank One. That $10 will support another $100 of fresh money in the banking system in the form of new customer deposit accounts. But the new $100 doesn’t materialize all at once, or on the books of Big Bank One alone. Instead, it comes into being as the result of a gradual series of loan transactions that Big Bank One sets in motion. In what Rothbard calls a “ripple effect”, Big Bank One lends out a portion of the $10, namely $9, (1 minus the reserve requirement, or .9, times $10). That $9 ultimately gets deposited at Big Bank Two, which is the second stop in the series. Big Bank Two lends out .9 times the $9, or $8.10, and so forth, throughout the series. At the end of the series, the total new money thus created in the form of fresh deposit accounts is roughly equal to $100. Thus is our money borrowed into existence.

The same process works in reverse if the Fed, instead of buying something, sells it. This has the effect of draining reserves from the banking system, and will result in a similarly high powered contraction of the money supply.

The Fed buys things from, and sells things to, its primary dealers in what are known as “open market” transactions, so called because the Fed is operating outside its cloistered walls in the open market. The contact point is a trading desk set up in the Federal Reserve Bank of New York, one of the 12 regional Fed branches. The Desk is daily in the market for U.S. Treasury securities, which comprises one of the deepest and most liquid markets in the world, with average daily turnover in the hundreds of billions of dollars. It does so in order to implement the monetary policy adopted by the “Fed Open Market Committee” (the “FOMC”) in its monthly meetings, now followed breathlessly, often without the slightest comprehension, by a host of commentators.

The way Open Market Operations work is at root quite simple. The Desk and the primary dealers maintain a market in reserves, the so called “Fed funds market.” To increase the supply of reserves in the banking system, the Desk will buy Treasuries from the primary dealers, on either a short or a longer term basis, thereby putting fresh cash in their pockets. If the supply of fresh reserves on offer from the Fed exceeds the system’s demand, as reflected in the primary dealers’ appetite, the price of those reserves, the so-called “Fed funds rate”, will tend to go down. Conversely, to decrease reserves in the banking system, the Desk will in effect bid for reserves by offering securities from its portfolio. This requires the buying primary dealers to cough up cash, thereby draining reserves. If the Fed’s demand for reserves from the primary dealers exceeds the supply available, the price of reserves, the Fed funds rate, will tend to go up.

Note that these simple hydraulics give the Fed only two things it can focus on in implementing monetary policy. It can focus on the quantity of reserves in the system. Or, it can focus on the price of those reserves, the Fed funds rate. That’s it. If it focuses on quantity, it will pick a level of reserves it’s happy with and stick with it, regardless of ebb and flow of demand from within the system. If it focuses on price, it will be darting in and out of the market with countless transactions at the margin designed to keep the Fed funds rate, rather than the quantity of reserves in the system, at a desired level.

As to the quantity of money out in the system, the Fed has direct control over just one thing: the “monetary base”, or “base money.” This is the sum of Federal Reserve Notes outstanding and reserve balances, that is, member bank reserve-deposits at Fed banks. The power to create base money is limited. It does not extend to the many other permutations of paper that make up the alphabet soup of the so-called monetary aggregates, the Ms we hear so much about:[6]

M1, which consists of currency, travelers checks, demand deposits and other checkable deposits;

M2, which consists of M1 plus savings deposits (including money market deposit accounts) and small denomination (under $100,000) time deposits issued by financial institutions; and shares in retail money market mutual funds (funds with initial investments under $50,000), net of retirement accounts;

M3, which consists of M2 plus large-denomination ($100,000 or more) time deposits; repurchase agreements issued by depository institutions; Eurodollar deposits, specifically, dollar-denominated deposits due to nonbank U.S. addresses held at foreign offices of U.S. banks worldwide and all banking offices in Canada and the United Kingdom; and institutional money market mutual funds (funds with initial investments of $50,000 or more); and the most recent (and arguably the trendiest) entry,

MZM (Money, Zero Maturity), which consists of M2 minus small-denomination time deposits, plus institutional money market funds (that is, those included in M3 but excluded from M2).

The Fed’s control over the monetary aggregates declines as the subscript numbers get bigger. M3, for example, includes institutional money market funds with a $50,000 minimum investment. This element of “broad money” is totally outside the Fed’s purview. No reserves need be posted against any money market funds, let alone those held by big institutions. Technically, such funds should not be considered fiat “money” at all, as they are not immediately convertible into cash. Nevertheless, they are a prominent component in a monetary aggregate that is closely identified with Fed policy. Even M1, the narrowest monetary aggregate, consists principally of things not subject to the Fed’s direct control. So when you read breathless Internet commentary that claims the Fed is ramping up, or chopping, M3, you know you are in the presence of a misunderstanding.

As to the price of money in the system, we see that the Fed can directly influence the Fed funds rate through its open market operations. But this is just overnight money. How does the Fed funds rate actually influence the price of money farther out on the yield curve? According to the Fed’s website, it just does: it “triggers events”:

Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.

Right. Actually, Fed economists and others have written a lot over the years analyzing the relationship among the various interest rates in terms of concepts such as the “Liquidity Effect”, the “Fisher Effect”, etc.[7] To those of the Austrian persuasion, these sorts of complex ratios and formulas are presumptively bogus. The real answer is that somebody has to buy or sell longer dated securities farther out on the curve in order to bring those other rates into line. If the market won’t do it, the Fed has to, directly or indirectly. Of late, the Asian central banks have acted as enforcers, freeing the Fed from the need to bulk up its or its agent banks’ balance sheets.[8] We will see below, in our discussion of interest rates under the Volcker Fed, how divergent even short term rates can get when neither the Fed nor its proxies perform this function.

From a technical standpoint, the Achilles’ heel of the fiat money creation mechanism is its dependence, in Phase II, on human action outside the Fed’s control. This is the downside of keeping the old pre-fiat form in place. The Fed can force reserves into the system, because if primary dealers don’t play they don’t stay primary dealers. And the dealers (or their banks, as the case may be) have an economic incentive to put reserves so injected to work, because reserves don’t pay interest, and thus “excess reserves”, or reserves over the minimum required, are undesirable. But it is still the case that once inside the system, reserves need to be needed. Banks have to want to lend, and people have to want to borrow, before the reserves can work their way through the system and become money. The system is like a shark that has to keep moving, or it dies. If the Fed sets the table and nobody shows up, it gets a deflationary contraction that it cannot influence, let alone control. This is what the Fed confronted in everybody’s favorite oxymoron, the Great Depression, when, as Rothbard put it:[9]

The Fed tried frantically to inflate after the 1929 crash, including massive open market purchases and heavy loans to banks. These attempts succeeded in driving interest rates down, but they foundered on the rock of massive distrust of the banks. Furthermore, bank fears of runs as well as bankruptcies by their borrowers led them to pile up excess reserves in a manner not seen before or since the 1930s.

Seventy years later, despite the massive substantive change that’s occurred since then, this remains the Fed’s nightmare scenario. The more recent experience in Japan following the collapse of its bubble is a subject of intense scrutiny and dread at today’s Fed.[10] That’s why Fed officials spend so much time giving speeches telling us they’re in charge and everything’s okay so go ahead and borrow (create) money. Please.

But speeches and spin only go so far. How do you get people to borrow money into existence if they don’t feel like it? The same way you get people to take anything off your hands: you price it to sell. Here it is helpful to consider the nebulous concept of “real” interest rates, as opposed to “nominal” interest rates.[11]

The theoretical concept is often roughly approximated as a market, or nominal, rate less the expected rate of inflation, and sometimes—after the fact—the real rate is crudely calculated by subtracting the actual rate of inflation from the prevailing nominal rate of interest, or market yield. More sophisticated modelers of expectations usually assume that expected future rates of inflation are formed by current and/or recent past inflation rates. There is thus no real rate of interest to be discovered, there are merely a variety of attempts approximately to measure it.

If the Fed wants to induce money creation in Phase II that it thinks would otherwise not occur, it can offer money at negative real rates, by setting the Fed funds rate below inflation expectations. This is in fact what it is doing now. At 1.5%, the Fed funds rate is well below inflation expectations. Consequently, people are literally being paid to create money.

But what if people get full, and won’t borrow even if they’re paid to do so? We quote Fed Governor Ben Bernanke, who has publicly articulated the issue:[12]

Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition"--that is, it no longer has the power to expand aggregate demand and hence economic activity. It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory.

The Fed’s solution? Simple, says Governor Bernanke. We’ll just slip into something a little more comfortable, and let our inner self shine through. No more reliance on pesky human action (id.):

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

The disconnect between form and substance in the system’s architecture is rivaled by the disconnect between means and ends in the Fed’s mission.

With only the crude hydraulics of a fractional reserve system ostensibly at its command, the Fed is charged, not with maintaining a stable monetary unit, a defensible goal for a central bank that would be difficult enough (indeed, historically unprecedented) for a fiat currency, but rather with achieving “maximum employment, sustainable economic growth, and price stability.”[13] Its mission is thus preposterous. But instead of owning up to the limitations inherent in the Fed’s architecture, its officials always play along, pretending to be all knowing and all powerful. This puts them under rather severe pressure, and inevitably leads, we submit, to cheating – undisclosed market intervention in furtherance of otherwise unattainable policy objectives. But we get ahead of ourselves.

So now, having completed our little refresher course in fiat money, we can turn to consider what happened to save the system in the early 1980’s.

That Eighties Show

Looking back at the monetary world of 1980 is rather like viewing a Currier & Ives print. It was a simpler time. The ongoing experiment in fiat money and “managed currencies” was only nine years old. The global monetary system was limited in geographic scope: the Soviet empire was still a closed system cut off from the West, and China had not yet begun to recover from its destructive internal upheavals. A plausible contender for the role of competing reserve currency was scarcely a gleam in daddy’s eye.

The U.S. domestic financial system was itself a relic of the Bretton Woods era. Commercial banks, still separated from investment banks and still performing traditional banking functions like lending and intermediation of private savings, were the principal financial institutions. The Government Sponsored Entities that today function as sectoral central banks, Fannie Mae and Freddy Mac, were mere striplings. Fannie Mae’s first purchase of a mortgage-backed security was still a year away. The system was tightly regulated: interest rates paid by financial institutions were capped, and only certain financial institutions were permitted to pay interest at all.

Financial technology was primitive. Spreadsheets were still done by hand inside the Wall Street banks, and Vydec still vied with Wang in the steno pools in the major law firms. Andy Krieger, the young derivatives trader dubbed “Patient Zero” who in 1987 would single-handedly short “the entire money supply of New Zealand,” was still studying South Asian philosophy.[14] Global OTC derivatives, had they been tracked back then by the Bank for International Settlements, would have had an aggregate notional amount of near zero.

The United States was a creditor, not a debtor. The world’s largest, in fact. The term “carry trade” had not been invented, and the Fed would not succeed in turning the United States into “The Greenspan Nation”[15] and the world into a “gigantic hedge fund”[16] for another 24 years.

But for all its quaintness in today’s terms, the monetary world of 1980 was in grave danger.

The Second Stage of Inflation

Inflation, wrote Mises early in his career, is a monetary expansion that results in a decline in the exchange value of money:[17]

In theoretical investigation there is only one meaning that can rationally be attached to the expression inflation: an increase in the quantity of money (in the broadest sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange value of money must occur.

Later, writing at the height of the German inflation, Mises described how inflationary psychology creates a decreased demand for money. This decreased demand is reflected in higher turnover of money, as people hasten to get out of cash and into something else. This is probably the closest he ever came to embracing a concept of velocity:[18]

…as the monetary depreciation progresses, it is evident that the demand for money, that is for the monetary units already in existence, begins to decline. If the loss a person suffers becomes greater the longer he holds on to money, he will try to keep his cash holding as low as possible. The desire of every individual for cash no longer remains as strong as it was before the start of the inflation, even if his situation may not have otherwise changed. As a result, the demand for money throughout the entire economy, which can be nothing more than the sum of the demands for money on the part of all individuals in the economy, goes down.

And some thirty years after that, he described the three main stages of inflation in a homely metaphor:[19]

Inflation works as long as the housewife thinks: “I need a new frying pan badly. But prices are too high today; I shall wait until they drop again.” It comes to an abrupt end when people discover that the inflation will continue, that it causes the rise in prices, and that therefore prices will skyrocket infinitely. The critical stage begins when the housewife thinks: “I don’t need a new frying pan today; I may need one in a year or two. But I’ll buy it today because it will be much more expensive later.” Then the catastrophic end of the inflation is close. In its last stage the housewife thinks: “I don’t need another table; I shall never need one. But it’s wiser to buy a table than keep these scraps of paper that the government calls money, one minute longer.”

By the end of the 1970’s, we had reached stage two. The Appendix to the Minority Report contains a number of charts and tables that graphically depict the gravity of the situation as seen by contemporary observers. We reproduce a few below for ease of reference.

The Consumer Price Index had reached worrying levels.

Source: Minority Report Appendix, Chart 3

Today, the CPI has lost credibility among knowledgeable observers due to results-oriented adjustments of its components in defiance of the reality of everyday experience.[20] At the time of the Gold Commission, however, such measures had not yet fallen into disrepute. Even Austrian economists conceded that for all their inherent flaws, price indexes contributed to inflationary psychology:[21]

The index-numbering method is a very crude and imperfect means of “measuring” changes occurring in the monetary unit’s purchasing power. As there are in the field of social affairs no constant relations between magnitudes, no measurement is possible and economics can never become quantitative. But the index-number method, notwithstanding its inadequacy, plays an important role in the process which in the course of an inflationary movement makes the people inflation-conscious.

People were indeed becoming inflation-conscious. Contracts routinely contained inflation adjustment clauses, and housewives were beginning to buy that frying pan sooner rather than later.

The bounty needed to induce people to hold dollar-denominated assets was skyrocketing, at both ends of the yield curve. Long term nominal interest rates were stratospheric, reflecting utter destruction in the bond market.

Source: Minority Report Appendix, Chart 9

Short term rates were climbing too.

Source: Minority Report Appendix, Chart 5

It did not help matters that real interest rates, given the high price inflation, were actually low or negative for much of the 1970’s. Rates were still shocking, and the high rates were emblematic of systemic distress.

Ominously, the fiat monetary system had already lost several pitched battles in its war with gold. Lacking today’s price management technology, the U.S. and European monetary authorities had been forced to attempt to quell the gold price by means of open sales of physical metal throughout the preceding 18 years. The London Gold Pool of the 1960’s had broken down in abject failure in March 1968, leading to the abrogation of the Bretton Woods gold exchange monetary system three years later. The U.S. Treasury gold sales of the 1970’s ended in 1979, and the last of the parallel sales by the International Monetary Fund occurred on May 7, 1980.

Like interest rates, and despite the best efforts of the monetary authorities, the gold price was soaring, hitting $850 in the afternoon London fix on January 15, 1980. The false premise at the core of the fiat monetary system, the conceit that paper printed by a government bureau is money and that gold is not, was being exposed for all to see.

Source: Minority Report Appendix, Chart 1

Public confidence, the essential support for fiat money, was at risk. The memory of gold as money had not yet been fully extinguished, as reflected in the very fact that shortly thereafter a Congressional Commission was established to study the issue. Moreover, the next President of the United States, who had popularized the term “misery index” during the election campaign, was himself a closet gold bug:[22]

Like the supply siders in congress, Reagan privately advocated restoration of the gold standard as the ultimate way of guaranteeing stable money. “You can’t control inflation as long as you have fiat money,” he told his aides. The President’s attachment to gold was almost never mentioned in public, however. His political advisers feared that it would sound “kooky” and “old-fashioned” to voters.

The very structure of the system was eroding. Membership in the Federal Reserve System was at that time elective for banks operating under state, rather than federal charters. Fed membership was expensive: member banks had to comply with the reserve ratio, and tie up funds in reserve assets that paid no interest. So new banks were being formed under state statutes, and existing members were quitting the Federal Reserve System altogether, switching their charters from federal to state and opting out of the Fed’s burdensome regulatory scheme.[23] The power of the central bank, the linchpin of the fiat monetary system, was waning.

Something had to be done. There was still time to avert a stage three inflation, but there was no time to lose.

The Making of a Legend: Volcker the Monetarist

On August 6, 1979, Paul Adolph Volcker, a tall, cigar-smoking ascetic, had become Chairman of the Fed, replacing mid-term the hapless G. William Miller. In Volcker, one of its original architects, the fiat monetary system had finally found the perfect champion:[24]

Volcker was a public servant who had served the government in both capitals, Washington and Wall Street. He was a policy maker under four Republican and Democratic Presidents and had spent years on Capitol Hill fencing with congressional committees and lobbying for votes. He was in Treasury when John F. Kennedy proposed the stimulative tax cuts of the early 1960s and when Lyndon Johnson launched the U.S. war in Indochina. Under Nixon, he worked closely with Treasury Secretary John Connally, an urbane Texas politician who frequently complained about Volcker’s dowdy appearance. (Connally once threatened to fire him if Volcker did not get a haircut and buy a new suit.) / Together, Connally and Volcker engineered the most fundamental change in the world’s monetary system since World War II – the dismantling of the Bretton Woods agreement that had made the U.S. dollar the stable bench mark for all currencies.

Actually, the foregoing passage likely understates Volcker’s role in killing Bretton Woods, as his boss, the only U.S. Treasury Secretary ever to declare personal bankruptcy, was not noted for his mastery of monetary arcana.

According to legend, once installed as Chairman, Volcker quickly sized up the situation and reoriented monetary policy to focus on the quantity of money, rather than its price. This famous policy shift was announced to the world in the October 6 Record of Policy Actions of the FOMC, which heralded:[25]

...a shift in the conduct of open market operations to an approach placing emphasis on supplying the volume of bank reserves estimated to be consistent with the desired rates of growth in monetary aggregates, while permitting much greater fluctuations in the federal funds rate than before.

As the Fed’s primer puts it:[26]

The reserve targeting procedure from 1979 to 1982 gradually came to provide assurance to financial markets and the public at large that the Federal Reserve would not underwrite a continuation of high and accelerating inflation. Reinforcing this procedure’s built-in effects on money market conditions were judgmental changes in nonborrowed reserve objectives and in the discount rate. Monetary policy contributed importantly to lowering the inflation rate sharply, albeit not without a significant increase in interest rate volatility and a period of marked decline in output.

It is easy to see why it is in the interest of the Fed to embrace the Volcker legend. For its moral is that the all-knowing, all-seeing Fed, reluctantly but sternly facing down a crisis, did what it had to do to kill inflation. It had the power, it had the knowledge, and, with the right person in charge, it had the will. If things ever get out of hand again – not that they’d ever tolerate that, mind you – they’d do the same thing, and whip inflation’s sorry backside once more.

Volcker’s monetary policy was dubbed “monetarism” by a media unschooled in monetary theory. True monetarists, like Keynsians, accept the legitimacy of a fiat monetary system. But unlike Keynsians, they believe there must be a strict, rule-based method of gradually and consistently increasing the money supply, in contradistinction to the herky-jerky instincts of the modern Fed. The Gold Commission contained a number of monetarists, and their influence is evident in the Majority Report. But the Fed’s monetary statistics plainly show that while Chairman Volcker was no doubt many things, a monetarist he was not.

The Quantity of Money under the Volcker Fed

Consistent with legend, the Volcker Fed during its so-called monetarist period was indeed rather stingy with the supply of non-borrowed reserves to the system.

Source: Federal Reserve

It should be noted, however, that even during its stingy phase, the Volcker Fed made sure to enhance the system’s back door access to borrowed reserves, just in case. It did this by means of discount rates that were generally set at significantly lower levels than Fed funds rates. See table entitled “Key Interest Rates during the Volcker Fed” in the following section.

In any event, the stinginess was short-lived. Things changed dramatically in July 1982. From that point on, the Fed put the hammer to the floor and inaugurated what would become its standard response thereafter to any perceived systemic threat: extremely aggressive monetary expansion. The specific catalyst for this was the failure on July 6, 1982, of a “reckless little bank in Oklahoma” known as Penn Square.[27] Penn Square’s paper was widely held by a number of important money center banks whose failure in turn was not an attractive prospect to the monetary authorities. A more general catalyst was the imminent sovereign default of Mexico.

Over the next five years, non-borrowed reserves (“NBR”) expanded at a heroic rate, roughly doubling the levels at the beginning of the Volcker Fed. By way of comparison, over the eight year period commencing August 1971, that is to say, during the inflationary hurricane preceding Volcker, Seasonally Adjusted NBR only increased from 14,380 to 18,923, and Not Seasonally Adjusted NBR only increased from 14,094 to 18,612. By way of further comparison, over the eight year period commencing August 1987, that is to say, during the warmup phase of the Greenspan Fed, Seasonally Adjusted NBR only increased from 38,651 to 57,326, and Not Seasonally Adjusted NBR only increased 38,412 to 56,655. The Maestro, no slouch himself in the monetary reserve creation department, was a piker in comparison to post-Penn Square Volcker.

The vaunted monetary aggregates followed suit. As with the reserve levels themselves, in the pre-Penn Square period, the increases in the money stock, while hardly hairshirt material, were modest in comparison to the carnival that followed.

Source: Federal Reserve

The Monetary Base under the Volcker Fed

An important plank in the monetarist critique of the Volcker Fed is the erratic behavior of the monetary base, the only monetary aggregate that the Fed can directly control. The basic charge is that rather than focus on what it could control, the Volcker Fed focused on what it couldn’t, namely the other monetary aggregates. The following table shows the rate of increase in the monetary base for the periods indicated. By comparison, the rate of change in the monetary base in the year leading up to Volcker’s appointment was 7.2%.

Source: Monetary Trends, Federal Reserve Bank of St. Louis, September 1983, cited in Richard Timberlake, Monetary Policy in the United States (University of Chicago Press, 1993), p. 359.

Indeed, Richard Timberlake marshals the foregoing data to support his charge that Volcker’s Fed, far from being monetarist in its policies, was just another Fed, ramping up the money supply to aid an incumbent president in an election year, and choking back once the results were in.[29]

Prior to the presidential election of 1980, Fed policy had been highly stimulative in the face of manifest inflation. This experience, as well as the Fed’s performance in earlier presidential elections, inspired observers to rename the FOMC the “Committee to Reelect the President.” The Record of Policy Actions of the FOMC never mentioned the retention of the incumbent president as a “goal” of policy. Nonetheless, most of the Reserve Board members in any given election year owed their appointments to the incumbent and had every incentive to “play ball.” The Fed’s performances just before, during, and just after elections in 1960, 1964, 1968, 1972, 1976, and 1980 seemed to be clearcut examples of a pattern that was restrictive and then stimulative during the year before the election, and then usually restrictive enough to slow down the inflationary reaction after the election.

And the wide swings in the monetary base were clearly inconsistent with monetarist doctrine, which prescribed “a gentle and systematic reduction in the rate of increase in the monetary base until the growth rates of the money stocks, observed as indicators, came down to noninflationary values.”[30]

Having said that, in fairness it is not clear that what was happening to the monetary base was entirely within the Fed’s control. The problem is that, as Rothbard points out,[31] the two constituents of the monetary base, cash and reserves, move in opposite directions. That is, cash in circulation represents reduced reserves: once outside the banks, it no longer counts as a reserve asset, and loses its multiplier. If people decide to pull money out of their bank accounts and hold it in the form of cash as opposed to leaving it in the form of abstract deposits on the banks’ books, this depletes reserves, turning high powered money into chump change and initiating a rippling contractionary process. So adjustments must be made at the bank: aggregate deposits must shrink or reserves must be replenished through Open Market Operations. The contradictions inherent in our fiat money, the spawn of a beast with the brain of a printing press and the body of a fractional reserve banking system, are not to be reconciled simply by focusing on the “right” monetary aggregate.

The Price of Money under the Volcker Fed

For all the talk of quantity, under the Volcker Fed the real action was in price. The Fed essentially stood aside and let short rates rip; the monetarist mumbo jumbo provided intellectual cover:[32]

Throughout Volcker’s anti-inflation campaign, the nation was instructed by the Fed to watch M-1 and the monetary aggregates as the correct gauge of its monetary policy. But the monetary numbers zig-zagged up and down in a bewildering manner that confused even the economists. The public and the politicians would have had a far more accurate sense of what was happening if they had ignored M-1 and simply followed interest rates and their relative levels. Except for two brief periods in the summer months of 1980 and the last quarter of 1981, the Federal Reserve had succeeded in holding most short-term interest rates above long-term rates for an extraordinary length of time – two and one half years. This abnormality explained things far more reliably than what was happening to M-1 growth or the other aggregates.

Interestingly, the average annual Fed funds rate was actually higher than the one year Treasury rate throughout Volcker’s tenure. Take note, convergence theorists.

Source: Federal Reserve

The Demand for Money under the Volcker Fed

But more important than changes in the supply or even in the price of money under the Volcker Fed was a pronounced increase in the demand for money.

Volcker himself, sounding like an Austrian economist, put his finger on the demand issue in 1983: “Individuals and businesses apparently desired to hold more money than usual relative to incomes.”[33]

This increase in demand left tracks in statistics generated by a mainstream mathematical formula known as velocity. Velocity is a term used to express the concept of turnover of units of money in relation to broader measures of economic activity, like GNP. As such, it is one of those equations without meaning for Austrian economists. Indeed, Mises specifically rejected velocity as a top-down explanatory formula:[34]

The mathematical economists refuse to start from the various individuals’ demand for and supply of money. They introduce instead the spurious notion of velocity of circulation fashioned according to the patterns of mechanics.

Mises grudgingly acknowledged the possibility of using velocity as a record of bottom-up behavior, however:[35]

If there is any sense in such notions as volume of trade and velocity of circulation, then they refer to the resultant of the individuals' actions. It is not permissible to resort to these notions in order to explain the actions of the individuals.

We propose to seize that opening. The following table shows how, after increasing steadily for 35 years, velocity of M1 suddenly fell off a cliff.

Source: Courtney C. Stone and Daniel L. Thornton, Solving the 1980s’ Velocity Puzzle: A Progress Report (Federal Reserve Bank of St. Louis, August/September 1987)

What the Fed’s chart appears to signify is that instead of trying to get rid of their depreciating cash, people were holding on to it. This behavior is the exact opposite of that associated with inflation, and the Fed’s chart, viewed merely as an historical record, neatly captures the breaking of the fever. It doesn’t explain why the housewife was no longer so anxious to swap out of her cash to get that frying pan, it just reflects the fact that this was happening.

Back in 1914, Mises defined deflation as the converse of inflation:[36]

Again, deflation (or restriction, or contraction) signifies a diminution of the quantity of money (in the broader sense) which is not offset by a corresponding diminution of the demand for money (in the broader sense), so that an increase in the objective exchange value of money must occur.

This definition does not appear to encompass a demand-driven deflation occurring within the context of a credit expansion, that is, a situation in which an increase in the quantity of money is insufficient to satisfy a disproportionate increase in the demand for money. So it is with some trepidation that we observe that such a micro-deflation is precisely what appears to have occurred under the Volcker Fed. The associated decline in the rate of increase in price levels is what mainstream economists refer to when they use the term “disinflation.”

The resultant increase in the objective exchange value of money found expression in a steep decline in the rate of increase in prices tracked by the various indexes.

Source: Federal Reserve Bank of St. Louis

The increased demand for money was also reflected in a marked increase in its price in real terms. Notwithstanding the decline in nominal rates under the Volcker Fed as shown in a previous table, real interest rates reached levels seen only once before in the Twentieth Century, during the Great Depression. [37]

Auf Wiedersehen, Inflation

A similar decline in velocity had marked the monetary stabilization that followed the storied German inflation some 60 years earlier. This was the catastrophic, stage three inflation mentioned in the initial excerpt from the Minority Report.

Costatino Bresciani-Turroni, a first hand observer of the German inflation who later wrote the definitive treatment of the subject, describes what Austrian economists refer to as the “crack-up boom” that was unfolding by August 1923:[38]

In the autumn of 1923 the monetary situation was as follows: There was a great quantity of paper marks, whose nominal value increased at a fantastic rate, but which in reality, despite the great increase in the velocity of the circulation, were sufficient only for a part of the transactions in German internal business. In the total circulation legal money now only played a secondary part, and the need of a circulating medium was largely satisfied by “emergency” means of payment, or by illegal currencies.

The reduced role of the legal issue created the necessary conditions for monetary reform, a process that took place roughly from August through November 1923. The reform involved the introduction of new types of money. These were all conjuror’s tricks, unbacked paper experiments issued in great quantity and announced with great fanfare as “money with a stable value.” The first of the new money issued was in the form of “Gold Treasury Bonds” and notes backed by a “Gold Loan”, issued principally at the provincial and town level. Bresciani-Turroni describes them thus:[39]

It is unnecessary to state that the guarantee of the so-called “money with a stable value” was purely fictitious. Actually the Gold Loan and the Gold Treasury Bonds were mere paper without any cover. / Indeed, the law of August 14th, 1923, on the Gold Loan of 500 million gold marks, contained only this limited promise: “In order to guarantee the payment of interest and the redemption of the loan of 500 million gold marks, the Government of the Reich is authorized, if the ordinary receipts do not provide sufficient cover, to raise supplements to the tax on capital, in accordance with detailed regulations to be determined later.” These vague words constituted the entire guarantee behind the Gold Loan! Nevertheless, the Gold Loan Bonds and the notes issued against the Gold Loan deposits did not depreciate in value. The public allowed itself to be hypnotized by the word “wertbestandig” (Stable-value) written on the new paper money. And the public accordingly accepted and hoarded these notes (the Gold Loan Bonds almost disappeared from circulation) even whilst it rejected the old paper mark—preferring not to trade rather than receive a currency in which it had lost all faith.

The most famous of these expedients was the Rentenmark, which was authorized in October and introduced into circulation in November 1923. Its introduction was not accompanied by the recall of any of the existing legal money in circulation, and its enabling decree expressly authorized issuance in the amount of 2.4 billion, or approximately ten times the aggregate real value of legal money then in circulation. Despite this, and largely for psychological reasons, it was a smashing success:[40]

In October and in the first half of November lack of confidence in the German legal currency was such that, as Luther wrote, “any piece of paper, however problematical its guarantee, on which was written ‘constant value’ was accepted more willingly than the paper mark.” If the Government had been able to suspend the issues of paper money for the State, probably confidence in the mark would have revived, as had happened in the case of the Austrian crown, and as occurred later with the Hungarian crown. But think what would have been the psychological effect of the Government announcing that it would issue more paper marks to about ten times the value of the total amount of paper circulating on November 15th, 1923! No one would have had any faith in the promise of the Government that later the issues would be stopped. The precipitous depreciation of the paper mark would have continued. But on the basis of the simple fact that the new paper money had a different name from the old, the public thought it was something different from the paper mark, believed in the efficacy of the mortgage guarantee and had confidence. The new money was accepted, despite the fact it was an inconvertible paper currency. It was held and not spent rapidly, as had happened in the last months with the paper mark.

Bresciani-Turroni explicitly describes the success of the Rentenmark in terms of lower velocity:[41]

It is not difficult to explain why the monetary reform had been accompanied not by a contraction but by an actual increase in the quantity of legal money in circulation. The lack of confidence in the paper mark being lessened, consumers, producers, and merchants ceased to be pre-occupied with the necessity of reducing their holdings of paper marks to the minimum. In other words, the velocity of circulation of paper marks declined. That helped to create the need for a new circulating medium, so that new paper marks could be issued within the limits of this need, without imperiling the stability of the exchange. [Emphasis in original.]

In the United States of the early 1980’s, the earlier stage inflation had not run its course to currency collapse. No new currency had been introduced. No grand plan had been implemented. The fiat monetary spigots were opened wide after a few short years of relative restraint, and the Fed explicitly repudiated its “tight money” policies in October 1982.[42] So the question remains, what accounted for this increase in the demand for fiat money?

The answer appears to reside principally in two key factors identified by Richard Timberlake: deregulation, brought about by legislated structural change, and the internationalization of the U.S. currency.[43]

Let us consider these in turn.

DIDMCA: Not Just Another Pretty Name

If you’ve never read the provisions of the Depository Institutions Deregulation and Monetary Control Act of 1980, you’re not alone. Congress never read it either.

Source: Federal Reserve Bank of Boston

This was a complex statute that had two important Titles: Title I, which strengthened the Fed, and Title II, which deregulated interest rates.

The monetary control provisions of Title I strengthened the Fed in two ways. First, they pulled the entire U.S. banking system under its control. All depository institutions, not just member banks, were now subject to reserve requirements set by the Fed. Second, they expanded the list of “eligible collateral” for the Fed’s Open Market operations to include assets, such as foreign securities, that were previously not eligible for purchase. In the context of the implementation of conventional monetary policy, the notion of “eligible collateral” is meaningless, since fiat money is legal tender, and requires no collateral in any event. The practical import of this expansion of authority is that the Fed could now pretty much monetize anything it wanted, including, according to an unnamed senior Fed official quoted in a 2002 Financial Times (London) article, gold mines.[44] The structural import, according to Timberlake, is that the Fed achieved its ambition of becoming an imperial central bank:[45]

Nothing in Volcker’s statements or letters substantiates either the technical or operational necessity for the extended collateral provisions. What, then, could have been the real reason for Volcker to have insisted that Congress extend the Fed’s money-creating hegemony if the Fed already had infinite control over the U.S. money supply? / The only answer seems to be that the Fed as an agency of the U.S. government was designing itself to become the international financial arm of the Executive Branch. / Very few congressmen who voted for the DIDMCA of 1980 realized the additional powers that the act granted the Federal Reserve System in its quest to provide itself with imperial financial control.

But our present focus is on the deregulation, rather than the monetary control, provisions of the DIDMCA. These permitted all depository institutions to pay interest on checkbook balances of demand deposits. They also phased out Regulation Q, which had allowed the Fed to limit the amount of interest paid on time deposits.

The impact of this deregulation was immense. Now, for the first time, fiat checkbook money paid interest. This, and not the Fed’s jiggery-pokery on monetary policy, was the key to breaking the fever. That giant sucking sound throughout the 1980’s was the flood of wealth into deposit accounts.

Timberlake notes the accidental nature of the rescue:[46]

The disinflation of 1982-1986 was both an unanticipated bonanza and a self-reinforcing phenomenon. No one foresaw the reduction in the velocity of money that would result from the institutional changes that took place. The reinforcing element was the deflationary effect on interest rates that accompanied the general price level disinflation.

Fiat Goes Global

The interest rate deregulation under Title II was not the only factor feeding the demand for fiat money, however. Another, also outside the purview of Fed policy, was the growing use of the greenback as a currency outside the United States. Timberlake describes the process:[47]

As the value of the dollar tended to stabilize during the first half of the 1980’s, foreign business firms and households increased their demand for Federal Reserve notes for use in their day-to-day transactions. Many third world central banks and government treasuries were at the same time devastating their local economies with hyperinflationary issues of paper currency, so many of the inflation-bedeviled peoples began to use U.S. currency. While the dollar had not stabilized at a zero inflation rate, it was far superior as a store of value to most of the other major currencies around the globe. A few other currencies, such as the Swiss franc, were closer to absolute stability than the dollar; but none had the combination of stability and volumetric availability that the dollar possessed.

The precise impact of this phenomenon is difficult to measure because the Fed can only guess how much of its notes in circulation are actually circulating abroad. They do know that it’s a big number. The Fed's estimate as of the end of 1995 was that of the $375 billion then circulating outside the banks, between $200 and $250 billion, or well over half, was held outside the United States.[48]

Aside from representing a significant benefit for the United States -- currency used abroad being equivalent to an interest free loan to the home team -- the internationalization of U.S. currency obviously makes difficult the measurement of even the narrowest monetary aggregate, for purposes of implementing domestic monetary policy.

Another Lucky Break

Deregulation and internationalization were the primary factors behind the decline in velocity. But a further contribution to an increase in the objective exchange value of fiat money came from left field, namely, a crack in the overheated commodity markets. Indeed, Mark Faber gives this factor pride of place:[49]

This very tight monetary policy implemented by Paul Volcker is usually credited for having brought down the rate of inflation after 1980. However, it is my view that the rate of inflation would have come down regardless of monetary policies because strong price increases for all commodities between 1965 and 1980 had led to additional supplies, which after 1980 began to flood the market and depress prices. This was particularly true for oil, which had risen in price from $1.70 per barrel in 1970 to close to $50 per barrel in 1980. In addition, conservation efforts all over the world had curtailed demand.

Questions for Extra Credit

So we see how an increase in the demand for fiat money, brought about by a confluence of monetary policy, deregulation and market expansion, importantly aided by a collapse in commodity prices, proved sufficient to save the system in the 1980’s. The gold bugs were right; Havenstein’s choice could not be ducked. What they didn't know was that it had in fact been made, largely by accident, and that the system had managed to stumble through Door Number One.

Our immediate inquiry is therefore concluded. Two related questions remain, however. We will touch on them only briefly, as they bring us in contact with the subject matter of numerous current commentaries, posted here and elsewhere.

The first question is: what explains the extraordinary longevity of the preference for paper, a move that has now lasted a generation. After all, as Timberlake points out (id.):

This series of reinforcing events, nonetheless, was limited; it could not continue forever unless the Fed constantly reduced the rate of increase in money growth, or developed new "institutional" factors that would stimulate U.S. and world demand to hold U.S. dollars.

The effects of interest rate deregulation had pretty well worked their way into the system by August 7, 1987, when Alan Greenspan was anointed Fed Chairman. It hardly bears mention that the Greenspan Fed has not constantly reduced the rate of increase in monetary growth. To the contrary, the Greenspan Fed has been directly responsible for the greatest monetary and credit expansion in the history of the world. What, then, are these new "institutional" factors that kept the party going?

They are the much-discussed fruit of the dramatic changes that have transformed the global financial system over the last 25 years, making the early 1980's more distant to us in practical terms than Weimar Germany was to the members of the Gold Commission. Not all are the Fed's doing. For example, it presided over (or, perhaps more accurately, adapted to) rather than directly instigated, the transformation of the global trading system into a giant vendor finance scheme in which the United States is permitted to borrow itself into oblivion for so long as foreign producers are prepared to accept payment in dollars and recycle them into dollar denominated assets.[50] In the case of others, its role was, to a greater or lesser degree, more direct. These include the rise of the capital markets and the decline of the traditional banking function; the triumph of derivatives and the relative decline in importance of underlying assets; the rise of huge pools of speculative capital able to drain or swamp markets with the click of a keystroke; the transformation of banks into a species of leveraged speculator; the mountain of debt and derivatives that now menaces the financial landscape; the proliferation of money substitutes that diminish further the control of the Fed over the money supply; and the transformation of the Fed itself from regulator to enabler in the destabilization of markets and the expansion of financial risk.[51]

Still another "institutional" factor, one integrally related to the foregoing structural changes, is official sector cheating: undisclosed, direct or indirect intervention in financial and commodity markets undertaken to alter market appearances and influence the behavior of market participants. It is difficult to quantify, and virtually impossible to prove. It is even difficult to define. In a system in which even the financial exposures of a private hedge fund are effectively socialized, where does the "market" stop, and the Fed begin?[52] Wherever the line is drawn, we submit that it is not possible to understand how the demand for dollar assets has been sustained since 1987 without reference to such activity.[53]

The ultimate rationalization for the market manipulation, that it is done in order to stave off the collapse of the dollar system and our privileged position within it, is no doubt seen by those involved as worthy; indeed, a patriotic calling that sanctions their enrichment. Those to whom the ends justify the means, a category which, truth to tell, probably includes most of us when our financial well being is at stake, might be inclined therefore to give the Fed and its agents a pass. After all, the Fed's mandate is interventionist on its face, the Fed's very existence is an affront to the Constitution; having swallowed the elephant, why should we now choke on the gnat? Perhaps this inclination, and not just fear of negative career consequences, can explain why so few will acknowledge the obvious. In any event, the dispensation is not ours to give. In the end, as Mises teaches in an oft-quoted passage, the market will have its way:[54]

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

The second and closely related question is: why are gold bugs still singing the same tired refrain? The Fed cheated the hangman in the 1980's; why can't it just keep doing it, wrong-footing those gloomy Guses in perpetuity?

In this essay, we have attempted to lay out in some detail the confluence of factors that came together to save the system in the 1980’s. We think it clear from this exercise that this was a one-off event, an historical accident that could not be repeated even if there were an identical threat, a common understanding of the nature of that threat, and the political will to implement a solution. Which of the indicated policy precedents would be open to us, even if we could satisfy the foregoing conditions? Deregulate? Clearly not; been there, done that. Hike rates to historic highs in real terms? No way. We gambol in the shadow of Debt Mountain. If the Fed were to raise the Fed funds rate even to within spitting distance of a positive real rate of interest, it would risk an avalanche of defaults, threatening economic and political upheaval. Expand the market for dollars? Get real. Just how do you expand a saturated market? The challenge now is rather to ward off blowback of the big foreign dollar float. How about rigging commodity prices? Now we’re getting somewhere. Trouble is, we can’t rig them all, and we can’t keep it up forever, even for the ones we can rig. Sooner or later, the law of supply and demand in the marketplace for real things will trump the price management effected in the markets for paper derivatives.

No, the die is cast: we shall have the catastrophe. Our fiat monetary system got a reprieve in the 1980's, not a deliverance. All that has happened since, with the fantastic mispricing of credit the Greenspan Fed has engineered, and the massive global malinvestment this has engendered, is that the dimensions of the unraveling have become more dire.

Mises called this one too:[55]

Certainly, the banks would be able to postpone the collapse; but nevertheless, as has been shown, the moment must eventually come when no further extension of the circulation of fiduciary media is possible. Then the catastrophe occurs, and its consequences are the worse and the reaction against the bull tendency of the market the stronger, the longer the period during which the rate of interest on loans has been below the natural rate of interest and the greater the extent to which roundabout processes of production that are not justified by the state of the capital market have been adopted.

With respect to the form the denouement will take, much has been written within the gold community on the subject of whether we face hyperinflation or deflationary depression as the prelude to monetary collapse. Both sides of the debate appear to accept the premise that whatever may transpire will bear a linear relationship to what now exists. The disagreement centers on the direction the line will go. But today's markets are fully linked by derivatives and technology, and they are patrolled by wolf packs of large, leveraged speculators not noted for their patient outlook. So it seems likely that the terminal monetary crisis will unfold on virtually an instantaneous and discontinuous basis, once the fog of statistical deceit and false market cues begins to lift and a clear trend either way becomes evident. We are not likely to enjoy the luxury of observing either a deflation or an inflation unfold in the fullness of time, but rather, just as Mises foretold, a final and total catastrophe of our fiat monetary system. All we can hope is that once the curtain falls on the current system, the wisdom in the gold bugs' submissions to the Gold Commission will finally find a receptive audience.


August 21, 2004



1. Minority Report, page 283.

2. Ludwig von Mises, The Theory of Money and Credit (LibertyClassics Edition, 1981), p. 458.

3. Sean Corrigan of Sage Capital, a practicing Austrian, has expressed doubts whether the traditional formulation of the Fed’s role in the creation of money applies under today’s institutional circumstances. He notes, among other things, that bidding for reserves occurs on a post-hoc basis; that is, banks do their lending and borrowing, and “work out over the course of the two week maintenance period what they need in reserves and then go bid for the balance retrospectively,” and that banks today are more on a BIS-style capital standard than subject to meaningful reserve restraints. Fair point. As a result of the structural changes that have occurred in the system since 1980, noted later in this essay, the practical significance of the reserve creation activity summarized below has been radically diminished, even though there remains a tacit agreement among the Fed, market participants and commentators to continue the pretence. As James Grant points out in the April 9, 2004, edition of Grant’s Interest Rate Observer, less than 4% of the broadly defined money supply is now subject to reserve requirements. However, as our focus is the early 1980’s, before deregulation and technology had wrested control over the creation of “money” from the monetary authorities, we rationalize that current theory is at least reasonably consonant with early 1980’s practice.

4. As of August 15, 2004, the primary dealers were:

ABN AMRO Bank, N.V., New York Branch
BNP Paribas Securities Corp.
Banc of America Securities LLC
Barclays Capital Inc.
Bear, Stearns & Co., Inc.
CIBC World Markets Corp.
Citigroup Global Markets Inc.
Countrywide Securities Corporation
Credit Suisse First Boston LLC
Daiwa Securities America Inc.
Deutsche Bank Securities Inc.
Dresdner Kleinwort Wasserstein Securities LLC.
Goldman, Sachs & Co.
Greenwich Capital Markets, Inc.
HSBC Securities (USA) Inc.
J. P. Morgan Securities, Inc./Banc One Capital Markets, Inc.
Lehman Brothers Inc.
Merrill Lynch Government Securities Inc.
Mizuho Securities USA Inc.
Morgan Stanley & Co. Incorporated
Nomura Securities International, Inc.
UBS Securities LLC.

5. See Murray N. Rothbard, The Mystery of Banking (Richardson & Snyder, 1983), ch. XI (

6. The components of the monetary aggregates are summarized from Monetary Trends, Federal Reserve Bank of St. Louis, June 2004.

7. See, e.g., Daniel L. Thornton, The Effect of Monetary Policy on Short-Term Interest Rates (Federal Reserve Bank of St. Louis, 1988) (

8. This phenomenon is discussed in detail in the April 9, 2004, edition of Grant’s Interest Rate Observer.

9. Rothbard, op. cit., p. 145.

10. See, e.g., Board of Governors of the Federal Reserve System, International Finance Discussion Papers, No. 729, June 2002, “Preventing Deflation: Lessons from Japan's Experience in the 1990s” ( In concluding that “...when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus -- both monetary and fiscal -- should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity,” this paper amplified the January FOMC discussion cited in note 10 and prefigured Governor Bernake’s November remarks cited in the same note.

11. Sidney Homer and Richard Sylla, A History of Interest Rates (Rutgers University Press, 3rd ed. rev., 1996), p.429.

12. Remarks by Governor Ben S. Bernanke before the National Economists Club, Washington, D.C., November 21, 2002: Deflation: Making Sure "It" Doesn't Happen Here (

Governor Bernanke was not just out on a frolic of his own. See also the (heavily redacted; full minutes are not released until five years after the event) Minutes of the FOMC, January 29-30, 2002, in which the following curious passage appears:

At this meeting, members discussed staff background analyses of the implications for the conduct of monetary policy if the economy were to deteriorate substantially in a period when nominal short-term interest rates were already at very low levels. Under such conditions, while unconventional policy measures might be available, their efficacy was uncertain, and it might be impossible to ease monetary policy sufficiently through the usual interest rate process to achieve System objectives.

A March 25, 2002 Financial Times article by Peronet Despeignes quoted an unnamed senior Fed official who attended the meeting as stating that the term “unconventional means” was “commonly understood by academics,” and that the Fed “could theoretically buy anything to pump money into the system”, including “state and local debt, real estate and gold mines—any asset.”

It does not appear that this purchase of “any asset” can be reconciled with the Fed’s statutory authority. Perhaps that is why the “senior official” in the FT article chose to remain nameless, and no such specific brainstorming can be found in Governor Bernanke’s remarks.

13. See Remarks by Chairman Alan Greenspan at the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research, Washington, D.C., December 5, 1996 (

14. Frank Partnoy, Infectious Greed (Henry Holt & Co., 2003), p. 18.

15. Dan Chung and Zachary Karabell, “The Greenspan Nation,” The Wall Street Journal, August 12, 2004.

16. Stephen Roach, “The World's Biggest Hedge Fund,” Morgan Stanley Research (New York), July 19, 2004.

17. Mises, Theory of Money and Credit, p. 272.

18. Mises, Stabilization of the Monetary Unit—From the Viewpoint of Theory (monograph,1923) (

19. Mises, Theory of Money and Credit, p. 459.

20. See, e.g., Market Observations, Contrary, June 15, 2000 (

21. Mises, Theory of Money and Credit, p. 460.

22. William Greider, Secrets of the Temple (Simon & Schuster, 1989), p. 380.

23. See, e.g., John T. Rove, An Analysis of Federal Reserve System Attrition Since 1960 (Federal Reserve Staff Study 93, 1977).

24. Greider, op. cit., p. 68.

25. Cited in Richard Timberlake, Monetary Policy in the United States (University of Chicago Press, 1993), p. 348.

26. M.A. Akhtar, Understanding Open Market Operations, Public Information Department, FRBNY, 1977, p. 7 (

27. Greider, op. cit., p. 501.

28. These aggregates are not identical in composition to today’s aggregates, as defined supra. However, they are close enough for our purposes.

29. Timberlake, op. cit., p. 356.

30. Timberlake, op. cit., p. 358.

31. Rothbard, op. cit., p. 151.

32. Greider, op. cit., p. 507.

33. Federal Reserve Bulletin 69, August 1983, p. 619, cited in Timberlake, op. cit., p. 379.

34. Mises, Human Action, A Treatise on Economics (Fox & Wilkes, 4th rev. ed., 1963), p 399.

35. Ibid., p. 400.

36. Mises, Theory of Money and Credit, p. 272.

37. Just how historically anomalous these levels of real rates were can be seen in the following table from Homer and Sylla, op. cit., p. 430.

38. Costantino Bresciani-Turroni, The Economics of Inflation (Augustus M. Kelley, 3rd ed., 1968), p. 347.

39. Ibid., p. 344.

40. Ibid., pp 347-348.

41. Ibid., p. 348.

42. Timberlake, op. cit., p. 360.

43. Timberlake, op. cit., ch. 25.

44. See Note 10. DIDMCA did not in fact authorize the purchase of real estate and gold mines, but the quote attributed to the “senior Fed official,” if true, would indicate that the FOMC doesn’t know it.

45. Timberlake, op. cit., pp. 371, 374.

46. Ibid., p. 382.

47. Ibid., p. 377.

48. See Richard A. Porter and Ruth A. Judson, “The Location of U.S. Currency: How Much Is Abroad?” Federal Reserve Bulletin, October 1996 (

49. Mark Faber, “A President Bush Economic Boom?”, July 8, 2004 (

50. For a useful analysis of the imbalances in the global trading system, see Richard Duncan, The Dollar Crisis (John Wiley & Sons (Asia) Pte Ltd, 2003).

51. A number of these structural changes are discussed in Peter Warburton, Debt & Delusion (Penguin Press, 1999), recently reviewed by Robert Blumen at A most lucid treatment of the debt issue may be found in Jonathan Laing, “Debt Bomb,” Barron’s, January 23, 2003. Doug Noland of discusses the decline in significance of the traditional monetary aggregates in “The Fragile Stability of Monetary Disorder,”

52. The New York Fed orchestrated, but did not directly fund, the bailout of Long Term Capital Management. See Roger Lowenstein, When Genius Failed (Fourth Estate/HarperCollins, 2001). For market participants whose livelihoods depend on correct assessments of how far they can push the house in the game of moral hazard it was a distinction without a difference.

53. It is worth recalling what appears to be the origin of the contemporary stripe of market intervention. Fittingly, it remains ambiguous as to whence directed and how effected, and thus where the line between official and “private” action can be drawn. The setting was the October 1987 crash. Sometime after 11:20 on the morning of October 20, just when all seemed lost, the Major Market Index, an obscure stock index futures contract on the Chicago Mercantile Exchange, suddenly soared heavenward. Tim Metz, the reporter who covered the Crash of 1987 for The Wall Street Journal and later expanded his reportage in Black Monday (Dow Jones, 1988) described it as follows (pp. 217-218):

So while the MMI contract price hurtles skyward during the next ten minutes, most investors-even the pros-won't even notice. Nobody really believes that a rally produced by purchases of just over 800 MMI stock index futures contracts in Chicago means the end of the Stock Market Crash of 1987.

In what may be the last time a Dow Jones publication would give voice to a financial market “conspiracy theory”, Metz attributed what happened to human intervention (p.210):

To me, those facts strongly suggest that only a broadly coordinated manipulation of stock and futures markets information and prices averted a stock market plunge on October 20 that could have rivaled, or even exceeded, that of the day before. Bluntly stated, the question these facts forcefully raises is whether some leaders and market makers at the New York Stock Exchange and the Chicago Mercantile Exchange collaborated to save the stock market by rigging stock information and prices.

54. Mises, Human Action, p. 572.

55. Mises, Theory of Money and Credit, p. 404.