Finance and Philosophy, and Dorothy Too!
The British economist John Maynard Keynes said this about the importance of ideas to everyday life:
The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. . . . it is ideas, not vested interests, which are dangerous for good or evil.
The truth of this view is explored by Alex J. Pollock, the former Chief Executive Officer of the Federal Home Loan Bank of Chicago and then the Principal Deputy Director of the Office of Financial Research, in his recent book, Finance and Philosophy. Pollock explores numerous fundamental questions, such as whether the Federal Reserve should be independent of elected officials or answerable to them. This cover letter will address his discussion of monetary policy.
The seemingly dry term “monetary policy” refers to the federal government’s efforts to control the quantity of money in the economy and the channels by which new money is supplied. Two philosophical questions that immediately arise from this description are (1) what is money and (2) from where does the government obtain the authority to exercise this power?
As to the first question, for much of the history of the United States “it was argued that only gold and silver coins were really money.” And as to the second question, the United States Constitution gives to the Congress the power “to coin Money, regulate the Value thereof, and of foreign Coin” (the reference to “foreign coin” was not happenstance, foreign coins constituted much of the coinage in the United States until Congress outlawed their usage in 1857). Even if money was printed on paper and not coined, “it was thought that normal, proper paper currency could always be redeemed for gold or silver coins.” At least this was the case absent extraordinary circumstances, typically a war (the War of 1812, the Civil War and World War I all saw disruptions to the convertibility of paper money to “species”) or financial “panics.”
The nation faced a host of difficult financial issues after the Civil War, but in terms of money supply a key area of dispute was whether gold alone, or both gold and silver (so called “bimetallism”) should back the dollar, or whether the “fiat” currency regime should continue. This debate took almost 15 years to resolve in favor of gold – establishing the “gold standard” that is still mentioned in seemingly arcane debates in the finance pages of some newspapers.
Life was different during this period – for one thing deflation, not inflation, often ruled the day — for example, during the 35-year period from the end of the Civil War in 1865 to 1900, prices declined an average of 1.9% a year, meaning that over this period prices fell by more than 60%. A 1900 dollar, therefore, had over 200% the purchasing power of an 1865 dollar. This deflationary period caused its own form of political turmoil, culminating in the “cross of gold” speech by 36-year-old “free silver” candidate William Jennings Bryan at the 1896 Democratic Convention, in which he advocated that paper money be backed by silver and not just by gold. ¹
The gold standard regime within the United States continued until 1933 (other than a disruption during World War I). Bank runs then made it impossible for the government to honor its promise to convert currency for gold, and various governmental actions then permanently ended the ability of any citizen to exchange his/her dollar notes for gold coins. However, during a conference of 44 nations held in Bretton Woods, New Hampshire in 1944, the United States committed to a system whereby dollars held by foreign central banks would continue to be convertible to gold at a fixed rate. This last vestige of the “gold standard” operated for the next twenty-six years, until 1971 when President Nixon suspended the dollar’s convertibility into gold.
Pollock describes these events more dramatically: “a historic and fundamental transition occurred on August 15, 1971” because since “then we have been on a pure fiat money, or pure paper money standard. Since most money is held as a credit balance in a bank or central bank accounts, rather than as paper currency, it might be better described as accounting money.”
As to which system is better – fiat money or money backed by a precious metal – Pollock is agnostic, stating, philosophically, “in my opinion, neither of these choices is perfect and both (indeed all) monetary regimes present inevitable problems.” The question with our current system, as he sees it, is: “Is the worldwide system of fiat currencies, government deficits, central bank monetization of the government debt, and permanent inflation, sustainable for another several decades?” He responds to his stated question with: “I do not know the answer.”
We also do not know the answer, but we do know that there is one critical facet to the equation which Pollock acknowledges but does not seem to give its due weight, and that is that the United States of America is the greatest wealth producing generator in the history of the world. The chart included in our inserts illustrates this by comparing the output of each of the 50 states in the Union to the output of other nations, i.e., California, with a working population of 19.5 million, has an economic output comparable to India, with a working population of 519 million; New York, with a working population of 9.5 million is comparable to all of Canada with its working population of 20.4 million, and so on. This wealth generating machine is the reason that, as Pollock puts it, “relative to almost all of the past, life now for the ordinary citizen of economically developed societies is rich, comfortable, educated and long.”
Thus, while the United States dollar is not convertible into gold, it is backed by an economic wonder unlike any seen before. Economic actors in the United States are constantly striving to improve the goods and services they offer in the marketplace, and to invent better goods and services, and by doing so have enabled improvements in life far beyond any improvements that could be achieved by locking bars of gold in a safe. Moreover, the worldwide marketplace arguably recognizes these facts, and it is for this reason that in countries where the currency has failed, such as Venezuela, that real prices are set in dollar terms. The many countries that want a stabilizing mechanism for their currency “peg” their currency to the dollar.
In other words, in another of his famous phrases, Keynes dismissed gold as a “barbarous relic” of an earlier time. In this respect, PMA’s philosophy is also more aligned with Keynes, because we believe that there is something “real” backing the American dollar, which is the wealth and vitality of the nation, and that the collective wealth of the United States is not a mere figment of financial machinations conducted by the “high priests” of the Federal Reserve, which is what Pollock’s question suggests is the case.
Nevertheless, a caveat is in order – despite the massive wealth generation produced by the United States’ economy, fiscal mismanagement by the Federal Reserve and/or the Congress are a potential long-term problem that cannot be discounted, and which does create its own risk. While Pollock does not fully consider the unprecedented wealth generated by the American economy, he is right to express concern with “government deficits, central bank monetization of the government debt, and permanent inflation.” Massive spending and entitlements promised by the United States may at some point outstrip the ability of even the dynamic economy to support governmental obligations. While the dollar is currently the world’s most preferred reserve currency, there is no guarantee it will remain so for the indefinite future.
These difficult and complex problems have no easy resolution and do create a system risk. Despite this, Pollock seems to agree that although financial crises are an unavoidable part of an open free enterprise system, those who predict doom may be “right once a cycle” but “the optimists own the trend.” Others perhaps state this view more emphatically, such as Wharton Professor of Finance Jeremy Siegel who argues that no one “has made money in the long run from betting against stocks or the future growth of our economy.” This sentiment was one of the principles upon which PMA was founded and remains an essential element of our philosophy today.
¹ The 1896 Convention was held in Chicago, the then home of L. Frank Baum, author of The Wizard of Oz. As detailed in the enclosed article, “The Wonderful Wizard of Oz and the Gold Standard,” a reasonable argument can be made that the classic, published in 1900, was meant to be an allegory about monetary policy in America, beginning with the charmed “silver shoes” bestowed on Dorothy upon her arrival in Oz – silver, not ruby as depicted in the movie.