The Austrian Way

The complete meltdown of the financial system seems to have abated, but we are still living with the uncertainty that the Panic of '08 generated. The uncertainty comes from the revelation that our largest financial institutions, and their regulators, were built on a house of cards, rather than the solid citizens that their marketing and regulatory filings had suggested. The panic may have passed, but the suspicion remains that there are significant weaknesses in our government and financial system. What to do? Well, we could always muddle through. But some are not satisfied with this and propose more radical surgery, such as abolishing the Federal Reserve: End The Fed? A Not So Crazy Idea

The Fed's apologists suggest otherwise, of course. They note that the US spent nearly half the years between 1854 to 1913 in recession, as opposed to just 21 percent of the time since the Fed's establishment in 1913. Who would want to go back to those bad old days?

But consider: the US economy has actually grown less rapidly since 1914 than it did before. And inflation has been much worse, despite both the Civil War, which featured the nation's worst inflation, and the Great Depression, which featured its severest deflation!

What's more, the frequent downturns before 1914 were due, not to the lack of a central bank, but to foolish government regulations. Topping the list were bans on branch banking, initiated by state governments and then incorporated into federal banking law.

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But the Federal Reserve plan proved to be a poor substitute for deregulation. By granting monopoly privileges to the Federal Reserve banks, it allowed them to inflate recklessly: By 1919, the US inflation rate, which had cleaved close to zero ever since the Civil War, was close to 20 percent! Yet the Fed was also capable of failing to supply enough money to avert crises. The first downturn over which it presided – that of 1921 – was among the sharpest in US history. Still it was nothing compared to the unprecedented monetary contraction of 1929-1933.

Would asset currency have been any better? Canada's was: Between 1929 and 1933, for instance, 6,000 US banks failed, and a third of the US money stock was wiped out. In contrast, and despite a fixed Canadian-US dollar exchange rate, Canada's money stock shrank by just 13 percent, and no Canadian bank failed.

While it's fun to consider the idea of abolishing the Federal Reserve (an idea that has kicked around on both the hard left and hard right over the years), I think anyone advocating this needs to admit that this would strike many Americans as being on a par with abolishing the FBI, simply because the Fed has been part of the national landscape for so long. On the other hand, most regular folks don't have a clear idea of what the Fed does all day, beyond setting interest rates. But, while the Fed seems permanent, it's important to remember that it is solely a creature of statute. There is no specific provision in the Constitution that allows for the creation of a central bank. Thus, the seemingly solid Fed could be legislated out of existence tomorrow if necessary (I don't think this should happen, but it could).

More disturbing is the question of what to do with our ever-increasing load of public debt. No matter how many times Paul Krugman might talk about multipliers and the like, our pojected debt is politically and financially unsustainable. Voters hate the idea of running huge deficits, and eventually, bond holders will refuse to continue to purchase US Treasuries. We could always cut spending and lower taxes, but that always manages to be "impossible." So, we are left with vague statements from policy makers about "keeping our options open," which mollify for a minute, but do nothing to settle the great unstated unease out there.

Some are already looking to the future to see what can be done. There is Jeffrey Rogers Hummel's prediction that, in order for the US to escape it's massive debt load, it will need to either inflate its debt away, or default on our national debt. Given the domestic political turmoil that would follow hyperinflation, Hummel thinks that a default would be much more likely: Why Default on US Treasuries Is Likely

It is not literally impossible that the Federal Reserve could unleash the Zimbabwe option and repudiate the national debt indirectly through hyperinflation, rather than have the Treasury repudiate it directly. But my guess is that, faced with the alternatives of seeing both the dollar and the debt become worthless or defaulting on the debt while saving the dollar, the U.S. government will choose the latter. Treasury securities are second-order claims to central-bank-issued dollars. Although both may be ultimately backed by the power of taxation, that in no way prevents government from discriminating between the priority of the claims. After the American Revolution, the United States repudiated its paper money and yet successfully honored its debt (in gold). It is true that fiat money, as opposed to a gold standard, makes it harder to separate the fate of a government's money from that of its debt. But Russia in 1998 is just one recent example of a government choosing partial debt repudiation over a complete collapse of its fiat currency.

The cause of all this is not the the Iraq War or "de-regulation." It arises from a combination of the current economic depression, the Fed's bailouts, the incredible national debt racked up in the last year, and the implacable, vurtually unrestrained rise in entitlement spending. As in CA, there is a crisis of Big Government and the welfare state that is gathering, and may already be here:

A century of experience has taught us that the client-oriented, power-broker State is the gravity well toward which public choice drives both command and market economies. What will ultimately kill the welfare State is that its centerpiece, government-provided social insurance, is simultaneously above reproach and beyond salvation. Fully-funded systems could have survived, but politicians had little incentive to enact them, and much less incentive to impose the huge costs of converting from pay-as-you-go. Whether this inevitable collapse of social democracies will ultimately be a good or bad thing depends on what replaces them.

Hummel is talking about nothing less than the end of the political arrangements that have defined US politics since 1932. We may be a center-right country in theory, but in practice the liberal-left defines our government's spending priororties, and sets out the parameters of political debate. This is not something that will be resolved in 2012, nor is it something that Rush Limbaugh and Sarah Palin can cook up on the Internet. But, this is the project: to transfer out of our unsustainable welfare state to one that returns the federal government to its ideal low-tax, limited government state.