N AT I O N A L C E N T E R F O R P O L I C Y A N A LY S I S

The Federal Reserve and Sound Money

Issue Brief No. 188

by Richard M. Ebeling

February 2016

We are living in a time of monetary chaos. The U.S. Federal Reserve has
manipulated key interest rates down to practically zero for the last six years,
and expanded the money supply in the banking system by $4 trillion over that
period. And with the true mentality of the monetary central planner, the Fed
Board of Governors now plans to manipulate key interest rates in an upward
direction that they deem more desirable.

Interest Rate Manipulation and Monetary Expansion. The European

Central Bank (ECB) has instituted a conscious policy of negative interest
rates and planned an additional monetary expansion of well over a trillion
Euros over the next year. Plus, the head of the ECB assured the public and
financial markets that there is no limit to the amount of paper money
that will be produced to push the European economies in the direction that
monetary central planners consider best.
Remember, the Federal Reserve undertook a similar monetary expansion
and policy of interest rate manipulation earlier in the 21st century which, in
conjunction with federal subsidies that distorted the housing market, set the
stage for the severe and prolonged great recession that began in 20082009.

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The media and the policy pundits may focus on the day-to-day zigs and
zags of central bank monetary and interest rate policy, but what really needs
to be asked is whether or not we should continue to leave monetary and
banking policy in the discretionary hands of central banks and the monetary
central planners.
Central Banking and Monetary Planning. Central bankingismonetary
central planning. The United States and, indeed, virtually the entire world
operate under a regime of monetary socialism. Historically, socialism has
meant an economic system in which the government owned, managed and
planned the use of the factors of production.
Modern central banking reflects those themes. In the current system,
the government, either directly or through some appointed agency such as
the Federal Reserve, has monopoly ownership and control of the medium
of exchange. Through this control the government and its agency has
predominant influence over the value, or purchasing power, of the monetary
unit, and can significantly influence a variety of market relationships. These
include the rates of interest for borrowing and lending in the banking and
financial sectors of the economy, and therefore the patterns of savings and
investment in the market.
If there is one lesson to be learned from the last one hundred years
during which the world and the United States moved off the gold standard

The Federal Reserve and Sound Money

and onto a government-managed fiat, or paper, money
system it is the fundamental disaster of placing control
of the money supply in the hands of governments.
Continual Government Abuse of Money. Money
did not originate in the laws or decrees of kings and
princes. Money emerged out of the market transactions of
a growing number of buyers and sellers in an expanding
arena of trade as the most widely used and generally
accepted medium of exchange. Commodities such as
gold and silver were selected over generations of market
participants as the monies of free choice due to their
useful characteristics, to better facilitate the exchange of
goods in the market place.

It is the corrosive, distortive and destructive effects

from monetary manipulation by governments that
led virtually all of the leading economists of the 19th
century to endorse the anchoring of the monetary
system in a commodity such as gold. This would prevent
governments from using their power over the creation of
paper money to cover their budgetary extravagance.
The Social Benefits of a Gold Standard. Under a
gold standard, gold is the actual money. Paper currency
and various forms of checking and other deposit accounts
used in market transactions aremoney substitutes. They
represent a fixed quantity of the gold-money on deposit
with a banking or other financial institution that is
redeemable on demand.

For almost all of recorded history, governments have

attempted to gain control of the production of money and
Any net increases in the quantity of currency, checking
manipulate its value to serve their seemingly insatiable
and related deposits are dependent upon increases in the
appetite to extract more and more wealth from ordinary
quantity of gold that depositors add to their individual
members of society. For example,
accounts. And any withdrawal of
ancient rulers would clip and debase
gold from their accounts through
the gold and silver coins of their
redemption requires that the quantity
subjects to sustain their own power.
A gold standard would take of currency notes and checking and
related accounts in circulation be
away the ability of central
More modern rulers whether
reduced by the same amount. Under
despotically self-appointed through
banks to inflate.
a gold standard, a central bank is
force or democratically elected by
relieved of all authority and power
voting majorities have taken
to arbitrarily manage the monetary
advantage of the monetary printing
order.
press to churn out paper money to fund

Insert callout here.

their expenditures and redistributive largess in excess of

the taxes they impose on the citizenry. Today the process
has become even easier through the mere click of a
mouse on a computer screen. In the blink of an eye a
planner can create tens of billions of dollars out of thin air.
Monetary debasement and the price inflation that
normally accompanies it have served as a method for
imposing a hidden taxation on the wealth of the
citizenry. As John Maynard Keynes before he became
a Keynesian! insightfully observed in 1919:

By a continuous process of inflation, governments

can confiscate, secretly and unobserved, an
important part of the wealth of their citizens. By this
method, they not only confiscate, but they confiscate
arbitrarily; and while the process impoverishes
many, it actually enriches some. The process engages
all of the hidden forces of economic law on the side
of destruction, and does it in a manner that not one
man in a million can diagnose.1
2

Many critics of the gold standard consider this a

rigid and inflexible rule that constrains the monetary
system and the quantity of money in the society. Yet, the
advocates of the gold standard have long argued that this
relative inflexibility is essential to confine governments to
a hard budget.
A Gold Standard Can Limit Government Monetary
Abuse. Without the escape hatch of the monetary
printing press, a government either must tax the citizenry
or borrow a part of the savings of the private sector to
cover its expenditures. Those proposing government
spending must either justify it by explaining where the tax
dollars will come from and upon whom the taxes will fall
or make the case for borrowing a part of the savings of
society to cover those expenditures. Modern government
simply monetizes its debt and increases the money
supply; a gold standard would prevent that. The borrowed
sums could not be created out of thin air through central
bank monetary expansion. Under a gold standard, the

government cannot create the illusion that something can

be had for nothing.
Milton Friedmans Second Thoughts About the
Benefits of Paper Money. Some advocates of economic
freedom and limited government have also championed
paper money. Nobel Prize economist Milton Friedman
often argued that maintaining a gold standard was a
waste of societys resources. Why squander the men,
material and machinery digging gold out of the ground
to then simply store it away in the vaults of banks? It
is better to use those scarce resources to produce more
of the ordinary goods and services that can enhance the
standard and quality of peoples lives. To control the
potential arbitrary recklessness of central banks, Friedman
proposed setting up a monetary rule that says: Increase
the paper money supply by some small annual percent,
with no discretion left in the hands of the monetary
managers.

And in another article in 1986, Friedman said that

while he was not ready to advocate a return to the gold
standard, he did conclude that that leaving monetary and
banking arrangements to the market would have produced
a more satisfactory outcome than was actually achieved
through government involvement.3
Monetary Mismanagement versus Markets and
Gold. But it is not only the political dangers arising from
government mismanagement of paper money that justifies
the establishment of a gold standard. Monetary central
planning is also unworkable as a means to maintain
economy-wide stability, full employment and growth.

Especially since the 1930s, many economists and

policy makers influenced by Keynes and the Keynesian
Revolution have believed markets are potentially unstable
and susceptible to wide and prolonged fluctuations in
employment and output, which can only be prevented or
reduced in severity through activist
monetary and fiscal policy. But, in
reality, central bank manipulations of
Central bank manipulation money, credit and interest rates have
of money, credit and interest generated more instability and periodic
in economy-wide production
rates generates instability. swings
and employment.

But years after winning the

Nobel Prize in Economics in 1976,
Friedman had second thoughts
about this monetary prescription.
In a 1986 article on The Resource
Costs of Irredeemable Paper Money,
he argued that when looking over
the monetary mismanagement and
mischief caused by governments and
central banks during the 20th century, it was crystal
clear that the costs of mining, minting and storing gold
as the basis of a monetary system would have been far
less disruptive and destabilizing than the inflations and the
booms and busts of the business cycle brought about by
central bank manipulations of paper money and interest
rates.2

Insert callout here.

In his 1985 presidential address before the Western

Economic Association on Economists and Public
Policy, Friedman said that Public Choice theory the
use of economics to analyze the workings of the political
process had persuaded him that it would never be
in the self-interest of governments or central bankers
to manage the monetary system according to some
hypothetical public interest. Those in government or
holding the levers of the monetary printing press will
always be susceptible to the temptations and pressures
of short-run political gains that monetary expansion can
fund. He admitted that it had been a waste of time on
his part to try to get governments and central banks to
follow his idea for a monetary rule.

Financial institutions and interest

rates have important work to do in
the market economy. Banks and
other financial intermediaries are supposed to serve as
the middlemen who bring together those who wish
to save portions of their earned income with others
who desire to borrow and invest that savings in profitoriented, productive ways that generate capital formation,
technological improvements and cost-efficient production
of new, better and more goods and services. Marketdetermined interest rates are meant to bring those savings
and investment plans into coordination with each other,
so the amount of invested capital and the time-shape of
investment horizons are consistent with the available real
savings to support investment plans to completion.
Monetary expansion by central banks creates the
illusion that there is more actual investable savings in
the economy than really exists. And the false interest rate
signals generated in the banking system by the monetary
expansion not only misinforms potential investment
borrowers about the amount of real savings available for
capital projects, but also creates an incorrect basis for
3

The Federal Reserve and Sound Money

determining the present values that influence the time
horizons for the investments undertaken.
These false monetary and interest rate signals induce
a misdirection of resources, the mal-investment of
capital and an incorrect allocation of labor among
employments in the economy. That sets the stage
for an inevitable and inescapable correction and
readjustment, representing the recession stage of the
business cycle that follows the collapse of the artificial
boom.
Monetary central planners can no more determine
an optimal quantity of money or the right interest
rates to assure savings-investment coordination than
past socialist planners when they tried to centrally
plan agricultural production or investment output for
an entire society. All such attempts are what Friedrich
A. Hayek called in his Nobel Lecture a pretense of
knowledge, that they can know better and do better
than the outcomes generated by the competitive
interactions of market participants. And as Adam
Smith warned, nowhere is such regulatory power so
dangerous as in the hands of a man who had the folly
and presumption enough to fancy himself fit to exercise
it.4
There is no way of knowing the optimal amount
of money in the economy other than allowing market
participants in the competitive exchange process to
decide what they want to use as money which has
historically been a commodity such as gold or silver.
And there is no way of knowing what interest rates
should be other than allowing the market forces of
supply and demand for lending and borrowing to
determine those interest rates.
Return to the Gold Standard as a Monetary
Constitution. Under the current government and central
bank-controlled monetary system, the simplest method
might be for the monetary authority to stop creating and
printing money and credit. Over a short period of time
a fairly reasonable estimate could be made about the
actual quantity of a nations currency and checking and
related deposits. A new legal redemption ratio could be
established by dividing the estimated total quantity of
all forms of these money-substitutes into the quantity of
gold possessed by the government and the central bank.
A country following this procedure would then, once
again, be on the gold standard.
4

Its long-run maintainability would require the

government and the central bank to follow rules of
the game that no increase in the quantity of moneysubstitutes may be created and brought into circulation
unless there have been net deposits of gold in peoples
accounts with banking and other financial institutions.
The temptations to violate those rules will still remain
strong in a political environment dominated by
ideologies of wealth redistribution, special interest
favoritism and numerous entitlement demands.
It is why the real long-run goal of monetary reform
should be the denationalization of money. That is, the
separation of money from the state by ending central
banking altogether. In its place would emerge private,
competitive free banking a truly market-based
money and banking system.
But nevertheless, in the meantime, a gold standard
can serve as a form of a monetary constitution
setting formal limits and imposing restraints on those
in government who would want to abuse the monetary
printing press, similar to the way political constitutions,
however imperfectly, are meant to limit the abuses of
power-lusting monarchs and the plundering majorities
in functioning democracies.
Conclusion. If a gold standard fails, it should not
be for want of trying. It could be one of the positive
institutional reforms in the attempt and on the way to a
fully free market monetary system.
Richard Ebeling is the BB&T Distinguished
Professor of Ethics and Free Enterprise Leadership at
The Citadel in Charleston, South Carolina.

Notes
1. John Maynard Keynes, The Economic Consequences
of the Peace (New York: Harcourt, Brace, 1920), page
235.
2. Milton Friedman, The Resource Cost of
Irredeemable Paper Money, Journal of Political
Economy, Vol. 94, No. 3, Part 1, June 1986, pages 642647.
3. Milton Friedman and Anna Schwartz, Has
Government Any Role in Money? Journal of
Monetary Economics, 1986.
4. Adam Smith, The Wealth of Nations (New York:
Modern Library, [1776] 1937), page 448.