To better understand the particulars of Bernanke's response and to better grasp the ultimate solution to the economic crisis, it is helpful to understand why it is we even have a central bank in the first place. If it is true, as I asserted, that central banking itself coupled with fractional reserve banking is largely responsible for the current crisis, why do modern economists believe a central bank is even necessary? Why does Bernanke think we need a central bank and what informs his actions as chairman?
Bernanke did his thesis on the Great Depression and is considered an expert on the subject. His formal conclusions from this work led to his nickname, "Helicopter Ben", since he famously claimed to be willing to drop freshly created paper money from helicopters if necessary to ward off a monetary crisis. Anthony Mueller, in a recent article, discussed "Helicopter Ben's" belief that inflation is always the solution to a monetary crisis:
Bernanke is an economist by trade, specializing in the study of the Great Depression. That was a bad omen from the beginning — because he has studied economics and the Great Depression in the framework of a particular, flawed paradigm. His studies make him believe that the central bank could have prevented the great economic decline of the 1930s if only it had more aggressively expanded the money supply. This was the lesson that Bernanke learnt from Milton Friedman. Apparently unfamiliar with alternative explanations, Bernanke has never doubted Friedman's thesis.
What has led Bernanke to this "flawed paradigm", a paradigm asserted to follow from the work of Milton Friedman? In the biggest picture terms, this paradigm follows from a flawed epistemological method and its logical consequence: flawed, or at best, incomplete conclusions.
First, Milton Friedman and Anna Schwartz authored a highly influential book, A Monetary History of the United States: 1867-1960. Bernanke no doubt adopted Friedman's interpretation of the economic history of the Great Depression including the view that the government could have prevented the Great Depression by creating massive amounts of paper money in the aftermath of the 1929 crash. In other words, instead of focusing on how the Federal Reserve's expansion of credit in the 1920's (along with a mountain of statist anti-business policies) set the stage for a bust in the early 1930's and thus caused the Great Depression, Bernanke focuses only on the more narrow question of the Fed's monetary response.
Such an approach derives from what Mueller refers to as Friedman's (and by implication Bernanke's) "positivist" approach to analyzing economic history. Positivism, in essence, is an extreme form of empiricism where one attempts to rely solely on empirical data. It is associated with "scientism" which is the view that the methods of the natural sciences can be applied to every field including economics. As part of this approach, Friedman argued that economics should be free of value judgments or so-called "normative" statements. In the introduction to Murray Rothbard's, A History of Money and Banking in the United States, Joseph T. Salerno contrasts Friedman's positivist approach with Rothbard's Austrian approach (known as praxeology):
Rather, the positivist methodology they [Friedman and Schwartz] espouse constrains them to narrowly focus their historical narrative on the observable outcomes of these actions and never to formally address their motivation. For, according to the positivist philosophy of science, it is only observable and quantifiable phenomena that can be assigned the status of "cause" in a scientific investigation, while human motives are intensive qualities lacking a quantifiable dimension. So, if one is to write a monetary history that is scientific in the strictly positivist sense, the title must be construed quite literally as the chronicling of quantitative variations in a selected monetary aggregate and the measurable effects of these variations on other quantifiable economic variables, such as the price level and the real output.
Salerno points out that such an approach leads Friedman and Schwartz to "forays into human history which are cursory and unilluminating, when not downright misleading." He states:
Friedman and Schwartz thus portray the drive toward a central bank as completely unconnected with the money issue and as only getting under way in reaction to the panic of 1907 and the problem with "inelasticity of the currency" that was then commonly construed as its cause. The result is that they characterize the Federal reserve System as the product of a straightforward, disinterested, bipartisan effort to provide a practical solution to a purely technical problem afflicting the monetary system.
Salerno goes on to show that this empirical approach fails to account for all the causal factors that give rise to a particular result in any given context. For example, he discusses their treatment of the panic of 1907 in which they observe that banks "restricted cash payments to their depositors within weeks after the financial crisis struck, and there ensued no large-scale failure" thus conjecturing that "when a financial crisis strikes, early restrictions on currency payments, work to prevent large scale disruptions of the banking system." They "test this conjecture" by observing that banks did not restrict bank depositors after the stock market crash of 1929 and there occurred a "massive wave of bank failures" from 1930 to 1933. Salerno summarizes the conclusion of Friedman and Schwartz:
The theoretical conjecture, or "counterfactual statement," that a timely restriction of cash payments would have checked the spread of a financial crisis, is therefore empirically validated by this episode because, in the absence of a timely bank restriction, a wave of bank failures did , in fact, occur after 1929.
Of course, unlike a natural science experiment, causal factors in this context can not be strictly "controlled." Salerno states:
Friedman and Schwartz do recognize that these theoretical conjectures cannot be truly tested because "there is no way to repeat the experiment precisely and to test these conjectures in detail." Nonetheless, they maintain that "all analytical history, history that seeks to interpret and not simply record the past, is of this character, which is why history must be continuously rewritten in the light of new evidence as it unfolds."
In rejecting the historical method of specific understanding, Friedman and Schwartz are led not by reason, but by a narrow positivist prepossession with using history as a laboratory, albeit imperfect, for formulating and testing theories that will allow prediction and control of future phenomena.
To narrowly focus on concrete quantitative data without accounting for potential causal factors applicable to varying degrees in varying contexts is a fundamentally flawed approach. Yet, not surprisingly, this is Bernanke's approach to monetary policy. Rather than being guided by universal principles of economics based on an integrated grasp of theory and history, modern economists like Bernanke are in a state of almost constant intellectual flux, awaiting the latest round of data in order to guide their actions. Quoting Mueller:
It is Bernanke's unwavering creed that central banking can be practiced as a science. If things don't work out as they are supposed to, it must be because of insufficient data and inadequate models. Thus, in his anguish, he decided to create a special "brain trust," a creation called MAQS: the Fed's "Macroeconomic and Quantitative Studies" unit. Bernanke wants this team to sift through as many models, projections, stats, and scenarios as possible.
Blinded by scientism, the chairman obviously is unable to see that no sound conclusion or reliable policy formulation can be reached this way. The more data the studies team collects and sifts, the more confusions and contradictions they will bring to light; the longer they collect and sift, the less relevant the data will become.
Of course, it is not only Bernanke that is mired in this kind of brute empiricism. The entire field of economics, excepting advocates of Austrian economics, consists of glorified statisticians unable or unwilling to offer any principled understanding of economics.
The argument made in Part I, that central banking is the problem, is an argument that has been made countless times for decades. Understanding the epistemological milieu of the economics profession is important in grasping why mainstream economists are so unable to grasp this. Once again, the solution was put forth in essentialized terms by Robert Klein and George Reisman in their recently published Barron's article, Central Problem: the Central Bank :
Lurching from crisis to crisis in boom-bust fashion is unacceptable and unnecessary. The Federal Reserve must stop juicing the economy with massive amounts of newly created money and move to a monetary system free of government-caused booms and busts. The only effective way to do this would be to remove control of our money supply from politicians and their appointees. We need to move to a money that is 100% backed by a commodity, such as gold. Only then can we rid the economy of the devastating effects of the creation of money and credit out of thin air.
I have observed that any criticism of central banking or advocacy of gold is virtually always met by a similar argument. In essence, the argument is made that even under a gold standard, reoccurring panics occurred that followed the same pattern as today's boom-bust cycles. I hold that only the positivist approach to economic history could account for such a complete misunderstanding of the events of the 19th century. In other words, the positivist observes that in the 19th century there was a gold standard and yet, there were boom-busts. Then, he sees no gold standard today but stills observes boom-busts. Ergo, he concludes, gold does not prevent boom bust.
In fact, this kind of thinking has led to a kind of mythical narrative of the 19th century. The narrative goes something like this:
Once upon a time, the United States had laissez faire and a totally free banking system based on a gold standard. This "free market" system led to reoccuring panics, runs on banks, and a volatile business cycle throughout the 19th century. Finally, after the 1907 panic, a group of wise businessmen and government officials got together and created the quasi-public Federal Reserve system to act as lender of last resort and to permanently eliminate reliance on the "barbarous relic" (gold) which stood in the way of economic progress by causing continual liquidity crises. With the banking system and money supply in the hands of wise and prescient central planners (like Ben Bernanke), the United States economy would live happily ever after. The End.
I hold that such a view betrays a complete disregard for cause and effect. To fully understand the monetary history of the United States and grasp the causal factors, economic and political, which led to the unfortunate advent of the Fed, would require a volume. Fortunately, much of that work has already been done by Murray Rothbard in the aforementioned, A History of Money and Banking in the United States. Other excellent volumes have been published that detail the effects of government inflation around the world from antiquity forward such as Money, Bank Credit, and Economic Cycles by Jesus Huerta De Soto, Peter Bernholz, Monetary Regimes and Inflation, and the recent volume, This Time is Different, by Reinhart and Rogoff.
In Part 3, I will attempt to address the specific history and detail my arguments including an explanation of the "tools" that Bernanke is proposing to use to reign in his recently created excess reserves, but the essence of my historical argument is as follows.
The government has been intimately involved in the monetary system since the inception of the country leading to one disaster after another. This involvement takes two general forms. The first form is direct intervention such as the First Bank of the United States (chartered in 1791), which pyramided paper money upon specie in the form of treasury notes and set the stage for destructive inflation-depression in the early 1800's. The second form of intervention represents a default by the government to perform its legitimate and necessary function as a protector of property - call it misintervention. I claim that this default took two primary forms. First, during various crises, it continually failed to uphold banks contractual obligations to redeem in specie. Second, through various court cases, it failed to legally define property in such a way as to effectively outlaw the practice known as fractional reserve banking, i.e., legally distinguish between a deposit and a loan contract.
In Part 3, I will discuss in detail my contention that it is government intervention (or misintervention) that caused the banking crises and panics of the 19th century, not the gold standard per se. In fact, it was gold that kept any semblance of price stability at all and led to phenomenal economic expansion. Ultimately, I will argue that the permanent solution is a 100% reserve specie standard and a complete separation of state and economy.