It’s time to restore sound money

The standard bearer for the Libertarian agenda has been U.S. Rep. Ron Paul. Congressman Paul made news last week by declaring that his efforts to audit the Federal Reserve were less about “Ending the Fed” (the title of his book) and more about making its actions more transparent. By doing so, it is his hope that we can wean both politicians and bankers from their addiction to easy money and easy credit.

The Libertarian philosophy is about self determination; involvement by government and its institutions distort capitalism; determine winners and losers; and create perverse outcomes. Libertarians favor both sound money and small government. The key to sound money is to limit the growth of credit in the banking system. It is the growth of credit that results in the tendency of the economy to gyrate between conditions of boom and bust. When excess credit flows into the real economy it has a tendency to create inflation; when it flows into the capital markets we get asset bubbles. Both outcomes create economic instability.

Sound money can only be assured when we contain its growth. We can rely on the judgment of men (the managed money of the Federal Reserve) or tie money to the growth of a scarce commodity (gold). The beauty of commodity money is that it imparts discipline. Balance of payments deficit -- like that currently existing with China -- would be self-correcting as they redeem their paper money claims for gold. To avoid losing gold and shrinking the money supply, the central bank would raise interest rates and curtail both domestic credit growth and the “external leakage” of gold.

Domestically, the banking system would be controlled by every American having the right to convert his paper money into gold on demand. Should citizens exercise that right, the banks would have to shrink their loan portfolios consistent with the shrinkage of gold that would then reside in citizen’s safes and not in the bank vaults. This is termed an “internal leakage.”

Now let’s apply the later concept to the recent experience with the subprime mortgages and the financial crisis of 2008. Your neighbor gets a mortgage and you hear that he put up no down payment and provided no documentation. This does not appear consistent with prudent banking and if your deposits at the bank were not guaranteed by the FDIC, you would withdraw your deposit and go to another bank, forcing your original bank to slow its careless rate of loan growth. If all banks were doing the same thing and we were on the gold standard, you would convert your paper money to gold and force the entire system to curtail the imprudent lending.

But we are not on the gold standard and deposits are insured so we fall back to the judgment of the Federal Reserve to recognize that these were not loans that were being made but people merely using the banking system to inventory credit risk for a brief period while they flipped real estate. The Federal Reserve chairman, when called upon to address whether or not there was a housing bubble, fell back upon his early years as a homebuilding analyst and proclaimed that it was impossible to have a national real estate bubble because real estate is a local market. The chairman had the resources of the system’s 12 regional banks to draw upon. As Texas Gov. Rick Perry noted during the Republican primary debates, Texas did not have a real estate crisis because Texas has a law mandating that homes be financed with a 20 percent down payment. There is a regional reserve bank in Dallas. Had the Fed chairman consulted the head of the Dallas bank he might have drawn the linkage between the appreciation in real estate prices and the financing provided everywhere else but not in Texas.

The subprime mortgage / real estate bubble was preceded by the bubble in technology, media and telecommunication stocks between 1996 and 2000. It was the expert judgment of the Federal Reserve that we were experiencing a productivity miracle and not a speculative bubble. Furthermore, if it was a bubble, the Fed had no motivation to curtail the speculation but stood ready to intervene to pick up the pieces when the bubble popped. Yes, Virginia, there is a Santa Claus and moral hazard is alive and well. The Fed stands ready to socialize the losses when privatized gains evaporate.

What is the solution for a Federal Reserve system that cannot make judgments related to the quality of loans and assets on bank balance sheets or detect the development of an asset bubble? It is to contain the growth of credit. It is for the Fed to impose a commodity rule upon itself; to pretend that a leakage exists such that gold would be flowing out of the country and raise interest rates to curtail the leakage. Second, the Federal Reserve must elevate financial stability to parity with inflation and employment goals. Only then can we be assured that we will never again be called upon to bailout the banking system.

Today, the Federal Reserve has committed itself to holding short-term rates at zero through 2014 and buying long-term treasurys to keep interest rates below inflation. The financial dislocations created by this policy are huge and the policy should be aborted.

Contact Glensky, a former Wall Street financial manager who now lives in North Myrtle Beach, at bwglensky@sccoast.net.