“Capitalism and Freedom” Summary, Chapter 3: The Control of Money

by Danny Fenster

This chapter is a free excerpt from Quicklet on Capitalism and Freedom.

It's said that "private free-enterprise economies" are unstable. This is untrue, and has let "full employment" and "economic growth" become excuses for increased government intervention. This peaked after the Great Depression with the New Deal policies.

The Great Depression was the result of poor governance rather than still-present Federal Reserve policies like trade restrictions, high taxes, and regulations. Their elimination still leaves a role for government: providing a stable monetary framework through monetary and fiscal policies.

Two methods are the Scylla, which utilizes a pure gold standard, and the Charybdis, which combines central planning and banking. "Neither has proved a satisfactory solution."


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It's said that "private free-enterprise economies" are unstable. This is untrue, and has let "full employment" and "economic growth" become excuses for increased government intervention. This peaked after the Great Depression with the New Deal policies.

The Great Depression was the result of poor governance rather than still-present Federal Reserve policies like trade restrictions, high taxes, and regulations. Their elimination still leaves a role for government: providing a stable monetary framework through monetary and fiscal policies.

Two methods are the Scylla, which utilizes a pure gold standard, and the Charybdis, which combines central planning and banking. "Neither has proved a satisfactory solution."

Freedom requires that power be dispersed. There is a conflict between the need for government in monetary policy and the dangerous concentration of power that need can lead to; the problem is to create the institutional framework to balance the two.

A commodity standard like gold or silver would, in principle, make a government's role unnecessary; monetary supply would depend on the ability to produce the commodity and changes in demand for it.

Because commodity production is resource intensive, commodity standards often come with fiduciary money that can be converted into the commodity at a fixed rate.

If an absolute gold standard were feasible, the tension would be resolved, but this has never been the case. Fiduciary elements, once introduced, necessitate the government to enforce their validity and prevent counterfeiting. Most gold-standard advocates call for some mix of commodities and state-backed fiduciary elements.  

Crises throughout the late nineteenth and early twentieth century created a demand for banking regulation, leading first to a National Monetary Commission and eventually to the Federal Reserve Act of 1913. The then partial gold standard was supposed to limit the power of the latter, but many abandoned gold when World War I began. The act became a "powerful discretionary authority able to determine the quantity of money," at home and abroad.

This was the most profound change in monetary policy since the Civil War. It was said to aid stability in the market, but the period from 1914 to the present was far less stable than from the Civil War to 1914. While world wars had an impact, the trend remained in peacetime. "No other twenty-year period in American history contains as many as three such severecontractions" as in 1920-21, 1929-33 and 1937-38.

Perhaps circumstances were to blame and we would have been worse off without the Federal Reserve System, Friedman suggests, but comparison should cause one to question the system's effectiveness--history suggests it made contractions worse.

The 1929 stock market crash is often blamed for causing the Great Depression. But the crash only deepened ongoing trends; business had already peaked and started to descend before the crash, according to Friedman.

"There is nothing in the economic situation as it stood in, say, September or October, 1930 that made" the depression inevitable. A series of bank failures in 1930 sparked bank runs across the country, climaxing with the Bank of the United States failure. Liquidity crises became recurring events, which diminished money stocks.

To break the cycle banks must stop converting deposits into currency or the Federal Reserve must create and give money banks to give to depositors. The Federal Reserve was given the ability to this, but at the end of 1930 they did little or nothing. After a brief stabilization, a cycle of runs again ensued; the Reserve system again stood idly by.

The Reserve System reacted vigorously to increased gold withdrawals from the United States in 1931 even though gold stocks were at an all-time high. The gold drain was arrested but a more dramatic increase in bank runs and failures followed.

The Reserve's 1932 purchase of $1 billion in government bonds slowed this, and would have prevented much of it if done earlier. By 1932 it was only palliative. The System again became passive. A renewed collapse led to the Banking Holiday in 1933, wherein all US banks were officially closed for over a week.

But "so great is the capacity for self-justification" that the Federal Reserve Board wrote in its 1933 annual report of its ability to "meet enormous demands for currency during the crisis."

"Had the money stock been kept from declining, as it clearly could and should have been, the contraction would have been both shorter and far milder."

The Great Depression is a testament to how destructive the power of a few decision-makers over the monetary system can be. Such a system is bad both for freedom and for stability.

The only solution is to "achieve a government of law instead of men" by legislating rules for monetary policy.

When decisions are made on the particulars of a single case, decision-makers won't likely take into account the broader implications of their actions. If a general rule is adopted for a group of cases, it is more likely to do so. Free speech, for instance, may be voted against if decision-makers disagree with a man's right to preach benefits of, say, communism. But asked about everyone's free speech, generally, they would likely vote to preserve it.

"If the bundle is viewed as a whole, it becomes clear that the policy followed has cumulative effects that tend neither to be recognized nor taken into account when each case is voted on separately."

Reserve System's control of the growth of money ought to be legislated. "I would specify that the Reserve System shall see to it that the total stock of money so defined rises month by month, and indeed, so far as possible, day by day, at an annual rate of X percent, where X is some number between 3 and 5."

This, with reforms elaborated elsewhere, would curtail the discretionary powers of the state. These are not be-all and end-all solutions "to be written on tablets of stone," but are the best we can do with current knowledge. We should hope to improve even further as our knowledge grows.

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