The Magazine

Putting the Toothpaste Back into the Tube

Federal Reserve chairman Ben Bernanke needs to spell out how he plans to head off hyperinflation.

Apr 27, 2009, Vol. 14, No. 30 • By ANDY KESSLER
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Periods of rapid economic growth would often follow huge gold discoveries. The Spanish "found" Inca gold in the 1500s, which the British and French eventually stole or traded for, which funded the Industrial Revolution. The Gold Rush of 1849 funded the post-Civil War expansion. More gold, more money supply, more room for innovation.

Even without more gold, goldsmiths and money changers learned long ago to hold gold for their clients, maybe even paying them a small interest rate for the privilege of holding their gold, and then turn around and lend out money (often creating their own currencies) backed by that gold. And not $1 for each $1 in gold held. No, no, no. They might as well lend out ten times as much money as the gold they held, figuring not all the "depositors" would want their gold back at the same time. Money from nothing (and your checks for free). Sort of, anyway. This sleight of hand, called fractional reserve banking, was an easy way to increase money supply to again, make room for productivity and wealth creation. But increase by how much? No one knew, which is why there were occasionally bank runs and panics and depressions that followed easy credit, one of the hazards of this flimsy system. Sixteen of them since 1812. As American as apple pie!

But banking did increase the money supply beyond the amount of gold that could be extracted. In fact, since Adam and Eve, 160,000 tons of gold have been panned and mined from Mother Earth. At $35 per ounce under the gold standard, that came to $180 billion in value, not nearly enough to support all the value created by entrepreneurs; heck, Google is worth almost that much.

In the long run, the economy grew faster than population, ushering in railroads and interstate highways and even Carrot Top performing at the Luxor in Las Vegas. Now that's wealth. So something eventually went right. One something was the Federal Reserve, created in 1913 to control how much money is in circulation. The Fed would create a monetary base, originally backed by the gold in Fort Knox, that private banks would then lend against.

One of the tasks of the Federal Reserve is to serve as the lender of last resort, which they unfortunately learned after the stock market crash of 1929 and the bank runs that followed. Roughly 40 percent of banks failed, wiping out $2 billion in deposits. Some 30 percent of the money supply disappeared. So did a similar percentage of GDP, and unemployment hit 25 percent. You can see that lost money supply is not a good thing.

The other big something happened in 1933. The Federal Deposit Insurance Corp, the FDIC, was set up to insure depositors' money, relieving people of the need to line up to get their money out at the first sign of a bank's weakness. No more bank runs. Not many, anyway. (We can argue if the FDIC is really an insurance policy, as it undercharges banks for the privilege of insuring against bank runs, and you and I, the taxpayers, make up the difference. Still, it's a decent bargain--a backstop to panics, ordinary bank-run panics anyway!)

Twin bargains. Twin safety nets for fractional reserve banking, so we don't have to go back to the stifling days of gold. But that still means the Federal Reserve has to figure out how much money to create to fill the bucket--an almost impossible task.

The Fed has few levers. Interest rates are set in order to try to create just the right amount of money, with the Fed looking at prices, consumer prices and producer prices, as a surrogate for the price level. Prices are everything. Even though lower costs of computers and cell phones and LCD TVs are a positive for the economy and a wealth creator, as the productive use of technology always creates wealth, it is often interpreted as deflationary or at least dis-inflationary, and even as our technotoys get cheaper, interest rates may still be cut to "stimulate" the economy.

Sometimes, when too much money is created, it doesn't show up in consumer or producer prices, but flows into the stock market, or housing, and it appears to everyone as new wealth. Sometimes it is--Apple going from $15 to $100 was wealth creation based on the iPod and the iPhone, although the move of the stock to $175 was probably excess money creation.

But the run-up in house prices was worse. Incomes go up from real wealth, and some of that money goes into housing. But housing is often a false signal: Too much money, especially leveraged, can increase housing beyond what wealth created.