The Man Who Justified the Fed


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Rise of the T-Bill Standard
he stage was thus set for the final “run” on the dollar
and for a spectacular default by the designated “reserve currency”
provider under the gold exchange standard’s second outing. And
as it happened, the American people saw fit to install in the White House
in January 1969 just the man to crush what remained of gold-based money
and the financial discipline that it enabled.
Richard M. Nixon, as we know, possessed numerous and notable flaws.
Foremost was his capacity to carry a grudge against anyone whom he be-
lieved had caused him to lose an election, especially any economist, policy
maker, or bystander who could be pinned with accountability for the mild
1960 recession that he believed responsible for his loss to John F. Kennedy.
Nixon’s vendetta on the matter of the 1960 election literally knew no lim-
its. For example, he insisted that a midlevel career bureaucrat named Jack
Goldstein, who headed the Bureau of Labor Statistics (BLS), had deliber-
ately spun the monthly unemployment report issued on the eve of the 1960
election so as to damage his campaign. Eight years later, Nixon informed
the White House staff that job one was to determine if Goldstein was still
at the BLS, and to get him fired if he was.
It is not surprising, therefore, that Nixon rolled into the Oval Office ob-
sessed with replacing Chairman Martin and bringing the Fed to heel. To be
sure, his only real interest in monetary policy consisted of ensuring that
the one great threat to Republican success, a rising unemployment rate,
did not happen in the vicinity of an election.
Yet it was that very cynicism which made him prey to Milton Friedman’s
alluring doctrine of floating paper money. As has been seen, Nixon wanted
absolute freedom to cause the domestic economy to boom during his 1972
reelection campaign. Friedman’s disciples at Camp David served up ex-
actly that gift, and wrapped it in the monetary doctrine of the nation’s lead-
ing conservative intellectual.
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Those adhering to traditional monetary doctrine always and properly
feared the inflationary threat of state-issued fiat money. So when the CPI
reached the unheard of peacetime level of 6.3 percent by January 1969, it
was a warning that the tottering structure of Bretton Woods was reaching a
dangerous turning point and that the monetary foundation of the postwar
world was in peril.
But not according to Professor Milton Friedman. As was typical of the
Chicago school conservatives, he simply brushed off the gathering infla-
tionary crisis as the product of dimwits at the Fed. Martin’s “mistake” in
succumbing to pressure to open up the monetary spigot to fund LBJ’s
deficits, Friedman insisted, could be easily fixed. Literally, with the flick of
a switch.
According to Professor Friedman’s vast archive of historic data, inflation
would be rapidly extinguished if money supply was harnessed to a fixed
and unwavering rate of growth, such as 3 percent per annum. If that disci-
pline was adhered to consistently, nothing more was needed to unleash
capitalist prosperity—not gold convertibility, fixed exchange rates, cur-
rency swap lines, or any of the other accoutrements of central banking
which had grown up around the Bretton Woods system.
Indeed, once the central bank got the money supply growth rate into a
fixed and reliable groove, the free market would take care of everything
else, including determination of the correct exchange rate between the
dollar and every other currency on the planet. Under Friedman’s monetary
deus ex machina, for example, the unseen hand would silently and effi-
ciently mete out rewards for success and punishments for failure in the
banking and securities markets. The need for clumsy and inefficient regu-
lation of financial institutions would be eliminated.
Friedman’s “fixed rule” monetary theory was fundamentally flawed,
however, for reasons Martin had long ago discovered down in the trenches
of the financial markets. The killer was that the Federal Reserve couldn’t
control Friedman’s single variable, which is to say, the “money supply” as
measured by the sum of demand deposits and currency (M1).
During nearly two decades at the helm, Martin learned that the only
thing the Fed could roughly gauge was the level of bank reserves in the sys-
tem. Beyond that there simply weren’t any fixed arithmetic ratios, starting
with the “money multiplier.”
The latter measured the ratio between bank reserves, which are potential
money, and bank deposits, which are actual money. As previously indicated,
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however, commercial banks don’t create actual money (checking account
deposits) directly; they make loans and then credit the proceeds to cus-
tomer accounts. So the transmission process between bank reserves and
money supply wends through bank lending departments and the credit
creation process.
Needless to say, the Fed couldn’t control the animal spirits of either
lenders or borrowers; that was the job of free market interest rates. Accord-
ingly, banks would utilize their reserves aggressively during periods of ro-
bust loan demand until borrower exuberance was choked off by high
interest rates. By contrast, bank reserves would lie fallow during times of
slumping loan demand and low free market rates. The “money multiplier”
therefore varied enormously, depending upon economic and financial
Furthermore, even if the resulting “money supply” could be accurately
measured and controlled, which was not the case, it did not have a fixed
“velocity” or relationship to economic activity or GDP, either. In fact, dur-
ing deflationary times of weak credit expansion, velocity tended to fall,
meaning less new GDP for each new dollar of M1. On the other hand, dur-
ing inflationary times of rapid bank credit expansion it would tend to rise,
resulting in higher GDP gains per dollar of M1 growth.
So the chain of causation was long and opaque. The linkages from open
market operations (adding to bank reserves) to commercial bank credit
creation (adding to the money supply) to credit-fueled additional spending
(adding to GDP) resembled nothing so much as the loose steering gear on
an old jalopy: turning the steering wheel did not necessarily mean the
ditch would be avoided.
Most certainly there was no possible reason to believe that M1 could be
managed to an unerring 3 percent growth rate, and that, in any event,
keeping M1 growth on the straight and narrow would lead to any pre-
dictable rate of economic activity or mix of real growth and inflation. In
short, Friedman’s single variable–fixed money supply growth rule was ba-
sically academic poppycock.
The monetarists, of course, had a ready answer to all of these disabili-
ties; namely, that there were “leads and lags” in the transmission of mone-
tary policy, and that given sufficient time the money multipliers and
velocity would regress to a standard rate. Yet that “sufficient time” caveat
had two insurmountable flaws: it meant that Friedman’s fixed rule could
not be implemented in the real day-to-day world of fast-moving financial
markets; and more importantly, it betrayed the deep, hopeless political
naïveté of the monetarists and Professor Friedman especially.
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As to practicality, I had a real-time encounter with it during the Reagan
years when the Treasury’s monetary policy post was held by a religious dis-
ciple of Friedman: Beryl Sprinkel. Week after week at White House eco-
nomic briefings he presented a graph based on the patented “monetarist
cone.” The graph consisted of two upward-sloping dotted lines from a
common starting date which showed where the money supply would be if
it had been growing at an upper boundary of, say, 4 percent and a lower
boundary of, say, 2 percent.
The implication was that if the Fed were following Professor Friedman’s
rule, the path of the actual money supply would fall snugly inside the
“cone” as it extended out over months and quarters, thereby indicating that
all was well on the monetary front, the only thing which mattered. Except
the solid line on the graph tracking the actual week-to-week growth of
money supply gyrated wildly and was almost always outside the cone,
sometimes on the high side and other times on the low.
In other words, the greatest central banker of modern times, Paul Vol-
cker, was flunking the monetarists’ test week after week, causing Sprinkel
to engage in alternating bouts of table pounding because the Fed was ei-
ther dangerously too tight or too loose. Fortunately, Sprinkel’s graphs didn’t
lead to much: President Reagan would look puzzled, Jim Baker, the chief of
staff, would yawn, and domestic policy advisor Ed Meese would suggest
moving on to the next topic.
More importantly, Volcker could easily explain the manifold complexi-
ties and anomalies in the short-term movement of the reported money
supply numbers, and that on an “adjusted” basis he was actually inside the
cone. Besides that, credit growth was slowing sharply, from a rate of 12 per-
cent in 1979 to 7 percent in 1981 and 3 percent in 1982. That caused the
economy to temporarily buckle and inflation to plunge from double digits
to under 4 percent in less than twenty-four months. Volcker was getting the
job done, in compliance with the monetarist cone or not.
In fact, the monetarist cone was just a Silly Putty numbers exercise, rep-
resenting annualized rates of change from an arbitrary starting date that
kept getting reset owing to one alleged anomaly or another. The far more
relevant imperative was to slow the perilous expansion of the Fed’s balance
sheet. It had doubled from $60 billion to $125 billion in the nine years be-
fore Volcker’s arrival at the Eccles Building, thereby saturating the banking
system with newly minted reserves and the wherewithal for inflationary
credit growth.
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Volcker accomplished this true anti-inflation objective with alacrity. By
curtailing the Fed’s balance sheet growth rate to less than 5 percent by
1982, Volcker convinced the markets that the Fed would not continue to
passively validate inflation, as Burns and Miller had done, and that specu-
lating on rising prices was no longer a one-way bet. Volcker thus cracked
the inflation spiral through a display of central bank resolve, not through a
single-variable focus on a rubbery monetary statistic called M1.
Volcker also demonstrated that the short-run growth rate of M1 was
largely irrelevant and impossible to manage, but that the Fed could nev-
ertheless contain the inflationary furies by tough-minded discipline of its
own balance sheet. Yet that very success went straight to an even more
fatal flaw in the monetarist fixed money growth rule: Friedman never ex-
plained how the Fed, once liberated from the external discipline of the
Bretton Woods gold standard, would be continuously populated with
iron-willed statesmen like Volcker, and how they would even remain in
office when push came to shove like it did during the monetary crunch
of 1982.
In fact, Volcker’s reappointment the next year was a close call because
most of the White House staff and the Senate Republican leadership
wanted to take him down, owing to the considerable political inconven-
ience of the recessionary trauma his policies had induced. Senate leader
Howard Baker, for example, angrily demanded that Volcker “get his foot off
the neck of American business now.”
Volcker survived only because of Ronald Reagan’s stubborn (and cor-
rect) belief that the Fed’s long bout of profligacy had caused inflation and
that only a period of painful monetary parsimony could cure it. The next
several decades would prove decisively, however, that the process of Amer-
ican governance produces few Reagans and even fewer Volckers.
So Friedman unleashed the demon of floating-rate money based on the
naïve view that the inhabitants of the Eccles Building could and would fol-
low his monetary rules. That was a surprising posture because Friedman’s
splendid scholarship on the free market, going all the way back to his pio-
neering critique of New York City rent controls in the late 1940s, was in-
fused with an abiding skepticism of politicians and all of their mischievous
Yet by unshackling the Fed from the constraints of fixed exchange rates
and the redemption of dollar liabilities for gold, Friedman’s monetary doc-
trine actually handed politicians a stupendous new prize. It rendered triv-
ial by comparison the ills owing to garden variety insults to the free market,
such as rent control or the regulation of interstate trucking.
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The Friedman monetary theory actually placed the nation’s stock of bank
reserves, money, and credit under the unfettered sway of what amounted
to a twelve-member monetary politburo. Once relieved of the gold stan-
dard’s external discipline, the central banking branch of the state thus had
unlimited scope to extend its mission to plenary management of the na-
tion’s entire GDP and for deep, persistent, and ultimately suffocating inter-
vention in the money and capital markets.
It goes without saying, of course, that the libertarian professor was not
peddling a statist scheme. So the implication was that the Fed would be
run by self-abnegating monetary eunuchs who would never be tempted to
deviate from the fixed money growth rule or by any other manifestation of
mission creep. Needless to say, Friedman never sought a franchise to train
and appoint such governors, nor did he propose any significant reforms
with respect to the Fed’s selection process or of the manner in which its
normal operations were conducted.
This glaring omission, however, is what made Friedman’s monetarism
all the more dangerous. His monetary opus, A Monetary History of the
United States, was published only four years before his disciples, led by
George Shultz, filled the ranks of the Nixon White House in 1969.
Possessed with the zeal of recent converts, they soon caused a real-
world experiment in Friedman’s grand theory. In so doing, they were also
implicitly betting on an improbable proposition: that monetarism would
work because the run-of-the-mill political appointees—bankers, econo-
mists, businessmen, and ex-politicians who then sat on the Federal Open
Market Committee (FOMC), along with their successors—would be forever
smitten with the logic of 3 percent annual money supply growth.
The very idea that the FOMC would function as faithful monetary eunuchs,
keeping their eyes on the M1 gauge and deftly adjusting the dial in either
direction upon any deviation from the 3 percent target, was sheer fantasy.
And not only because of its political naïveté, something Nixon’s brutaliza-
tion of the hapless Arthur Burns aptly conveyed.
Friedman’s austere, rule-bound version of discretionary central banking
also completely ignored the Fed’s susceptibility to capture by the Wall Street
bond dealers and the vast network of member banks, large and small, which
maintained their cash reserves on deposit there. Yet once the Fed no longer
had to worry about protecting the dollar’s foreign exchange value and the
US gold reserve, it had a much wider scope to pursue financial repression
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policies, such as low interest rates and a steep yield curve, that inherently
fuel Wall Street prosperity.
As it happened, the Fed’s drift into these Wall Street–pleasing policies
was temporarily stalled by Volcker’s epic campaign against the Great Infla-
tion. Dousing inflation the hard way, through brutal tightening of money
market conditions, Volcker had produced the singular nightmare that Wall
Street and the banking system loathe; namely, a violent and unprece-
dented inversion of the yield curve.
With short-term interest rates at 20 percent or more and way above
long-term bond yields (12–15 percent), it meant that speculators and
banks could not make money on the carry trade and that the value of
dealer stock and bond inventories got clobbered: high and rising interest
rates mean low and falling financial asset values. Accordingly, the Volcker
Fed did not even dream of levitating the economy through the “wealth ef-
fects” or by coddling Wall Street speculators.
Yet once Volcker scored an initial success and was unceremoniously
dumped by the Baker Treasury Department (in 1987), the anti-inflation
brief passed on to a more congenial mechanism; that is, Mr. Deng’s indus-
trial army and the “China price” deflation that rolled across the US econ-
omy in the 1990s and after. With inflation-fighting stringency no longer
having such immediate urgency, it did not take long for the Greenspan Fed
to adopt a prosperity promotion agenda.
First, however, it had to rid itself of any vestigial restraints owing to the
Friedman fixed money growth rule. The latter was dispatched easily by a
regulatory change in the early 1990s which allowed banks to offer “sweep”
accounts; that is, checking accounts by day which turned into savings ac-
counts overnight. Accordingly, Professor Friedman’s M1 could no longer be
measured accurately.
Out of sight was apparently out of mind: for the last two decades, the
central bank that Friedman caused to be liberated from the alleged tyranny
of Bretton Woods so that it could swear an oath of fixed money supply
growth has not even bothered to review or mention money supply. Indeed,
the Greenspan and Bernanke Fed have been wholly preoccupied with ma-
nipulation of the price of money, that is, interest rates, and have relegated
Friedman’s entire quantity theory of money to the dustbin of history. And
Bernanke claims to have been a disciple!
Constrained neither by gold nor a fixed money growth rule, the Fed in
due course declared itself to be the open market committee for the man-
agement and planning of the nation’s entire GDP . In this Brobdingnagian
endeavor, of course, the Wall Street bond dealers were the vital transmission
belt which brought credit-fueled prosperity to Main Street and delivered the
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elixir of asset inflation to the speculative classes. Consequently, when it
came to Wall Street, the Fed became solicitous at first, and craven in the end.
Apologists might claim that Milton Friedman could not have foreseen
that the great experiment in discretionary central banking unleashed by
his disciples in the Nixon White House would result in the abject capitula-
tion to Wall Street which emerged during the Greenspan era and became a
noxious, unyielding reality under Bernanke. But financial statesmen of an
earlier era had embraced the gold standard for good reason: it was the ulti-
mate bulwark against the pretensions and follies of central bankers.
At the end of the day, Friedman jettisoned the gold standard for a remark-
able statist reason. Just as Keynes had been, he was afflicted with the econ-
omist’s ambition to prescribe the route to higher national income and
prosperity and the intervention tools and recipes that would deliver it. The
only difference was that Keynes was originally and primarily a fiscalist,
whereas Friedman had seized upon open market operations by the central
bank as the route to optimum aggregate demand and national income.
There were massive and multiple ironies in that stance. It put the central
bank in the proactive and morally sanctioned business of buying the gov-
ernment’s debt in the conduct of its open market operations. Friedman
said, of course, that the FOMC should buy bonds and bills at a rate no
greater than 3 percent per annum, but that limit was a thin reed.
Indeed, it cannot be gainsaid that it was Professor Friedman, the
scourge of Big Government, who showed the way for Republican central
bankers to foster that very thing. Under their auspices, the Fed was soon
gorging on the Treasury’s debt emissions, thereby alleviating the inconven-
ience of funding more government with more taxes.
Friedman also said democracy would thrive better under a régime of
free markets, and he was entirely correct. Yet his preferred tool of prosper-
ity promotion, Fed management of the money supply, was far more anti-
democratic than Keynes’s methods. Fiscal policy activism was at least
subject to the deliberations of the legislature and, in some vague sense,
electoral review by the citizenry.
By contrast, the twelve-member FOMC is about as close to an unelected
politburo as is obtainable under American governance. When in the full-
ness of time, the FOMC lined up squarely on the side of debtors, real estate
owners, and leveraged financial speculators—and against savers, wage
earners, and equity financed businessmen—the latter had no recourse
from its policy actions.
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The greatest untoward consequence of the closet statism implicit in
Friedman’s monetary theories, however, is that it put him squarely in op-
position to the vision of the Fed’s founders. As has been seen, Carter Glass
and Professor Willis assigned to the Federal Reserve System the humble
mission of passively liquefying the good collateral of commercial banks
when they presented it.
Consequently, the difference between a “banker’s bank” running a dis-
count window service and a central bank engaged in continuous open
market operations was fundamental and monumental, not merely a ques-
tion of technique. By facilitating a better alignment of liquidity between
the asset and liability side of the balance sheets of fractional reserve de-
posit banks, the original “reserve banks” of the 1913 act would, arguably,
improve banking efficiency, stability, and utilization of systemwide
Yet any impact of these discount window operations on the systemwide
banking aggregates of money and credit, especially if the borrowing rate
were properly set at a penalty spread above the free market interest rate,
would have been purely incidental and derivative, not an object of policy.
Obviously, such a discount window–based system could have no preten-
sions at all as to managing the macroeconomic aggregates such as produc-
tion, spending, and employment.
In short, under the original discount window model, national employ-
ment, production prices, and GDP were a bottoms-up outcome on the free
market, not an artifact of state policy. By contrast, open market operations
inherently lead to national economic planning and targeting of GDP and
other macroeconomic aggregates. The truth is, there is no other reason to
control M1 than to steer demand, production, and employment from
Why did the libertarian professor, who was so hostile to all of the proj-
ects and works of government, wish to empower what even he could have
recognized as an incipient monetary politburo with such vast powers to
plan and manage the national economy, even if by means of the remote
and seemingly unobtrusive steering gear of M1? There is but one answer:
Friedman thoroughly misunderstood the Great Depression and concluded
erroneously that undue regard for the gold standard rules by the Fed dur-
ing 1929–1933 had resulted in its failure to conduct aggressive open market
purchases of government debt, and hence to prevent the deep slide of M1
during the forty-five months after the crash.
Yet the historical evidence is unambiguous; there was no liquidity short-
age and no failure by the Fed to do its job as a banker’s bank. Indeed, the
six thousand member banks of the Federal Reserve System did not make
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heavy use of the discount window during this period and none who pre-
sented good collateral were denied access to borrowed reserves. Conse-
quently, commercial banks were not constrained at all in their ability to
make loans or generate demand deposits (M1).
But from the lofty perch of his library at the University of Chicago three
decades later, Professor Friedman determined that the banking system
should have been flooded with new reserves, anyway. And this post facto
academician’s edict went straight to the heart of the open market opera-
tions issue.
The discount window was the mechanism by which real world bankers
voluntarily drew new reserves into the system in order to accommodate an
expansion of loans and deposits. By contrast, open market bond purchases
were the mechanism by which the incipient central planners at the Fed
forced reserves into the banking system, whether sought by member banks
or not.
Friedman thus sided with the central planners, contending that the
market of the day was wrong and that thousands of banks that already had
excess reserves should have been doused with more and still more re-
serves, until they started lending and creating deposits in accordance with
the dictates of the monetarist gospel. Needless to say, the historic data
show this proposition to be essentially farcical, and that the real-world ex-
ercise in exactly this kind of bank reserve flooding maneuver conducted by
the Bernanke Fed forty years later has been a total failure—a monumental
case of “pushing on a string.”
The historical truth is that the Fed’s core mission of that era, to rediscount
bank loan paper, had been carried out consistently, effectively, and fully by
the twelve Federal Reserve banks during the crucial forty-five months be-
tween the October 1929 stock market crash and FDR’s inauguration in
March 1933. And the documented lack of member bank demand for dis-
count window borrowings was not because the Fed had charged a punish-
ingly high interest rate. In fact, the Fed’s discount rate had been
progressively lowered from 6 percent before the crash to 2.5 percent by
early 1933.
More crucially, the “excess reserves” in the banking system grew dramat-
ically during this forty-five-month period, implying just the opposite of
monetary stringency. Prior to the stock market crash in September 1929,
excess reserves in the banking system stood at $35 million, but then rose
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to $100 million by January 1931 and ultimately to $525 million by January
In short, the tenfold expansion of excess (i.e., idle) reserves in the bank-
ing system was dramatic proof that the banking system had not been
parched for liquidity but was actually awash in it. The only mission the Fed
failed to perform is one that Professor Friedman assigned to it thirty years
after the fact; that is, to maintain an arbitrary level of M1 by forcing re-
serves into the banking system by means of open market purchases of Un-
cle Sam’s debt.
As it happened, the money supply (M1) did drop by about 23 percent
during the same forty-five-month period in which excess reserves soared
tenfold. As a technical matter, this meant that the money multiplier had
crashed. As has been seen, however, the big drop in checking account de-
posits (the bulk of M1) did not represent a squeeze on money. It was merely
the arithmetic result of the nearly 50 percent shrinkage of the commercial
loan book during that period.
As previously detailed, this extensive liquidation of bad debt was an un-
avoidable and healthy correction of the previous debt bubble. Bank loans
outstanding, in fact, had grown at manic rates during the previous fifteen
years, nearly tripling from $14 billion to $42 billion. As in most credit-
fueled booms, the vast expansion of lending during the Great War and the
Roaring Twenties left banks stuffed with bad loans that could no longer be
rolled over when the music stopped in October 1929.
Consequently, during the aftermath of the crash upward of $20 billion of
bank loans were liquidated, including billions of write-offs due to business
failures and foreclosures. As previously explained, nearly half of the loan
contraction was attributable to the $9 billion of stock market margin loans
which were called in when the stock market bubble collapsed in 1929.
Likewise, loan balances for working capital borrowings also fell sharply
in the face of falling production. Again, this was the passive consequence
of the bursting industrial and export sector bubble, not something caused
by the Fed’s failure to supply sufficient bank reserves. In short, the liquida-
tion of bank loans was almost exclusively the result of bubbles being punc-
tured in the real economy, not stinginess at the central bank.
In fact, there has never been any wide-scale evidence that bank loans
outstanding declined during 1930–1933 on account of banks calling per-
forming loans or denying credit to solvent potential borrowers. Yet unless
those things happened, there is simply no case that monetary stringency
caused the Great Depression.
Friedman and his followers, including Bernanke, came up with an aca-
demic canard to explain away these obvious facts. Since the wholesale
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price level had fallen sharply during the forty-five months after the crash,
they claimed that “real” interest rates were inordinately high after adjusting
for deflation.
Yet this is academic pettifoggery. Real-world businessmen confronted
with plummeting order books would have eschewed new borrowing for the
obvious reason that they had no need for funds, not because they deemed
the “deflation-adjusted” interest rate too high.
At the end of the day, Friedman’s monetary treatise offers no evidence
whatsoever and simply asserts false causation; namely, that the passive de-
cline of the money supply was the active cause of the drop in output and
spending. The true causation went the other way: the nation’s stock of
money fell sharply during the post-crash period because bank loans are
the mother’s milk of bank deposits. So, as bloated loan books were cut
down to sustainable size, the stock of deposit money (M1) fell on a parallel
Given this credit collapse and the associated crash of the money multi-
plier, there was only one way for the Fed to even attempt to reflate the
money supply. It would have been required to purchase and monetize
nearly every single dime of the $16 billion of US Treasury debt then out-
Today’s incorrigible money printers undoubtedly would say, “No prob-
lem.” Yet there is no doubt whatsoever that, given the universal antipathy
to monetary inflation at the time, such a move would have triggered sheer
panic and bedlam in what remained of the financial markets. Needless to
say, Friedman never explained how the Fed was supposed to reignite the
drooping money multiplier or, failing that, explain to the financial markets
why it was buying up all of the public debt.
Beyond that, Friedman could not prove at the time of his writing A Mon-
etary History of the United States in 1965 that the creation out of thin air of
a huge new quantity of bank reserves would have caused the banking sys-
tem to convert such reserves into an upwelling of new loans and deposits.
Indeed, Friedman did not attempt to prove that proposition, either. Ac-
cording to the quantity theory of money, it was an a priori truth.
In actual fact, by the bottom of the depression in 1932, interest rates
proved the opposite. Rates on T-bills and commercial paper were one-half
percent and 1 percent, respectively, meaning that there was virtually no
unsatisfied loan demand from credit-worthy borrowers. The dwindling
business at the discount windows of the twelve Federal Reserve banks fur-
ther proved the point. In September 1929 member banks borrowed nearly
$1 billion at the discount windows, but by January 1933 this declined to
only $280 million. In sum, banks were not lending because they were short
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of reserves; they weren’t lending because they were short of solvent bor-
rowers and real credit demand.
In any event, Friedman’s entire theory of the Great Depression was thor-
oughly demolished by Ben S. Bernanke, his most famous disciple, in a real-
world experiment after September 2008. The Bernanke Fed undertook
massive open market operations in response to the financial crisis, pur-
chasing and monetizing more than $2 trillion of treasury and agency debt.
As is by now transparently evident, the result was a monumental wheel-
spinning exercise. The fact that there is now $1.7 trillion of “excess re-
serves” parked at the Fed (compared to a mere $40 billion before the crisis)
meant that nearly all of the new bank reserves resulting from the Fed’s
bond-buying sprees have been stillborn.
By staying on deposit at the central bank, they have fueled no growth at
all of Main Street bank loans or money supply. There is no reason whatso-
ever, therefore, to believe that the outcome would have been any different
in 1930–1932.
The great irony, then, is that the nation’s most famous modern conserva-
tive economist became the father of Big Government, chronic deficits, and
national fiscal bankruptcy. It was Friedman who first urged the removal of
the Bretton Woods gold standard restraints on central bank money print-
ing, and then added insult to injury by giving conservative sanction to per-
petual open market purchases of government debt by the Fed. Friedman’s
monetarism thereby institutionalized a régime which allowed politicians
to chronically spend without taxing.
Likewise, it was the free market professor of the Chicago school who also
blessed the fundamental Keynesian proposition that Washington must
continuously manage and stimulate the national economy. To be sure,
Friedman’s “freshwater” proposition, in Paul Krugman’s famous paradigm,
was far more modest than the vast “fine-tuning” pretensions of his “salt-
water” rivals. The saltwater Keynesians of the 1960s proposed to stimulate
the economy until the last billion dollars of potential GDP was realized;
that is, they would achieve prosperity by causing the state to do anything
that was needed through a multiplicity of fiscal interventions.
By contrast, the freshwater Keynesian, Milton Friedman, thought that
capitalism could take care of itself as long as it had precisely the right
quantity of money at all times; that is, Friedman would attain prosperity
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by causing the state to do the one thing that was needed through the single
spigot of M1 growth.
But the common predicate is undeniable. As has been seen, Friedman
thought that member banks of the Federal Reserve System could not be
trusted to keep the economy adequately stocked with money by voluntar-
ily coming to the discount window when they needed reserves to accom-
modate business activity. Instead, the central bank had to target and
deliver a precise quantity of M1 so that the GDP would reflect what eco-
nomic wise men thought possible, not merely the natural level resulting
from the interaction of consumers, producers, and investors on the free
For all practical purposes, then, it was Friedman who shifted the foun-
dation of the nation’s money from gold to T-bills. Indeed, in Friedman’s
scheme of things central bank purchase of Treasury bonds and bills was
the monetary manufacturing process by which prosperity could be man-
aged and delivered.
What Friedman failed to see was that one wise man’s quantity rule for
M1 could be supplanted by another wise man’s quantity rule for M2 (a
broader measure of money supply that included savings deposits) or still
another quantity target for aggregate demand (nominal GDP targeting) or
even the quantity of jobs created, such as the target of 200,000 per month
recently enunciated by Fed governor Charles Evans. It could even be the
quantity of change in the Russell 2000 index of stock prices, as Bernanke
has advocated.
Yet it is hard to imagine a world in which any of these alternative “quan-
tities” would not fall short of the “target” level deemed essential to the na-
tion’s economic well-being by their proponents. In short, the committee of
twelve wise men and women unshackled by Friedman’s plan for floating
paper dollars would always find reasons to buy government debt, thereby
laying the foundation for fiscal deficits without tears.
Open-ended monetization of US Treasury debt by the nation’s central bank
was only part of the sound money demise triggered by the Camp David
events. The decision to destroy Bretton Woods and float the dollar also
caused an irreparable breakdown of international financial discipline.
Never again were trade accounts between nations properly settled, and
most especially in the case of the United States. As previously indicated, the
cumulative current account deficit since 1971 exceeds $8 trillion, meaning
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that Americans have borrowed one-half “turn” of national income from the
rest of the world in order to live permanently beyond their means.
These massive US trade deficits have actually become a way of life since
Camp David, yet they were not supposed to even happen. Professor Fried-
man advised the Nixon White House at the time that market forces would
actually eliminate the incipient US trade deficit by “price discovery” of the
“correct” market clearing exchange rates.
In this manner, floating exchange rates would continuously rebalance
the flows of merchandise trade, direct investment, portfolio capital, and
short-term financial instruments according to the changing circumstances
of each nation. A global variant of Adam Smith’s “unseen hand” would sup-
plant the financial stabilization and trade settlement functions of the old-
fashioned gold standard that the discarded Bretton Woods system had
been built upon.
In short, international markets would be cleared by the continuous
repricing of exchange rates. This meant that deficit countries would suffer
currency depreciation and surplus countries the opposite, thereby main-
taining international payments equilibrium.
As previously demonstrated, this seemingly enlightened, pragmatic, and
market-driven arrangement didn’t work in practice. As it turned out, Adam
Smith’s unseen hand never even reported for work after Professor Fried-
man’s floating-rate contraption was put into global operation.
Instead of floating with market forces, exchange rates have been chron-
ically and heavily manipulated by governments. This is especially the case
with respect to the mercantilist nations of Asia in pursuit of an “export your
way to prosperity” economic growth model.
In pegging their currencies far below market-clearing levels in mono-
maniacal pursuit of export advantage, Japan, China, South Korea, and the
caravan of imitators along the East Asian rim accumulated more and more
dollars. They then parked these excess dollars in Treasury bills and bonds,
and sequestered the latter in the vaults of their central banks.
Over the years, these staggering accumulations of dollar liabilities have
been labeled as “foreign exchange reserves” in deference to the wholly ar-
chaic notion that the dollar is a “reserve currency.” But the $7 trillion of dol-
lar liabilities now held by foreign central banks are not classic monetary
reserves at all.
The classic system’s monetary reserves were designed to function as in-
ternational petty cash accounts; that is, world money in the form of gold
was available to clear temporary imbalances in trade and capital flows be-
tween national currency areas. But the current system does not need petty
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cash reserves to clear international account imbalances because the latter
can persist indefinitely so long as mercantilist nations peg their currencies.
Consequently, the more apt characterization of these vast dollar accu-
mulations is that they are vendor-supplied export loans to the American
economy. Like any other vendor loan, they are designed to enable Ameri-
can customers to collectively purchase foreign goods and services far in ex-
cess of their actual earnings on current production.
This continuous stream of vendor loans was heavily channeled into
Treasury bonds and bills, along with the implicitly guaranteed paper of
Fannie Mae and Freddie Mac. Thus, the true foundation of the post–
Bretton Woods monetary system was US government debt. The latter be-
came the medium of exchange which permitted Americans to consume far
more than they produced, while enabling the developing Asian economies
to export vastly more goods than their customers could afford.
Indeed, with the passage of time the swap of mercantilist nation exports
for US government paper became embedded as the modus operandi of the
global economy. Milton Friedman’s monetary contraption has thus be-
come a ravenous consumer of Uncle Sam’s debt emissions, an outcome
that the idealistic professor had apparently never even contemplated.
By the end of 2012, however, the facts were unassailable. After three
decades of “deficits don’t matter” fiscal policy, the nation’s publicly held
debt amounted to $11.5 trillion. Yet as indicated, a stunning $5 trillion, or
nearly 50 percent, of that total was not held by private investors either at
home or overseas. Instead, it had been sequestered in the vaults of central
banks, including the Federal Reserve and those of major exporters.
This freakish central bank accumulation of dollar liabilities, in turn, was
the result of the greatest money-printing spree in world history. In essence,
we printed and then they printed, and the cycle never stopped repeating.
In this manner, the massive excess of dollar liabilities generated by the Fed
were absorbed by its currency-pegging counterparts, and then recycled
into swelling domestic money supplies of yuan, yen, won, ringgit, and
Hong Kong dollars.
As the US debt-based global monetary system became increasingly
more unstable in recent years, central bank absorption of incremental
Treasury debt reached stunning proportions. Thus, United States publicly
held debt rose by $6 trillion between 2004 and 2012, but upward of $4 tril-
lion, or 70 percent, of this was taken down by central banks.
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It could be truly said, therefore, that the world’s central banks have
morphed into a global chain of monetary roach motels. The bonds went
in, but they never came out. And therein lays the secret of “deficits without
American politicians thus found themselves in the great fiscal sweet
spot of world history. For several decades to come, they would have the
unique privilege to issue bonds, notes, and bills from the US Treasury with-
out limit. Only in the foggy future, when the world finally ran out of mer-
cantilist rulers willing to swap the sweat of their people for Washington’s
profligate debt emissions, would fiscal limits reemerge.
As it happened, not all American politicians immediately recognized
that they had essentially died and gone to fiscal heaven. Hence in the first
half of the 1990s, under George H. W. Bush and then President Bill Clinton,
old-guard Republicans joined bourbon Democrats in the enactment of
comprehensive fiscal plans that did actually reduce spending and raise
new tax revenues.
But Bill Clinton’s courageously balanced budgets were the last hurrah of
the old fiscal orthodoxy. These outcomes rested on a frail reed of personal
conviction among politicians who had learned the fiscal rules of an earlier
In the emerging world of American crony capitalism, however, fiscal or-
thodoxy based on mere conviction untethered to real-world economic and
financial pressures was not destined to survive. Instead, the assembled
lobbies of K Street would soon have their way with the nation’s public
In due course, the revenue base would be depleted in the name of
spurring the growth of everything from ethanol plants to private aircraft to
the gross national product itself. Meanwhile, the spending side of the
budget became swollen with new subventions to the sick-care complex,
the housing complex, the education behemoth, the farm subsidy har-
vesters’ alliance, and the alphabet soup of energy alternatives.
In the larger scheme of things, the nation’s descent into permanent fis-
cal profligacy during the late twentieth century should not have been sur-
prising. The historical record prior to the T-bill standard quite clearly
demonstrates that fiscal discipline had never really depended upon the
fortitude of principled statesmen.
After the Greenspan Fed abruptly abandoned its 1994 effort to impose a
mild semblance of monetary discipline, the world’s T-bill-based monetary
system was off to the races. Frenetic money pumping by the Fed was re-
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ciprocated by even more aggressive currency pegging in East Asia, most es-
pecially in China, where the exchange rate was devalued by nearly 60 per-
cent at the beginning of Mr. Deng’s export campaign in 1994.
Fueled by this reciprocating monetary engine of central bank printing
presses, the world economy was soon booming and the US current ac-
count deficits swelled to massive proportions. Thus, the current account
deficit of $114 billion in 1995 was already an alarming 1.6 percent of GDP,
but that was just a warm-up for the coming binge of borrowed prosperity.
Thereafter, the US current account deficit with the rest of the world went
parabolic, rising to $416 billion, or 4.2 percent, of GDP by the year 2000.
Indeed, for the entire 1990s decade the nation’s cumulative deficit with the
world was $2.0 trillion—a giant loan from abroad that bought a lot of de-
signer jeans, personal computers, granite-top kitchen counters, gas-
chugging SUVs, and luxury cruises that American households had not
actually earned.
Yet the borrowing binge fostered by the Greenspan Fed was just getting
warmed-up. American overspending financed by exporter nation loans at-
tained nearly riotous proportions after the turn of the century, reaching, a
peak current account deficit of $800 billion, or 6.1 percent, of GDP in 2006.
For the decade ending in 2011, cumulative borrowings from the rest of
the world tripled from $2 billion in the 1990s to $6 trillion. And so America’s
garages, pantries, media rooms, and second homes filled up with even
more stuff bought on the prodigious flow of credit generated by the world’s
T-bill-based monetary system.
In the fullness of time, floating-rate money led to fiscal profligacy on a
scale never before imagined. Spending without the inconvenience of tax-
ing opened the door to state subventions, bailouts, and endless tax breaks
throughout the length and breadth of the American economy.
But the plenary mobilization of the state and all its agencies and organs
of intervention, including the prosperity management régime of the cen-
tral banking branch, is what fueled the rise of crony capitalism. It is a long-
standing truism of political science that focused, organized special
interests will always trump the diffuse public interest. So once raiding the
Treasury and leveraging Wall Street and the banking system were deemed
to be the pathway to the greater good, K Street lobbies and political action
committees (PACs) captured the instruments of policy and extracted the
resources of the public purse like never before.
So the irony was abundant. Friedman the historian was dead wrong on
the gold standard and the Fed’s responsibility for the Great Depression. Ac-
cordingly, the libertarian economist from the University of Chicago, more
than any other single intellectual, fostered the Nixonian breakdown of
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monetary integrity and helped crush the last age of fiscal rectitude so
painstakingly restored by Dwight D. Eisenhower.
Proffering what is by the hindsight of history a spurious rule of money
supply growth, Friedman gave birth to the T-bill standard and a massively
disordered and unbalanced international system in which mercantilist
governments swap the labor of their people and natural resources of their
lands for “money” which is merely dollar-denominated American debt.
Worse still, the later process became the foundation for the age of bub-
ble finance, a great financial deformation that resulted in a Wall Street
crescendo of speculation and rent seeking that had no historical parallel.
Neither did Friedman’s folly.
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