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Hayek and the Dangers of Monetary Nationalism

Author: Benn Steil, Senior Fellow and Director of International Economics
November 30, 2010
Council on Foreign Relations


Manuel Hinds and I have many, many people to be thankful to tonight, but I’ll confine myself here at the podium to thanking the Manhattan Institute for the enormous honor of this Hayek Prize, Tom Smith for his vision and generosity in underwriting the prize, and Jim Grant for his gracious introduction.

I should perhaps, though, extend a supplementary thanks to Mr. Guido Mantega. Mr. Mantega, whose name I did not know until very recently, is the Brazilian finance minister. In declaring that the world was “in the midst of an international currency war,” Mr. Mantega graciously created a new and timely backdrop for our book—Money, Markets and Sovereignty—and our lectures this evening. Mr. Mantega’s dark observations rang true enough to set off alarm bells in national treasuries and central banks around the world. They also brought to life Friedrich Hayek’s writings in the 1930s on the destructive rise of what he called “Monetary Nationalism.”

Hayek believed that the demise of a credible international medium of exchange, and the rise of independently managed national fiat currencies, continuously fluctuating in value against one another, would inevitably foster massively destabilizing short-term capital flows and a breakdown in international trade relations.

The seeds of this destruction were sown in the aftermath of the first World War, when the United States and others decided to restore the international gold standard in name only. In practice, the newly created Federal Reserve and other national central banks would manage their currencies entirely on a discretionary basis, abandoning the rules of the international monetary system that underlay the rapid integration of the international economy that marked the late nineteenth century.

Let me briefly focus on what this turn toward monetary nationalism meant for the United States and the wider world, and what the parallels are to our current situation.

In contrast to popular mythology, the Fed in the 1920s was not following the dictates of the gold standard. Far from it. The Fed was openly pursuing a policy it called price stabilization. Of course, the idea that the job of a central bank was to stabilize some collection of prices is orthodox today. Yet to stabilize the prices the Fed was targeting in the 1920s in the face of persistent downward pressure on such prices from rapid technological advance, the Fed had to “force enormous quantities of bank credit into the economic system as an offsetting factor.” Writing three years after the crash, the British economist D.H. Robertson observed that “the great American ‘stabilisation’ of 1922-1929 was really a vast attempt to de-stabilise the value of money in terms of human effort by means of a colossal programme of investment in buildings, motor car plants, etc. . . . which no human ingenuity could have managed to direct indefinitely on sound and balanced lines.” Not even the human ingenuity lodged in the Federal Reserve.

Well, what was the result? Everyone today knows about the stock market boom and subsequent crash in 1929. But few are aware of just how pervasive the credit bubble was. Over the decade to 2007 we witnessed here in the United States “a constructional boom of previously unheard-of dimensions. A real estate boom developed, first in Florida, but soon was transferred to the urban real estate market on a nation-wide scale.” But whereas this is an apt description of recent history, I actually took this quote from a book written in 1937, by three economists writing about the mid-1920s.

There was also a critical international dimension to the American credit bubble and crash, which has precise parallels today.

Consider first how the United States and China would interact under a classical gold standard. If the U.S. sent a dollar to China, China would have to redeem that dollar for American gold. A fall in the U.S. gold stock would necessitate a rise in U.S. interest rates, which would reduce credit growth, reduce prices, and reduce the trade deficit. This is the mechanism by which the gold standard automatically corrected global imbalances.

Compare this with today’s actual monetary structure. When the U.S. sends a dollar to China, China immediately returns it in the form of a low interest rate loan. That dollar is then recycled through the U.S. financial system, causing further credit growth and, critically, no countervailing Federal Reserve action.

The bubbles and imbalances that have marked the past decade—as they did the 1920s—are features of a monetary regime which operates in precisely the opposite fashion as the one which operated during the great globalization of the late nineteenth century. America is not, as Fed chairman Ben Bernanke would have it, a passive victim of “a global savings glut.” It should not, therefore, be surprising that bubbles continue to emerge in one asset market after another, and will continue to burst with damaging consequences.

To grasp what we are getting ourselves into, consider this analogy.

Imagine you get into the shower, turn on the water, and nothing comes out. You call the plumber. He tells you there’s a hole in the pipes, and that it will cost you a thousand dollars to repair it. You tell him just to turn up the water pressure instead.

Sound sensible? Well, this is the logic behind QE2, the Fed’s strategy to keep flooding the money pipes until credit starts flowing freely again from banks to businesses.

You wouldn’t expect this to work in your shower, and there’s little reason to expect it to work in the commercial lending market. The credit transmission mechanism in the United States has been seriously damaged since 2007. There is a hole in the pipes. Small- and medium-sized businesses in this country are dependent on small- and medium-sized banks for access to vital credit, yet too many of these banks remain walking dead, unable to lend because their balance sheets are littered with bad commercial and real estate loans made during the boom years.

The Troubled Asset Relief Program (TARP) was an opportunity to force banks to disgorge bad assets. This would have repaired the credit pipes. Instead, banks were obliged only to take equity injections from the government, equity they consider politically toxic, and they have therefore been focused on returning it at the earliest opportunity—not on using it to boost lending. The net result is that, even though the Fed has driven its short-term lending rate down to zero, most banks will only lend on vastly greater collateral and at much higher real interest rates than before the bust. So now we plow on with the cheap option: flood the pipes and see what comes out.

Make no mistake, something will come out. We’ve already seen the liquidity intended to boost domestic bank lending instead spill out through the cracks into markets as diverse as agricultural commodities, metals, and poor country debt.

What is remarkable about this is that some of QE2’s most prominent cheerleaders actually think it is all well and good wherever new demand shows up. After all, it is only “aggregate demand” that matters to the Keynesian faithful. To worry about the composition of demand, like a Hayekian, is silly. It only complicates the algebra. Nobel economist and New York Times columnist Paul Krugman, who today berates the Fed for not opening the sluice far wider, in August 2001 wrote that “The driving force behind the current slowdown is a plunge in business investment.” Yet “to reflate the economy,” he told us, “the Fed doesn’t have to restore business investment; any kind of increase in demand will do.” In particular, he continued, “Housing, which is highly sensitive to interest rates, could help lead a recovery.” A year later, the Fed having not moved aggressively enough for him, Krugman divined that “[the Fed] needs soaring household spending to offset moribund business investment. And to do that [it] needs to create a housing bubble to replace the Nasdaq bubble.” Wish granted.

It is the great seduction of Keynesianism that its economics consists merely of the government’s manipulation of national aggregates, and that the flagging animal spirits of the inscrutable entrepreneur need only be compensated for, quickly and painlessly, by government money-printing and spending. But we cannot afford a sequel to the crisis we are only just now unsteadily emerging from. The outside world, which relies on the U.S. dollar as its primary trade vehicle and therefore reserve asset, cannot be expected to watch passively as dollars continue to spew forth into their currency, commodity, and asset markets, with no clear end in sight. The idea that freely floating exchange rates will take care of everything is contradicted by the post-1971 history of recurrent international financial crises, which compares abominably with the pre-1914 era of the classical gold standard. And it was Hayek who observed in the 1930s that floating exchange rates combined with monetary nationalism was a recipe for trade wars and political conflict.

One conviction that Hayek did share with Keynes was the belief that, ultimately, the power of good ideas trumped the power of organized interests, no matter how entrenched such interests were. In Money, Markets and Sovereignty, Manuel Hinds and I have tried, in the spirit of Hayek, to capture the good ideas which, over millennia, going back to the great Stoic thinkers of the ancient Hellenistic world, have been essential to creating sound law, sound money, and enduring international cooperation—ideas which underlay what Hayek called “the Great Society.” We hope in some small way to encourage a renewed interest in such good ideas.