There are many economists, commentators, and investment advisors (mostly conservatives) that for years have been preaching that the American monetary system and economy will go into crisis and collapse due to the Federal Reserve’s monetary policies. Despite their predictions being wrong, they refuse to give up their theories, mainly based on their understanding of the writings of Ludwig von Mises and Milton Friedman. Yet it’s because they do not fully understand the monetary theories of these two men that their predictions have failed to come true. The fatal flaw in their reasoning can be broken into two parts. The first being their misconception of the "crack up boom" theory posed by von Mises and the second mistake coming from their misunderstanding of the monetary theories of Milton Friedman.

These theories, which most conservatives cite, are correct. But the interpretation and application of theory by many on the right is off. The process goes like this: The government intervenes into the economy to stimulate growth. It increases the money supply and artificially lowers interest rates while increasing spending on projects such as infrastructure, national defense, or welfare programs. The result at first is a burst of economic activity. But as the increased money runs its course, and the make-work projects begin to ebb, the economy begins to slump again.

At this point the government has a choice: Allow the economy to slump or re-stimulate. But in order to regain previous levels of economic activity it takes even more stimulation. If government injects a similar or smaller amount of stimulus, there isn’t the same "bang for the buck." So it must simulate more than before. Prices rise due to more money chasing fewer goods. Interest rates rise with inflation. Economic activity is curbed and the government finds itself with the same choice to make again—endure a recession or create even more stimulation! Greater and greater amounts of stimulation lead to ever higher inflation and interest rates. It becomes a vicious cycle.

Like a drug addict requiring a greater dose with each injection to achieve the same high, a government fully committed to financing the economy through increasing inflation faces a final blow up, i.e., the crack-up boom. And should the government stop the stimulation, the economy falls quickly into recession or worse. The result can eventually lead to complete monetary and economic collapse as we have seen recently in Zimbabwe. This is why you can't buy prosperity.

America flirted with this path to "prosperity" during the late 60's and 70's. During that time we totally ignored the link between the monetary unit and gold. We went from spending huge amounts of money on the "Great Society" to financing the Vietnam War, all by artificially increasing the amount of money and credit. Soon we moved from an overheated economy to recession. Next came increased money creation to stimulate the economy which led to sky high oil and home prices and then predictably to another recession. We then stimulated even more which led to double digit inflation, interest rates, unemployment, and the free fall of the dollar in international markets while gold pushed to all time highs. This led to another recession in 1980 with yet another try at stimulation and another recession in 1981.

Then came Reaganomics. The monetary policies of the Fed were finally reversed by Paul Volker, carried on by Greenspan, and augmented by Bernanke. These policies were neither Keynesian nor Monetarist, but a mixture of classical monetary and economic policies that were time tested and always successful when employed.

A lot of people misinterpret the period from 1980 to 2007. Many conservatives, led by David Stockman OMB chief under Reagan, believed that we were still employing the same kind of inflationary finance as in the 70's and that this would lead us into a "crack-up boom" scenario. They believe the same thing today. This is a mistake. If inflationary finance worked we would not have had the disaster of the 70's, or achieved in the 80's and 90’s one of the most prosperous periods in history. They were two entirely different periods. If it was inflationary finance that worked in the 80's it would be employed today by every government in the world, trying to recapture the 25 years of unprecedented growth the US experienced.

On the contrary, the prosperity of the 80's and beyond were built on contracting increases in money supply from double digit rates to low single digit levels; on lower tax rates, greater freedoms, and less government intrusion into the economy. Free trade blossomed during this period and the dollar soared while gold averaged about four hundred dollars an ounce for a generation. During the 70's, however, money supply and inflation rates grew progressively higher. This led to a crashing dollar and a soaring gold price, as opposed to 80’s and 90’s. A lot of conservatives mistakenly believe that both eras were periods of artificial growth caused by easy money policies of the Fed, when in fact these two periods were opposites.

We had our share of typical capitalist booms and busts during the 80's and beyond, but distinctly different from the crack-up boom scenario. We had the stock market crash of '87, yet we recouped and went to new highs shortly thereafter. We had the Asian Contagion and Long Term Capital crisis of the early 90's, but it was over quickly. We had the dot com boom and bust and the toppling of major companies like Enron and WorldCom. But, we also had one of the greatest periods of technological innovation and productivity known to man. And we did not have progressively higher inflation rates and higher interest rates and the resulting multiple recessions like we saw in the 70's. In fact we only had about three or four quarters of negative growth in an entire quarter century.

The era of the late 60’s to 1980 was an era of stagflation. The era from 1980 to 2007 rivaled the American industrial revolution in innovation and duration. The monetary policies that characterize the crack-up boom did not create over twenty-five years of prosperity. Again, you cannot buy that kind of prosperity.Those that have claimed year after year that the entire technological revolution was an artificial boom, continue to predict a "crack-up boom" today. But they are wrong. We do not have nor did we ever have progressive inflation. Inflation has been contained since 1980. From then to now we have lived in a period of disinflation.

The misinterpretation of the 25 year burst of prosperity comes from a fatal misunderstanding of the way inflation works. There is a difference between inflation and progressive inflation. Inflation, which is caused by the artificial increase of money and credit, dilutes all other dollar claims outstanding. It is a tax. The initial increase affects prices, interest rates, production, and investment decisions, throughout the economy, and distorts the market process along the way.

But, once the new money has worked its way through the economy the market adjusts to the new set of conditions and the affects stop there. A tax has been levied, distortions occur, but as long as this is a one-time only injection, the economy tends to adjust and return to normal. The effects run their course and prices become stable again. This by the way is also true under a gold standard, when major gold discoveries temporarily balloon the money supply and raise prices. But gold standard or fiat, once the increase of money returns to normal levels,everything else also returns to normal levels.

Progressive increases in the supply of money and credit is a very different story. Progressive increases, going from 2% rates, to 5% rates, to 7% rates, to 12% rates ad infinitum; create vast distortion leading to mal-investment, over-consumption, and the misallocation of resources. Unchecked this leads to progressive increases in prices and interest rates. This is the cycle that results in the monetary system exploding as it becomes impossible for the market to keep adjusting. This was the road we were on in the 70's, not the road we followed in the 80's and thereafter. Reaganomics reversed that trend.

While the crack-up boom is the scenario doom and gloomers have been expecting to happen—it hasn't. Because we do not have a Fed promoting progressive inflation like we did in the 70's. The Fed promotes anti-deflationary monetary policies and by doing so is preventing this country from enduring a deflationary Great Depression as in the 30's or a 25 year deflationary recession such as Japan.

This is not an era of easy money, leading to too much money chasing too few goods, leading to higher and higher prices. Nor is it an era characterized by easy credit. Money is hard to get, and credit is scarce. The velocity of money which is at historic lows verifies these facts.

Most conservatives cite Milton Friedman as a source of authority who stressed that increases in money supply will cause inflation but these same conservatives, gold bugs, and libertarians refuse to acknowledge Friedman’s views that the Fed in the 30's, and Japan in the 80's and 90's, needed to dramatically fight deflation by increasing the money supply. Try to square Friedman's views with today's gurus that want to end the Fed and end all increases in money supply. The fact is that Milton Friedman argued for the existence of a Federal Reserve System as a lender of last resort. Friedman was for a fiat system, and was for increasing the money supply to whatever amounts were necessary to fight deflation:

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What Would Milton Friedman Say about Fed Policy Under Bernanke? | David Beckworth, William Ruger | Cato Institute

The sad truth is most conservatives just don't understand the monetary theories of Friedman or von Mises, yet they cite them as evidence for their views. This fatal flaw in their thinking can lead to massive mistakes in their investment decisions, to say nothing of the damage it could do to our monetary system and economy if ever implemented. Yet, the leaders of the Republican Party are committed to taking America down a deflationary/recessionary road if elected someday. Hopefully there is time for them to correct their views.

For a further discussion of the remedies of today's stagnation, see my many articles in the commentary section on the Fed and monetary policy at paulnathan.biz.

Paul Nathan
Paulnathan.biz