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Chapter V
Fiscal Policy
Ever since the new deal, a primary excuse for the expansion of governmental activity at the federal level has been the supposed necessity for government spending to eliminate unemployment. The excuse has gone through several stages. At first, government spending was needed to "prime the pump." Temporary expenditures would set the economy going and the government could then step out of the picture.
When the initial expenditures failed to eliminate unemployment and were followed by a sharp economic contraction in 1937-38, the theory of "secular stagnation" developed to justify a permanently high level of government spending. The economy had become mature, it was argued. Opportunities for investment had been largely exploited and no substantial new opportunities were likely to arise. Yet individuals would still want to save. Hence, it was essential for government to spend and run a perpetual deficit. The securities issued to finance the deficit would provide individuals with a way to accumulate savings while the government expenditures provided employment. This view has been thoroughly discredited by theoretical analysis and even more by actual experience, including the emergence of wholly new lines for private investment not dreamed of by the secular stagnationists. Yet it has left its heritage. The idea may be accepted by none, but the government programs undertaken in its name, like some of those intended to prime the pump, are still with us and indeed account for ever-growing government expenditures.
More recently, the emphasis has been on government expenditures neither to prime die pump nor to hold in check the specter of secular stagnation but as a balance wheel. When private expenditures decline for any reason, it is said, governmental expenditures should rise to keep total expenditures stable; conversely, when private expenditures rise, governmental expenditures should decline. Unfortunately, the balance wheel is unbalanced. Each recession, however minor, sends a shudder through politically sensitive legislators and administrators with their ever present fear that perhaps it is the harbinger of another 1929/-33. They hasten to enact federal spending programs of one kind or another. Many of the programs do not in fact come into effect until after the recession has passed. Hence, insofar as they do affect total expenditures, on which I shall have more to say later, they tend to exacerbate the succeeding expansion rather than to mitigate the recession. The haste with which spending programs are approved is not matched by an equal haste to repeal them or to eliminate others when the recession is passed and expansion is under way. On the contrary, it is then argued that a "healthy" expansion must not be "jeopardized" by cuts in governmental expenditures. The chief harm done by the balance-wheel theory is therefore not that it has failed to offset recessions, which it has, and not that it has introduced an inflationary bias into governmental policy, which it has done too, but that it has continuously fostered an expansion in the range of governmental activities at the federal level and prevented a reduction in the burden of federal taxes.
In view of the emphasis on using the federal budget as a balance wheel, it is ironic that the most unstable component of national income in the postwar period is federal expenditure, and the instability has not at all been in a direction to offset movements of other expenditure components. Far from being a balance wheel offsetting other forces making for fluctuations, the federal budget has if anything been itself a major source of disturbance and instability.
Because its expenditures are now so large a part of the total for the economy as a whole, the federal government cannot avoid having significant effects on the economy. The first requisite is therefore that the government mend its own fences, that it adopt procedures that will lead to reasonable stability in its own flow of expenditures. If it would do that, it would make a clear contribution to reducing the adjustments required in the rest of the economy. Until it does that, it is farcical for government officials to adopt the self-righteous tones of the schoolmaster keeping unruly pupils in line. Of course, their doing so is not surprising. Passing the buck and blaming others for one's own deficiencies are not vices of which governmental officials have a monopoly.
Even if one were to accept the view that the federal budget should be and can be used as a balance wheel -- a view I shall consider in more detail below -- there is no necessity to use the expenditure side of the budget for this purpose. The tax side is equally available. A decline in national income automatically reduces the tax revenue of the federal government in greater proportion and thus shifts the budget in the direction of a deficit, and conversely during a boom. If it is desired to do more, taxes can be lowered during recessions and raised during expansions. Of course, politics might well enforce an asymmetry here too, making the declines politically more palatable than the rises.
If the balance-wheel theory has in practice been applied on the expenditure side, it has been because of the existence of other forces making for increased governmental expenditures; in particular, the widespread acceptance by intellectuals of the belief that government should play a larger role in economic and private affairs; the triumph, that is, of the philosophy of the welfare state. This philosophy has found a useful ally in the balance-wheel theory; it has enabled governmental intervention to proceed at a faster pace than would otherwise have been possible.
How different matters might now be if the balance-wheel theory had been applied on die tax side instead of the expenditure side. Suppose each recession had seen a cut in taxes and suppose the political unpopularity of raising taxes in the succeeding expansion had led to resistance to newly proposed governmental expenditure programs and to curtailment of existing ones. We might now be in a position where federal expenditures would be absorbing a good deal less of a national income that would be larger because of the reduction in die depressing and inhibiting effects of taxes.
I hasten to add that this dream is not intended to indicate support for the balance-wheel theory. In practice, even if the effects would be in the direction expected under the balance-wheel theory, they would be delayed in time and spread. To make them an effective offset to other forces making for fluctuations, we would have to be able to forecast those fluctuations a long time in advance. In fiscal policy as in monetary policy, all political considerations aside, we simply do not know enough to be able to use deliberate changes in taxation or expenditures as a sensitive stabilizing mechanism. In the process of trying to do so, we almost surely make matters worse. We make matters worse not by being consistently perverse -- that would be easily cured by simply doing the opposite of what seemed at first the thing to do. We make matters worse by introducing a largely random disturbance that is simply added to other disturbances. That is what we seem in fact to have done in the past -- in addition, of course to the major mistakes that have been seriously perverse. What I have written elsewhere in respect of monetary policy is equally applicable to fiscal policy: "What we need is not a skillful monetary driver of the economic vehicle continuously turning the steering wheel to adjust to the unexpected irregularities of the route, but some means of keeping the monetary passenger who is in the back seat as ballast from occasionally leaning over and giving the steering wheel a jerk that threatens to send the car off the road."1
For fiscal policy, the appropriate counterpart to the monetary rule would be to plan expenditure programs entirely in terms of what the community wants to do through government rather than privately, and without any regard to problems of year-to-year economic stability; to plan tax rates so as to provide sufficient revenues to cover planned expenditures on the average of one year with another, again without regard to year-to-year changes in economic stability; and to avoid erratic changes in either governmental expenditures or taxes. Of course, some changes may be unavoidable. A sudden change in the international situation may dictate large increases in military expenditures or permit welcome decreases. Such changes account for some erratic shifts in federal expenditures in the postwar period. But they by no means account for all.
Before leaving the subject of fiscal policy, I should like to discuss the view, now so widely held, that an increase in governmental expenditures relative to tax-receipts is necessarily expansionary and a decrease contractionary. This view, which is at the heart of the belief that fiscal policy can serve as a balance wheel, is by now almost taken for granted by businessmen, professional economists, and laymen alike. Yet it cannot be demonstrated to be true by logical considerations alone, has never been documented by empirical evidence, and is in fact inconsistent with the revelant empirical evidence of which I know.
The belief has its origin in a crude Keynesian analysis. Suppose governmental expenditures are raised by $100 and taxes are kept unchanged. Then, goes the simple analysis, on die first round, the people who receive die extra hundred dollars will have that much more income. They will save some of it, say one-third, and spend the remaining two-thirds. But this means that on the second round, someone else receives an extra $66 2/3 of income. He in turn will save some and spend some, and so on and on in infinite sequence. If at every stage one-third is saved and two-thirds spent, then the extra $100 of government expenditures will ultimately, on this analysis, add $300 to income. This is the simple Keynesian multiplier analysis with a multiplier of three. Of course, if there is one injection, the effects will die off, the initial jump in income of $100 being succeeded by a gradual decline back to the earlier level. But if government expenditures are kept $100 higher per unit of time, say $100 a year higher, then, on this analysis, income will remain higher by $300 a year.
This simple analysis is extremely appealing. But the appeal is spurious and arises from neglecting other relevant effects of the change in question. When these are taken into account, the final result is much more dubious: it may be anything from no change in income at all, in which case private expenditures will go down by the $100 by which government expenditures go up, to the full increase specified. And even if money income increases, prices may rise, so real income will increase less or not at all. Let us examine some of the possible slips 'twixt cup and lip.
In the first place, nothing is said in the simple account about what the government spends the $100 on. Suppose, for example, it spends it on something that individuals were otherwise obtaining for themselves. They were, for example, spending $100 on paying fees to a park which paid the cost of attendants to keep it clean. Suppose the government now pays these costs and permits people to enter the park "free." The attendants still receive the same income, but the people who paid the fees have $100 available. The government spending does not, even in the initial stage, add $100 to anyone's income. What it does is to leave some people with $100 available to use for purposes other than the park, and presumably purposes they value less highly. They can be expected to spend less out of their total income for consumer goods than formerly, since they are receiving the park services free. How much less, it is not easy to say. Even if we accept, as in the simple analysis, that people save one-third of additional income, it does not follow that when they get one set of consumer goods "free," two-thirds of die released money will be spent on other consumer goods. One extreme possibility, of course, is that they will continue to buy the same collection of other consumer goods as they did before and add the released $100 to their savings. In this case even in the simple Keynesian analysis, the effect of the government expenditures is completely offset: government expenditures go up by $100, private down by $100. Or, to take another example, the $100 may be spent to build a road that a private enterprise would otherwise have built or the availability of which may make repairs to the company's trucks unnecessary. The firm then has funds released, but presumably will not spend them all on what are less attractive investments. In these cases, government expenditures simply divert private expenditures and only the net excess of government expenditures is even available at the outset for the multiplier to work on. From this point of view, it is paradoxical that the way to assure no diversion is to have the government spend the money for something utterly useless -- this is the limited intellectual content to the "filling-holes" type of make-work. But of course this itself shows that there is something wrong with the analysis.
In the second place, nothing is said in the simple account about where the government gets the $100 to spend. So far as the analysis goes, the results are the same whether the government prints extra money or borrows from the public. But surely which it does will make a difference. To separate fiscal from monetary policy, let us suppose the government borrows the $100 so that the stock of money is the same as it would have been in the absence of the government expenditure. This is the proper assumption because the stock of money can be increased without extra government expenditure, if that is desired, simply by printing the money and buying outstanding government bonds with it. But we must now ask what the effect of borrowing is. To analyze this problem, let us assume that diversion does not occur, so in the first instance there is no direct offset to the $100 in the form of a compensating drop in private expenditures. Note that the government's borrowing to spend does not alter the amount of money in private hands. The government borrows $100 with its right hand from some individuals and hands the money with its left hand to those individuals to whom its expenditures go. Different people hold the money but the total amount of money held is unchanged.
The simple Keynesian analysis implicitly assumes that borrowing the money does not have any effects on other spending. There are two extreme circumstances under which this can occur. First, suppose people are utterly indifferent to whether they hold bonds or money, so that bonds to get die $100 can be sold without having to offer a higher return to the buyer than such bonds were yielding before. (Of course, $100 is so small an amount that it would in practice have a negligible effect on the required rate of return, but die issue is one of principle whose practical effect can be seen by letting the $100 stand for $100 million or $100 ten-million.) In Keynesian jargon, there is a "liquidity trap" so people buy die bonds with "idle money." If this is not die case, and clearly it cannot be indefinitely, then the government can sell the bonds only by offering a higher rate of return on it. A higher rate will then have to be paid also by other borrowers. This higher rate will in general discourage private spending on the part of would-be borrowers. Here comes the second extreme circumstance under which the simple Keynesian analysis will hold: if potential borrowers are so stubborn about spending that no rise in interest rates however steep will cut down their expenditures, or, in Keynesian jargon, if the marginal efficiency schedule of investment is perfectly inelastic with respect to the interest rate.
I know of no established economist, no matter how much of a Keynesian he may regard himself as being, who would regard either of these extreme assumptions as holding currently, or as being capable of holding over any considerable range of borrowing or rise in interest rates, or as having held except under rather special circumstances in die past. Yet many an economist, let alone non-economist, whether regarding himself as Keynesian or not, accepts as valid the belief that a rise in governmental expenditures relative to tax receipts, even when financed by borrowing, is necessarily expansionist, though as we have seen, this belief implicitly requires one of these extreme circumstances to hold.
If neither assumption holds, the rise in government expenditures will be offset by a decline in private expenditures on the part either of those who lend funds to the government, or of those who would otherwise have borrowed the funds. How much of the rise in expenditures will be offset? This depends on the holders of money. The extreme assumption, implicit in a rigid quantity theory of money, is that the amount of money people want to hold depends, on the average, only on their income and not on die rate of return that they can get on bonds and similar securities. In this case, since the total stock of money is the same before and after, die total money income will also have to be the same in order to make people just satisfied to hold that money stock. This means that interest rates will have to rise enough to choke off an amount of private spending exactly equal to the increased public expenditure. In this extreme case, there is no sense at all in which the government expenditures are expansionary. Not even money income goes up, let alone real income. All that happens is that government expenditures go up and private expenditures down.
I warn the reader that this is a highly simplified analysis. A full analysis would require a lengthy textbook. But even this simplified analysis is enough to demonstrate that any result is possible between a $300 rise in income and a zero rise. The more stubborn consumers are with respect to how much they will spend on consumption out of a given income, and die more stubborn purchasers of capital goods are with respect to how much they will spend on such goods regardless of cost, the nearer the result will be to the Keynesian extreme of a $300 rise. On the other side, the more stubborn money holders are with respect to the ratio they wish to maintain between their cash balances and their income, the closer the result will be to the rigid quantity theory extreme of no change in income. In which of these respects the public is more stubborn is an empirical question to be judged from the factual evidence, not something that can be determined by reason alone.
Before the Great Depression of the 1930's, the bulk of economists would unquestionably have concluded that the result would be nearer to no rise in income than to a $300 rise. Since then, the bulk of economists would unquestionably conclude the opposite. More recently, there has been a movement back toward the earlier position. Sad to say, none of these shifts can be said to be based on satisfactory evidence. They have been based rather on intuitive judgments from crude experience.
In co-operation with some of my students, I have done some fairly extensive empirical work, for the U.S. and other countries, to get some more satisfactory evidence.2 The results are striking. They strongly suggest that the actual outcome will be closer to the quantity theory extreme than to the Keynesian. The judgement that seems justified on the basis of this evidence is that the assumed $100 increase in government expenditures can on the average be expected to add just about $100 to income, sometimes less, sometimes more. This means that a rise in government expenditures relative to income is not expansionary in any relevant sense. It may add to money income but all of this addition is absorbed by government expenditures. Private expenditures are unchanged. Since prices are likely to rise in the process, or fall less than they otherwise would, the effect is to leave private expenditures smaller in real terms. Converse propositions hold for a decline in government expenditures.
These conclusions cannot of course be regarded as final. They are based on the broadest and most comprehensive body of evidence I know about, but that body of evidence still leaves much to be desired.
One thing is however clear. Whether the views so widely accepted about the effects of fiscal policy be right or wrong, they are contradicted by at least one extensive body of evidence. I know of no other coherent or organized body of evidence justifying them. They are part of economic mythology, not the demonstrated conclusions of economic analysis or quantitative studies. Yet they have wielded immense influence in securing widespread public backing for far-reaching governmental interference in economic life.
--------------------------------------------------------------------------------
Notes
1 A Program for Monetary Stability (New York: Fordham University Press, 1959), p. 23.
2 Some of the results are contained in Milton Friedman and David Meiselman, The Relative Stability of the Investment Multiplier and Monetary Velocity in the United States, 1896-1958 (forthcoming publication of Commission on Money and Credit).
Fiscal Policy
Ever since the new deal, a primary excuse for the expansion of governmental activity at the federal level has been the supposed necessity for government spending to eliminate unemployment. The excuse has gone through several stages. At first, government spending was needed to "prime the pump." Temporary expenditures would set the economy going and the government could then step out of the picture.
When the initial expenditures failed to eliminate unemployment and were followed by a sharp economic contraction in 1937-38, the theory of "secular stagnation" developed to justify a permanently high level of government spending. The economy had become mature, it was argued. Opportunities for investment had been largely exploited and no substantial new opportunities were likely to arise. Yet individuals would still want to save. Hence, it was essential for government to spend and run a perpetual deficit. The securities issued to finance the deficit would provide individuals with a way to accumulate savings while the government expenditures provided employment. This view has been thoroughly discredited by theoretical analysis and even more by actual experience, including the emergence of wholly new lines for private investment not dreamed of by the secular stagnationists. Yet it has left its heritage. The idea may be accepted by none, but the government programs undertaken in its name, like some of those intended to prime the pump, are still with us and indeed account for ever-growing government expenditures.
More recently, the emphasis has been on government expenditures neither to prime die pump nor to hold in check the specter of secular stagnation but as a balance wheel. When private expenditures decline for any reason, it is said, governmental expenditures should rise to keep total expenditures stable; conversely, when private expenditures rise, governmental expenditures should decline. Unfortunately, the balance wheel is unbalanced. Each recession, however minor, sends a shudder through politically sensitive legislators and administrators with their ever present fear that perhaps it is the harbinger of another 1929/-33. They hasten to enact federal spending programs of one kind or another. Many of the programs do not in fact come into effect until after the recession has passed. Hence, insofar as they do affect total expenditures, on which I shall have more to say later, they tend to exacerbate the succeeding expansion rather than to mitigate the recession. The haste with which spending programs are approved is not matched by an equal haste to repeal them or to eliminate others when the recession is passed and expansion is under way. On the contrary, it is then argued that a "healthy" expansion must not be "jeopardized" by cuts in governmental expenditures. The chief harm done by the balance-wheel theory is therefore not that it has failed to offset recessions, which it has, and not that it has introduced an inflationary bias into governmental policy, which it has done too, but that it has continuously fostered an expansion in the range of governmental activities at the federal level and prevented a reduction in the burden of federal taxes.
In view of the emphasis on using the federal budget as a balance wheel, it is ironic that the most unstable component of national income in the postwar period is federal expenditure, and the instability has not at all been in a direction to offset movements of other expenditure components. Far from being a balance wheel offsetting other forces making for fluctuations, the federal budget has if anything been itself a major source of disturbance and instability.
Because its expenditures are now so large a part of the total for the economy as a whole, the federal government cannot avoid having significant effects on the economy. The first requisite is therefore that the government mend its own fences, that it adopt procedures that will lead to reasonable stability in its own flow of expenditures. If it would do that, it would make a clear contribution to reducing the adjustments required in the rest of the economy. Until it does that, it is farcical for government officials to adopt the self-righteous tones of the schoolmaster keeping unruly pupils in line. Of course, their doing so is not surprising. Passing the buck and blaming others for one's own deficiencies are not vices of which governmental officials have a monopoly.
Even if one were to accept the view that the federal budget should be and can be used as a balance wheel -- a view I shall consider in more detail below -- there is no necessity to use the expenditure side of the budget for this purpose. The tax side is equally available. A decline in national income automatically reduces the tax revenue of the federal government in greater proportion and thus shifts the budget in the direction of a deficit, and conversely during a boom. If it is desired to do more, taxes can be lowered during recessions and raised during expansions. Of course, politics might well enforce an asymmetry here too, making the declines politically more palatable than the rises.
If the balance-wheel theory has in practice been applied on the expenditure side, it has been because of the existence of other forces making for increased governmental expenditures; in particular, the widespread acceptance by intellectuals of the belief that government should play a larger role in economic and private affairs; the triumph, that is, of the philosophy of the welfare state. This philosophy has found a useful ally in the balance-wheel theory; it has enabled governmental intervention to proceed at a faster pace than would otherwise have been possible.
How different matters might now be if the balance-wheel theory had been applied on die tax side instead of the expenditure side. Suppose each recession had seen a cut in taxes and suppose the political unpopularity of raising taxes in the succeeding expansion had led to resistance to newly proposed governmental expenditure programs and to curtailment of existing ones. We might now be in a position where federal expenditures would be absorbing a good deal less of a national income that would be larger because of the reduction in die depressing and inhibiting effects of taxes.
I hasten to add that this dream is not intended to indicate support for the balance-wheel theory. In practice, even if the effects would be in the direction expected under the balance-wheel theory, they would be delayed in time and spread. To make them an effective offset to other forces making for fluctuations, we would have to be able to forecast those fluctuations a long time in advance. In fiscal policy as in monetary policy, all political considerations aside, we simply do not know enough to be able to use deliberate changes in taxation or expenditures as a sensitive stabilizing mechanism. In the process of trying to do so, we almost surely make matters worse. We make matters worse not by being consistently perverse -- that would be easily cured by simply doing the opposite of what seemed at first the thing to do. We make matters worse by introducing a largely random disturbance that is simply added to other disturbances. That is what we seem in fact to have done in the past -- in addition, of course to the major mistakes that have been seriously perverse. What I have written elsewhere in respect of monetary policy is equally applicable to fiscal policy: "What we need is not a skillful monetary driver of the economic vehicle continuously turning the steering wheel to adjust to the unexpected irregularities of the route, but some means of keeping the monetary passenger who is in the back seat as ballast from occasionally leaning over and giving the steering wheel a jerk that threatens to send the car off the road."1
For fiscal policy, the appropriate counterpart to the monetary rule would be to plan expenditure programs entirely in terms of what the community wants to do through government rather than privately, and without any regard to problems of year-to-year economic stability; to plan tax rates so as to provide sufficient revenues to cover planned expenditures on the average of one year with another, again without regard to year-to-year changes in economic stability; and to avoid erratic changes in either governmental expenditures or taxes. Of course, some changes may be unavoidable. A sudden change in the international situation may dictate large increases in military expenditures or permit welcome decreases. Such changes account for some erratic shifts in federal expenditures in the postwar period. But they by no means account for all.
Before leaving the subject of fiscal policy, I should like to discuss the view, now so widely held, that an increase in governmental expenditures relative to tax-receipts is necessarily expansionary and a decrease contractionary. This view, which is at the heart of the belief that fiscal policy can serve as a balance wheel, is by now almost taken for granted by businessmen, professional economists, and laymen alike. Yet it cannot be demonstrated to be true by logical considerations alone, has never been documented by empirical evidence, and is in fact inconsistent with the revelant empirical evidence of which I know.
The belief has its origin in a crude Keynesian analysis. Suppose governmental expenditures are raised by $100 and taxes are kept unchanged. Then, goes the simple analysis, on die first round, the people who receive die extra hundred dollars will have that much more income. They will save some of it, say one-third, and spend the remaining two-thirds. But this means that on the second round, someone else receives an extra $66 2/3 of income. He in turn will save some and spend some, and so on and on in infinite sequence. If at every stage one-third is saved and two-thirds spent, then the extra $100 of government expenditures will ultimately, on this analysis, add $300 to income. This is the simple Keynesian multiplier analysis with a multiplier of three. Of course, if there is one injection, the effects will die off, the initial jump in income of $100 being succeeded by a gradual decline back to the earlier level. But if government expenditures are kept $100 higher per unit of time, say $100 a year higher, then, on this analysis, income will remain higher by $300 a year.
This simple analysis is extremely appealing. But the appeal is spurious and arises from neglecting other relevant effects of the change in question. When these are taken into account, the final result is much more dubious: it may be anything from no change in income at all, in which case private expenditures will go down by the $100 by which government expenditures go up, to the full increase specified. And even if money income increases, prices may rise, so real income will increase less or not at all. Let us examine some of the possible slips 'twixt cup and lip.
In the first place, nothing is said in the simple account about what the government spends the $100 on. Suppose, for example, it spends it on something that individuals were otherwise obtaining for themselves. They were, for example, spending $100 on paying fees to a park which paid the cost of attendants to keep it clean. Suppose the government now pays these costs and permits people to enter the park "free." The attendants still receive the same income, but the people who paid the fees have $100 available. The government spending does not, even in the initial stage, add $100 to anyone's income. What it does is to leave some people with $100 available to use for purposes other than the park, and presumably purposes they value less highly. They can be expected to spend less out of their total income for consumer goods than formerly, since they are receiving the park services free. How much less, it is not easy to say. Even if we accept, as in the simple analysis, that people save one-third of additional income, it does not follow that when they get one set of consumer goods "free," two-thirds of die released money will be spent on other consumer goods. One extreme possibility, of course, is that they will continue to buy the same collection of other consumer goods as they did before and add the released $100 to their savings. In this case even in the simple Keynesian analysis, the effect of the government expenditures is completely offset: government expenditures go up by $100, private down by $100. Or, to take another example, the $100 may be spent to build a road that a private enterprise would otherwise have built or the availability of which may make repairs to the company's trucks unnecessary. The firm then has funds released, but presumably will not spend them all on what are less attractive investments. In these cases, government expenditures simply divert private expenditures and only the net excess of government expenditures is even available at the outset for the multiplier to work on. From this point of view, it is paradoxical that the way to assure no diversion is to have the government spend the money for something utterly useless -- this is the limited intellectual content to the "filling-holes" type of make-work. But of course this itself shows that there is something wrong with the analysis.
In the second place, nothing is said in the simple account about where the government gets the $100 to spend. So far as the analysis goes, the results are the same whether the government prints extra money or borrows from the public. But surely which it does will make a difference. To separate fiscal from monetary policy, let us suppose the government borrows the $100 so that the stock of money is the same as it would have been in the absence of the government expenditure. This is the proper assumption because the stock of money can be increased without extra government expenditure, if that is desired, simply by printing the money and buying outstanding government bonds with it. But we must now ask what the effect of borrowing is. To analyze this problem, let us assume that diversion does not occur, so in the first instance there is no direct offset to the $100 in the form of a compensating drop in private expenditures. Note that the government's borrowing to spend does not alter the amount of money in private hands. The government borrows $100 with its right hand from some individuals and hands the money with its left hand to those individuals to whom its expenditures go. Different people hold the money but the total amount of money held is unchanged.
The simple Keynesian analysis implicitly assumes that borrowing the money does not have any effects on other spending. There are two extreme circumstances under which this can occur. First, suppose people are utterly indifferent to whether they hold bonds or money, so that bonds to get die $100 can be sold without having to offer a higher return to the buyer than such bonds were yielding before. (Of course, $100 is so small an amount that it would in practice have a negligible effect on the required rate of return, but die issue is one of principle whose practical effect can be seen by letting the $100 stand for $100 million or $100 ten-million.) In Keynesian jargon, there is a "liquidity trap" so people buy die bonds with "idle money." If this is not die case, and clearly it cannot be indefinitely, then the government can sell the bonds only by offering a higher rate of return on it. A higher rate will then have to be paid also by other borrowers. This higher rate will in general discourage private spending on the part of would-be borrowers. Here comes the second extreme circumstance under which the simple Keynesian analysis will hold: if potential borrowers are so stubborn about spending that no rise in interest rates however steep will cut down their expenditures, or, in Keynesian jargon, if the marginal efficiency schedule of investment is perfectly inelastic with respect to the interest rate.
I know of no established economist, no matter how much of a Keynesian he may regard himself as being, who would regard either of these extreme assumptions as holding currently, or as being capable of holding over any considerable range of borrowing or rise in interest rates, or as having held except under rather special circumstances in die past. Yet many an economist, let alone non-economist, whether regarding himself as Keynesian or not, accepts as valid the belief that a rise in governmental expenditures relative to tax receipts, even when financed by borrowing, is necessarily expansionist, though as we have seen, this belief implicitly requires one of these extreme circumstances to hold.
If neither assumption holds, the rise in government expenditures will be offset by a decline in private expenditures on the part either of those who lend funds to the government, or of those who would otherwise have borrowed the funds. How much of the rise in expenditures will be offset? This depends on the holders of money. The extreme assumption, implicit in a rigid quantity theory of money, is that the amount of money people want to hold depends, on the average, only on their income and not on die rate of return that they can get on bonds and similar securities. In this case, since the total stock of money is the same before and after, die total money income will also have to be the same in order to make people just satisfied to hold that money stock. This means that interest rates will have to rise enough to choke off an amount of private spending exactly equal to the increased public expenditure. In this extreme case, there is no sense at all in which the government expenditures are expansionary. Not even money income goes up, let alone real income. All that happens is that government expenditures go up and private expenditures down.
I warn the reader that this is a highly simplified analysis. A full analysis would require a lengthy textbook. But even this simplified analysis is enough to demonstrate that any result is possible between a $300 rise in income and a zero rise. The more stubborn consumers are with respect to how much they will spend on consumption out of a given income, and die more stubborn purchasers of capital goods are with respect to how much they will spend on such goods regardless of cost, the nearer the result will be to the Keynesian extreme of a $300 rise. On the other side, the more stubborn money holders are with respect to the ratio they wish to maintain between their cash balances and their income, the closer the result will be to the rigid quantity theory extreme of no change in income. In which of these respects the public is more stubborn is an empirical question to be judged from the factual evidence, not something that can be determined by reason alone.
Before the Great Depression of the 1930's, the bulk of economists would unquestionably have concluded that the result would be nearer to no rise in income than to a $300 rise. Since then, the bulk of economists would unquestionably conclude the opposite. More recently, there has been a movement back toward the earlier position. Sad to say, none of these shifts can be said to be based on satisfactory evidence. They have been based rather on intuitive judgments from crude experience.
In co-operation with some of my students, I have done some fairly extensive empirical work, for the U.S. and other countries, to get some more satisfactory evidence.2 The results are striking. They strongly suggest that the actual outcome will be closer to the quantity theory extreme than to the Keynesian. The judgement that seems justified on the basis of this evidence is that the assumed $100 increase in government expenditures can on the average be expected to add just about $100 to income, sometimes less, sometimes more. This means that a rise in government expenditures relative to income is not expansionary in any relevant sense. It may add to money income but all of this addition is absorbed by government expenditures. Private expenditures are unchanged. Since prices are likely to rise in the process, or fall less than they otherwise would, the effect is to leave private expenditures smaller in real terms. Converse propositions hold for a decline in government expenditures.
These conclusions cannot of course be regarded as final. They are based on the broadest and most comprehensive body of evidence I know about, but that body of evidence still leaves much to be desired.
One thing is however clear. Whether the views so widely accepted about the effects of fiscal policy be right or wrong, they are contradicted by at least one extensive body of evidence. I know of no other coherent or organized body of evidence justifying them. They are part of economic mythology, not the demonstrated conclusions of economic analysis or quantitative studies. Yet they have wielded immense influence in securing widespread public backing for far-reaching governmental interference in economic life.
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Notes
1 A Program for Monetary Stability (New York: Fordham University Press, 1959), p. 23.
2 Some of the results are contained in Milton Friedman and David Meiselman, The Relative Stability of the Investment Multiplier and Monetary Velocity in the United States, 1896-1958 (forthcoming publication of Commission on Money and Credit).
Chapter IV
International Financial and Trade Arrangements
The problem of international monetary arrangements is the relation among different national currencies: the terms and conditions under which individuals are able to convert U.S. dollars to pounds sterling, Canadian dollars to U.S. dollars, and so on. This problem is closely connected with the control of money discussed in the preceding chapter. It is connected also with governmental policies about international trade, since control over international trade is one technique for affecting international payments.
THE IMPORTANCE OF INTERNATIONAL MONETARY ARRANGEMENTS FOR ECONOMIC FREEDOM
Despite its technical character and forbidding complexity, the subject of international monetary arrangements is one that a liberal cannot afford to neglect. It is not too much to say that the most serious short-run threat to economic freedom in the United States today -- aside, of course, from the outbreak of World War III -- is that we shall be led to adopt far-reaching economic controls in order to "solve" balance of payments problems. Interferences with international trade appear innocuous; they can get the support of people who are otherwise apprehensive of interference by government into economic affairs; many a business man even regards them as part of the "American Way of Life"; yet there are few interferences which are capable of spreading so far and ultimately being so destructive of free enterprise. There is much experience to suggest that the most effective way to convert a market economy into an authoritarian economic society is to start by imposing direct controls on foreign exchange. This one step leads inevitably to the rationing of imports, to control over domestic production that uses imported products or that produces substitutes for imports, and so on in a never-ending spiral. Yet even so generally staunch a champion of free enterprise as Senator Barry Goldwater has at times been led, when discussing the so-called "gold flow," to suggest that restrictions on transactions in foreign exchange may be necessary as a "cure." This "cure" would be vastly worse than the disease.
There is seldom anything truly new under the sun in economic policy, where the allegedly new generally turns out to be the discard of a prior century in flimsy disguise. Unless I am mistaken, however, full-fledged exchange controls and so-called "inconvertibility of currencies" are an exception and their origin reveals their authoritarian promise. To the best of my knowledge they were invented by Hjalmar Schacht in the early years of the Nazi regime. On many occasions in the past, of course, currencies have been described as inconvertible. But what the word then meant was that the government of the day was unwilling or unable to convert paper currency into gold or silver, or whatever the monetary commodity was, at the legally stipulated rate. It seldom meant that a country prohibited its citizens or residents from trading pieces of paper promising to pay specified sums in the monetary unit of that country for corresponding pieces of paper expressed in the monetary unit of another country -- or for that matter for coin or bullion. During the Civil War in the United States and for a decade and a half thereafter, for example, U.S. currency was inconvertible in the sense that the holder of a greenback could not turn it in to the Treasury and get a fixed amount of gold for it. But throughout the period he was free to buy gold at the market price or to buy and sell British pounds for U.S. greenbacks at any price mutually agreeable to the two parties. In the United States, the dollar has been inconvertible in the older sense ever since 1933. It has been illegal for American citizens to hold gold or to buy and sell gold. The dollar has not been inconvertible in the newer sense. But unfortunately we seem to be adopting policies that are highly likely, sooner or later, to drive us in that direction.
THE ROLE OF GOLD IN THE U.S. MONETARY SYSTEM
Only a cultural lag leads us still to think of gold as the central element in our monetary system. A more accurate description of the role of gold in U.S. policy is that it is primarily a commodity whose price is supported, like wheat or other agricultural products. Our price-support program for gold differs in three important respects from our price-support program for wheat: first, we pay the support price to foreign as well as domestic producers; second, we sell freely at the support price only to foreign purchasers and not to domestic; third, and this is the one important relic of the monetary role of gold, the Treasury is authorized to create money to pay for gold it buys -- to print paper money as it were -- so that expenditures for the purchase of gold do not appear in the budget and the sums required need not be explicitly appropriated by Congress; similarly, when the Treasury sells gold, the books show simply a reduction in gold certificates, and not a receipt that enters into the budget.
When the price of gold was first set at its present level of $35 an ounce in 1934, this price was well above the free market price of gold. In consequence, gold flooded the United States, our gold stock tripled in six years, and we came to hold well over half the world's gold stock. We accumulated a "surplus" of gold for the same reason we accumulated a "surplus" of wheat -- because the government offered to pay a higher price than the market price. More recently, the situation has changed. While the legally fixed price of gold has remained $35, prices of other goods have doubled or tripled. Hence $35 is now less than what die free market price would be.1 As a result, we now face a "shortage" rather than a "surplus" for precisely the same reason that rent ceilings inevitably produce a "shortage" of housing -- because the government is trying to hold the price of gold below the market price.
The legal price of gold would long since have been raised -- as wheat prices have been raised from time to time -- except for the accident that the major producers of gold, and hence the major beneficiaries from a rise in its price, are Soviet Russia and South Africa, the two countries with whom the United States has least political sympathy.
Governmental control of the price of gold, no less than the control of any other price, is inconsistent with a free economy. Such a pseudo gold standard must be distinguished sharply from the use of gold as money under a real gold standard which is entirely consistent with a free economy though it may not be feasible. Even more than the price fixing itself, the associated measures taken in 1933 and 1934 by the Roosevelt administration when it raised the price of gold represented a fundamental departure from liberal principles and established precedents that have returned to plague the free world. I refer to the nationalization of the gold stock, the prohibition of private possession of gold for monetary purposes, and the abrogation of gold clauses in public and private contracts.
In 1933 and early 1934, private holders of gold were required by law to turn over their gold to the federal government. They were compensated at a price equal to the prior legal price, which was at the time decidedly below the market price. To make this requirement effective, private ownership of gold within the U.S. was made illegal except for use in the arts. One can hardly imagine a measure more destructive of the principles of private property on which a free enterprise society rests. There is no difference in principle between this nationalization of gold at an artificially low price and Fidel Castro's nationalization of land and factories at an artificially low price. On what grounds of principle can the U.S. object to the one after having itself engaged in the other? Yet so great is the blindness of some supporters of free enterprise with respect to anything touching gold that in i960 Henry Alexander, head of the Morgan Guaranty Trust Company, successor to J. P. Morgan and Company, proposed that the prohibition against the private ownership of gold by U.S. citizens be extended to cover gold held abroad! And his proposal was adopted by President Eisenhower with hardly a protest from the banking community.
Though rationalized in terms of "conserving" gold for monetary use, prohibition of private ownership of gold was not enacted for any such monetary purpose, whether itself good or bad. The nationalization of gold was enacted to enable the government to reap the whole of the "paper" profit from the rise in the price of gold -- or perhaps, to prevent private individuals from benefiting.
The abrogation of the gold clauses had a similar purpose. And this too was a measure destructive of the basic principles of free enterprise. Contracts entered into in good faith and with full knowledge on the part of both parties to them were declared invalid for the benefit of one of the parties!
CURRENT PAYMENTS AND CAPITAL FLIGHT
In discussing international monetary relations on a more general level, it is necessary to distinguish two rather different problems: the balance of payments, and the danger of a run on gold. The difference between the problems can be illustrated most simply by considering the analogy of an ordinary commercial bank. The bank must so arrange its affairs that it takes in as service charges, interest on loans, and so on a large enough sum to enable it to pay its expenses -- wages and salaries, interest on borrowed funds, cost of supplies, returns to stockholders, and so on. It must strive, that is, for a healthy income account. But a bank which is in good shape on its income account may nonetheless experience serious trouble if for any reason its depositors should lose confidence in it and suddenly demand their deposits en masse. Many a sound bank was forced to close its doors because of such a run on it during the liquidity crises described in the preceding chapter.
These two problems are not of course unrelated. One important reason why a bank's depositors may lose confidence in it is because the bank is experiencing losses on income account. Yet the two problems are also very different. For one thing, problems on income account are generally slow to arise and considerable time is available to solve them. They seldom come as sudden surprises. A run, on the other hand, may arise suddenly and unpredictably out of thin air.
The situation of the U.S. is precisely parallel. Residents of the United States and the U.S. government itself are seeking to buy foreign currencies with dollars in order to purchase goods and services in other countries, to invest in foreign enterprises, to pay interest on debts, to repay loans, or to give gifts to others, whether private or public. At the same time, foreigners are seeking to acquire dollars with foreign currencies for corresponding purposes. After the event, the number of dollars spent for foreign currency will precisely equal the number of dollars purchased with foreign currency -- just as the number of pairs of shoes sold is precisely equal to the number bought. Arithmetic is arithmetic and one man's purchase is another man's sale. But there is nothing to assure that, at any given price of foreign currency in terms of dollars, the number of dollars that some want to spend will equal the number others want to buy -- just as there is nothing to assure that at any given price of shoes the number of pairs of shoes people want to buy is exactly equal to the number of pairs other people want to sell. The ex post equality reflects some mechanism that eliminates any ex ante discrepancy. The problem of achieving an appropriate mechanism for this purpose is the counterpart of the bank's problem on income account.
In addition, the United States has a problem like the bank's of avoiding a run. The U.S. is committed to sell gold to foreign central banks and governments at $35 an ounce. Foreign central banks, governments, and residents hold large funds in the United States in the form of deposit accounts or U.S. securities that can be readily sold for dollars. At any time, the holders of these balances can start a run on the U.S. Treasury by trying to convert their dollar balances into gold. This is precisely what happened in the fall of i960, and what is very likely to happen again at some unpredictable date in the future (perhaps before this is printed).
The two problems are related in two ways. In the first place, as for a bank, income account difficulties are a major source of loss of confidence in the ability of die U.S. to honor its promise to sell gold at $35 an ounce. The fact that the U.S. has in effect been having to borrow abroad in order to achieve balance on current account is a major reason why holders of dollars are interested in converting them into gold or other currencies. In the second place, the fixed price of gold is the device we have adopted for pegging another set of prices -- the price of the dollar in terms of foreign currencies -- and flows of gold are the device we have adopted for resolving ex ante discrepancies in the balance of payments.
ALTERNATIVE MECHANISMS FOR ACHIEVING BALANCE IN FOREIGN PAYMENTS
We can get more light on both of these relations by considering what alternative mechanisms are available for achieving balance in payments -- the first and in many ways the more fundamental of the two problems.
Suppose that the U.S. is roughly in balance in its international payments and that something comes along which alters the situation by, let us say, reducing the number of dollars that foreigners want to buy compared to the number that U.S. residents want to sell; or, looking at it from the other side, increasing the amount of foreign currency that holders of dollars want to buy compared to the amount that holders of foreign currency want to sell for dollars. That is, something threatens to produce a "deficit" in U.S. payments. This might result from increased efficiency in production abroad or decreased efficiency at home, increased foreign aid expenditures by the U.S. or reduced ones by other countries, or a million and one other changes of the kind that are always occurring. There are four, and only four ways, in which a country can adjust to such a disturbance and some combination of these ways must be used.
1. U.S. reserves of foreign currencies can be drawn down or foreign reserves of U.S. currency built up. In practice, this means that the U.S. government can let its stock of gold go down, since gold is exchangeable for foreign currencies, or it can borrow foreign currencies and make them available for dollars at official exchange rates; or foreign governments can accumulate dollars by selling U.S. residents foreign currencies at official rates. Reliance on reserves is obviously at best a temporary expedient. Indeed, it is precisely the extensive use by the U.S. of this expedient that accounts for the great concern with the balance of payments.
2. Domestic prices within the U.S. can be forced down relative to foreign prices. This is the main adjustment mechanism under a full-fledged gold standard. An initial deficit would produce an outflow of gold (mechanism 1, above); the outflow of gold would produce a decline in the stock of money; the decline in the stock of money would produce a fall in prices and incomes at home. At the same time, the reverse effects would occur abroad: the inflow of gold would expand the stock of money and thereby raise prices and income. Lowered U.S. prices and increased foreign prices would make U.S. goods more attractive to foreigners and thereby raise the number of dollars they wanted to buy; at the same time, the price changes would make foreign goods less attractive to U.S. residents and thereby lower the number of dollars they wanted to sell. Both effects would operate to reduce the deficit and restore balance without the necessity for further gold flows.
Under the modern managed standard, these effects are not automatic. Gold flows may still occur as the first step, but they will not affect the stock of money in either the country that loses, or the country that gains gold, unless the monetary authorities in the separate countries decide that they should. In every country today, the central bank or the Treasury has the power to offset die influence of gold flows, or to change the stock of money without gold flows. Hence this mechanism will be used only if the authorities in the country experiencing the deficit are willing to produce a deflation, thereby creating unemployment, in order to resolve its payments problem, or the authorities in the country experiencing the surplus are willing to produce an inflation.
3. Exactly die same effects can be achieved by a change in exchange rates as by a change in domestic prices. For example, suppose that under mechanism 2 the price of a particular car in the United States fell by 10 per cent from $2,800 to $2,520. If the price of the pound is throughout $2.80, this means that the price in Britain (neglecting freight and other charges) would fall from £1,000 to £900. Exactly the same decline in the British price will occur without any change in the United States price if the price of a pound rises from $2.80 to $3.11. Formerly, the Englishman had to spend £1,000 to get $2,800. Now he can get $2,800 for only £900. He would not know the difference between this reduction in cost and the corresponding reduction through a fall in the U.S. price without a change in exchange rate.
In practice, there are several ways in which the change in exchange rates can occur. With the kinds of pegged exchange rates many countries now have, it can occur through devaluation or appreciation, which is to say, a governmental declaration that it is changing the price at which it proposes to peg its currency. Alternatively, the exchange rate does not need to be pegged at all. It can be a market rate changing from day to day, as was the case with the Canadian dollar from 1950 to 1962. If a market rate, it can be a truly free market rate determined primarily by private transactions as the Canadian rate apparently was from 1952 to 1961, or it can be manipulated by government speculation as was the situation in Britain from 1931 to 1939, and in Canada from 1950 to 1952 and again from 1961 to 1962.
Of these various techniques, only the freely floating exchange rate is fully automatic and free from governmental control.
4. The adjustments produced by mechanisms 2 and 3 consist of changes in flows of commodities and services induced by changes either in internal prices or exchange rates. Instead, direct governmental controls or interferences with trade could be used to reduce attempted U.S. expenditures of dollars and expand U.S. receipts. Tariffs could be raised to choke off imports, subsidies could be given to stimulate exports, import quotas could be imposed on a variety of goods, capital investment abroad by U.S. citizens or firms could be controlled, and so on and on up to the whole paraphernalia of exchange controls. In this category must be included not only controls over private activities but also changes in governmental programs for balance of payments purposes. Recipients of foreign aid may be required to spend the aid in the U.S.; the military may procure goods in the United States at greater expense instead of abroad in order to save "dollars" -- in the self-contradictory terminology used -- and so on in bewildering array.
The important thing to note is that one or another of these four ways will and must be used. Double entry books must balance. Payments must equal receipts. The only question is how.
Our announced national policy has been and continues to be that we shall do none of these things. In a speech in December 1961, to the National Association of Manufacturers, President Kennedy stated "This administration, therefore, during its term of office -- and I repeat this and make it as a flat statement -- has no intention of imposing exchange controls, devaluing the dollar, raising trade barriers or choking off our economic recovery." As a matter of logic, this leaves only two possibilities: getting other countries to take the relevant measures, which is hardly a recourse that we can be sure of, or drawing down reserves, which the President and other officials repeatedly stated must not be permitted to continue. Yet Time magazine reports that the President's "promise drew a burst of applause" from the assembled businessmen. So far as our announced policy is concerned, we are in the position of a man living beyond his income who insists that he cannot possibly earn more, or spend less, or borrow, or finance the excess out of his assets!
Because we have been unwilling to adopt any one coherent policy, we and our trading partners -- who make the same ostrich-like pronouncements as we do -- have perforce been led to resort to all four mechanisms. In the early postwar years, U.S. reserves rose; more recently they have been declining. We welcomed inflation more readily than we otherwise would have when reserves were rising, and we have been more deflationary since 1958 than we would otherwise have been because of the drain of gold. Though we have not changed our official price of gold, our trading partners have changed theirs, and thereby the exchange rate between their currency and the dollar, and U.S. pressure has not been absent in producing these adjustments. Finally, our trading partners used direct controls extensively and, since we instead of they have been faced with deficits, we too have resorted to a wide range of direct interferences with payments, from reducing die amount of foreign goods that tourists can bring in free of duty -- a trivial yet highly symptomatic step -- to requiring foreign aid expenditures to be spent in the U.S., to keeping families from joining servicemen overseas, to more stringent import quotas on oil. We have been led also to engage in the demeaning step of asking foreign governments to take special measures to strengthen the U.S. balance of payments.
Of the four mechanisms, die use of direct controls is clearly die worst from almost any point of view and certainly the most destructive of a free society. Yet in lieu of any clear policy, we have been led increasingly to rely on such controls in one form or another. We preach publicly the virtues of free trade; yet we have been forced by the inexorable pressure of the balance of payments to move in the opposite direction and there is great danger that we shall move still farther. We can pass all the laws imaginable to reduce tariffs; the Administration may negotiate any number of tariff reductions; yet unless we adopt an alternative mechanism for resolving balance of payments deficits, we shall be led to substitute one set of trade impediments for another -- indeed, to substitute a worse set for a better. While tariffs are bad, quotas and other direct interferences are even worse. A tariff, like a market price, is impersonal and does not involve direct interference by government in business affairs; a quota is likely to involve allocation and other administrative interferences, besides giving administrators valuable plums to pass out to private interests. Perhaps worse than either tariffs or quotas are extra-legal arrangements, such as the "voluntary" agreement by Japan to restrict textile exports.
FLOATING EXCHANGE RATES AS THE FREE MARKET SOLUTION
There are only two mechanisms that are consistent with a free market and free trade. One is a fully automatic international gold standard. This, as we saw in the preceding chapter, is neither feasible nor desirable. In any event, we cannot adopt it by ourselves. The other is a system of freely floating exchange rates determined in the market by private transactions without governmental intervention. This is the proper free-market counterpart to the monetary rule advocated in the preceding chapter. If we do not adopt it, we shall inevitably fail to expand the area of free trade and shall sooner or later be induced to impose widespread direct controls over trade. In this area, as in others, conditions can and do change unexpectedly. It may well be that we shall muddle through the difficulties that are facing us as this is written (April, 1962) and indeed that we may find ourselves in a surplus rather than deficit position, accumulating reserves rather than losing them. If so, this will only mean that other countries will be faced with the necessity of imposing controls. When, in 1950,1 wrote an article proposing a system of floating exchange rates, it was in the context of European payments difficulties accompanying the then alleged "dollar shortage." Such a turnabout is always possible. Indeed, it is the very difficulty of predicting when and how such changes occur that is the basic argument for a free market. Our problem is not to "solve" a balance of payments problem. It is to solve the balance of payments problem by adopting a mechanism that will enable free market forces to provide a prompt, effective, and automatic response to changes in conditions affecting international trade.
Though freely floating exchange rates seem so clearly to be die appropriate free-market mechanism, they are strongly supported only by a fairly small number of liberals, mostly professional economists, and are opposed by many liberals who reject governmental intervention and governmental price-fixing in almost every other area. Why is this so? One reason is simply the tyranny of the status quo. A second reason is the confusion between a real gold standard and a pseudo gold standard. Under a real gold standard, the prices of different national currencies in terms of one another would be very nearly rigid since the different currencies would simply be different names for different amounts of gold. It is easy to make the mistake of supposing that we can get the substance of the real gold standard by the mere adoption of the form of a nominal obeisance to gold -- the adoption of a pseudo gold standard under which the prices of different national currencies in terms of one another are rigid only because they are pegged prices in rigged markets. A third reason is the inevitable tendency for everyone to be in favor of a free market for everyone else, while regarding himself as deserving of special treatment. This particularly affects bankers in respect of exchange rates. They like to have a guaranteed price. Moreover, they are not familiar with the market devices that would arise to cope with fluctuations in exchange rates. The firms that would specialize in speculation and arbitrage in a free market for exchange do not exist. This is one way the tyranny of the status quo is enforced. In Canada, for example, some bankers, after a decade of a free rate which gave them a different status quo, were in the forefront of those favoring its continuation and objecting to either a pegged rate or government manipulation of the rate.
More important than any of these reasons, I believe, is a mistaken interpretation of experience with floating rates, arising out of a statistical fallacy that can be seen easily in a standard example. Arizona is clearly the worst place in the U.S. for a person with tuberculosis to go because the death rate from tuberculosis is higher in Arizona than in any other state. The fallacy is in this case obvious. It is less obvious in connection with exchange rates. When countries have gotten into severe financial difficulties through internal monetary mismanagement or for any other reason, they have had ultimately to resort to flexible exchange rates. No amount of exchange control or direct restrictions on trade enabled them to peg an exchange rate that was far out of line with economic realities. In consequence, it is unquestionably true that floating ex- change rates have frequently been associated with financial and economic instability -- as, for example, in hyperinflations, or severe but not hyperinflations such as have occurred in many South American countries. It is easy to conclude, as many have, that floating exchange rates produce such instability.
Being in favor of floating exchange rates does not mean being in favor of unstable exchange rates. When we support a free price system at home, this does not imply that we favor a system in which prices fluctuate wildly up and down. What we want is a system in which prices are free to fluctuate but in which the forces determining them are sufficiently stable so that in fact prices move within moderate ranges. This is equally true of a system of floating exchange rates. The ultimate objective is a world in which exchange rates, while free to vary, are, in fact, highly stable because basic economic policies and conditions are stable. Instability of exchange rates is a symptom of instability in the underlying economic structure. Elimination of this symptom by administrative freezing of exchange rates cures none of the underlying difficulties and only makes adjustments to them more painful.
THE POLICY MEASURES NECESSARY FOR A FREE MARKET IN GOLD AND FOREIGN EXCHANGE
It may help bring out in concrete terms the implications of this discussion if I specify in detail the measures that I believe the U.S. should take to promote a truly free market in both gold and foreign exchange.
1. The U.S. should announce that it no longer commits itself to buy or sell gold at any fixed price.
2. Present laws making it illegal for individuals to own gold or to buy and sell gold should be repealed, so that there are no restrictions on the price at which gold can be bought or sold in terms of any other commodity or financial instrument, including national currencies.
3. The present law specifying that the Reserve System must hold gold certificates equal to 25 per cent of its liabilities should be repealed.
4. A major problem in getting rid completely of the gold price-support program, as of the wheat price-support program, is the transitional one of what to do with accumulated government stocks. In both cases, my own view is that the government should immediately restore a free market by instituting steps 1 and 2, and should ultimately dispose of all of its stocks. However, it would probably be desirable for the government to dispose of its stocks only gradually. For wheat, five years has always seemed to me a long enough period, so I have favored the government committing itself to dispose of one-fifth of its stocks in each of five years. This period seems reasonably satisfactory for gold as well. Hence, I propose that the government auction off its gold stocks on the free market over a five-year period. With a free gold market, individuals may well find warehouse certificates for gold more useful than actual gold. But if so, private enterprise can certainly provide the service of storing the gold and issuing certificates. Why should gold storage and the issuance of warehouse certificates be a nationalized industry ?
5. The U.S. should announce also that it will not proclaim any official exchange rates between the dollar and other currencies and in addition that it will not engage in any speculative or other activities aimed at influencing exchange rates. These would then be determined in free markets.
6. These measures would conflict with our formal obligation as a member of the International Monetary Fund to specify an official parity for the dollar. However, the Fund found it possible to reconcile Canada's failure to specify a parity with its Articles and to give its approval to a floating rate for Canada. There is no reason why it cannot do the same for the U.S.
7. Other nations might choose to peg their currencies to the dollar. That is their business and there is no reason for us to object so long as we undertake no obligations to buy or sell their currency at a fixed price. They will be able to succeed in pegging their currency to ours only by one or more of the measures listed earlier -- drawing on or accumulating reserves, co-ordinating their internal policy with U.S. policy, tightening or loosening direct controls on trade.
ELIMINATING U.S. RESTRICTIONS ON TRADE
A system such as that just outlined would solve the balance of payments problem once and for all. No deficit could possibly arise to require high government officials to plead with foreign countries and central banks for assistance, or to require an American President to behave like a harried country banker trying to restore confidence in his bank, or to force an administration preaching free trade to impose import restrictions, or to sacrifice important national and personal interests to the trivial question of the name of the currency in which payments are made. Payments would always balance because a price -- the foreign exchange rate -- would be free to produce a balance. No one could sell dollars unless he could find someone to buy them and conversely.
A system of floating exchange rates would therefore enable us to proceed effectively and directly toward complete free trade in goods and services -- barring only such deliberate interference as may be justified on strictly political and military grounds; for example, banning the sale of strategic goods to communist countries. So long as we are firmly committed to the strait jacket of fixed exchange rates, we cannot move definitively to free trade. The possibility of tariffs or direct controls must be retained as an escape valve in case of necessity.
A system of floating exchange rates has the side advantage that it makes almost transparently obvious the fallacy in the most popular argument against free trade, the argument that "low" wages elsewhere make tariffs somehow necessary to protect "high" wages here. Is 100 yen an hour to a Japanese worker high or low compared with $4 an hour to an American worker? That all depends on the exchange rate. What determines the exchange rate ? The necessity of making payments balance; i.e., of making the amount we can sell to the Japanese roughly equal to the amount they can sell to us.
Suppose for simplicity that Japan and the U.S. are the only two countries involved in trade and that at some exchange rate, say 1,000 yen to the dollar, Japanese could produce every single item capable of entering into foreign trade more cheaply than the U.S. At that exchange rate the Japanese could sell much to us, we, nothing to them. Suppose we pay them in paper dollars. What would the Japanese exporters do with the dollars ? They cannot eat them, wear them, or live in them. If they were willing simply to hold them, then die printing industry -- printing the dollar bills -- would be a magnificent export industry. Its output would enable us all to have the good things of life provided nearly free by the Japanese.
But, of course, Japanese exporters would not want to hold die dollars. They would want to sell them for yen. By assumption, there is nothing they can buy for a dollar that they cannot buy for less than the 1,000 yen that a dollar will by assumption exchange for. This is equally true for other Japanese. Why then would any holder of yen give up 1,000 yen for a dollar that will buy less in goods than the 1,000 yen will? No one would. In order for die Japanese exporter to exchange his dollars for yen, he would have to offer to take fewer yen -- the price of the dollar in terms of the yen would have to be less than 1,000, or of the yen in terms of the dollar more than i mill. But at 500 yen to the dollar Japanese goods are twice as expensive to Americans as before; American goods half as expensive to the Japanese. The Japanese will no longer be able to undersell American producers on all items.
Where will the price of the yen in terms of dollars settle? At whatever level is necessary to assure that all exporters who desire to do so can sell the dollars they get for the goods they export to America to importers who use them to buy goods in America. To speak loosely, at whatever level is necessary to assure that the value of U.S. exports (in dollars) is equal to the value of U.S. imports (again in dollars). Loosely, because a precise statement would have to take into account capital transactions, gifts, and so on. But these do not alter the central principle.
It will be noted that this discussion says nothing about the level of living of the Japanese worker or the American worker. These are irrelevant. If the Japanese worker has a lower standard of living than the American, it is because he is less productive on the average than the American, given the training he has, the amount of capital and land and so on that he has to work with. If the American worker is, let us say, on the aver- age four times as productive as the Japanese worker, it is wasteful to use him to produce any goods in the production of which he is less than four times as productive. It is better to produce those goods at which he is more productive and trade them for the goods at which he is less productive. Tariffs do not assist the Japanese worker to raise his standard of living or protect the high standard of the American worker. On the contrary, they lower the Japanese standard and keep the American standard from being as high as it could be.
Given that we should move to free trade, how should we do so? The method that we have tried to adopt is reciprocal negotiation of tariff reductions with other countries. This seems to me a wrong procedure. In the first place, it ensures a slow pace. He moves fastest who moves alone. In the second place, it fosters an erroneous view of the basic problem. It makes it appear as if tariffs help the country imposing them but hurt other countries, as if when we reduce a tariff we give up something good and should get something in return in the form of a reduction in the tariffs imposed by other countries. In truth, the situation is quite different. Our tariffs hurt us as well as other countries. We would be benefited by dispensing with our tariffs even if other countries did not.2 We would of course be benefited even more if they reduced theirs but our benefiting does not require that they reduce theirs. Self interests coincide and do not conflict.
I believe that it would be far better for us to move to free trade unilaterally, as Britain did in the nineteenth century when it repealed the corn laws. We, as they did, would experience an enormous accession of political and economic power. We are a great nation and it ill behooves us to require reciprocal benefits from Luxembourg before we reduce a tariff on Luxembourg products, or to throw thousands of Chinese refugees suddenly out of work by imposing import quotas on textiles from Hong Kong. Let us live up to our destiny and set the pace not be reluctant followers.
1 have spoken in terms of tariffs for simplicity but, as already noted, non-tariff restrictions may now be more serious impediments to trade than tariffs. We should remove both. A prompt yet gradual program would be to legislate that all import quotas or other quantitative restrictions, whether imposed by us or "voluntarily" accepted by other countries, be raised 20 per cent a year until they are so high that they become irrelevant and can be abandoned, and that all tariffs be reduced by one-tenth of the present level in each of the next ten years.
There are few measures we could take that would do more to promote the cause of freedom at home and abroad. Instead of making grants to foreign governments in the name of economic aid -- and thereby promoting socialism -- while at the same time imposing restrictions on the products they succeed in producing -- and thereby hindering free enterprise -- we could assume a consistent and principled stance. We could say to the rest of the world: We believe in freedom and intend to practice it. No one can force you to be free. That is your business. But we can offer you full co-operation on equal terms to all. Our market is open to you. Sell here what you can and wish to. Use the proceeds to buy what you wish. In this way co-operation among individuals can be world wide yet free.
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Notes
1 A warning is in order that this is a subtle point that depends on what is held constant in estimating the free market price, particularly with respect to gold's monetary role.
2 There are conceivable exceptions to these statements but, so far as I can see, they are theoretical curiosities, not relevant practical possibilities.
International Financial and Trade Arrangements
The problem of international monetary arrangements is the relation among different national currencies: the terms and conditions under which individuals are able to convert U.S. dollars to pounds sterling, Canadian dollars to U.S. dollars, and so on. This problem is closely connected with the control of money discussed in the preceding chapter. It is connected also with governmental policies about international trade, since control over international trade is one technique for affecting international payments.
THE IMPORTANCE OF INTERNATIONAL MONETARY ARRANGEMENTS FOR ECONOMIC FREEDOM
Despite its technical character and forbidding complexity, the subject of international monetary arrangements is one that a liberal cannot afford to neglect. It is not too much to say that the most serious short-run threat to economic freedom in the United States today -- aside, of course, from the outbreak of World War III -- is that we shall be led to adopt far-reaching economic controls in order to "solve" balance of payments problems. Interferences with international trade appear innocuous; they can get the support of people who are otherwise apprehensive of interference by government into economic affairs; many a business man even regards them as part of the "American Way of Life"; yet there are few interferences which are capable of spreading so far and ultimately being so destructive of free enterprise. There is much experience to suggest that the most effective way to convert a market economy into an authoritarian economic society is to start by imposing direct controls on foreign exchange. This one step leads inevitably to the rationing of imports, to control over domestic production that uses imported products or that produces substitutes for imports, and so on in a never-ending spiral. Yet even so generally staunch a champion of free enterprise as Senator Barry Goldwater has at times been led, when discussing the so-called "gold flow," to suggest that restrictions on transactions in foreign exchange may be necessary as a "cure." This "cure" would be vastly worse than the disease.
There is seldom anything truly new under the sun in economic policy, where the allegedly new generally turns out to be the discard of a prior century in flimsy disguise. Unless I am mistaken, however, full-fledged exchange controls and so-called "inconvertibility of currencies" are an exception and their origin reveals their authoritarian promise. To the best of my knowledge they were invented by Hjalmar Schacht in the early years of the Nazi regime. On many occasions in the past, of course, currencies have been described as inconvertible. But what the word then meant was that the government of the day was unwilling or unable to convert paper currency into gold or silver, or whatever the monetary commodity was, at the legally stipulated rate. It seldom meant that a country prohibited its citizens or residents from trading pieces of paper promising to pay specified sums in the monetary unit of that country for corresponding pieces of paper expressed in the monetary unit of another country -- or for that matter for coin or bullion. During the Civil War in the United States and for a decade and a half thereafter, for example, U.S. currency was inconvertible in the sense that the holder of a greenback could not turn it in to the Treasury and get a fixed amount of gold for it. But throughout the period he was free to buy gold at the market price or to buy and sell British pounds for U.S. greenbacks at any price mutually agreeable to the two parties. In the United States, the dollar has been inconvertible in the older sense ever since 1933. It has been illegal for American citizens to hold gold or to buy and sell gold. The dollar has not been inconvertible in the newer sense. But unfortunately we seem to be adopting policies that are highly likely, sooner or later, to drive us in that direction.
THE ROLE OF GOLD IN THE U.S. MONETARY SYSTEM
Only a cultural lag leads us still to think of gold as the central element in our monetary system. A more accurate description of the role of gold in U.S. policy is that it is primarily a commodity whose price is supported, like wheat or other agricultural products. Our price-support program for gold differs in three important respects from our price-support program for wheat: first, we pay the support price to foreign as well as domestic producers; second, we sell freely at the support price only to foreign purchasers and not to domestic; third, and this is the one important relic of the monetary role of gold, the Treasury is authorized to create money to pay for gold it buys -- to print paper money as it were -- so that expenditures for the purchase of gold do not appear in the budget and the sums required need not be explicitly appropriated by Congress; similarly, when the Treasury sells gold, the books show simply a reduction in gold certificates, and not a receipt that enters into the budget.
When the price of gold was first set at its present level of $35 an ounce in 1934, this price was well above the free market price of gold. In consequence, gold flooded the United States, our gold stock tripled in six years, and we came to hold well over half the world's gold stock. We accumulated a "surplus" of gold for the same reason we accumulated a "surplus" of wheat -- because the government offered to pay a higher price than the market price. More recently, the situation has changed. While the legally fixed price of gold has remained $35, prices of other goods have doubled or tripled. Hence $35 is now less than what die free market price would be.1 As a result, we now face a "shortage" rather than a "surplus" for precisely the same reason that rent ceilings inevitably produce a "shortage" of housing -- because the government is trying to hold the price of gold below the market price.
The legal price of gold would long since have been raised -- as wheat prices have been raised from time to time -- except for the accident that the major producers of gold, and hence the major beneficiaries from a rise in its price, are Soviet Russia and South Africa, the two countries with whom the United States has least political sympathy.
Governmental control of the price of gold, no less than the control of any other price, is inconsistent with a free economy. Such a pseudo gold standard must be distinguished sharply from the use of gold as money under a real gold standard which is entirely consistent with a free economy though it may not be feasible. Even more than the price fixing itself, the associated measures taken in 1933 and 1934 by the Roosevelt administration when it raised the price of gold represented a fundamental departure from liberal principles and established precedents that have returned to plague the free world. I refer to the nationalization of the gold stock, the prohibition of private possession of gold for monetary purposes, and the abrogation of gold clauses in public and private contracts.
In 1933 and early 1934, private holders of gold were required by law to turn over their gold to the federal government. They were compensated at a price equal to the prior legal price, which was at the time decidedly below the market price. To make this requirement effective, private ownership of gold within the U.S. was made illegal except for use in the arts. One can hardly imagine a measure more destructive of the principles of private property on which a free enterprise society rests. There is no difference in principle between this nationalization of gold at an artificially low price and Fidel Castro's nationalization of land and factories at an artificially low price. On what grounds of principle can the U.S. object to the one after having itself engaged in the other? Yet so great is the blindness of some supporters of free enterprise with respect to anything touching gold that in i960 Henry Alexander, head of the Morgan Guaranty Trust Company, successor to J. P. Morgan and Company, proposed that the prohibition against the private ownership of gold by U.S. citizens be extended to cover gold held abroad! And his proposal was adopted by President Eisenhower with hardly a protest from the banking community.
Though rationalized in terms of "conserving" gold for monetary use, prohibition of private ownership of gold was not enacted for any such monetary purpose, whether itself good or bad. The nationalization of gold was enacted to enable the government to reap the whole of the "paper" profit from the rise in the price of gold -- or perhaps, to prevent private individuals from benefiting.
The abrogation of the gold clauses had a similar purpose. And this too was a measure destructive of the basic principles of free enterprise. Contracts entered into in good faith and with full knowledge on the part of both parties to them were declared invalid for the benefit of one of the parties!
CURRENT PAYMENTS AND CAPITAL FLIGHT
In discussing international monetary relations on a more general level, it is necessary to distinguish two rather different problems: the balance of payments, and the danger of a run on gold. The difference between the problems can be illustrated most simply by considering the analogy of an ordinary commercial bank. The bank must so arrange its affairs that it takes in as service charges, interest on loans, and so on a large enough sum to enable it to pay its expenses -- wages and salaries, interest on borrowed funds, cost of supplies, returns to stockholders, and so on. It must strive, that is, for a healthy income account. But a bank which is in good shape on its income account may nonetheless experience serious trouble if for any reason its depositors should lose confidence in it and suddenly demand their deposits en masse. Many a sound bank was forced to close its doors because of such a run on it during the liquidity crises described in the preceding chapter.
These two problems are not of course unrelated. One important reason why a bank's depositors may lose confidence in it is because the bank is experiencing losses on income account. Yet the two problems are also very different. For one thing, problems on income account are generally slow to arise and considerable time is available to solve them. They seldom come as sudden surprises. A run, on the other hand, may arise suddenly and unpredictably out of thin air.
The situation of the U.S. is precisely parallel. Residents of the United States and the U.S. government itself are seeking to buy foreign currencies with dollars in order to purchase goods and services in other countries, to invest in foreign enterprises, to pay interest on debts, to repay loans, or to give gifts to others, whether private or public. At the same time, foreigners are seeking to acquire dollars with foreign currencies for corresponding purposes. After the event, the number of dollars spent for foreign currency will precisely equal the number of dollars purchased with foreign currency -- just as the number of pairs of shoes sold is precisely equal to the number bought. Arithmetic is arithmetic and one man's purchase is another man's sale. But there is nothing to assure that, at any given price of foreign currency in terms of dollars, the number of dollars that some want to spend will equal the number others want to buy -- just as there is nothing to assure that at any given price of shoes the number of pairs of shoes people want to buy is exactly equal to the number of pairs other people want to sell. The ex post equality reflects some mechanism that eliminates any ex ante discrepancy. The problem of achieving an appropriate mechanism for this purpose is the counterpart of the bank's problem on income account.
In addition, the United States has a problem like the bank's of avoiding a run. The U.S. is committed to sell gold to foreign central banks and governments at $35 an ounce. Foreign central banks, governments, and residents hold large funds in the United States in the form of deposit accounts or U.S. securities that can be readily sold for dollars. At any time, the holders of these balances can start a run on the U.S. Treasury by trying to convert their dollar balances into gold. This is precisely what happened in the fall of i960, and what is very likely to happen again at some unpredictable date in the future (perhaps before this is printed).
The two problems are related in two ways. In the first place, as for a bank, income account difficulties are a major source of loss of confidence in the ability of die U.S. to honor its promise to sell gold at $35 an ounce. The fact that the U.S. has in effect been having to borrow abroad in order to achieve balance on current account is a major reason why holders of dollars are interested in converting them into gold or other currencies. In the second place, the fixed price of gold is the device we have adopted for pegging another set of prices -- the price of the dollar in terms of foreign currencies -- and flows of gold are the device we have adopted for resolving ex ante discrepancies in the balance of payments.
ALTERNATIVE MECHANISMS FOR ACHIEVING BALANCE IN FOREIGN PAYMENTS
We can get more light on both of these relations by considering what alternative mechanisms are available for achieving balance in payments -- the first and in many ways the more fundamental of the two problems.
Suppose that the U.S. is roughly in balance in its international payments and that something comes along which alters the situation by, let us say, reducing the number of dollars that foreigners want to buy compared to the number that U.S. residents want to sell; or, looking at it from the other side, increasing the amount of foreign currency that holders of dollars want to buy compared to the amount that holders of foreign currency want to sell for dollars. That is, something threatens to produce a "deficit" in U.S. payments. This might result from increased efficiency in production abroad or decreased efficiency at home, increased foreign aid expenditures by the U.S. or reduced ones by other countries, or a million and one other changes of the kind that are always occurring. There are four, and only four ways, in which a country can adjust to such a disturbance and some combination of these ways must be used.
1. U.S. reserves of foreign currencies can be drawn down or foreign reserves of U.S. currency built up. In practice, this means that the U.S. government can let its stock of gold go down, since gold is exchangeable for foreign currencies, or it can borrow foreign currencies and make them available for dollars at official exchange rates; or foreign governments can accumulate dollars by selling U.S. residents foreign currencies at official rates. Reliance on reserves is obviously at best a temporary expedient. Indeed, it is precisely the extensive use by the U.S. of this expedient that accounts for the great concern with the balance of payments.
2. Domestic prices within the U.S. can be forced down relative to foreign prices. This is the main adjustment mechanism under a full-fledged gold standard. An initial deficit would produce an outflow of gold (mechanism 1, above); the outflow of gold would produce a decline in the stock of money; the decline in the stock of money would produce a fall in prices and incomes at home. At the same time, the reverse effects would occur abroad: the inflow of gold would expand the stock of money and thereby raise prices and income. Lowered U.S. prices and increased foreign prices would make U.S. goods more attractive to foreigners and thereby raise the number of dollars they wanted to buy; at the same time, the price changes would make foreign goods less attractive to U.S. residents and thereby lower the number of dollars they wanted to sell. Both effects would operate to reduce the deficit and restore balance without the necessity for further gold flows.
Under the modern managed standard, these effects are not automatic. Gold flows may still occur as the first step, but they will not affect the stock of money in either the country that loses, or the country that gains gold, unless the monetary authorities in the separate countries decide that they should. In every country today, the central bank or the Treasury has the power to offset die influence of gold flows, or to change the stock of money without gold flows. Hence this mechanism will be used only if the authorities in the country experiencing the deficit are willing to produce a deflation, thereby creating unemployment, in order to resolve its payments problem, or the authorities in the country experiencing the surplus are willing to produce an inflation.
3. Exactly die same effects can be achieved by a change in exchange rates as by a change in domestic prices. For example, suppose that under mechanism 2 the price of a particular car in the United States fell by 10 per cent from $2,800 to $2,520. If the price of the pound is throughout $2.80, this means that the price in Britain (neglecting freight and other charges) would fall from £1,000 to £900. Exactly the same decline in the British price will occur without any change in the United States price if the price of a pound rises from $2.80 to $3.11. Formerly, the Englishman had to spend £1,000 to get $2,800. Now he can get $2,800 for only £900. He would not know the difference between this reduction in cost and the corresponding reduction through a fall in the U.S. price without a change in exchange rate.
In practice, there are several ways in which the change in exchange rates can occur. With the kinds of pegged exchange rates many countries now have, it can occur through devaluation or appreciation, which is to say, a governmental declaration that it is changing the price at which it proposes to peg its currency. Alternatively, the exchange rate does not need to be pegged at all. It can be a market rate changing from day to day, as was the case with the Canadian dollar from 1950 to 1962. If a market rate, it can be a truly free market rate determined primarily by private transactions as the Canadian rate apparently was from 1952 to 1961, or it can be manipulated by government speculation as was the situation in Britain from 1931 to 1939, and in Canada from 1950 to 1952 and again from 1961 to 1962.
Of these various techniques, only the freely floating exchange rate is fully automatic and free from governmental control.
4. The adjustments produced by mechanisms 2 and 3 consist of changes in flows of commodities and services induced by changes either in internal prices or exchange rates. Instead, direct governmental controls or interferences with trade could be used to reduce attempted U.S. expenditures of dollars and expand U.S. receipts. Tariffs could be raised to choke off imports, subsidies could be given to stimulate exports, import quotas could be imposed on a variety of goods, capital investment abroad by U.S. citizens or firms could be controlled, and so on and on up to the whole paraphernalia of exchange controls. In this category must be included not only controls over private activities but also changes in governmental programs for balance of payments purposes. Recipients of foreign aid may be required to spend the aid in the U.S.; the military may procure goods in the United States at greater expense instead of abroad in order to save "dollars" -- in the self-contradictory terminology used -- and so on in bewildering array.
The important thing to note is that one or another of these four ways will and must be used. Double entry books must balance. Payments must equal receipts. The only question is how.
Our announced national policy has been and continues to be that we shall do none of these things. In a speech in December 1961, to the National Association of Manufacturers, President Kennedy stated "This administration, therefore, during its term of office -- and I repeat this and make it as a flat statement -- has no intention of imposing exchange controls, devaluing the dollar, raising trade barriers or choking off our economic recovery." As a matter of logic, this leaves only two possibilities: getting other countries to take the relevant measures, which is hardly a recourse that we can be sure of, or drawing down reserves, which the President and other officials repeatedly stated must not be permitted to continue. Yet Time magazine reports that the President's "promise drew a burst of applause" from the assembled businessmen. So far as our announced policy is concerned, we are in the position of a man living beyond his income who insists that he cannot possibly earn more, or spend less, or borrow, or finance the excess out of his assets!
Because we have been unwilling to adopt any one coherent policy, we and our trading partners -- who make the same ostrich-like pronouncements as we do -- have perforce been led to resort to all four mechanisms. In the early postwar years, U.S. reserves rose; more recently they have been declining. We welcomed inflation more readily than we otherwise would have when reserves were rising, and we have been more deflationary since 1958 than we would otherwise have been because of the drain of gold. Though we have not changed our official price of gold, our trading partners have changed theirs, and thereby the exchange rate between their currency and the dollar, and U.S. pressure has not been absent in producing these adjustments. Finally, our trading partners used direct controls extensively and, since we instead of they have been faced with deficits, we too have resorted to a wide range of direct interferences with payments, from reducing die amount of foreign goods that tourists can bring in free of duty -- a trivial yet highly symptomatic step -- to requiring foreign aid expenditures to be spent in the U.S., to keeping families from joining servicemen overseas, to more stringent import quotas on oil. We have been led also to engage in the demeaning step of asking foreign governments to take special measures to strengthen the U.S. balance of payments.
Of the four mechanisms, die use of direct controls is clearly die worst from almost any point of view and certainly the most destructive of a free society. Yet in lieu of any clear policy, we have been led increasingly to rely on such controls in one form or another. We preach publicly the virtues of free trade; yet we have been forced by the inexorable pressure of the balance of payments to move in the opposite direction and there is great danger that we shall move still farther. We can pass all the laws imaginable to reduce tariffs; the Administration may negotiate any number of tariff reductions; yet unless we adopt an alternative mechanism for resolving balance of payments deficits, we shall be led to substitute one set of trade impediments for another -- indeed, to substitute a worse set for a better. While tariffs are bad, quotas and other direct interferences are even worse. A tariff, like a market price, is impersonal and does not involve direct interference by government in business affairs; a quota is likely to involve allocation and other administrative interferences, besides giving administrators valuable plums to pass out to private interests. Perhaps worse than either tariffs or quotas are extra-legal arrangements, such as the "voluntary" agreement by Japan to restrict textile exports.
FLOATING EXCHANGE RATES AS THE FREE MARKET SOLUTION
There are only two mechanisms that are consistent with a free market and free trade. One is a fully automatic international gold standard. This, as we saw in the preceding chapter, is neither feasible nor desirable. In any event, we cannot adopt it by ourselves. The other is a system of freely floating exchange rates determined in the market by private transactions without governmental intervention. This is the proper free-market counterpart to the monetary rule advocated in the preceding chapter. If we do not adopt it, we shall inevitably fail to expand the area of free trade and shall sooner or later be induced to impose widespread direct controls over trade. In this area, as in others, conditions can and do change unexpectedly. It may well be that we shall muddle through the difficulties that are facing us as this is written (April, 1962) and indeed that we may find ourselves in a surplus rather than deficit position, accumulating reserves rather than losing them. If so, this will only mean that other countries will be faced with the necessity of imposing controls. When, in 1950,1 wrote an article proposing a system of floating exchange rates, it was in the context of European payments difficulties accompanying the then alleged "dollar shortage." Such a turnabout is always possible. Indeed, it is the very difficulty of predicting when and how such changes occur that is the basic argument for a free market. Our problem is not to "solve" a balance of payments problem. It is to solve the balance of payments problem by adopting a mechanism that will enable free market forces to provide a prompt, effective, and automatic response to changes in conditions affecting international trade.
Though freely floating exchange rates seem so clearly to be die appropriate free-market mechanism, they are strongly supported only by a fairly small number of liberals, mostly professional economists, and are opposed by many liberals who reject governmental intervention and governmental price-fixing in almost every other area. Why is this so? One reason is simply the tyranny of the status quo. A second reason is the confusion between a real gold standard and a pseudo gold standard. Under a real gold standard, the prices of different national currencies in terms of one another would be very nearly rigid since the different currencies would simply be different names for different amounts of gold. It is easy to make the mistake of supposing that we can get the substance of the real gold standard by the mere adoption of the form of a nominal obeisance to gold -- the adoption of a pseudo gold standard under which the prices of different national currencies in terms of one another are rigid only because they are pegged prices in rigged markets. A third reason is the inevitable tendency for everyone to be in favor of a free market for everyone else, while regarding himself as deserving of special treatment. This particularly affects bankers in respect of exchange rates. They like to have a guaranteed price. Moreover, they are not familiar with the market devices that would arise to cope with fluctuations in exchange rates. The firms that would specialize in speculation and arbitrage in a free market for exchange do not exist. This is one way the tyranny of the status quo is enforced. In Canada, for example, some bankers, after a decade of a free rate which gave them a different status quo, were in the forefront of those favoring its continuation and objecting to either a pegged rate or government manipulation of the rate.
More important than any of these reasons, I believe, is a mistaken interpretation of experience with floating rates, arising out of a statistical fallacy that can be seen easily in a standard example. Arizona is clearly the worst place in the U.S. for a person with tuberculosis to go because the death rate from tuberculosis is higher in Arizona than in any other state. The fallacy is in this case obvious. It is less obvious in connection with exchange rates. When countries have gotten into severe financial difficulties through internal monetary mismanagement or for any other reason, they have had ultimately to resort to flexible exchange rates. No amount of exchange control or direct restrictions on trade enabled them to peg an exchange rate that was far out of line with economic realities. In consequence, it is unquestionably true that floating ex- change rates have frequently been associated with financial and economic instability -- as, for example, in hyperinflations, or severe but not hyperinflations such as have occurred in many South American countries. It is easy to conclude, as many have, that floating exchange rates produce such instability.
Being in favor of floating exchange rates does not mean being in favor of unstable exchange rates. When we support a free price system at home, this does not imply that we favor a system in which prices fluctuate wildly up and down. What we want is a system in which prices are free to fluctuate but in which the forces determining them are sufficiently stable so that in fact prices move within moderate ranges. This is equally true of a system of floating exchange rates. The ultimate objective is a world in which exchange rates, while free to vary, are, in fact, highly stable because basic economic policies and conditions are stable. Instability of exchange rates is a symptom of instability in the underlying economic structure. Elimination of this symptom by administrative freezing of exchange rates cures none of the underlying difficulties and only makes adjustments to them more painful.
THE POLICY MEASURES NECESSARY FOR A FREE MARKET IN GOLD AND FOREIGN EXCHANGE
It may help bring out in concrete terms the implications of this discussion if I specify in detail the measures that I believe the U.S. should take to promote a truly free market in both gold and foreign exchange.
1. The U.S. should announce that it no longer commits itself to buy or sell gold at any fixed price.
2. Present laws making it illegal for individuals to own gold or to buy and sell gold should be repealed, so that there are no restrictions on the price at which gold can be bought or sold in terms of any other commodity or financial instrument, including national currencies.
3. The present law specifying that the Reserve System must hold gold certificates equal to 25 per cent of its liabilities should be repealed.
4. A major problem in getting rid completely of the gold price-support program, as of the wheat price-support program, is the transitional one of what to do with accumulated government stocks. In both cases, my own view is that the government should immediately restore a free market by instituting steps 1 and 2, and should ultimately dispose of all of its stocks. However, it would probably be desirable for the government to dispose of its stocks only gradually. For wheat, five years has always seemed to me a long enough period, so I have favored the government committing itself to dispose of one-fifth of its stocks in each of five years. This period seems reasonably satisfactory for gold as well. Hence, I propose that the government auction off its gold stocks on the free market over a five-year period. With a free gold market, individuals may well find warehouse certificates for gold more useful than actual gold. But if so, private enterprise can certainly provide the service of storing the gold and issuing certificates. Why should gold storage and the issuance of warehouse certificates be a nationalized industry ?
5. The U.S. should announce also that it will not proclaim any official exchange rates between the dollar and other currencies and in addition that it will not engage in any speculative or other activities aimed at influencing exchange rates. These would then be determined in free markets.
6. These measures would conflict with our formal obligation as a member of the International Monetary Fund to specify an official parity for the dollar. However, the Fund found it possible to reconcile Canada's failure to specify a parity with its Articles and to give its approval to a floating rate for Canada. There is no reason why it cannot do the same for the U.S.
7. Other nations might choose to peg their currencies to the dollar. That is their business and there is no reason for us to object so long as we undertake no obligations to buy or sell their currency at a fixed price. They will be able to succeed in pegging their currency to ours only by one or more of the measures listed earlier -- drawing on or accumulating reserves, co-ordinating their internal policy with U.S. policy, tightening or loosening direct controls on trade.
ELIMINATING U.S. RESTRICTIONS ON TRADE
A system such as that just outlined would solve the balance of payments problem once and for all. No deficit could possibly arise to require high government officials to plead with foreign countries and central banks for assistance, or to require an American President to behave like a harried country banker trying to restore confidence in his bank, or to force an administration preaching free trade to impose import restrictions, or to sacrifice important national and personal interests to the trivial question of the name of the currency in which payments are made. Payments would always balance because a price -- the foreign exchange rate -- would be free to produce a balance. No one could sell dollars unless he could find someone to buy them and conversely.
A system of floating exchange rates would therefore enable us to proceed effectively and directly toward complete free trade in goods and services -- barring only such deliberate interference as may be justified on strictly political and military grounds; for example, banning the sale of strategic goods to communist countries. So long as we are firmly committed to the strait jacket of fixed exchange rates, we cannot move definitively to free trade. The possibility of tariffs or direct controls must be retained as an escape valve in case of necessity.
A system of floating exchange rates has the side advantage that it makes almost transparently obvious the fallacy in the most popular argument against free trade, the argument that "low" wages elsewhere make tariffs somehow necessary to protect "high" wages here. Is 100 yen an hour to a Japanese worker high or low compared with $4 an hour to an American worker? That all depends on the exchange rate. What determines the exchange rate ? The necessity of making payments balance; i.e., of making the amount we can sell to the Japanese roughly equal to the amount they can sell to us.
Suppose for simplicity that Japan and the U.S. are the only two countries involved in trade and that at some exchange rate, say 1,000 yen to the dollar, Japanese could produce every single item capable of entering into foreign trade more cheaply than the U.S. At that exchange rate the Japanese could sell much to us, we, nothing to them. Suppose we pay them in paper dollars. What would the Japanese exporters do with the dollars ? They cannot eat them, wear them, or live in them. If they were willing simply to hold them, then die printing industry -- printing the dollar bills -- would be a magnificent export industry. Its output would enable us all to have the good things of life provided nearly free by the Japanese.
But, of course, Japanese exporters would not want to hold die dollars. They would want to sell them for yen. By assumption, there is nothing they can buy for a dollar that they cannot buy for less than the 1,000 yen that a dollar will by assumption exchange for. This is equally true for other Japanese. Why then would any holder of yen give up 1,000 yen for a dollar that will buy less in goods than the 1,000 yen will? No one would. In order for die Japanese exporter to exchange his dollars for yen, he would have to offer to take fewer yen -- the price of the dollar in terms of the yen would have to be less than 1,000, or of the yen in terms of the dollar more than i mill. But at 500 yen to the dollar Japanese goods are twice as expensive to Americans as before; American goods half as expensive to the Japanese. The Japanese will no longer be able to undersell American producers on all items.
Where will the price of the yen in terms of dollars settle? At whatever level is necessary to assure that all exporters who desire to do so can sell the dollars they get for the goods they export to America to importers who use them to buy goods in America. To speak loosely, at whatever level is necessary to assure that the value of U.S. exports (in dollars) is equal to the value of U.S. imports (again in dollars). Loosely, because a precise statement would have to take into account capital transactions, gifts, and so on. But these do not alter the central principle.
It will be noted that this discussion says nothing about the level of living of the Japanese worker or the American worker. These are irrelevant. If the Japanese worker has a lower standard of living than the American, it is because he is less productive on the average than the American, given the training he has, the amount of capital and land and so on that he has to work with. If the American worker is, let us say, on the aver- age four times as productive as the Japanese worker, it is wasteful to use him to produce any goods in the production of which he is less than four times as productive. It is better to produce those goods at which he is more productive and trade them for the goods at which he is less productive. Tariffs do not assist the Japanese worker to raise his standard of living or protect the high standard of the American worker. On the contrary, they lower the Japanese standard and keep the American standard from being as high as it could be.
Given that we should move to free trade, how should we do so? The method that we have tried to adopt is reciprocal negotiation of tariff reductions with other countries. This seems to me a wrong procedure. In the first place, it ensures a slow pace. He moves fastest who moves alone. In the second place, it fosters an erroneous view of the basic problem. It makes it appear as if tariffs help the country imposing them but hurt other countries, as if when we reduce a tariff we give up something good and should get something in return in the form of a reduction in the tariffs imposed by other countries. In truth, the situation is quite different. Our tariffs hurt us as well as other countries. We would be benefited by dispensing with our tariffs even if other countries did not.2 We would of course be benefited even more if they reduced theirs but our benefiting does not require that they reduce theirs. Self interests coincide and do not conflict.
I believe that it would be far better for us to move to free trade unilaterally, as Britain did in the nineteenth century when it repealed the corn laws. We, as they did, would experience an enormous accession of political and economic power. We are a great nation and it ill behooves us to require reciprocal benefits from Luxembourg before we reduce a tariff on Luxembourg products, or to throw thousands of Chinese refugees suddenly out of work by imposing import quotas on textiles from Hong Kong. Let us live up to our destiny and set the pace not be reluctant followers.
1 have spoken in terms of tariffs for simplicity but, as already noted, non-tariff restrictions may now be more serious impediments to trade than tariffs. We should remove both. A prompt yet gradual program would be to legislate that all import quotas or other quantitative restrictions, whether imposed by us or "voluntarily" accepted by other countries, be raised 20 per cent a year until they are so high that they become irrelevant and can be abandoned, and that all tariffs be reduced by one-tenth of the present level in each of the next ten years.
There are few measures we could take that would do more to promote the cause of freedom at home and abroad. Instead of making grants to foreign governments in the name of economic aid -- and thereby promoting socialism -- while at the same time imposing restrictions on the products they succeed in producing -- and thereby hindering free enterprise -- we could assume a consistent and principled stance. We could say to the rest of the world: We believe in freedom and intend to practice it. No one can force you to be free. That is your business. But we can offer you full co-operation on equal terms to all. Our market is open to you. Sell here what you can and wish to. Use the proceeds to buy what you wish. In this way co-operation among individuals can be world wide yet free.
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Notes
1 A warning is in order that this is a subtle point that depends on what is held constant in estimating the free market price, particularly with respect to gold's monetary role.
2 There are conceivable exceptions to these statements but, so far as I can see, they are theoretical curiosities, not relevant practical possibilities.
Chapter III
The Control of Money
"Full employment" and "economic growth" have in the past few decades become primary excuses for widening the extent of government intervention in economic affairs. A private free-enterprise economy, it is said, is inherently unstable. Left to itself, it will produce recurrent cycles of boom and bust. The government must therefore step in to keep things on an even keel. These arguments were particularly potent during and after the Great Depression of the 1930's, and were a major element giving rise to the New Deal in this country and comparable extensions of governmental intervention in others. More recently, "economic growth" has become the more popular rallying call. Government must, it is argued, see to it that the economy expands to provide the wherewithal for the cold war and demonstrate to the uncommitted nations of the world that a democracy can grow more rapidly than a communist state.
These arguments are thoroughly misleading. The fact is that the Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy. A governmentally established agency -- the Federal Reserve. System -- had been assigned responsibility for monetary policy. In 1930 and 1931, it exercised this responsibility so ineptly as to convert what otherwise would have been a moderate contraction into a major catastrophe (see further discussion, pages 45-50, below). Similarly today, governmental measures constitute the major impediments to economic growth in the United States. Tariffs and other restrictions on international trade, high tax burdens and a complex and inequitable tax structure, regulatory commissions, government price and wage fixing, and a host of other measures give individuals an incentive to misuse and misdirect resources, and distort the investment of new savings. What we urgently need, for both economic stability and growth, is a reduction of government intervention not an increase.
Such a reduction would still leave an important role for government in these areas. It is desirable that we use government to provide a stable monetary framework for a free economy -- this is part of the function of providing a stable legal framework. It is desirable too that we use government to provide a general legal and economic framework that will enable individuals to produce growth in the economy, if that is in accord with their values.
The major areas of governmental policy that are relevant to economic stability are monetary policy and fiscal or budgetary policy. This chapter discusses domestic monetary policy, the next, international monetary arrangements, and chapter v, fiscal or budgetary policy.
Our task in this and the following chapter is to steer a course between two views, neither of which is acceptable though both have their attractions. The Scylla is the belief that a purely automatic gold standard is both feasible and desirable and would resolve all the problems of fostering economic co-operation among individuals and nations in a stable environment. The Charybdis is the belief that the need to adapt to unforeseen circumstances requires the assignment of wide discretionary powers to a group of technicians, gathered together in an "independent" central bank, or in some bureaucratic body. Neither has proved a satisfactory solution in the past; and neither is likely to in the future.
A liberal is fundamentally fearful of concentrated power. His objective is to preserve the maximum degree of freedom for each individual separately that is compatible with one man's freedom not interfering with other men's freedom. He believes that this objective requires that power be dispersed. He is suspicious of assigning to government any functions that can be performed through the market, both because this substitutes coercion for voluntary co-operation in the area in question and because, by giving government an increased role, it threatens freedom in other areas.
The need for the dispersal of power raises an especially difficult problem in the field of money. There is widespread agreement that government must have some responsibility for monetary matters. There is also widespread recognition that control over money can be a potent tool for controlling and shaping the economy. Its potency is dramatized in Lenin's famous dictum that the most effective way to destroy a society is to destroy its money. It is exemplified in more pedestrian fashion by the extent to which control of money has, from time immemorial, enabled sovereigns to exact heavy taxes from the populace at large, very often without the explicit agreement of the legislature when there has been one. This has been true from early times when monarchs clipped coins and adopted similar expedients to the present with our more sophisticated modern techniques for turning the printing press or simply altering book entries. The problem is to establish institutional arrangements that will enable government to exercise responsibility for money, yet at the same time limit the power thereby given to government and prevent this power from being used in ways that will tend to weaken rather than strengthen a free society.
A COMMODITY STANDARD
Historically, the device that has evolved most frequently in many different places and over the course of centuries is a commodity standard; i.e., the use as money of some physical commodity such as gold or silver, brass or tin, cigarettes or cognac, or various other goods. If money consisted wholly of a physical commodity of this type, there would be, in principle, no need for control by the government at all. The amount of money in society would depend on the cost of producing the monetary commodity rather than other things. Changes in the amount of money would depend on changes in the technical conditions of producing the monetary commodity and on changes in the demand for money. This is an ideal that animates many believers in an automatic gold standard.
Actual commodity standards have deviated very far from this simple pattern which requires no governmental intervention. Historically, a commodity standard -- such as a gold standard or a silver standard -- has been accompanied by the development of fiduciary money of one kind or another, ostensibly convertible into the monetary commodity on fixed terms. There was a very good reason for this development. The fundamental defect of a commodity standard, from the point of view of the society as a whole, is that it requires the use of real resources to add to the stock of money. People must work hard to dig gold out of the ground in South Africa -- in order to rebury it in Fort Knox or some similar place. The necessity of using real resources for the operation of a commodity standard establishes a strong incentive for people to find ways to achieve the same result without employing these resources. If people will accept as money pieces of paper on which is printed "I promise to pay -------- units of the commodity standard," these pieces of paper can perform the same function as the physical pieces of gold or silver, and they require very much less in resources to produce. This point, which I have discussed at somewhat greater length elsewhere,1 seems to me the fundamental difficulty with a commodity standard.
If an automatic commodity standard were feasible, it would provide an excellent solution to the liberal's dilemma: a stable monetary framework without the danger of the irresponsible exercise of monetary powers. If, for example, an honest-to-good-ness gold standard, in which 100 per cent of the money in a country consisted literally of gold, were widely backed by the public at large, imbued with the mythology of a gold standard and with the belief that it is immoral and improper for government to interfere with its operation, it would provide an effective guarantee against governmental tinkering with the currency and against irresponsible monetary action. Under such a standard, any monetary powers of government would be very minor in scope. But, as just noted, such an automatic system has historically never proved feasible. It has always tended to develop in the direction of a mixed system containing fiduciary elements such as bank notes and deposits, or government notes in addition to the monetary commodity. And once fiduciary elements have been introduced, it has proved difficult to avoid governmental control over them, even when they were initially issued by private individuals. The reason is basically the difficulty of preventing counterfeiting or its economic equivalent. Fiduciary money is a contract to pay standard money. It so happens that there tends to be a long interval between the making of such a contract and its realization. This enhances the difficulty of enforcing the contract and hence also the temptation to issue fraudulent contracts. In addition, once fiduciary elements have been introduced, the temptation for government itself to issue fiduciary money is almost irresistible. In practice, therefore, commodity standards have tended to become mixed standards involving extensive intervention by the state.
It should be noted that despite the great amount of talk by many people in favor of the gold standard, almost no one today literally desires an honest-to-goodness, full gold standard. People who say they want a gold standard are almost invariably talking about the present kind of standard, or the kind of standard that was maintained in the 1930's; a gold standard managed by a central bank or other governmental bureau, which holds a small amount of gold as "backing" -- to use that very misleading term -- for fiduciary money. Some do go so far as to favor the kind of standard maintained in the 1920's, in which there was literal circulation of gold or gold certificates as hand-to-hand currency -- a gold-coin standard -- but even they favor the coexistence with gold of governmental fiduciary currency plus deposits issued by banks holding fractional reserves in either gold or fiduciary currency. Even during the so-called great days of the gold standard in the nineteenth century, when the Bank of England was supposedly running the gold standard skilfully, the monetary system was far from a fully automatic gold standard. Even then it was a highly managed standard. And certainly the situation is now more extreme as a result of the adoption by country after country of the view that government has responsibility for "full employment."
My conclusion is that an automatic commodity standard is neither a feasible nor a desirable solution to the problem of establishing monetary arrangements for a free society. It is not desirable because it would involve a large cost in die form of resources used to produce the monetary commodity. It is not feasible because the mythology and beliefs required to make it effective do not exist.
This conclusion is supported not only by the general historical evidence referred to but also by the specific experience of the United States. From 1879, when the United States resumed gold payments after the Civil War, to 1913, the United States was on a gold standard. Though closer to a thoroughly automatic gold standard than anything we have had since the end of World War I, the gold standard was still far from a 100 per cent gold standard. There were government issues of paper money, and private banks issued most of the effective circulating medium of the country in the form of deposits; the banks were closely regulated in their operations by governmental agencies -- national banks by the Comptroller of the Currency, state banks by state banking authorities. Gold, whether held by the Treasury, by banks, or directly by individuals as coins or gold certificates, accounted for between 10 per cent and 20 per cent of the money stock, the exact percentage varying from year to year. The remaining 80 per cent to 90 per cent consisted of silver, fiduciary currency, and bank deposits not matched by gold reserves.
In retrospect, the system may seem to us to have worked reasonably well. To Americans of the time, it clearly did not. The agitation over silver in tie 1880's, culminating in Bryan's Cross of Gold speech which set the tone for the 1896 election, was one sign of dissatisfaction. In turn, the agitation was largely responsible for the severely depressed years in the early 1890's. The agitation led to widespread fears that the United States would go off gold and that hence the dollar would lose value in terms of foreign currencies. This led to a flight from the dollar and a capital outflow that forced deflation at home.
Successive financial crises, in 1873, 1884, 1890, and 1893 produced a widespread demand for banking reform on the part of the business and banking community. The panic of 1907, involving the concerted refusal by banks to convert deposits into currency on demand, finally crystallized the feeling of dissatisfaction with the financial system into an urgent demand for governmental action. A National Monetary Commission was established by Congress, and its recommendations, reported in 1910, were embodied in die Federal Reserve Act passed in 1913. Reforms along the lines of the Federal Reserve Act had the backing of every section of the community, from the working clashes to the bankers, and of both political parties. The chairman of the National Monetary Commission was a Republican, Nelson W. Aldrich; the Senator mainly responsible for the Federal Reserve Act was a Democrat, Carter W. Glass.
The change in monetary arrangements introduced by the Federal Reserve Act turned out in practice to be far more drastic than was intended by its authors or its supporters. At the time the Act was passed, a gold standard reigned supreme throughout the world -- not a fully automatic gold standard but something far closer to that ideal than anything we have experienced since. It was taken for granted that it would continue to do so and thus narrowly limit the powers of tie Federal Reserve System. No sooner was tie Act passed than World War I broke out. There was a large-scale abandonment of the gold standard. By the end of the war, the Reserve System was no longer a minor adjunct to the gold standard designed to insure the convertibility of one form of money into others and to regulate and supervise banks. It had become a powerful discretionary authority able to determine the quantity of money in the United States and to affect international financial conditions throughout the world.
A DISCRETIONARY MONETARY AUTHORITY
The establishment of the Federal Reserve System was the most notable change in United States monetary institutions since at least the Civil War National Banking Act. For the first time since the expiration of the charter of the Second Bank of the United States in 1836, it established a separate official body charged with explicit responsibility for monetary conditions, and supposedly clothed with adequate power to achieve monetary stability or, at least, to prevent pronounced instability. It is therefore instructive to compare experience as a whole before and after its establishment -- say, from just after the Civil War to 1914 and from 1914 to date, to take two periods of equal length.
The second period was clearly the more unstable economically, whether instability is measured by the fluctuations in the stock of money, in prices, or in output. Partly, the greater instability reflects the effect of two world wars during the second period; these would clearly have been a source of instability whatever our monetary system. But even if the war and immediate postwar years are omitted, and we consider only the peacetime years from, say, 1920 through 1939, and 1947 to date, the result is the same. The stock of money, prices, and output was decidedly more unstable after the establishment of the Reserve System than before. The most dramatic period of instability in output was of course the period between the two wars which includes the severe contractions of 1920-21, 1929-33, and 1937-38. No other twenty-year period in American history contains as many as three such severe contractions.
This crude comparison does not of course prove that the Federal Reserve System failed to contribute to monetary stability. Perhaps the problems that the System had to handle were more severe than those that impinged on the earlier monetary structure. Perhaps those problems would have produced an even greater degree of monetary instability under the earlier arrangements. But the crude comparison should at least give the reader pause before he takes for granted, as is so often done, that an agency as long established, as powerful, as pervasive as the Federal Reserve System is performing a necessary and desirable function and is contributing to the attainment of the objectives for which it was established.
I am myself persuaded, on the basis of extensive study of the historical evidence, that the difference in economic stability revealed by the crude comparison is in fact attributable to the difference in monetary institutions. This evidence persuades me that at least a third of die price rise during and just after World War I is attributable to the establishment of die Federal Reserve System and would not have occurred if die earlier banking system had been retained; that the severity of each of the major contractions -- 1920-21, 1929-33, and 1937-38 -- is directly attributable to acts of commission and omission by the Reserve authorities and would not have occurred under earlier monetary and banking arrangements. There might well have been recessions on these or other occasions, but it is highly unlikely that any would have developed into a major contraction.
1clearly cannot present this evidence here.2 However, in view of the importance which the Great Depression of 1929-33 played in forming -- or, I would say, deforming -- general attitudes toward the role of government in economic affairs, it may be worth indicating more fully for this episode the kind of interpretation suggested by the evidence.
Because of its dramatic character, die stock market crash in October, 1929, which terminated the bull market of 1928 and 1929 is often regarded as both the start and the major proximate cause of the Great Depression. Neither is correct. The peak of business was reached in mid-1929, some months prior to the crash. The peak may well have come as early as it did partly as a result of relatively tight money conditions imposed by the Federal Reserve System in an attempt to curb "speculation" -- in this indirect way, the stock market may have played a role in bringing about the contraction. The stock market crash in turn undoubtedly had some indirect effects on business confidence and on the willingness of individuals to spend which exerted a depressing influence on the course of business. But by themselves, these effects could not have produced a collapse in economic activity. At most, they would have made the contraction somewhat longer and more severe than the usual mild recessions that have punctuated American economic growth throughout our history; they would not have made it the catastrophe it was.
For something like the first year, the contraction showed none of those special features that were to dominate its later course. The economic decline was more severe than during the first year of most contractions, possibly in response to the stock market crash plus the unusually tight monetary conditions that had been maintained since mid-1928. But it showed no qualitatively different characteristics, no signs of degenerating into a major catastrophe. Except on naive post hoc ergo propter hoc reasoning, there is nothing in the economic situation as it stood in, say, September or October, 1930 that made the continued and drastic decline of the following years inevitable or even highly probable. In retrospect, it is clear that the Reserve System should already have been behaving differently than it did, that it should not have allowed the money stock to decline by nearly 3 per cent from August 1929 to October 1930 -- a larger decline than during the whole of all but the most severe prior contractions. Though this was a mistake, it was perhaps excusable, and certainly not critical.
The character of the contraction changed drastically in November 1930, when a series of bank failures led to widespread runs on banks, which is to say attempts by depositors to convert deposits into currency. The contagion spread from one part of the country to another and reached a climax with the failure on December n, 1930 of the Bank of the United States. This failure was critical not only because the Bank was one of the largest in the country, with over $200 million in deposits, but also because, though an ordinary commercial bank, its name had led many both at home and even more abroad to regard it as somehow an official bank.
Prior to October, 1930, there had been no sign of a liquidity crisis, or any loss of confidence in banks. From this time on, the economy was plagued by recurrent liquidity crises. A wave of bank failures would taper down a while, and then start up again as a few dramatic failures or other events produced a new loss of confidence in the banking system and a new series of runs on banks. These were important not only or even primarily because of the failures of die banks but because of their effect on the money stock.
In a fractional reserve banking system like ours, a bank does not of course have a dollar of currency (or its equivalent) for a dollar of deposits. That is why "deposits" is such a misleading term. When you deposit a dollar of cash in a bank, the bank may add fifteen or twenty cents to its cash; the rest it will lend out through another window. The borrower may in turn rede-posit it, in this or another bank, and the process is repeated. The result is that for every dollar of cash owned by banks, they owe several dollars of deposits. The total stock of money -- cash plus deposits -- for a given amount of cash is therefore higher the larger the fraction of its money the public is willing to hold as deposits. Any widespread attempt on the part of depositors to "get their money" must therefore mean a decline in the total amount of money unless there is some way in which additional cash can be created and some way for banks to get it. Otherwise, one bank, in trying to satisfy its depositors, will put pressure on other banks by calling loans or selling investments or withdrawing its deposits and these other banks in turn will put pressure on still others. The vicious cycle, if allowed to proceed, grows on itself as the attempt of banks to get cash forces down the prices of securities, renders banks insolvent that would otherwise have been entirely sound, shakes the confidence of depositors, and starts the cycle over again.
This was precisely the kind of a situation that had led to a banking panic under the pre-Federal-Reserve banking system, and to a concerted suspension of the convertibility of deposits into currency, as in 1907. Such a suspension was a drastic step and for a short while made matters worse. But it was also a therapeutic measure. It cut short the vicious cycle by preventing the spread of the contagion, by keeping the failure of a few banks from producing pressure on other banks and leading to the failure of otherwise sound banks. In a few weeks or months, when the situation had stabilized, the suspension could be lifted, and recovery begin without monetary contraction.
As we have seen, one of the major reasons for establishing the Federal Reserve System was to deal with such a situation. It was given the power to create more cash if a widespread demand should arise on the part of the public for currency instead of deposits, and was given the means to make the cash available to banks on the security of the bank's assets. In this way, it was expected that any threatened panic could be averted, that there would be no need for suspension of convertibility of deposits into currency, and that the depressing effects of monetary crises could be entirely avoided.
The first need for these powers and hence the first test of their efficacy came in November and December of 1930 as a result of the string of bank closings already described. The Reserve System failed the test miserably. It did little or nothing to provide the banking system with liquidity, apparently regarding the bank closings as calling for no special action. It is worth emphasizing, however, that the System's failure was a failure of will, not of power. On this occasion, as on the later ones that followed, the System had ample power to provide the banks with the cash their depositors were demanding. Had this been done, the bank closings would have been cut short and the monetary debacle averted.
The initial wave of bank failures died down and in early 1931 there were signs of returning confidence. The Reserve System took advantage of die opportunity to reduce its own credit outstanding -- which is to say, it offset the naturally expansionary forces by engaging in mild deflationary action. Even so, there were clear signs of improvement not only in the monetary sector but also in other economic activities. The figures for the first four or five months of 1931, if examined without reference to what actually followed, have all the earmarks of the bottom of a cycle and the beginning of revival.
The tentative revival was however short-lived. Renewed bank failures started another series of runs and again set in train a renewed decline in the stock of money. Again, the Reserve System stood idly by. In die face of an unprecedented liquidation of the commercial banking system, the books of the "lender of last resort" show a decline in the amount of credit it made available to its member banks.
In September 1931, Britain went off the gold standard. This act was preceded and followed by gold withdrawals from the United States. Although gold had been flowing into the United States in the prior two years, and the U.S. gold stock and the Federal Reserve gold reserve ratio were at an all time high, the Reserve System reacted vigorously and promptly to the external drain as it had not to the previous internal drain. It did so in a manner that was certain to intensify the internal financial difficulties. After more than two years of severe economic contraction, the System raised the discount rate -- the rate of interest at which it stood ready to lend to member bank& -- more sharply than it has within so brief a period in its whole history before or since. The measure arrested the gold drain. It was also accompanied by a spectacular increase in bank failures and runs on banks. In the six months from August 1931 through January 1932, roughly one out of ten banks in existence suspended operations and total deposits in commercial banks fell by 15 per cent.
A temporary reversal of policy in 1932 involving the purchase of $1 billion of government bonds slowed down the rate of decline. Had this measure been taken in 1931, it would almost surely have been sufficient to prevent the debacle just described. By 1932, it was too late to be more than a palliative and, when the System relapsed into passivity, the temporary improvement was followed by a renewed collapse terminating in the Banking Holiday of 1933 -- when every bank in the United States was officially closed for over a week. A system established in large part to prevent a temporary suspension of convertibility of deposits into currency -- a measure that had formerly prevented banks from failing -- first let nearly a third of the banks of the country go out of existence and then welcomed a suspension of convertibility that was incomparably more sweeping and severe than any earlier suspension. Yet so great is the capacity for self-justification that the Federal Reserve Board could write in its annual report for 1933, "The ability of the Federal Reserve Banks to meet enormous demands for currency during the crisis demonstrated the effectiveness of the country's currency system under the Federal Reserve Act. ... It is difficult to say what the course of die depression would have been had the Federal Reserve System not pursued a policy of liberal open market purchases."
All told, from July 1929 to March 1933, the money stock in tie United States fell by one-third, and over two-thirds of the decline came after England's departure from the gold standard. 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. It might still have been relatively severe by historical standards. But it is literally inconceivable that money income could have declined by over one-half and prices by over one-third in the course of four years if there had been no decline in the stock of money. I know of no severe depression in any country or any time that was not accompanied by a sharp decline in the stock of money and equally of no sharp decline in the stock of money that was not accompanied by a severe depression.
The Great Depression in the United States, far from being a sign of the inherent instability of the private enterprise system, is a testament to how much harm can be done by mistakes on the part of a few men when they wield vast power over the monetary system of a country.
It may be that these mistakes were excusable on the basis of the knowledge available to men at the time -- though I happen to think not. But that is really beside the point. Any system which gives so much power and so much discretion to a few men that mistakes -- excusable or not -- can have such far-reaching effects is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic -- this is the key political argument against an "independent" central bank. But it is a bad system even to those who set security higher than freedom. Mistakes, excusable or not, cannot be avoided in a system which disperses responsibility yet gives a few men great power, and which thereby makes important policy actions highly dependent on accidents of personality. This is the key technical argument against an "independent" bank. To paraphrase Clemenceau, money is much too serious a matter to be left to the Central Bankers.
RULES INSTEAD OF AUTHORITIES
If we can achieve our objectives neither by relying on the working of a thoroughly automatic gold standard nor by giving wide discretion to independent authorities, how else can we establish a monetary system that is stable and at the same time free from irresponsible governmental tinkering, a system that will provide the necessary monetary framework for a free enterprise economy yet be incapable of being used as a source of power to threaten economic and political freedom?
The only way that has yet been suggested that offers promise is to try to achieve a government of law instead of men by legislating rules for the conduct of monetary policy that will have the effect of enabling the public to exercise control over monetary policy through its political authorities, while at the same time it will prevent monetary policy from being subject to the day-by-day whim of political authorities.
The issue of legislating rules for monetary policy has much in common with a topic that seems at first altogether different, namely, the argument for the first amendment to the Constitution. Whenever anyone suggests the desirability of a legislative rule for control over money, the stereotyped answer is that it makes little sense to tie the monetary authority's hands in this way because the authority, if it wants to, can always do of its own volition what the rule would require it to do, and in addition has other alternatives, hence "surely," it is said, it can do better than the rule. An alternative version of the same argument applies it to the legislature. If the legislature is willing to adopt the rule, it is said, surely it will also be willing to legislate the "right" policy in each specific case. How then, it is said, does the adoption of the rule provide any protection against irresponsible political action?
The same argument could apply with only minor verbal changes to the first amendment to the Constitution and, equally, to the entire Bill of Rights. Is it not absurd, one might say, to have a standard proscription of interference with free speech? Why not take up each case separately and treat it on its own merits? Is this not the counterpart to the usual argument in monetary policy that it is undesirable to bind the hands of the monetary authority in advance; that it should be left free to treat each case on its merits as it comes up ? Why is not the argument equally valid for speech ? One man wants to stand up on a street corner and advocate birth control; another, communism; a third, vegetarianism, and so on, ad infinitum. Why not enact a law affirming or denying to each the right to spread his particular views ? Or, alternatively, why not give the power to decide the issue to an administrative agency? It is immediately clear that if we were to take each case up as it came, a majority would almost surely vote to deny free speech in most cases and perhaps even in every case taken separately. A vote on whether Mr. X should spread birth control propaganda would almost surely yield a majority saying no; and so would one on communism. The vegetarian might perhaps get by though even that is by no means a foregone conclusion.
But now suppose all these cases were grouped together in one bundle, and the populace at large were asked to vote for them as a whole; to vote whether free speech should be denied in all cases or permitted in all alike. It is perfectly conceivable, and I would say, highly probable, that an overwhelming majority would vote for free speech; that, acting on the bundle as a whole, the people would vote exactly the opposite to the way they would have voted on each case separately. Why ? One reason is that each person feels much more strongly about being deprived of his right to free speech when he is in a minority than he feels about depriving somebody else of the right to free speech when he is in the majority. In consequence, when he votes on the bundle as a whole, he gives much more weight to the infrequent denial of free speech to himself when he is in the minority than to the frequent denial of free speech to others.
Another reason, and one that is more directly relevant to monetary policy, is that 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. When a vote is taken on whether Mr. Jones can speak on the corner, it cannot allow for the favorable effects of an announced general policy of free speech. It cannot allow for the fact that a society in which people are not free to speak on the corner without special legislation will be a society in which the development of new ideas, experimentation, change, and the like will all be hampered in a great variety of ways that are obvious to all, thanks to our good fortune of having lived in a society which did adopt the self-denying ordinance of not considering each case of speech separately.
Exactly the same considerations apply in the monetary area. If each case is considered on its merits, the wrong decision is likely to be made in a large fraction of cases because the decision-makers are examining only a limited area and not taking into account the cumulative consequences of the policy as a whole. On the other hand, if a general rule is adopted for a group of cases as a bundle, the existence of that rule has favorable effects on people's attitudes and beliefs and expectations that would not follow even from the discretionary adoption of precisely the same policy on a series of separate occasions.
If a rule is to be legislated, what rule should it be ? The rule that has most frequently been suggested by people of a generally liberal persuasion is a price level rule; namely, a legislative directive to the monetary authorities that they maintain a stable price level. I think this is the wrong kind of a rule. It is the wrong kind of a rule because it is in terms of objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions. It consequently raises the problem of dispersing responsibilities and leaving the authorities too much leeway. There is unquestionably a close connection between monetary actions and the price level. But the connection is not so close, so invariable, or so direct that the objective of achieving a stable price level is an appropriate guide to the day-to-day activities of the authorities.
The issue what rule to adopt is one that I have considered at some length elsewhere.3 Accordingly, I will limit myself here to stating my conclusion. In the present state of our knowledge, it seems to me desirable to state the rule in terms of the behavior of the stock of money. My choice at the moment would be a legislated rule instructing the monetary authority to achieve a specified rate of growth in the stock of money. For this purpose, I would define the stock of money as including currency outside commercial banks plus all deposits of commercial banks. 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 per cent, where X is some number between 3 and 5. The precise definition of money adopted, or the precise rate of growth chosen, makes far less difference than the definite choice of a particular definition and a particular rate of growth.
As matters now stand, while this rule would drastically curtail the discretionary power of the monetary authorities, it would still leave an undesirable amount of discretion in the hands of Federal Reserve and Treasury authorities with respect to how to achieve the specified rate of growth in the money stock, debt management, banking supervision, and the like. Further banking and fiscal reforms, which I have spelled out in detail elsewhere, are both feasible and desirable. They would have the effect of eliminating present governmental intervention into lending and investing activity and of converting governmental financing operations from a perpetual source of instability and uncertainty into a reasonably regular and predictable activity. But, though important, these further reforms are far less basic than the adoption of a rule to limit the discretion of the monetary authorities with respect to the stock of money.
I should like to emphasize that I do not regard my particular proposal as a be-all and end-all of monetary management, as a rule which is somehow to be written in tablets of stone and enshrined for all future time. It seems to me to be the rule that offers the greatest promise of achieving a reasonable degree of monetary stability in the light of our present knowledge. I would hope that as we operated with it, as we learned more about monetary matters, we might be able to devise still better rules, which would achieve still better results. Such a rule seems to me the only feasible device currently available for converting monetary policy into a pillar of a free society rather than a threat to its foundations.
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Notes
1 A Program for Monetary Stability (New York: Fordham University Press, 1959) pp. 4-8.
2 See my A Program for Monetary Stability and Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867-1960 (forthcoming by Princeton University Press for the National Bureau of Economic Research).
3 A Program for Monetary Stability, op. cit., pp. 77-99.
The Control of Money
"Full employment" and "economic growth" have in the past few decades become primary excuses for widening the extent of government intervention in economic affairs. A private free-enterprise economy, it is said, is inherently unstable. Left to itself, it will produce recurrent cycles of boom and bust. The government must therefore step in to keep things on an even keel. These arguments were particularly potent during and after the Great Depression of the 1930's, and were a major element giving rise to the New Deal in this country and comparable extensions of governmental intervention in others. More recently, "economic growth" has become the more popular rallying call. Government must, it is argued, see to it that the economy expands to provide the wherewithal for the cold war and demonstrate to the uncommitted nations of the world that a democracy can grow more rapidly than a communist state.
These arguments are thoroughly misleading. The fact is that the Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy. A governmentally established agency -- the Federal Reserve. System -- had been assigned responsibility for monetary policy. In 1930 and 1931, it exercised this responsibility so ineptly as to convert what otherwise would have been a moderate contraction into a major catastrophe (see further discussion, pages 45-50, below). Similarly today, governmental measures constitute the major impediments to economic growth in the United States. Tariffs and other restrictions on international trade, high tax burdens and a complex and inequitable tax structure, regulatory commissions, government price and wage fixing, and a host of other measures give individuals an incentive to misuse and misdirect resources, and distort the investment of new savings. What we urgently need, for both economic stability and growth, is a reduction of government intervention not an increase.
Such a reduction would still leave an important role for government in these areas. It is desirable that we use government to provide a stable monetary framework for a free economy -- this is part of the function of providing a stable legal framework. It is desirable too that we use government to provide a general legal and economic framework that will enable individuals to produce growth in the economy, if that is in accord with their values.
The major areas of governmental policy that are relevant to economic stability are monetary policy and fiscal or budgetary policy. This chapter discusses domestic monetary policy, the next, international monetary arrangements, and chapter v, fiscal or budgetary policy.
Our task in this and the following chapter is to steer a course between two views, neither of which is acceptable though both have their attractions. The Scylla is the belief that a purely automatic gold standard is both feasible and desirable and would resolve all the problems of fostering economic co-operation among individuals and nations in a stable environment. The Charybdis is the belief that the need to adapt to unforeseen circumstances requires the assignment of wide discretionary powers to a group of technicians, gathered together in an "independent" central bank, or in some bureaucratic body. Neither has proved a satisfactory solution in the past; and neither is likely to in the future.
A liberal is fundamentally fearful of concentrated power. His objective is to preserve the maximum degree of freedom for each individual separately that is compatible with one man's freedom not interfering with other men's freedom. He believes that this objective requires that power be dispersed. He is suspicious of assigning to government any functions that can be performed through the market, both because this substitutes coercion for voluntary co-operation in the area in question and because, by giving government an increased role, it threatens freedom in other areas.
The need for the dispersal of power raises an especially difficult problem in the field of money. There is widespread agreement that government must have some responsibility for monetary matters. There is also widespread recognition that control over money can be a potent tool for controlling and shaping the economy. Its potency is dramatized in Lenin's famous dictum that the most effective way to destroy a society is to destroy its money. It is exemplified in more pedestrian fashion by the extent to which control of money has, from time immemorial, enabled sovereigns to exact heavy taxes from the populace at large, very often without the explicit agreement of the legislature when there has been one. This has been true from early times when monarchs clipped coins and adopted similar expedients to the present with our more sophisticated modern techniques for turning the printing press or simply altering book entries. The problem is to establish institutional arrangements that will enable government to exercise responsibility for money, yet at the same time limit the power thereby given to government and prevent this power from being used in ways that will tend to weaken rather than strengthen a free society.
A COMMODITY STANDARD
Historically, the device that has evolved most frequently in many different places and over the course of centuries is a commodity standard; i.e., the use as money of some physical commodity such as gold or silver, brass or tin, cigarettes or cognac, or various other goods. If money consisted wholly of a physical commodity of this type, there would be, in principle, no need for control by the government at all. The amount of money in society would depend on the cost of producing the monetary commodity rather than other things. Changes in the amount of money would depend on changes in the technical conditions of producing the monetary commodity and on changes in the demand for money. This is an ideal that animates many believers in an automatic gold standard.
Actual commodity standards have deviated very far from this simple pattern which requires no governmental intervention. Historically, a commodity standard -- such as a gold standard or a silver standard -- has been accompanied by the development of fiduciary money of one kind or another, ostensibly convertible into the monetary commodity on fixed terms. There was a very good reason for this development. The fundamental defect of a commodity standard, from the point of view of the society as a whole, is that it requires the use of real resources to add to the stock of money. People must work hard to dig gold out of the ground in South Africa -- in order to rebury it in Fort Knox or some similar place. The necessity of using real resources for the operation of a commodity standard establishes a strong incentive for people to find ways to achieve the same result without employing these resources. If people will accept as money pieces of paper on which is printed "I promise to pay -------- units of the commodity standard," these pieces of paper can perform the same function as the physical pieces of gold or silver, and they require very much less in resources to produce. This point, which I have discussed at somewhat greater length elsewhere,1 seems to me the fundamental difficulty with a commodity standard.
If an automatic commodity standard were feasible, it would provide an excellent solution to the liberal's dilemma: a stable monetary framework without the danger of the irresponsible exercise of monetary powers. If, for example, an honest-to-good-ness gold standard, in which 100 per cent of the money in a country consisted literally of gold, were widely backed by the public at large, imbued with the mythology of a gold standard and with the belief that it is immoral and improper for government to interfere with its operation, it would provide an effective guarantee against governmental tinkering with the currency and against irresponsible monetary action. Under such a standard, any monetary powers of government would be very minor in scope. But, as just noted, such an automatic system has historically never proved feasible. It has always tended to develop in the direction of a mixed system containing fiduciary elements such as bank notes and deposits, or government notes in addition to the monetary commodity. And once fiduciary elements have been introduced, it has proved difficult to avoid governmental control over them, even when they were initially issued by private individuals. The reason is basically the difficulty of preventing counterfeiting or its economic equivalent. Fiduciary money is a contract to pay standard money. It so happens that there tends to be a long interval between the making of such a contract and its realization. This enhances the difficulty of enforcing the contract and hence also the temptation to issue fraudulent contracts. In addition, once fiduciary elements have been introduced, the temptation for government itself to issue fiduciary money is almost irresistible. In practice, therefore, commodity standards have tended to become mixed standards involving extensive intervention by the state.
It should be noted that despite the great amount of talk by many people in favor of the gold standard, almost no one today literally desires an honest-to-goodness, full gold standard. People who say they want a gold standard are almost invariably talking about the present kind of standard, or the kind of standard that was maintained in the 1930's; a gold standard managed by a central bank or other governmental bureau, which holds a small amount of gold as "backing" -- to use that very misleading term -- for fiduciary money. Some do go so far as to favor the kind of standard maintained in the 1920's, in which there was literal circulation of gold or gold certificates as hand-to-hand currency -- a gold-coin standard -- but even they favor the coexistence with gold of governmental fiduciary currency plus deposits issued by banks holding fractional reserves in either gold or fiduciary currency. Even during the so-called great days of the gold standard in the nineteenth century, when the Bank of England was supposedly running the gold standard skilfully, the monetary system was far from a fully automatic gold standard. Even then it was a highly managed standard. And certainly the situation is now more extreme as a result of the adoption by country after country of the view that government has responsibility for "full employment."
My conclusion is that an automatic commodity standard is neither a feasible nor a desirable solution to the problem of establishing monetary arrangements for a free society. It is not desirable because it would involve a large cost in die form of resources used to produce the monetary commodity. It is not feasible because the mythology and beliefs required to make it effective do not exist.
This conclusion is supported not only by the general historical evidence referred to but also by the specific experience of the United States. From 1879, when the United States resumed gold payments after the Civil War, to 1913, the United States was on a gold standard. Though closer to a thoroughly automatic gold standard than anything we have had since the end of World War I, the gold standard was still far from a 100 per cent gold standard. There were government issues of paper money, and private banks issued most of the effective circulating medium of the country in the form of deposits; the banks were closely regulated in their operations by governmental agencies -- national banks by the Comptroller of the Currency, state banks by state banking authorities. Gold, whether held by the Treasury, by banks, or directly by individuals as coins or gold certificates, accounted for between 10 per cent and 20 per cent of the money stock, the exact percentage varying from year to year. The remaining 80 per cent to 90 per cent consisted of silver, fiduciary currency, and bank deposits not matched by gold reserves.
In retrospect, the system may seem to us to have worked reasonably well. To Americans of the time, it clearly did not. The agitation over silver in tie 1880's, culminating in Bryan's Cross of Gold speech which set the tone for the 1896 election, was one sign of dissatisfaction. In turn, the agitation was largely responsible for the severely depressed years in the early 1890's. The agitation led to widespread fears that the United States would go off gold and that hence the dollar would lose value in terms of foreign currencies. This led to a flight from the dollar and a capital outflow that forced deflation at home.
Successive financial crises, in 1873, 1884, 1890, and 1893 produced a widespread demand for banking reform on the part of the business and banking community. The panic of 1907, involving the concerted refusal by banks to convert deposits into currency on demand, finally crystallized the feeling of dissatisfaction with the financial system into an urgent demand for governmental action. A National Monetary Commission was established by Congress, and its recommendations, reported in 1910, were embodied in die Federal Reserve Act passed in 1913. Reforms along the lines of the Federal Reserve Act had the backing of every section of the community, from the working clashes to the bankers, and of both political parties. The chairman of the National Monetary Commission was a Republican, Nelson W. Aldrich; the Senator mainly responsible for the Federal Reserve Act was a Democrat, Carter W. Glass.
The change in monetary arrangements introduced by the Federal Reserve Act turned out in practice to be far more drastic than was intended by its authors or its supporters. At the time the Act was passed, a gold standard reigned supreme throughout the world -- not a fully automatic gold standard but something far closer to that ideal than anything we have experienced since. It was taken for granted that it would continue to do so and thus narrowly limit the powers of tie Federal Reserve System. No sooner was tie Act passed than World War I broke out. There was a large-scale abandonment of the gold standard. By the end of the war, the Reserve System was no longer a minor adjunct to the gold standard designed to insure the convertibility of one form of money into others and to regulate and supervise banks. It had become a powerful discretionary authority able to determine the quantity of money in the United States and to affect international financial conditions throughout the world.
A DISCRETIONARY MONETARY AUTHORITY
The establishment of the Federal Reserve System was the most notable change in United States monetary institutions since at least the Civil War National Banking Act. For the first time since the expiration of the charter of the Second Bank of the United States in 1836, it established a separate official body charged with explicit responsibility for monetary conditions, and supposedly clothed with adequate power to achieve monetary stability or, at least, to prevent pronounced instability. It is therefore instructive to compare experience as a whole before and after its establishment -- say, from just after the Civil War to 1914 and from 1914 to date, to take two periods of equal length.
The second period was clearly the more unstable economically, whether instability is measured by the fluctuations in the stock of money, in prices, or in output. Partly, the greater instability reflects the effect of two world wars during the second period; these would clearly have been a source of instability whatever our monetary system. But even if the war and immediate postwar years are omitted, and we consider only the peacetime years from, say, 1920 through 1939, and 1947 to date, the result is the same. The stock of money, prices, and output was decidedly more unstable after the establishment of the Reserve System than before. The most dramatic period of instability in output was of course the period between the two wars which includes the severe contractions of 1920-21, 1929-33, and 1937-38. No other twenty-year period in American history contains as many as three such severe contractions.
This crude comparison does not of course prove that the Federal Reserve System failed to contribute to monetary stability. Perhaps the problems that the System had to handle were more severe than those that impinged on the earlier monetary structure. Perhaps those problems would have produced an even greater degree of monetary instability under the earlier arrangements. But the crude comparison should at least give the reader pause before he takes for granted, as is so often done, that an agency as long established, as powerful, as pervasive as the Federal Reserve System is performing a necessary and desirable function and is contributing to the attainment of the objectives for which it was established.
I am myself persuaded, on the basis of extensive study of the historical evidence, that the difference in economic stability revealed by the crude comparison is in fact attributable to the difference in monetary institutions. This evidence persuades me that at least a third of die price rise during and just after World War I is attributable to the establishment of die Federal Reserve System and would not have occurred if die earlier banking system had been retained; that the severity of each of the major contractions -- 1920-21, 1929-33, and 1937-38 -- is directly attributable to acts of commission and omission by the Reserve authorities and would not have occurred under earlier monetary and banking arrangements. There might well have been recessions on these or other occasions, but it is highly unlikely that any would have developed into a major contraction.
1clearly cannot present this evidence here.2 However, in view of the importance which the Great Depression of 1929-33 played in forming -- or, I would say, deforming -- general attitudes toward the role of government in economic affairs, it may be worth indicating more fully for this episode the kind of interpretation suggested by the evidence.
Because of its dramatic character, die stock market crash in October, 1929, which terminated the bull market of 1928 and 1929 is often regarded as both the start and the major proximate cause of the Great Depression. Neither is correct. The peak of business was reached in mid-1929, some months prior to the crash. The peak may well have come as early as it did partly as a result of relatively tight money conditions imposed by the Federal Reserve System in an attempt to curb "speculation" -- in this indirect way, the stock market may have played a role in bringing about the contraction. The stock market crash in turn undoubtedly had some indirect effects on business confidence and on the willingness of individuals to spend which exerted a depressing influence on the course of business. But by themselves, these effects could not have produced a collapse in economic activity. At most, they would have made the contraction somewhat longer and more severe than the usual mild recessions that have punctuated American economic growth throughout our history; they would not have made it the catastrophe it was.
For something like the first year, the contraction showed none of those special features that were to dominate its later course. The economic decline was more severe than during the first year of most contractions, possibly in response to the stock market crash plus the unusually tight monetary conditions that had been maintained since mid-1928. But it showed no qualitatively different characteristics, no signs of degenerating into a major catastrophe. Except on naive post hoc ergo propter hoc reasoning, there is nothing in the economic situation as it stood in, say, September or October, 1930 that made the continued and drastic decline of the following years inevitable or even highly probable. In retrospect, it is clear that the Reserve System should already have been behaving differently than it did, that it should not have allowed the money stock to decline by nearly 3 per cent from August 1929 to October 1930 -- a larger decline than during the whole of all but the most severe prior contractions. Though this was a mistake, it was perhaps excusable, and certainly not critical.
The character of the contraction changed drastically in November 1930, when a series of bank failures led to widespread runs on banks, which is to say attempts by depositors to convert deposits into currency. The contagion spread from one part of the country to another and reached a climax with the failure on December n, 1930 of the Bank of the United States. This failure was critical not only because the Bank was one of the largest in the country, with over $200 million in deposits, but also because, though an ordinary commercial bank, its name had led many both at home and even more abroad to regard it as somehow an official bank.
Prior to October, 1930, there had been no sign of a liquidity crisis, or any loss of confidence in banks. From this time on, the economy was plagued by recurrent liquidity crises. A wave of bank failures would taper down a while, and then start up again as a few dramatic failures or other events produced a new loss of confidence in the banking system and a new series of runs on banks. These were important not only or even primarily because of the failures of die banks but because of their effect on the money stock.
In a fractional reserve banking system like ours, a bank does not of course have a dollar of currency (or its equivalent) for a dollar of deposits. That is why "deposits" is such a misleading term. When you deposit a dollar of cash in a bank, the bank may add fifteen or twenty cents to its cash; the rest it will lend out through another window. The borrower may in turn rede-posit it, in this or another bank, and the process is repeated. The result is that for every dollar of cash owned by banks, they owe several dollars of deposits. The total stock of money -- cash plus deposits -- for a given amount of cash is therefore higher the larger the fraction of its money the public is willing to hold as deposits. Any widespread attempt on the part of depositors to "get their money" must therefore mean a decline in the total amount of money unless there is some way in which additional cash can be created and some way for banks to get it. Otherwise, one bank, in trying to satisfy its depositors, will put pressure on other banks by calling loans or selling investments or withdrawing its deposits and these other banks in turn will put pressure on still others. The vicious cycle, if allowed to proceed, grows on itself as the attempt of banks to get cash forces down the prices of securities, renders banks insolvent that would otherwise have been entirely sound, shakes the confidence of depositors, and starts the cycle over again.
This was precisely the kind of a situation that had led to a banking panic under the pre-Federal-Reserve banking system, and to a concerted suspension of the convertibility of deposits into currency, as in 1907. Such a suspension was a drastic step and for a short while made matters worse. But it was also a therapeutic measure. It cut short the vicious cycle by preventing the spread of the contagion, by keeping the failure of a few banks from producing pressure on other banks and leading to the failure of otherwise sound banks. In a few weeks or months, when the situation had stabilized, the suspension could be lifted, and recovery begin without monetary contraction.
As we have seen, one of the major reasons for establishing the Federal Reserve System was to deal with such a situation. It was given the power to create more cash if a widespread demand should arise on the part of the public for currency instead of deposits, and was given the means to make the cash available to banks on the security of the bank's assets. In this way, it was expected that any threatened panic could be averted, that there would be no need for suspension of convertibility of deposits into currency, and that the depressing effects of monetary crises could be entirely avoided.
The first need for these powers and hence the first test of their efficacy came in November and December of 1930 as a result of the string of bank closings already described. The Reserve System failed the test miserably. It did little or nothing to provide the banking system with liquidity, apparently regarding the bank closings as calling for no special action. It is worth emphasizing, however, that the System's failure was a failure of will, not of power. On this occasion, as on the later ones that followed, the System had ample power to provide the banks with the cash their depositors were demanding. Had this been done, the bank closings would have been cut short and the monetary debacle averted.
The initial wave of bank failures died down and in early 1931 there were signs of returning confidence. The Reserve System took advantage of die opportunity to reduce its own credit outstanding -- which is to say, it offset the naturally expansionary forces by engaging in mild deflationary action. Even so, there were clear signs of improvement not only in the monetary sector but also in other economic activities. The figures for the first four or five months of 1931, if examined without reference to what actually followed, have all the earmarks of the bottom of a cycle and the beginning of revival.
The tentative revival was however short-lived. Renewed bank failures started another series of runs and again set in train a renewed decline in the stock of money. Again, the Reserve System stood idly by. In die face of an unprecedented liquidation of the commercial banking system, the books of the "lender of last resort" show a decline in the amount of credit it made available to its member banks.
In September 1931, Britain went off the gold standard. This act was preceded and followed by gold withdrawals from the United States. Although gold had been flowing into the United States in the prior two years, and the U.S. gold stock and the Federal Reserve gold reserve ratio were at an all time high, the Reserve System reacted vigorously and promptly to the external drain as it had not to the previous internal drain. It did so in a manner that was certain to intensify the internal financial difficulties. After more than two years of severe economic contraction, the System raised the discount rate -- the rate of interest at which it stood ready to lend to member bank& -- more sharply than it has within so brief a period in its whole history before or since. The measure arrested the gold drain. It was also accompanied by a spectacular increase in bank failures and runs on banks. In the six months from August 1931 through January 1932, roughly one out of ten banks in existence suspended operations and total deposits in commercial banks fell by 15 per cent.
A temporary reversal of policy in 1932 involving the purchase of $1 billion of government bonds slowed down the rate of decline. Had this measure been taken in 1931, it would almost surely have been sufficient to prevent the debacle just described. By 1932, it was too late to be more than a palliative and, when the System relapsed into passivity, the temporary improvement was followed by a renewed collapse terminating in the Banking Holiday of 1933 -- when every bank in the United States was officially closed for over a week. A system established in large part to prevent a temporary suspension of convertibility of deposits into currency -- a measure that had formerly prevented banks from failing -- first let nearly a third of the banks of the country go out of existence and then welcomed a suspension of convertibility that was incomparably more sweeping and severe than any earlier suspension. Yet so great is the capacity for self-justification that the Federal Reserve Board could write in its annual report for 1933, "The ability of the Federal Reserve Banks to meet enormous demands for currency during the crisis demonstrated the effectiveness of the country's currency system under the Federal Reserve Act. ... It is difficult to say what the course of die depression would have been had the Federal Reserve System not pursued a policy of liberal open market purchases."
All told, from July 1929 to March 1933, the money stock in tie United States fell by one-third, and over two-thirds of the decline came after England's departure from the gold standard. 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. It might still have been relatively severe by historical standards. But it is literally inconceivable that money income could have declined by over one-half and prices by over one-third in the course of four years if there had been no decline in the stock of money. I know of no severe depression in any country or any time that was not accompanied by a sharp decline in the stock of money and equally of no sharp decline in the stock of money that was not accompanied by a severe depression.
The Great Depression in the United States, far from being a sign of the inherent instability of the private enterprise system, is a testament to how much harm can be done by mistakes on the part of a few men when they wield vast power over the monetary system of a country.
It may be that these mistakes were excusable on the basis of the knowledge available to men at the time -- though I happen to think not. But that is really beside the point. Any system which gives so much power and so much discretion to a few men that mistakes -- excusable or not -- can have such far-reaching effects is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic -- this is the key political argument against an "independent" central bank. But it is a bad system even to those who set security higher than freedom. Mistakes, excusable or not, cannot be avoided in a system which disperses responsibility yet gives a few men great power, and which thereby makes important policy actions highly dependent on accidents of personality. This is the key technical argument against an "independent" bank. To paraphrase Clemenceau, money is much too serious a matter to be left to the Central Bankers.
RULES INSTEAD OF AUTHORITIES
If we can achieve our objectives neither by relying on the working of a thoroughly automatic gold standard nor by giving wide discretion to independent authorities, how else can we establish a monetary system that is stable and at the same time free from irresponsible governmental tinkering, a system that will provide the necessary monetary framework for a free enterprise economy yet be incapable of being used as a source of power to threaten economic and political freedom?
The only way that has yet been suggested that offers promise is to try to achieve a government of law instead of men by legislating rules for the conduct of monetary policy that will have the effect of enabling the public to exercise control over monetary policy through its political authorities, while at the same time it will prevent monetary policy from being subject to the day-by-day whim of political authorities.
The issue of legislating rules for monetary policy has much in common with a topic that seems at first altogether different, namely, the argument for the first amendment to the Constitution. Whenever anyone suggests the desirability of a legislative rule for control over money, the stereotyped answer is that it makes little sense to tie the monetary authority's hands in this way because the authority, if it wants to, can always do of its own volition what the rule would require it to do, and in addition has other alternatives, hence "surely," it is said, it can do better than the rule. An alternative version of the same argument applies it to the legislature. If the legislature is willing to adopt the rule, it is said, surely it will also be willing to legislate the "right" policy in each specific case. How then, it is said, does the adoption of the rule provide any protection against irresponsible political action?
The same argument could apply with only minor verbal changes to the first amendment to the Constitution and, equally, to the entire Bill of Rights. Is it not absurd, one might say, to have a standard proscription of interference with free speech? Why not take up each case separately and treat it on its own merits? Is this not the counterpart to the usual argument in monetary policy that it is undesirable to bind the hands of the monetary authority in advance; that it should be left free to treat each case on its merits as it comes up ? Why is not the argument equally valid for speech ? One man wants to stand up on a street corner and advocate birth control; another, communism; a third, vegetarianism, and so on, ad infinitum. Why not enact a law affirming or denying to each the right to spread his particular views ? Or, alternatively, why not give the power to decide the issue to an administrative agency? It is immediately clear that if we were to take each case up as it came, a majority would almost surely vote to deny free speech in most cases and perhaps even in every case taken separately. A vote on whether Mr. X should spread birth control propaganda would almost surely yield a majority saying no; and so would one on communism. The vegetarian might perhaps get by though even that is by no means a foregone conclusion.
But now suppose all these cases were grouped together in one bundle, and the populace at large were asked to vote for them as a whole; to vote whether free speech should be denied in all cases or permitted in all alike. It is perfectly conceivable, and I would say, highly probable, that an overwhelming majority would vote for free speech; that, acting on the bundle as a whole, the people would vote exactly the opposite to the way they would have voted on each case separately. Why ? One reason is that each person feels much more strongly about being deprived of his right to free speech when he is in a minority than he feels about depriving somebody else of the right to free speech when he is in the majority. In consequence, when he votes on the bundle as a whole, he gives much more weight to the infrequent denial of free speech to himself when he is in the minority than to the frequent denial of free speech to others.
Another reason, and one that is more directly relevant to monetary policy, is that 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. When a vote is taken on whether Mr. Jones can speak on the corner, it cannot allow for the favorable effects of an announced general policy of free speech. It cannot allow for the fact that a society in which people are not free to speak on the corner without special legislation will be a society in which the development of new ideas, experimentation, change, and the like will all be hampered in a great variety of ways that are obvious to all, thanks to our good fortune of having lived in a society which did adopt the self-denying ordinance of not considering each case of speech separately.
Exactly the same considerations apply in the monetary area. If each case is considered on its merits, the wrong decision is likely to be made in a large fraction of cases because the decision-makers are examining only a limited area and not taking into account the cumulative consequences of the policy as a whole. On the other hand, if a general rule is adopted for a group of cases as a bundle, the existence of that rule has favorable effects on people's attitudes and beliefs and expectations that would not follow even from the discretionary adoption of precisely the same policy on a series of separate occasions.
If a rule is to be legislated, what rule should it be ? The rule that has most frequently been suggested by people of a generally liberal persuasion is a price level rule; namely, a legislative directive to the monetary authorities that they maintain a stable price level. I think this is the wrong kind of a rule. It is the wrong kind of a rule because it is in terms of objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions. It consequently raises the problem of dispersing responsibilities and leaving the authorities too much leeway. There is unquestionably a close connection between monetary actions and the price level. But the connection is not so close, so invariable, or so direct that the objective of achieving a stable price level is an appropriate guide to the day-to-day activities of the authorities.
The issue what rule to adopt is one that I have considered at some length elsewhere.3 Accordingly, I will limit myself here to stating my conclusion. In the present state of our knowledge, it seems to me desirable to state the rule in terms of the behavior of the stock of money. My choice at the moment would be a legislated rule instructing the monetary authority to achieve a specified rate of growth in the stock of money. For this purpose, I would define the stock of money as including currency outside commercial banks plus all deposits of commercial banks. 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 per cent, where X is some number between 3 and 5. The precise definition of money adopted, or the precise rate of growth chosen, makes far less difference than the definite choice of a particular definition and a particular rate of growth.
As matters now stand, while this rule would drastically curtail the discretionary power of the monetary authorities, it would still leave an undesirable amount of discretion in the hands of Federal Reserve and Treasury authorities with respect to how to achieve the specified rate of growth in the money stock, debt management, banking supervision, and the like. Further banking and fiscal reforms, which I have spelled out in detail elsewhere, are both feasible and desirable. They would have the effect of eliminating present governmental intervention into lending and investing activity and of converting governmental financing operations from a perpetual source of instability and uncertainty into a reasonably regular and predictable activity. But, though important, these further reforms are far less basic than the adoption of a rule to limit the discretion of the monetary authorities with respect to the stock of money.
I should like to emphasize that I do not regard my particular proposal as a be-all and end-all of monetary management, as a rule which is somehow to be written in tablets of stone and enshrined for all future time. It seems to me to be the rule that offers the greatest promise of achieving a reasonable degree of monetary stability in the light of our present knowledge. I would hope that as we operated with it, as we learned more about monetary matters, we might be able to devise still better rules, which would achieve still better results. Such a rule seems to me the only feasible device currently available for converting monetary policy into a pillar of a free society rather than a threat to its foundations.
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Notes
1 A Program for Monetary Stability (New York: Fordham University Press, 1959) pp. 4-8.
2 See my A Program for Monetary Stability and Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867-1960 (forthcoming by Princeton University Press for the National Bureau of Economic Research).
3 A Program for Monetary Stability, op. cit., pp. 77-99.
Chapter II
The Role of Government in a Free Society
A common objection to totalitarian societies is that they regard the end as justifying the means. Taken literally, this objection is clearly illogical. If the end does not justify the means, what does? But this easy answer does not dispose of the objection; it simply shows that the objection is not well put. To deny that the end justifies the means is indirectly to assert that the end in question is not the ultimate end, that the ultimate end is itself the use of the proper means. Desirable or not, any end that can be attained only by the use of bad means must give way to the more basic end of the use of acceptable means.
To the liberal, the appropriate means are free discussion and voluntary co-operation, which implies that any form of coercion is inappropriate. The ideal is unanimity among responsible individuals achieved on the basis of free and full discussion. This is another way of expressing the goal of freedom emphasized in the preceding chapter.
From this standpoint, the role of the market, as already noted, is that it permits unanimity without conformity; that it is a system of effectively proportional representation. On the other hand, the characteristic feature of action through explicitly political channels is that it tends to require or to enforce substantial conformity. The typical issue must be decided "yes" or "no"; at most, provision can be made for a fairly limited number of alternatives. Even the use of proportional representation in its explicitly political form does not alter this conclusion. The number of separate groups that can in fact be represented is narrowly limited, enormously so by comparison with the proportional representation of the market. More important, the fact that the final outcome generally must be a law applicable to all groups, rather than separate legislative enactments for each "party" represented, means that proportional representation in its political version, far from permitting unanimity without conformity, tends toward ineffectiveness and fragmentation. It thereby operates to destroy any consensus on which unanimity with conformity can rest.
There are clearly some matters with respect to which effective proportional representation is impossible. I cannot get the amount of national defense I want and you, a different amount. With respect to such indivisible matters we can discuss, and argue, and vote. But having decided, we must conform. It is precisely the existence of such indivisible matters -- protection of the individual and the nation from coercion are clearly the most basic -- that prevents exclusive reliance on individual action through the market. If we are to use some of our resources for such indivisible items, we must employ political channels to reconcile differences.
The use of political channels, while inevitable, tends to strain the social cohesion essential for a stable society. The strain is least if agreement for joint action need be reached only on a limited range of issues on which people in any event have common views. Every extension of the range of issues for which explicit agreement is sought strains further the delicate threads that hold society together. If it goes so far as to touch an issue on which men feel deeply yet differently, it may well disrupt the society. Fundamental differences in basic values can seldom if ever be resolved at the ballot box; ultimately they can only be decided, though not resolved, by conflict. The religious and civil wars of history are a bloody testament to this judgment.
The widespread use of the market reduces the strain on the social fabric by rendering conformity unnecessary with respect to any activities it encompasses. The wider the range of activities covered by the market, the fewer are the issues on which explicitly political decisions are required and hence on which it is necessary to achieve agreement. In turn, the fewer the issues on which agreement is necessary, the greater is the likelihood of getting agreement while maintaining a free society.
Unanimity is, of course, an ideal. In practice, we can afford neither the time nor the effort that would be required to achieve complete unanimity on every issue. We must perforce accept something less. We are thus led to accept majority rule in one form or another as an expedient. That majority rule is an expedient rather than itself a basic principle is clearly shown by the fact that our willingness to resort to majority rule, and the size of the majority we require, themselves depend on the seriousness of the issue involved. If the matter is of little moment and the minority has no strong feelings about being overruled, a bare plurality will suffice. On the other hand, if the minority feels strongly about the issue involved, even a bare majority will not do. Few of us would be willing to have issues of free speech, for example, decided by a bare majority. Our legal structure is full of such distinctions among kinds of issues that require different kinds of majorities. At the extreme are those issues embodied in the Constitution. These are the principles that are so important that we are willing to make minimal concessions to expediency. Something like essential consensus was achieved initially in accepting them, and we require something like essential consensus for a change in them.
The self-denying ordinance to refrain from majority rule on certain kinds of issues that is embodied in our Constitution and in similar written or unwritten constitutions elsewhere, and the specific provisions in these constitutions or their equivalents prohibiting coercion of individuals, are themselves to be regarded as reached by free discussion and as reflecting essential unanimity about means.
I turn now to consider more specifically, though still in very broad terms, what the areas are that cannot be handled through the market at all, or can be handled only at so great a cost that the use of political channels may be preferable.
GOVERNMENT AS RULE-MAKER AND UMPIRE
It is important to distinguish the day-to-day activities of people from the general customary and legal framework within which these take place. The day-to-day activities are like the actions of the participants in a game when they are playing it; the framework, like the rules of the game they play. And just as a good game requires acceptance by the players both of the rules and of the umpire to interpret and enforce them, so a good society requires that its members agree on the general conditions that will govern relations among them, on some means of arbitrating different interpretations of these conditions, and on some device for enforcing compliance with the generally accepted rules. As in games, so also in society, most of the general conditions are the unintended outcome of custom, accepted unthinkingly. At most, we consider explicitly only minor modifications in them, though the cumulative effect of a series of minor modifications may be a drastic alteration in the character of the game or of the society. In both games and society also, no set of rules can prevail unless most participants most of the time conform to them without external sanctions; unless that is, there is a broad underlying social consensus. But we cannot rely on custom or on this consensus alone to interpret and to enforce the rules; we need an umpire. These then are the basic roles of government in a free society: to provide a means whereby we can modify the rules, to mediate differences among us on the meaning of the rules, and to enforce compliance with the rules on the part of those few who would otherwise not play the game.
The need for government in these respects arises because absolute freedom is impossible. However attractive anarchy may be as a philosophy, it is not feasible in a world of imperfect men. Men's freedoms can conflict, and when they do, one man's freedom must be limited to preserve another's -- as a Supreme Court Justice once put it, "My freedom to move my fist must be limited by the proximity of your chin."
The major problem in deciding the appropriate activities of government is how to resolve such conflicts among the freedoms of different individuals. In some cases, the answer is easy. There is little difficulty in attaining near unanimity to the proposition that one man's freedom to murder his neighbor must be sacrificed to preserve the freedom of the other man to live. In other cases, the answer is difficult. In the economic area, a major problem arises in respect of the conflict between freedom to combine and freedom to compete. What meaning is to be attributed to "free" as modifying "enterprise" ? In the United States, "free" has been understood to mean that anyone is free to set up an enterprise, which means that existing enterprises are not free to keep out competitors except by selling a better product at the same price or the same product at a lower price. In the continental tradition, on the other hand, the meaning has generally been that enterprises are free to do what they want, including the fixing of prices, division of markets, and the adoption of other techniques to keep out potential competitors. Perhaps the most difficult specific problem in this area arises with respect to combinations among laborers, where the problem of freedom to combine and freedom to compete is particularly acute.
A still more basic economic area in which the answer is both difficult and important is the definition of property rights. The notion of property, as it has developed over centuries and as it is embodied in our legal codes, has become so much a part of us that we tend to take it for granted, and fail to recognize the extent to which just what constitutes property and what rights the ownership of property confers are complex social creations rather than self-evident propositions. Does my having title to land, for example, and my freedom to use my property as I wish, permit me to deny to someone else the right to fly over my land in his airplane ? Or does his right to use his airplane take precedence? Or does this depend on how high he flies ? Or how much noise he makes? Does voluntary exchange require that he pay me for the privilege of flying over my land? Or that I must pay him to refrain from flying over it? The mere mention of royalties, copyrights, patents; shares of stock in corporations; riparian rights, and the like, may perhaps emphasize the role of generally accepted social rules in the very definition of property. It may suggest also that, in many cases, the existence of a well specified and generally accepted definition of property is far more important than just what the definition is.
Another economic area that raises particularly difficult problems is the monetary system. Government responsibility for the monetary system has long been recognized. It is explicitly provided for in the constitutional provision which gives Congress the power "to coin money, regulate the value thereof, and of foreign coin." There is probably no other area of economic activity with respect to which government action has been so uniformly accepted. This habitual and by now almost unthinking acceptance of governmental responsibility makes thorough understanding of the grounds for such responsibility all the more necessary, since it enhances the danger that the scope of government will spread from activities that are, to those that are not, appropriate in a free society, from providing a monetary framework to determining the allocation of resources among individuals. We shall discuss this problem in detail in chapter iii.
In summary, the organization of economic activity through voluntary exchange presumes that we have provided, through government, for the maintenance of law and order to prevent coercion of one individual by another, the enforcement of contracts voluntarily entered into, the definition of the meaning of property rights, the interpretation and enforcement of such rights, and the provision of a monetary framework.
ACTION THROUGH GOVERNMENT ON GROUNDS OF TECHNICAL MONOPOLY AND NEIGHBORHOOD EFFECTS
The role of government just considered is to do something that the market cannot do for itself, namely, to determine, arbitrate, and enforce the rules of the game. We may also want to do through government some things that might conceivably be done through the market but that technical or similar conditions render it difficult to do in that way. These all reduce to cases in which strictly voluntary exchange is either exceedingly costly or practically impossible. There are two general classes of such cases: monopoly and similar market imperfections, and neighborhood effects.
Exchange is truly voluntary only when nearly equivalent alternatives exist. Monopoly implies the absence of alternatives and thereby inhibits effective freedom of exchange. In practice, monopoly frequently, if not generally, arises from government support or from collusive agreements among individuals. With respect to these, the problem is either to avoid governmental fostering of monopoly or to stimulate the effective enforcement of rules such as those embodied in our anti-trust laws. However, monopoly may also arise because it is technically efficient to have a single producer or enterprise. I venture to suggest that such cases are more limited than is supposed but they unquestionably do arise. A simple example is perhaps the provision of telephone services within a community. I shall refer to such cases as "technical" monopoly.
When technical conditions make a monopoly the natural outcome of competitive market forces, there are only three alternatives that seem available: private monopoly, public monopoly, or public regulation. All three are bad so we must choose among evils. Henry Simons, observing public regulation of monopoly in the United States, found the results so distasteful that he concluded public monopoly would be a lesser evil. Walter Eucken, a noted German liberal, observing public monopoly in German railroads, found the results so distasteful that he concluded public regulation would be a lesser evil. Having learned from both, I reluctantly conclude that, if tolerable, private monopoly may be the least of the evils.
If society were static so that the conditions which give rise to a technical monopoly were sure to remain, I would have little confidence in this solution. In a rapidly changing society, however, the conditions making for technical monopoly frequently change and I suspect that both public regulation and public monopoly are likely to be less responsive to such changes in conditions, to be less readily capable of elimination, than private monopoly.
Railroads in the United States are an excellent example. A large degree of monopoly in railroads was perhaps inevitable on technical grounds in the nineteenth century. This was the justification for the Interstate Commerce Commission. But conditions have changed. The emergence of road and air transport has reduced the monopoly element in railroads to negligible proportions. Yet we have not eliminated the ICC. On the contrary, the ICC, which started out as an agency to protect the public from exploitation by the railroads, has become an agency to protect railroads from competition by trucks and other means of transport, and more recently even to protect existing truck companies from competition by new entrants. Similarly, in England, when the railroads were nationalized, trucking was at first brought into the state monopoly. If railroads had never been subjected to regulation in the United States, it is nearly certain that by now transportation, including railroads, would be a highly competitive industry with little or no remaining monopoly elements.
The choice between the evils of private monopoly, public monopoly, and public regulation cannot, however, be made once and for all, independently of the factual circumstances. If the technical monopoly is of a service or commodity that is regarded as essential and if its monopoly power is sizable, even the short-run effects of private unregulated monopoly may not be tolerable, and either public regulation or ownership may be a lesser evil.
Technical monopoly may on occasion justify a de facto public monopoly. It cannot by itself justify a public monopoly achieved by making it illegal for anyone else to compete. For example, there is no way to justify our present public monopoly of the post office. It may be argued that the carrying of mail is a technical monopoly and that a government monopoly is the least of evils. Along these lines, one could perhaps justify a government post office but not the present law, which makes it illegal for anybody else to carry mail. If the delivery of mail is a technical monopoly, no one will be able to suceed in competition with the government. If it is not, there is no reason why the government should be engaged in it. The only way to find out is to leave other people free to enter.
The historical reason why we have a post office monopoly is because the Pony Express did such a good job of carrying the mail across the continent that, when the government introduced transcontinental service, it couldn't compete effectively and lost money. The result was a law making it illegal for anybody else to carry the mail. That is why the Adams Express Company is an investment trust today instead of an operating company. I conjecture that if entry into the mail-carrying business were open to all, there would be a large number of firms entering it and this archaic industry would become revolutionized in short order.
A second general class of cases in which strictly voluntary exchange is impossible arises when actions of individuals have effects on other individuals for which it is not feasible to charge or recompense them. This is the problem of "neighborhood effects". An obvious example is the pollution of a stream. The man who pollutes a stream is in effect forcing others to exchange good water for bad. These others might be willing to make the exchange at a price. But it is not feasible for them, acting individually, to avoid the exchange or to enforce appropriate compensation.
A less obvious example is the provision of highways. In this case, it is technically possible to identify and hence charge individuals for their use of the roads and so to have private operation. However, for general access roads, involving many points of entry and exit, the costs of collection would be extremely high if a charge were to be made for the specific services received by each individual, because of the necessity of establishing toll booths or the equivalent at all entrances. The gasoline tax is a much cheaper method of charging individuals roughly in proportion to their use of the roads. This method, however, is one in which the particular payment cannot be identified closely with the particular use. Hence, it is hardly feasible to have private enterprise provide the service and collect the charge without establishing extensive private monopoly.
These considerations do not apply to long-distance turnpikes with high density of traffic and limited access. For these, the costs of collection are small and in many cases are now being paid, and there are often numerous alternatives, so that there is no serious monopoly problem. Hence, there is every reason why these should be privately owned and operated. If so owned and operated, the enterprise running the highway should receive the gasoline taxes paid on account of travel on it.
Parks are an interesting example because they illustrate the difference between cases that can and cases that cannot be justified by neighborhood effects, and because almost everyone at first sight regards the conduct of National Parks as obviously a valid function of government. In fact, however, neighborhood effects may justify a city park; they do not justify a national park, like Yellowstone National Park or the Grand Canyon. What is the fundamental difference between the two ? For the city park, it is extremely difficult to identify the people who benefit from it and to charge them for the benefits which they receive. If there is a park in the middle of the city, the houses on all sides get the benefit of the open space, and people who walk through it or by it also benefit. To maintain toll collectors at the gates or to impose annual charges per window overlooking the park would be very expensive and difficult. The entrances to a national park like Yellowstone, on the other hand, are few; most of the people who come stay for a considerable period of time and it is perfectly feasible to set up toll gates and collect admission charges. This is indeed now done, though the charges do not cover the whole costs. If the public wants this kind of an activity enough to pay for it, private enterprises will have every incentive to provide such parks. And, of course, there are many private enterprises of this nature now in existence. I cannot myself conjure up any neighborhood effects or important monopoly effects that would justify governmental activity in this area.
Considerations like those I have treated under the heading of neighborhood effects have been used to rationalize almost every conceivable intervention. In many instances, however, this rationalization is special pleading rather than a legitimate application of the concept of neighborhood effects. Neighborhood effects cut both ways. They can be a reason for limiting the activities of government as well as for expanding them. Neighborhood effects impede voluntary exchange because it is difficult to identify the effects on third parties and to measure their magnitude; but this difficulty is present in governmental activity as well. It is hard to know when neighborhood effects are sufficiently large to justify particular costs in overcoming them and even harder to distribute the costs in an appropriate fashion. Consequently, when government engages in activities to overcome neighborhood effects, it will in part introduce an additional set of neighborhood effects by failing to charge or to compensate individuals properly. Whether the original or the new neighborhood effects are the more serious can only be judged by the facts of the individual case, and even then, only very approximately. Furthermore, the use of government to overcome neighborhood effects itself has an extremely important neighborhood effect which is unrelated to the particular occasion for government action. Every act of government intervention limits the area of individual freedom directly and threatens the preservation of freedom indirectly for reasons elaborated in the first chapter.
Our principles offer no hard and fast line how far it is appropriate to use government to accomplish jointly what it is difficult or impossible for us to accomplish separately through strictly voluntary exchange. In any particular case of proposed intervention, we must make up a balance sheet, listing separately the advantages and disadvantages. Our principles tell us what items to put on the one side and what items on the other and they give us some basis for attaching importance to the different items. In particular, we shall always want to enter on the liability side of any proposed government intervention, its neighborhood effect in threatening freedom, and give this effect considerable weight. Just how much weight to give to it, as to other items, depends upon the circumstances. If, for example, existing government intervention is minor, we shall attach a smaller weight to the negative effects of additional government intervention. This is an important reason why many earlier liberals, like Henry Simons, writing at a time when government was small by today's standards, were willing to have government undertake activities that today's liberals would not accept now that government has become so overgrown.
ACTION THROUGH GOVERNMENT ON PATERNALISTIC GROUNDS
Freedom is a tenable objective only for responsible individuals. We do not believe in freedom for madmen or children. The necessity of drawing a line between responsible individuals and others is inescapable, yet it means that there is an essential ambiguity in our ultimate objective of freedom. Paternalism is inescapable for those whom we designate as not responsible.
The clearest case, perhaps, is that of madmen. We are willing neither to permit them freedom nor to shoot them. It would be nice if we could rely on voluntary activities of individuals to house and care for the madmen. But I think we cannot rule out the possibility that such charitable activities will be inadequate, if only because of the neighborhood effect involved in the fact that I benefit if another man contributes to the care of the insane. For this reason, we may be willing to arrange for their care through government.
Children offer a more difficult case. The ultimate operative unit in our society is the family, not the individual. Yet the acceptance of the family as the unit rests in considerable part on expediency rather than principle. We believe that parents are generally best able to protect their children and to provide for their development into responsible individuals for whom freedom is appropriate. But we do not believe in the freedom of parents to do what they will with other people. The children are responsible individuals in embryo, and a believer in freedom believes in protecting their ultimate rights.
To put this in a different and what may seem a more callous way, children are at one and the same time consumer goods and potentially responsible members of society. The freedom of individuals to use their economic resources as they want includes the freedom to use them to have children -- to buy, as it were, the services of children as a particular form of consumption. But once this choice is exercised, the children have a value in and of themselves and have a freedom of their own that is not simply an extension of the freedom of the parents.
The paternalistic ground for governmental activity is in many ways the most troublesome to a liberal; for it involves the acceptance of a principle -- that some shall decide for others -- which he finds objectionable in most applications and which he rightly regards as a hallmark of his chief intellectual opponents, the proponents of collectivism in one or another of its guises, whether it be communism, socialism, or a welfare state. Yet there is no use pretending that problems are simpler than in fact they are. There is no avoiding the need for some measure of paternalism. As Dicey wrote in 1914 about an act for the protection of mental defectives, "The Mental Deficiency Act is the first step along a path on which no sane man can decline to enter, but which, if too far pursued, will bring statesmen across difficulties hard to meet without considerable interference with individual liberty."1 There is no formula that can tell us where to stop. We must rely on our fallible judgment and, having reached a judgment, on our ability to persuade our fellow men that it is a correct judgment, or their ability to persuade us to modify our views. We must put our faith, here as elsewhere, in a consensus reached by imperfect and biased men through free discussion and trial and error.
CONCLUSION
A government which maintained law and order, defined property rights, served as a means whereby we could modify property rights and other rules of the economic game, adjudicated disputes about the interpretation of the rules, enforced contracts, promoted competition, provided a monetary framework, engaged in activities to counter technical monopolies and to overcome neighborhood effects widely regarded as sufficiently important to justify government intervention, and which supplemented private charity and the private family in protecting the irresponsible, whether madman or child -- such a government would clearly have important functions to perform. The consistent liberal is not an anarchist.
Yet it is also true that such a government would have clearly limited functions and would refrain from a host of activities that are now undertaken by federal and state governments in the United States, and their counterparts in other Western countries. Succeeding chapters will deal in some detail with some of these activities, and a few have been discussed above, but it may help to give a sense of proportion about the role that a liberal would assign government simply to list, in closing this chapter, some activities currently undertaken by government in the U.S., that cannot, so far as I can see, validly be justified in terms of the principles outlined above:
Parity price support programs for agriculture.
Tariffs on imports or restrictions on exports, such as current oil import quotas, sugar quotas, etc.
Governmental control of output, such as through the farm program, or through prorationing of oil as is done by the Texas Railroad Commission.
Rent control, such as is still practiced in New York, or more general price and wage controls such as were imposed during and just after World War II!
Legal minimum wage rates, or legal maximum prices, such as the legal maximum of zero on the rate of interest that can be paid on demand deposits by commercial banks, or the legally fixed maximum rates that can be paid on savings and time deposits.
Detailed regulation of industries, such as the regulation of transportation by the Interstate Commerce Commission. This had some justification on technical monopoly grounds when initially introduced for railroads; it has none now for any means of transport. Another example is detailed regulation of banking.
A similar example, but one which deserves special mention because of its implicit censorship and violation of free speech, is the control of radio and television by the Federal Communications Commission.
Present social security programs, especially the old-age and retirement programs compelling people in effect (a) to spend a specified fraction of their income on the purchase of retirement annuity, (b) to buy the annuity from a publicly operated enterprise.
Licensure provisions in various cities and states which restrict particular enterprises or occupations or professions to people who have a license, where the license is more than a receipt for a tax which anyone who wishes to enter the activity may pay.
So-called "public-housing" and the host of other subsidy programs directed at fostering residential construction such as F.H.A. and V.A. guarantee of mortgage, and the like.
Conscription to man the military services~in" peacetime. The appropriate free market arrangement is volunteer military forces; which is to say, hiring men to serve. There is no justification for not paying whatever price is necessary to attract the required number of men. Present arrangements are inequitable and arbitrary, seriously interfere with the freedom of young men to shape their lives, and probably are even more costly than the market alternative. (Universal military training to provide a reserve for war time is a different problem and may be justified on liberal grounds.)
National parks, as noted above.
The legal prohibition on the carrying of mail for profit.
Publicly owned and operated toll roads, as noted above.
This list is far from comprehensive.
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Notes
1 A. V. Dicey, Lectures on the Relation between Law and Public Opinion in England during the Nineteenth Century (2d. ed.; London: Macmillan & Co., 1914), p. li
The Role of Government in a Free Society
A common objection to totalitarian societies is that they regard the end as justifying the means. Taken literally, this objection is clearly illogical. If the end does not justify the means, what does? But this easy answer does not dispose of the objection; it simply shows that the objection is not well put. To deny that the end justifies the means is indirectly to assert that the end in question is not the ultimate end, that the ultimate end is itself the use of the proper means. Desirable or not, any end that can be attained only by the use of bad means must give way to the more basic end of the use of acceptable means.
To the liberal, the appropriate means are free discussion and voluntary co-operation, which implies that any form of coercion is inappropriate. The ideal is unanimity among responsible individuals achieved on the basis of free and full discussion. This is another way of expressing the goal of freedom emphasized in the preceding chapter.
From this standpoint, the role of the market, as already noted, is that it permits unanimity without conformity; that it is a system of effectively proportional representation. On the other hand, the characteristic feature of action through explicitly political channels is that it tends to require or to enforce substantial conformity. The typical issue must be decided "yes" or "no"; at most, provision can be made for a fairly limited number of alternatives. Even the use of proportional representation in its explicitly political form does not alter this conclusion. The number of separate groups that can in fact be represented is narrowly limited, enormously so by comparison with the proportional representation of the market. More important, the fact that the final outcome generally must be a law applicable to all groups, rather than separate legislative enactments for each "party" represented, means that proportional representation in its political version, far from permitting unanimity without conformity, tends toward ineffectiveness and fragmentation. It thereby operates to destroy any consensus on which unanimity with conformity can rest.
There are clearly some matters with respect to which effective proportional representation is impossible. I cannot get the amount of national defense I want and you, a different amount. With respect to such indivisible matters we can discuss, and argue, and vote. But having decided, we must conform. It is precisely the existence of such indivisible matters -- protection of the individual and the nation from coercion are clearly the most basic -- that prevents exclusive reliance on individual action through the market. If we are to use some of our resources for such indivisible items, we must employ political channels to reconcile differences.
The use of political channels, while inevitable, tends to strain the social cohesion essential for a stable society. The strain is least if agreement for joint action need be reached only on a limited range of issues on which people in any event have common views. Every extension of the range of issues for which explicit agreement is sought strains further the delicate threads that hold society together. If it goes so far as to touch an issue on which men feel deeply yet differently, it may well disrupt the society. Fundamental differences in basic values can seldom if ever be resolved at the ballot box; ultimately they can only be decided, though not resolved, by conflict. The religious and civil wars of history are a bloody testament to this judgment.
The widespread use of the market reduces the strain on the social fabric by rendering conformity unnecessary with respect to any activities it encompasses. The wider the range of activities covered by the market, the fewer are the issues on which explicitly political decisions are required and hence on which it is necessary to achieve agreement. In turn, the fewer the issues on which agreement is necessary, the greater is the likelihood of getting agreement while maintaining a free society.
Unanimity is, of course, an ideal. In practice, we can afford neither the time nor the effort that would be required to achieve complete unanimity on every issue. We must perforce accept something less. We are thus led to accept majority rule in one form or another as an expedient. That majority rule is an expedient rather than itself a basic principle is clearly shown by the fact that our willingness to resort to majority rule, and the size of the majority we require, themselves depend on the seriousness of the issue involved. If the matter is of little moment and the minority has no strong feelings about being overruled, a bare plurality will suffice. On the other hand, if the minority feels strongly about the issue involved, even a bare majority will not do. Few of us would be willing to have issues of free speech, for example, decided by a bare majority. Our legal structure is full of such distinctions among kinds of issues that require different kinds of majorities. At the extreme are those issues embodied in the Constitution. These are the principles that are so important that we are willing to make minimal concessions to expediency. Something like essential consensus was achieved initially in accepting them, and we require something like essential consensus for a change in them.
The self-denying ordinance to refrain from majority rule on certain kinds of issues that is embodied in our Constitution and in similar written or unwritten constitutions elsewhere, and the specific provisions in these constitutions or their equivalents prohibiting coercion of individuals, are themselves to be regarded as reached by free discussion and as reflecting essential unanimity about means.
I turn now to consider more specifically, though still in very broad terms, what the areas are that cannot be handled through the market at all, or can be handled only at so great a cost that the use of political channels may be preferable.
GOVERNMENT AS RULE-MAKER AND UMPIRE
It is important to distinguish the day-to-day activities of people from the general customary and legal framework within which these take place. The day-to-day activities are like the actions of the participants in a game when they are playing it; the framework, like the rules of the game they play. And just as a good game requires acceptance by the players both of the rules and of the umpire to interpret and enforce them, so a good society requires that its members agree on the general conditions that will govern relations among them, on some means of arbitrating different interpretations of these conditions, and on some device for enforcing compliance with the generally accepted rules. As in games, so also in society, most of the general conditions are the unintended outcome of custom, accepted unthinkingly. At most, we consider explicitly only minor modifications in them, though the cumulative effect of a series of minor modifications may be a drastic alteration in the character of the game or of the society. In both games and society also, no set of rules can prevail unless most participants most of the time conform to them without external sanctions; unless that is, there is a broad underlying social consensus. But we cannot rely on custom or on this consensus alone to interpret and to enforce the rules; we need an umpire. These then are the basic roles of government in a free society: to provide a means whereby we can modify the rules, to mediate differences among us on the meaning of the rules, and to enforce compliance with the rules on the part of those few who would otherwise not play the game.
The need for government in these respects arises because absolute freedom is impossible. However attractive anarchy may be as a philosophy, it is not feasible in a world of imperfect men. Men's freedoms can conflict, and when they do, one man's freedom must be limited to preserve another's -- as a Supreme Court Justice once put it, "My freedom to move my fist must be limited by the proximity of your chin."
The major problem in deciding the appropriate activities of government is how to resolve such conflicts among the freedoms of different individuals. In some cases, the answer is easy. There is little difficulty in attaining near unanimity to the proposition that one man's freedom to murder his neighbor must be sacrificed to preserve the freedom of the other man to live. In other cases, the answer is difficult. In the economic area, a major problem arises in respect of the conflict between freedom to combine and freedom to compete. What meaning is to be attributed to "free" as modifying "enterprise" ? In the United States, "free" has been understood to mean that anyone is free to set up an enterprise, which means that existing enterprises are not free to keep out competitors except by selling a better product at the same price or the same product at a lower price. In the continental tradition, on the other hand, the meaning has generally been that enterprises are free to do what they want, including the fixing of prices, division of markets, and the adoption of other techniques to keep out potential competitors. Perhaps the most difficult specific problem in this area arises with respect to combinations among laborers, where the problem of freedom to combine and freedom to compete is particularly acute.
A still more basic economic area in which the answer is both difficult and important is the definition of property rights. The notion of property, as it has developed over centuries and as it is embodied in our legal codes, has become so much a part of us that we tend to take it for granted, and fail to recognize the extent to which just what constitutes property and what rights the ownership of property confers are complex social creations rather than self-evident propositions. Does my having title to land, for example, and my freedom to use my property as I wish, permit me to deny to someone else the right to fly over my land in his airplane ? Or does his right to use his airplane take precedence? Or does this depend on how high he flies ? Or how much noise he makes? Does voluntary exchange require that he pay me for the privilege of flying over my land? Or that I must pay him to refrain from flying over it? The mere mention of royalties, copyrights, patents; shares of stock in corporations; riparian rights, and the like, may perhaps emphasize the role of generally accepted social rules in the very definition of property. It may suggest also that, in many cases, the existence of a well specified and generally accepted definition of property is far more important than just what the definition is.
Another economic area that raises particularly difficult problems is the monetary system. Government responsibility for the monetary system has long been recognized. It is explicitly provided for in the constitutional provision which gives Congress the power "to coin money, regulate the value thereof, and of foreign coin." There is probably no other area of economic activity with respect to which government action has been so uniformly accepted. This habitual and by now almost unthinking acceptance of governmental responsibility makes thorough understanding of the grounds for such responsibility all the more necessary, since it enhances the danger that the scope of government will spread from activities that are, to those that are not, appropriate in a free society, from providing a monetary framework to determining the allocation of resources among individuals. We shall discuss this problem in detail in chapter iii.
In summary, the organization of economic activity through voluntary exchange presumes that we have provided, through government, for the maintenance of law and order to prevent coercion of one individual by another, the enforcement of contracts voluntarily entered into, the definition of the meaning of property rights, the interpretation and enforcement of such rights, and the provision of a monetary framework.
ACTION THROUGH GOVERNMENT ON GROUNDS OF TECHNICAL MONOPOLY AND NEIGHBORHOOD EFFECTS
The role of government just considered is to do something that the market cannot do for itself, namely, to determine, arbitrate, and enforce the rules of the game. We may also want to do through government some things that might conceivably be done through the market but that technical or similar conditions render it difficult to do in that way. These all reduce to cases in which strictly voluntary exchange is either exceedingly costly or practically impossible. There are two general classes of such cases: monopoly and similar market imperfections, and neighborhood effects.
Exchange is truly voluntary only when nearly equivalent alternatives exist. Monopoly implies the absence of alternatives and thereby inhibits effective freedom of exchange. In practice, monopoly frequently, if not generally, arises from government support or from collusive agreements among individuals. With respect to these, the problem is either to avoid governmental fostering of monopoly or to stimulate the effective enforcement of rules such as those embodied in our anti-trust laws. However, monopoly may also arise because it is technically efficient to have a single producer or enterprise. I venture to suggest that such cases are more limited than is supposed but they unquestionably do arise. A simple example is perhaps the provision of telephone services within a community. I shall refer to such cases as "technical" monopoly.
When technical conditions make a monopoly the natural outcome of competitive market forces, there are only three alternatives that seem available: private monopoly, public monopoly, or public regulation. All three are bad so we must choose among evils. Henry Simons, observing public regulation of monopoly in the United States, found the results so distasteful that he concluded public monopoly would be a lesser evil. Walter Eucken, a noted German liberal, observing public monopoly in German railroads, found the results so distasteful that he concluded public regulation would be a lesser evil. Having learned from both, I reluctantly conclude that, if tolerable, private monopoly may be the least of the evils.
If society were static so that the conditions which give rise to a technical monopoly were sure to remain, I would have little confidence in this solution. In a rapidly changing society, however, the conditions making for technical monopoly frequently change and I suspect that both public regulation and public monopoly are likely to be less responsive to such changes in conditions, to be less readily capable of elimination, than private monopoly.
Railroads in the United States are an excellent example. A large degree of monopoly in railroads was perhaps inevitable on technical grounds in the nineteenth century. This was the justification for the Interstate Commerce Commission. But conditions have changed. The emergence of road and air transport has reduced the monopoly element in railroads to negligible proportions. Yet we have not eliminated the ICC. On the contrary, the ICC, which started out as an agency to protect the public from exploitation by the railroads, has become an agency to protect railroads from competition by trucks and other means of transport, and more recently even to protect existing truck companies from competition by new entrants. Similarly, in England, when the railroads were nationalized, trucking was at first brought into the state monopoly. If railroads had never been subjected to regulation in the United States, it is nearly certain that by now transportation, including railroads, would be a highly competitive industry with little or no remaining monopoly elements.
The choice between the evils of private monopoly, public monopoly, and public regulation cannot, however, be made once and for all, independently of the factual circumstances. If the technical monopoly is of a service or commodity that is regarded as essential and if its monopoly power is sizable, even the short-run effects of private unregulated monopoly may not be tolerable, and either public regulation or ownership may be a lesser evil.
Technical monopoly may on occasion justify a de facto public monopoly. It cannot by itself justify a public monopoly achieved by making it illegal for anyone else to compete. For example, there is no way to justify our present public monopoly of the post office. It may be argued that the carrying of mail is a technical monopoly and that a government monopoly is the least of evils. Along these lines, one could perhaps justify a government post office but not the present law, which makes it illegal for anybody else to carry mail. If the delivery of mail is a technical monopoly, no one will be able to suceed in competition with the government. If it is not, there is no reason why the government should be engaged in it. The only way to find out is to leave other people free to enter.
The historical reason why we have a post office monopoly is because the Pony Express did such a good job of carrying the mail across the continent that, when the government introduced transcontinental service, it couldn't compete effectively and lost money. The result was a law making it illegal for anybody else to carry the mail. That is why the Adams Express Company is an investment trust today instead of an operating company. I conjecture that if entry into the mail-carrying business were open to all, there would be a large number of firms entering it and this archaic industry would become revolutionized in short order.
A second general class of cases in which strictly voluntary exchange is impossible arises when actions of individuals have effects on other individuals for which it is not feasible to charge or recompense them. This is the problem of "neighborhood effects". An obvious example is the pollution of a stream. The man who pollutes a stream is in effect forcing others to exchange good water for bad. These others might be willing to make the exchange at a price. But it is not feasible for them, acting individually, to avoid the exchange or to enforce appropriate compensation.
A less obvious example is the provision of highways. In this case, it is technically possible to identify and hence charge individuals for their use of the roads and so to have private operation. However, for general access roads, involving many points of entry and exit, the costs of collection would be extremely high if a charge were to be made for the specific services received by each individual, because of the necessity of establishing toll booths or the equivalent at all entrances. The gasoline tax is a much cheaper method of charging individuals roughly in proportion to their use of the roads. This method, however, is one in which the particular payment cannot be identified closely with the particular use. Hence, it is hardly feasible to have private enterprise provide the service and collect the charge without establishing extensive private monopoly.
These considerations do not apply to long-distance turnpikes with high density of traffic and limited access. For these, the costs of collection are small and in many cases are now being paid, and there are often numerous alternatives, so that there is no serious monopoly problem. Hence, there is every reason why these should be privately owned and operated. If so owned and operated, the enterprise running the highway should receive the gasoline taxes paid on account of travel on it.
Parks are an interesting example because they illustrate the difference between cases that can and cases that cannot be justified by neighborhood effects, and because almost everyone at first sight regards the conduct of National Parks as obviously a valid function of government. In fact, however, neighborhood effects may justify a city park; they do not justify a national park, like Yellowstone National Park or the Grand Canyon. What is the fundamental difference between the two ? For the city park, it is extremely difficult to identify the people who benefit from it and to charge them for the benefits which they receive. If there is a park in the middle of the city, the houses on all sides get the benefit of the open space, and people who walk through it or by it also benefit. To maintain toll collectors at the gates or to impose annual charges per window overlooking the park would be very expensive and difficult. The entrances to a national park like Yellowstone, on the other hand, are few; most of the people who come stay for a considerable period of time and it is perfectly feasible to set up toll gates and collect admission charges. This is indeed now done, though the charges do not cover the whole costs. If the public wants this kind of an activity enough to pay for it, private enterprises will have every incentive to provide such parks. And, of course, there are many private enterprises of this nature now in existence. I cannot myself conjure up any neighborhood effects or important monopoly effects that would justify governmental activity in this area.
Considerations like those I have treated under the heading of neighborhood effects have been used to rationalize almost every conceivable intervention. In many instances, however, this rationalization is special pleading rather than a legitimate application of the concept of neighborhood effects. Neighborhood effects cut both ways. They can be a reason for limiting the activities of government as well as for expanding them. Neighborhood effects impede voluntary exchange because it is difficult to identify the effects on third parties and to measure their magnitude; but this difficulty is present in governmental activity as well. It is hard to know when neighborhood effects are sufficiently large to justify particular costs in overcoming them and even harder to distribute the costs in an appropriate fashion. Consequently, when government engages in activities to overcome neighborhood effects, it will in part introduce an additional set of neighborhood effects by failing to charge or to compensate individuals properly. Whether the original or the new neighborhood effects are the more serious can only be judged by the facts of the individual case, and even then, only very approximately. Furthermore, the use of government to overcome neighborhood effects itself has an extremely important neighborhood effect which is unrelated to the particular occasion for government action. Every act of government intervention limits the area of individual freedom directly and threatens the preservation of freedom indirectly for reasons elaborated in the first chapter.
Our principles offer no hard and fast line how far it is appropriate to use government to accomplish jointly what it is difficult or impossible for us to accomplish separately through strictly voluntary exchange. In any particular case of proposed intervention, we must make up a balance sheet, listing separately the advantages and disadvantages. Our principles tell us what items to put on the one side and what items on the other and they give us some basis for attaching importance to the different items. In particular, we shall always want to enter on the liability side of any proposed government intervention, its neighborhood effect in threatening freedom, and give this effect considerable weight. Just how much weight to give to it, as to other items, depends upon the circumstances. If, for example, existing government intervention is minor, we shall attach a smaller weight to the negative effects of additional government intervention. This is an important reason why many earlier liberals, like Henry Simons, writing at a time when government was small by today's standards, were willing to have government undertake activities that today's liberals would not accept now that government has become so overgrown.
ACTION THROUGH GOVERNMENT ON PATERNALISTIC GROUNDS
Freedom is a tenable objective only for responsible individuals. We do not believe in freedom for madmen or children. The necessity of drawing a line between responsible individuals and others is inescapable, yet it means that there is an essential ambiguity in our ultimate objective of freedom. Paternalism is inescapable for those whom we designate as not responsible.
The clearest case, perhaps, is that of madmen. We are willing neither to permit them freedom nor to shoot them. It would be nice if we could rely on voluntary activities of individuals to house and care for the madmen. But I think we cannot rule out the possibility that such charitable activities will be inadequate, if only because of the neighborhood effect involved in the fact that I benefit if another man contributes to the care of the insane. For this reason, we may be willing to arrange for their care through government.
Children offer a more difficult case. The ultimate operative unit in our society is the family, not the individual. Yet the acceptance of the family as the unit rests in considerable part on expediency rather than principle. We believe that parents are generally best able to protect their children and to provide for their development into responsible individuals for whom freedom is appropriate. But we do not believe in the freedom of parents to do what they will with other people. The children are responsible individuals in embryo, and a believer in freedom believes in protecting their ultimate rights.
To put this in a different and what may seem a more callous way, children are at one and the same time consumer goods and potentially responsible members of society. The freedom of individuals to use their economic resources as they want includes the freedom to use them to have children -- to buy, as it were, the services of children as a particular form of consumption. But once this choice is exercised, the children have a value in and of themselves and have a freedom of their own that is not simply an extension of the freedom of the parents.
The paternalistic ground for governmental activity is in many ways the most troublesome to a liberal; for it involves the acceptance of a principle -- that some shall decide for others -- which he finds objectionable in most applications and which he rightly regards as a hallmark of his chief intellectual opponents, the proponents of collectivism in one or another of its guises, whether it be communism, socialism, or a welfare state. Yet there is no use pretending that problems are simpler than in fact they are. There is no avoiding the need for some measure of paternalism. As Dicey wrote in 1914 about an act for the protection of mental defectives, "The Mental Deficiency Act is the first step along a path on which no sane man can decline to enter, but which, if too far pursued, will bring statesmen across difficulties hard to meet without considerable interference with individual liberty."1 There is no formula that can tell us where to stop. We must rely on our fallible judgment and, having reached a judgment, on our ability to persuade our fellow men that it is a correct judgment, or their ability to persuade us to modify our views. We must put our faith, here as elsewhere, in a consensus reached by imperfect and biased men through free discussion and trial and error.
CONCLUSION
A government which maintained law and order, defined property rights, served as a means whereby we could modify property rights and other rules of the economic game, adjudicated disputes about the interpretation of the rules, enforced contracts, promoted competition, provided a monetary framework, engaged in activities to counter technical monopolies and to overcome neighborhood effects widely regarded as sufficiently important to justify government intervention, and which supplemented private charity and the private family in protecting the irresponsible, whether madman or child -- such a government would clearly have important functions to perform. The consistent liberal is not an anarchist.
Yet it is also true that such a government would have clearly limited functions and would refrain from a host of activities that are now undertaken by federal and state governments in the United States, and their counterparts in other Western countries. Succeeding chapters will deal in some detail with some of these activities, and a few have been discussed above, but it may help to give a sense of proportion about the role that a liberal would assign government simply to list, in closing this chapter, some activities currently undertaken by government in the U.S., that cannot, so far as I can see, validly be justified in terms of the principles outlined above:
Parity price support programs for agriculture.
Tariffs on imports or restrictions on exports, such as current oil import quotas, sugar quotas, etc.
Governmental control of output, such as through the farm program, or through prorationing of oil as is done by the Texas Railroad Commission.
Rent control, such as is still practiced in New York, or more general price and wage controls such as were imposed during and just after World War II!
Legal minimum wage rates, or legal maximum prices, such as the legal maximum of zero on the rate of interest that can be paid on demand deposits by commercial banks, or the legally fixed maximum rates that can be paid on savings and time deposits.
Detailed regulation of industries, such as the regulation of transportation by the Interstate Commerce Commission. This had some justification on technical monopoly grounds when initially introduced for railroads; it has none now for any means of transport. Another example is detailed regulation of banking.
A similar example, but one which deserves special mention because of its implicit censorship and violation of free speech, is the control of radio and television by the Federal Communications Commission.
Present social security programs, especially the old-age and retirement programs compelling people in effect (a) to spend a specified fraction of their income on the purchase of retirement annuity, (b) to buy the annuity from a publicly operated enterprise.
Licensure provisions in various cities and states which restrict particular enterprises or occupations or professions to people who have a license, where the license is more than a receipt for a tax which anyone who wishes to enter the activity may pay.
So-called "public-housing" and the host of other subsidy programs directed at fostering residential construction such as F.H.A. and V.A. guarantee of mortgage, and the like.
Conscription to man the military services~in" peacetime. The appropriate free market arrangement is volunteer military forces; which is to say, hiring men to serve. There is no justification for not paying whatever price is necessary to attract the required number of men. Present arrangements are inequitable and arbitrary, seriously interfere with the freedom of young men to shape their lives, and probably are even more costly than the market alternative. (Universal military training to provide a reserve for war time is a different problem and may be justified on liberal grounds.)
National parks, as noted above.
The legal prohibition on the carrying of mail for profit.
Publicly owned and operated toll roads, as noted above.
This list is far from comprehensive.
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Notes
1 A. V. Dicey, Lectures on the Relation between Law and Public Opinion in England during the Nineteenth Century (2d. ed.; London: Macmillan & Co., 1914), p. li
Capitalism and Freedom
(Milton friedman)
Chapter I
The Relation between Economic Freedom and Political Freedom
It is widely believed that politics and economics are separate and largely unconnected; that individual freedom is a political problem and material welfare an economic problem; and that any kind of political arrangements can be combined with any kind of economic arrangements. The chief contemporary manifestation of this idea is the advocacy of "democratic socialism" by many who condemn out of hand the restrictions on individual freedom imposed by "totalitarian socialism" in Russia, and who are persuaded that it is possible for a country to adopt the essential features of Russian economic arrangements and yet to ensure individual freedom through political arrangements. The thesis of this chapter is that such a view is a delusion, that there is an intimate connection between economics and politics, that only certain combinations of political and economic arrangements are possible, and that in particular, a society which is socialist cannot also be democratic, in the sense of guaranteeing individual freedom
Economic arrangements play a dual role in the promotion of a free society. On the one hand, freedom in economic arrangements is itself a component of freedom broadly understood, so economic freedom is an end in itself. In the second place, economic freedom is also an indispensable means toward the achievement of political freedom.
The first of these roles of economic freedom needs special emphasis because intellectuals in particular have a strong bias against regarding this aspect of freedom as important. They tend to express contempt for what they regard as material aspects of life, and to regard their own pursuit of allegedly higher values as on a different plane of significance and as deserving of special attention. For most citizens of the country, however, if not for the intellectual, the direct importance of economic freedom is at least comparable in significance to the indirect importance of economic freedom as a means to political freedom.
The citizen of Great Britain, who after World War II was not permitted to spend his vacation in the United States because of exchange control, was being deprived of an essential freedom no less than the citizen of the United States, who was denied the opportunity to spend his vacation in Russia because of his political views. The one was ostensibly an economic limitation on freedom and the other a political limitation, yet there is no essential difference between the two.
The citizen of the United States who is compelled by law to devote something like 10 per cent of his income to the purchase of a particular kind of retirement contract, administered by the government, is being deprived of a corresponding part of his personal freedom. How strongly this deprivation may be felt and its closeness to the deprivation of religious freedom, which all would regard as "civil" or "political" rather than "economic", were dramatized by an episode involving a group of farmers of the Amish sect. On grounds of principle, this group regarded compulsory federal old age programs as an infringement of their personal individual freedom and refused to pay taxes or accept benefits. As a result, some of their livestock were sold by auction in order to satisfy claims for social security levies. True, the number of citizens who regard compulsory old age insurance as a deprivation of freedom may be few, but the believer in freedom has never counted noses.
A citizen of the United States who under the laws of various states is not free to follow the occupation of his own choosing unless he can get a license for it, is likewise being deprived of an essential part of his freedom. So is the man who would like to exchange some of his goods with, say, a Swiss for a watch but is prevented from doing so by a quota. So also is the Californian who was thrown into jail for selling Alka Seltzer at a price below that set by the manufacturer under so-called "fair trade" laws. So also is the farmer who cannot grow the amount of wheat he wants. And so on. Clearly, economic freedom, in and of itself, is an extremely important part of total freedom.
Viewed as a means to the end of political freedom, economic arrangements are important because of their effect on the concentration or dispersion of power. The kind of economic organization that provides economic freedom directly, namely, competitive capitalism, also promotes political freedom because it separates economic power from political power and in this way enables the one to offset the other.
Historical evidence speaks with a single voice on the relation between political freedom and a free market. I know of no example in time or place of a society that has been marked by a large measure of political freedom, and that has not also used something comparable to a free market to organize the bulk of economic activity.
Because we live in a largely free society, we tend to forget how limited is the span of time and the part of the globe for which there has ever been anything like political freedom: the typical state of mankind is tyranny, servitude, and misery. The nineteenth century and early twentieth century in the Western world stand out as striking exceptions to the general trend of historical development. Political freedom in this instance clearly came along with the free market and the development of capitalist institutions. So also did political freedom in the golden age of Greece and in the early days of the Roman era.
History suggests only that capitalism is a necessary condition for political freedom. Clearly it is not a sufficient condition. Fascist Italy and Fascist Spain, Germany at various times in the last seventy years, Japan before World Wars I and II, tzarist Russia in the decades before World War I -- are all societies that cannot conceivably be described as politically free. Yet, in each, private enterprise was the dominant form of economic organization. It is therefore clearly possible to have economic arrangements that are fundamentally capitalist and political arrangements that are not free.
Even in those societies, the citizenry had a good deal more freedom than citizens of a modern totalitarian state like Russia or Nazi Germany, in which economic totalitarianism is combined with political totalitarianism. Even in Russia under the Tzars, it was possible for some citizens, under some circumstances, to change their jobs without getting permission from political authority because capitalism and the existence of private property provided some check to the centralized power of the state.
The relation between political and economic freedom is complex and by no means unilateral. In the early nineteenth century, Bentham and the Philosophical Radicals were inclined to regard political freedom as a means to economic freedom. They believed that the masses were being hampered by the restrictions that were being imposed upon them, and that if political reform gave the bulk of the people the vote, they would do what was good for them, which was to vote for laissez faire. In retrospect, one cannot say that they were wrong. There was a large measure of political reform that was accompanied by economic reform in the direction of a great deal of laissez faire. An enormous increase in the well-being of the masses followed this change in economic arrangements.
The triumph of Benthamite liberalism in nineteenth-century England was followed by a reaction toward increasing intervention by government in economic affairs. This tendency to collectivism was greatly accelerated, both in England and elsewhere, by the two World Wars. Welfare rather than freedom became the dominant note in democratic countries. Recognizing the implicit threat to individualism, the intellectual descendants of the Philosophical Radicals -- Dicey, Mises, Hayek, and Simons, to mention only a few -- feared that a continued movement toward centralized control of economic activity would prove The Road to Serfdom, as Hayek entitled his penetrating analysis of the process. Their emphasis was on economic freedom as a means toward political freedom.
Events since the end of World War II display still a different relation between economic and political freedom. Collectivist economic planning has indeed interfered with individual freedom. At least in some countries, however, the result has not been the suppression of freedom, but the reversal of economic policy. England again provides the most striking example. The turning point was perhaps the "control of engagements" order which, despite great misgivings, the Labour party found it necessary to impose in order to carry out its economic policy. Fully enforced and carried through, the law would have involved centralized allocation of individuals to occupations. This conflicted so sharply with personal liberty that it was enforced in a negligible number of cases, and then repealed after the law had been in effect for only a short period. Its repeal ushered in a decided shift in economic policy, marked by reduced reliance on centralized "plans" and "programs", by the dismantling of many controls, and by increased emphasis on the private market. A similar shift in policy occurred in most other democratic countries.
The proximate explanation of these shifts in policy is the limited success of central planning or its outright failure to achieve stated objectives. However, this failure is itself to be attributed, at least in some measure, to the political implications of central planning and to an unwillingness to follow out its logic when doing so requires trampling rough-shod on treasured private rights. It may well be that the shift is only a temporary interruption in the collectivist trend of this century. Even so, it illustrates the close relation between political freedom and economic arrangements.
Historical evidence by itself can never be convincing. Perhaps it was sheer coincidence that the expansion of freedom occurred at the same time as the development of capitalist and market institutions. Why should there be a connection? What are the logical links between economic and political freedom ? In discussing these questions we shall consider first the market as a direct component of freedom, and then the indirect relation between market arrangements and political freedom. A by-product will be an outline of the ideal economic arrangements for a free society.
As liberals, we take freedom of the individual, or perhaps the family, as our ultimate goal in judging social arrangements. Freedom as a value in this sense has to do with the interrelations among people; it has no meaning whatsoever to a Robinson Crusoe on an isolated island (without his Man Friday). Robinson Crusoe on his island is subject to "constraint," he has limited "power," and he has only a limited number of alternatives, but there is no problem of freedom in the sense that is relevant to our discussion. Similarly, in a society freedom has nothing to say about what an individual does with his freedom; it is not an all-embracing ethic. Indeed, a major aim of the liberal is to leave the ethical problem for the individual to wrestle with. The "really" important ethical problems are those that face an individual in a free society -- what he should do with his freedom. There are thus two sets of values that a liberal will emphasize -- the values that are relevant to relations among people, which is the context in which he assigns first priority to freedom; and the values that are relevant to the individual in the exercise of his freedom, which is the realm of individual ethics and philosophy.
The liberal conceives of men as imperfect beings. He regards the problem of social organization to be as much a negative problem of preventing "bad" people from doing harm as of enabling "good" people to do good; and, of course, "bad" and "good" people may be the same people, depending on who is judging them.
The basic problem of social organization is how to co-ordinate the economic activities of large numbers of people. Even in relatively backward societies, extensive division of labor and specialization of function is required to make effective use of available resources. In advanced societies, the scale on which coordination is needed, to take full advantage of the opportunities offered by modern science and technology, is enormously greater. Literally millions of people are involved in providing one another with their daily bread, let alone with their yearly automobiles. The challenge to the believer in liberty is to reconcile this widespread interdependence with individual freedom.
Fundamentally, there are only two ways of co-ordinating the economic activities of millions. One is central direction involving the use of coercion -- the technique of the army and of the modern totalitarian state. The other is voluntary co-operation of individuals -- the technique of the market place.
The possibility of co-ordination through voluntary co-operation rests on the elementary -- yet frequently denied -- proposition that both parties to an economic transaction benefit from it, provided the transaction is bi-laterally voluntary and informed.
Exchange can therefore bring about co-ordination without coercion. A working model of a society organized through voluntary exchange is a free private enterprise exchange economy -- what we have been calling competitive capitalism.
In its simplest form, such a society consists of a number of independent households -- a collection of Robinson Crusoes, as it were. Each household uses the resources it controls, to produce goods and services that it exchanges for goods and services produced by other households, on terms mutually acceptable to the two parties to the bargain. It is thereby enabled to satisfy its wants indirectly by producing goods and services for others, rather than directly by producing goods for its own immediate use. The incentive for adopting this indirect route is, of course, the increased product made possible by division of labor and specialization of function. Since the household always has the alternative of producing directly for itself, it need not enter into any exchange unless it benefits from it. Hence, no exchange will take place unless both parties do benefit from it. Co-operation is thereby achieved without coercion.
Specialization of function and division of labor would not go far if the ultimate productive unit were the household. In a modern society, we have gone much farther. We have introduced enterprises which are intermediaries between individuals in their capacities as suppliers of service and as purchasers of goods. And similarly, specialization of function and division of labor could not go very far if we had to continue to rely on the barter of product for product. In consequence, money has been introduced as a means of facilitating exchange, and of enabling the acts of purchase and of sale to be separated into two parts.
Despite the important role of enterprises and of money in our actual economy, and despite the numerous and complex problems they raise, the central characteristic of the market technique of achieving co-ordination is fully displayed in the simple exchange economy that contains neither enterprises nor money. As in that simple model, so in the complex enterprise and money-exchange economy, co-operation is strictly individual and voluntary provided: (a) that enterprises are private, so that the ultimate contracting parties are individuals and (b) that individuals are effectively free to enter or not to enter into any particular exchange, so that every transaction is strictly voluntary.
It is far easier to state these provisos in general terms than to spell them out in detail, or to specify precisely the institutional arrangements most conducive to their maintenance. Indeed, much of technical economic literature is concerned with precisely these questions. The basic requisite is the maintenance of law and order to prevent physical coercion of one individual by another and to enforce contracts voluntarily entered into, thus giving substance to "private". Aside from this, perhaps the most difficult problems arise from monopoly -- which inhibits effective freedom by denying individuals alternatives to the particular exchange -- and from "neighborhood effects" -- effects on third parties for which it is not feasible to charge or recompense them. These problems will be discussed in more detail in the following chapter.
So long as effective freedom of exchange is maintained, the central feature of the market organization of economic activity is that it prevents one person from interfering with another in respect of most of his activities. The consumer is protected from coercion by the seller because of the presence of other sellers with whom he can deal. The seller is protected from coercion by the consumer because of other consumers to whom he can sell. The employee is protected from coercion by the employer because of other employers for whom he can work, and so on. And the market does this impersonally and without centralized authority.
Indeed, a major source of objection to a free economy is precisely that it does this task so well. It gives people what they want instead of what a particular group thinks they ought to want. Underlying most arguments against the free market is a lack of belief in freedom itself.
The existence of a free market does not of course eliminate the need for government. On the contrary, government is essential both as a forum for determining the "rules of the game" and as an umpire to interpret and enforce the rules decided on. What the market does is to reduce greatly the range of issues that must be decided through political means, and thereby to minimize the extent to which government need participate directly in the game. The characteristic feature of action through political channels is that it tends to require or enforce substantial conformity. The great advantage of the market, on the other hand, is that it permits wide diversity. It is, in political terms, a system of proportional representation. Each man can vote, as it were, for the color of the he wants and get it; he does not have to see what color the majority wants and then, if he is in the minority, submit.
It is this feature of the market that we refer to when we say that the market provides economic freedom. But this characteristic also has implications that go far beyond the narrowly economic. Political freedom means the absence of coercion of a man by his fellow men. The fundamental threat to freedom is power to coerce, be it in the hands of a monarch, a dictator, an oligarchy, or a momentary majority. The preservation of freedom requires the elimination of such concentration of power to the fullest possible extent and the dispersal and distribution of whatever power cannot be eliminated -- a system of checks and balances. By removing the organization of economic activity from the control of political authority, the market eliminates this source of coercive power. It enables economic strength to be a check to political power rather than a reinforcement.
Economic power can be widely dispersed. There is no law of conservation which forces the growth of new centers of economic strength to be at the expense of existing centers. Political power, on the other hand, is more difficult to decentralize. There can be numerous small independent governments. But it is far more difficult to maintain numerous equipotent small centers of political power in a single large government than it is to have numerous centers of economic strength in a single large economy. There can be many millionaires in one large economy. But can there be more than one really outstanding leader, one person on whom the energies and enthusiasms of his countrymen are centered? If the central government gains power, it is likely to be at the expense of local governments. There seems to be something like a fixed total of political power to be distributed. Consequently, if economic power is joined to political power, concentration seems almost inevitable. On the other hand, if economic power is kept in separate hands from political power, it can serve as a check and a counter to political power.
The force of this abstract argument can perhaps best be demonstrated by example. Let us consider first, a hypothetical example that may help to bring out the principles involved, and then some actual examples from recent experience that illustrate the way in which the market works to preserve political freedom.
One feature of a free society is surely the freedom of individuals to advocate and propagandize openly for a radical change in the structure of the society -- so long as the advocacy is restricted to persuasion and does not include force or other forms of coercion. It is a mark of the political freedom of a capitalist society that men can openly advocate and work for socialism. Equally, political freedom in a socialist society would require that men be free to advocate the introduction of capitalism. How could the freedom to advocate capitalism be preserved and protected in a socialist society?
In order for men to advocate anything, they must in the first place be able to earn a living. This already raises a problem in a socialist society, since all jobs are under the direct control of political authorities. It would take an act of self-denial whose difficulty is underlined by experience in the United States after World War II with die problem of "security" among Federal employees, for a socialist government to permit its employees to advocate policies directly contrary to official doctrine.
But let us suppose this act of self-denial to be achieved. For advocacy of capitalism to mean anything, the proponents must be able to finance their cause -- to hold public meetings, publish pamphlets, buy radio time, issue newspapers and magazines, and so on. How could they raise the funds ? There might and probably would be men in the socialist society with large incomes, perhaps even large capital sums in the form of government bonds and the like, but these would of necessity be high public officials. It is possible to conceive of a minor socialist official retaining his job although openly advocating capitalism. It strains credulity to imagine the socialist top brass financing such "subversive" activities.
The only recourse for funds would be to raise small amounts from a large number of minor officials. But this is no real answer. To tap these sources, many people would already have to be persuaded, and our whole problem is how to initiate and finance a campaign to do so. Radical movements in capitalist societies have never been financed this way. They have typically been supported by a few wealthy individuals who have become persuaded -- by a Frederick Vanderbilt Field, or an Anita McCormick Blaine, or a Corliss Lamont, to mention a few names recently prominent, or by a Friedrich Engels, to go farther back. This is a role of inequality of wealth in preserving political freedom that is seldom noted -- the role of the patron.
In a capitalist society, it is only necessary to convince a few wealthy people to get funds to launch any idea, however strange, and there are many such persons, many independent foci of support. And, indeed, it is not even necessary to persuade people or financial institutions with available funds of the soundness of the ideas to be propagated. It is only necessary to persuade them that the propagation can he financially successful; that the newspaper or magazine or book or other venture will be profitable. The competitive publisher, for example, cannot afford to publish only writing with which he personally agrees; his touchstone must be the likelihood that the market will be large enough to yield a satisfactory return on his investment.
In this way, the market breaks the vicious circle and makes it possible ultimately to finance such ventures by small amounts from many people without first persuading them. There are no such possibilities in the socialist society; there is only the all-powerful state.
Let us stretch our imagination and suppose that a socialist government is aware of this problem and is composed of people anxious to preserve freedom. Could it provide the funds? Perhaps, but it is difficult to see how. It could establish a bureau for subsidizing subversive propaganda. But how could it choose whom to support? If it gave to all who asked, it would shortly find itself out of funds, for socialism cannot repeal the elementary economic law that a sufficiently high price will call forth a large supply. Make the advocacy of radical causes sufficiently remunerative, and the supply of advocates will be unlimited.
Moreover, freedom to advocate unpopular causes does not require that such advocacy be without cost. On the contrary, no society could be stable if advocacy of radical change were costless, much less subsidized. It is entirely appropriate that men make sacrifices to advocate causes in which they deeply believe. Indeed, it is important to preserve freedom only for people who are willing to practice self-denial, for otherwise freedom degenerates into license and irresponsibility. What is essential is that the cost of advocating unpopular causes be tolerable and not prohibitive.
But we are not yet through. In a free market society, it is enough to have the funds. The suppliers of paper are as willing to sell it to the Daily Worker as to the Wall Street Journal. In a socialist society, it would not be enough to have the funds. The hypothetical supporter of capitalism would have to persuade a government factory making paper to sell to him, the government printing press to print his pamphlets, a government post office to distribute them among the people, a government agency to rent him a hall in which to talk, and so on.
Perhaps there is some way in which one could overcome these difficulties and preserve freedom in a socialist society. One cannot say it is utterly impossible. What is clear, however, is that there are very real difficulties in establishing institutions that will effectively preserve the possibility of dissent. So far as I know, none of the people who have been in favor of socialism and also in favor of freedom have really faced up to this issue, or made even a respectable start at developing the institutional arrangements that would permit freedom under socialism. By contrast, it is clear how a free market capitalist society fosters freedom.
A striking practical example of these abstract principles is the experience of Winston Churchill. From 1933 to the outbreak of World War II, Churchill was not permitted to talk over the British radio, which was, of course, a government monopoly administered by the British Broadcasting Corporation. Here was a leading citizen of his country, a Member of Parliament, a former cabinet minister, a man who was desperately trying by every device possible to persuade his countrymen to take steps to ward off the menace of Hitler's Germany. He was not permitted to talk over the radio to the British people because the BBC was a government monopoly and his position was too "controversial".
Another striking example, reported in the January 26, 1959 issue of Time, has to do with the "Blacklist Fadeout". Says the Time story,
The Oscar-awarding ritual is Hollywood's biggest pitch for dignity, but two years ago dignity suffered. When one Robert Rich was announced as top writer for the The Brave One, he never stepped forward. Robert Rich was a pseudonym, masking one of about 150 writers . . . blacklisted by the industry since 1947 as suspected Communists or fellow travelers. The case was particularly embarrassing because the Motion Picture Academy had barred any Communist or Fifth Amendment pleader from Oscar competition. Last week both the Communist rule and the mystery of Rich's identity were suddenly rescripted.
Rich turned out to be Dalton (Johnny Got His Gun) Trumbo, one of the original "Hollywood Ten" writers who refused to testify at the 1947 hearings on Communism in the movie industry. Said producer Frank King, who had stoutly insisted that Robert Rich was "a young guy in Spain with a beard": "We have an obligation to our stockholders to buy the best script we can. Trumbo brought us The Brave One and we bought it". . . .
In effect it was the formal end of the Hollywood black list. For barred writers, the informal end came long ago. At least 15% of current Hollywood films arc reportedly written by blacklist members. Said Producer King, "There are more ghosts in Hollywood than in Forest Lawn. Every company in town has used the work of blacklisted people. We're just the first to confirm what everybody knows."
One may believe, as I do, that communism would destroy all of our freedoms, one may be opposed to it as firmly and as strongly as possible, and yet, at the same time, also believe that in a free society it is intolerable for a man to be prevented from making voluntary arrangements with others that are mutually attractive because he believes in or is trying to promote communism. His freedom includes his freedom to promote communism. Freedom also, of course, includes the freedom of others not to deal with him under those circumstances. The Hollywood blacklist was an unfree act that destroys freedom because it was a collusive arrangement that used coercive means to prevent voluntary exchanges. It didn't work precisely because the market made it costly for people to preserve the blacklist. The commercial emphasis, the fact that people who are running enterprises have an incentive to make as much money as they can, protected the freedom of the individuals who were blacklisted by providing them with an alternative form of employment, and by giving people an incentive to employ them.
If Hollywood and the movie industry had been government enterprises or if in England it had been a question of employment by the British Broadcasting Corporation it is difficult to believe that the "Hollywood Ten" or their equivalent would have found employment. Equally, it is difficult to believe that under those circumstances, strong proponents of individualism and private enterprise -- or indeed strong proponents of any view other than the status quo -- would be able to get employment.
Another example of the role of the market in preserving political freedom, was revealed in our experience with McCarthyism. Entirely aside from the substantive issues involved, and the merits of the charges made, what protection did individuals, and in particular government employees, have against irresponsible accusations and probings into matters that it went against their conscience to reveal? Their appeal to the Fifth Amendment would have been a hollow mockery without an alternative to government employment.
Their fundamental protection was the existence of a private-market economy in which they could earn a living. Here again, the protection was not absolute. Many potential private employers were, rightly or wrongly, averse to hiring those pilloried. It may well be that there was far less justification for the costs imposed on many of the people involved than for the costs generally imposed on people who advocate unpopular causes. But the important point is that the costs were limited and not prohibitive, as they would have been if government employment had been the only possibility.
It is of interest to note that a disproportionately large fraction of the people involved apparently went into the most competitive sectors of the economy -- small business, trade, farming -- where the market approaches most closely the ideal free market. No one who buys bread knows whether the wheat from which it is made was grown by a Communist or a Republican, by a constitutionalist or a Fascist, or, for that matter, by a Negro or a white. This illustrates how an impersonal market separates economic activities from political views and protects men from being discriminated against in their economic activities for reasons that are irrelevant to their productivity -- whether these reasons are associated with their views or their color.
As this example suggests, the groups in our society that have the most at stake in the preservation and strengthening of competitive capitalism are those minority groups which can most easily become the object of the distrust and enmity of the majority -- the Negroes, the Jews, the foreign-born, to mention only the most obvious. Yet, paradoxically enough, the enemies of the free market -- the Socialists and Communists -- have been recruited in disproportionate measure from these groups. Instead of recognizing that the existence of the market has protected them from the attitudes of their fellow countrymen, they mistakenly attribute the residual discrimination to the market.
komuniagos siekia revanšo ir toliau mojuoja kirviais. Tuoj ir verksnys Vaišvila su Ozolu pradės spausdintis. Ir kas toliau? O siaurovizija su kita užvaldyta žiniasklaida skelbs, kad Landsbergis skaldo tautą. Visa tai jau buvo ir bus. Kaip neįdomu.
o kodel neitraukei i savo sarasa Jim Marrs?
ir vel kova pries. ka siulai, Klimka? razrushim stary mir, postroim novy? gi tai jau buvo
Vilniaus socialistų-idiotų mafijos dvasinis vadovas Karolis Klimka ir vėl su savo „chebra“ mojuoja dar viena samokslo teorija, gasdindamas kietos Naujųjų Komunistų rankos išsiilgusius baudžiauninkus. Nors iš tiesų norėtų tik tų pačių baudžiauninkų pagalba uzurpuoti teises privatizuoti visuomenės išteklius ir turtą.
Mes taip pat neakli ir nekurti, tačiau labai durni.
Tiems, kuriuos šokiruoja A. Kubilius ir Seimas