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Randall Raus

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The Monetary Policy of the USA
by Randall Raus   

Last edited: Thursday, October 23, 2003
Posted: Tuesday, October 21, 2003

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There are those who stubbornly believe in the gold standard (in fact, Alan Greenspan did at one time). They (the critics) say our banking system is so elastic, it's illogical.

Why do we have the monetary system we have? And why does it work? Here is my answer.

The following article was written at the tail end of America's last expansion, but with an eye to the future--it proved to be somewhat prescient (i.e. the dollar has fallen, and manufacturing is expected to improve).

The Monetary Policy of the USA

American consumers have always lived on future earnings to a certain extent, and in the last ten years that has been especially true . This fact, in itself, doesn't necessarily mean very much. Strong offshore demand for the dollar (as the preferred vehicle for bank deposits and securities) has kept inflation at bay--despite a growing money supply--allowing the central bank to continue to ease credit.

In other words, it is the steadiness of the USA's economy that has led to demand for the dollar, thus making consumer loans possible.

However, even if the dollar were worth less, it still wouldn't necessarily be a bad thing (as Japan's booming export led economy of the 1980's demonstrated). There would indeed be less consumer credit, and the service economy would undoubtedly shrink, but the lower cost of goods exported from America would inevitably result in a buildup of the USA's manufacturing sector. Thus, America would do well either way.

Having said all that, a steadily expanding money supply is extremely important, and perhaps critical, to a healthy economy (e.g. the USA's money supply actually decreased just prior to the great depression of the 30's).

It is not often discussed, but the USA went through a period of hyperinflation during its war for independnce war (caused by printing paper money to finance the war). This caused so many problems (rioting, insurrection, etc.) during, and after the revolution, that George Washington decided to put America on the gold standard, making inflation impossible.

Moving forward about a hundred years, one of America's greatest leaders was William Jennings Bryan, who ran for, and almost won, the presidency three times. Bryan strongly advocated the tolerance of some inflation (by allowing the free coinage of silver). This, he said, would prevent severe economic downturns, and the suffering that goes with them. His "Cross of Gold Speech" ("mankind shall not be crucified on a cross of gold"), is considered one of the greatest speeches in history. But he lost, and America remained on a strict gold standard.

To make a long story short, the Federal Reserve System was created in 1913, which allowed the creation of money, but because the USA remained on the gold standard, only increases in the money supply equal to the growth of the economy were possible. Later, during the 1930's depression, President Franklin D. Roosevelt, a banker, at last took the USA off the gold standard. This established America's modern banking system.

The steady expansion of the money supply at a rate faster than economic growth--resulting in some inflation--is critically important. Money acts as a lubricant to the economy in the same way that oil does for a car's engine. If a an economy is not lubricated by money (oil in the case of a car's engine), it will cinch-up, and stop working. This is because creation of money allows for things going wrong, and in a imperfect world, things do indeed go wrong. For example, in a perfect world, an automobile's engine would not need to run in a bath of oil, because there would be no friction. Economically, in a perfect world, there would be steady growth with businesses, consumers, and goverment agencies paying their debts on time. And, in a perfect world, no individual, company, or agency would ever default. And there would not be shortages of raw material of any kind, or trade wars, or any of the many other things that cause downturns. But the economic world is imperfect in literally thousands of ways--everyday. So there must be something that compensates for that reality.

In America we have found--through a long process of trial and error--that the increase in the money supply should exceed economic growth by about two per cent annually. (This results in an inflation rate nearly the same--about two per cent a year.) If higher inflation rates are tolerated, the result is a variety of excesses that prove damaging to the economy.

The above can be illustrated by examining two post World War II periods: 1. During the thirteen year period from 1953 through 1965, inflation averaged 1.4 %, and personal income increased steadily, however, 2. during the nine year period from 1973 through 1981 inflation averaged an almost double digit 9.1 %, and incomes actually dropped--the only thing that resulted in some economic growth was the expansion of the work force (especially as woman flooded into the labor market to make ends meet).

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Reviewed by Randall Raus

From the writer:

Sorry for all the apostrophes that came out as double quotes. Soon as Author's Den tell me what's wrong I'm going to repost the article.

Also, I'm going to re-edit and rewrite, putting the historical references in perspective, adding one or two specific examples (the analogy with car's engine in itself is too vague), make the ending less abrupt, and clarify the references to the gold standard.

I won't change more than a hundred words, but it will require a lot of thought and research, so please bear with me.

On my web site this article looked great (check it out for yourself - click on Economist), and it was aimed for a different readership (in that context it was appropriate).
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