In the U.S., there's now really no check on monetary action. If you go back and compare the present day with the 1950s, when McChesney Martin was running the Fed, there were several checks on the central bank’s freedom of action. There was the definition of the dollar as one-thirty-fifth of an ounce of gold. Americans couldn't own the stuff legally, but foreign central banks and treasuries had the right to exchange green pieces of paper for gold at the statutory rate of $35 an ounce. A second check was a related check: the international payments position of the United States, which held that a chronic balance of payments was something to be avoided because that constrained our economic lives. This meant that interest rates had to be higher. It was something they had to navigate around at the Fed. They were also concerned about any show of inflation. When the inflation rate got to one percent or two percent, they were worried that it was accelerating. Martin and most of the brethren at the Fed thought this was a clear and present danger to the integrity of the dollar.
Contrast this to the present day. I can't see any constraint. They say that they want inflation, that they won't settle for less than two percent. Over a long and healthy life, that means the price level rises by five times. There's no particular constraint on America's foreign balance of payments. With the dollar being undefined, certainly there's no call on the collateral supporting the dollar --because there is no collateral. The Fed has almost uniquely a free hand in doing what it’s doing and the other central banks share the same body of economic doctrine. As we speak, we are digesting the news that China has sent up a trial balloon, that it too might do a little bit of quantitative easing.
OR: Do you think this is a currency war?
Grant: I don't think it’s a war. I think that the central bankers are in alliance against the people: the people are the holders of the money. Nowadays, money is no longer principally a store of value -- it is the instrument of public policy. That's something new and different as well. Money turning out to be, I mean, actually just a bunch of promises denominated in a currency that can be materialized and dematerialized by a keystroke. How could anyone have thought that this was a store of value? It’s not a store of value necessarily. The nature of currency is that it’s non-corporeal, it doesn't exist to the touch. You can touch the paper but that's not where the money really is -- the money is in the cloud, a digital entry on a server somewhere.
But the problem is not even so much the disembodied thing we call money. The problem is, I think, a problem of ideas. It’s that central bankers now have a mandate -- one we have collectively given them and one against which we don't protest -- to manipulate this thing we all agree to call money in the interest of another abstraction we call the gross domestic product.
OR: Do you think that the idea that we can actually measure the economy with precision is something of a fallacy as well?
Grant: Yes. I invite the learned economists who would dispute this to reread a book called The Accuracy of Economic Observations by Oskar Morgenstern. First published in about 1950, subsequently revised. The new edition is even more helpful. This book contends that there's a great deal of pretense in the collection and a great deal of gullibility, of credulousness, in the reading of these data.
I think it’s important to at least to recognize that the idea of “the economy” did not exist until the 1930s or 40s. I think Paul Samuelson really brought it into the mainstream. There was no “economy” before that. When people referred to “economy,” they were talking about essentially budgetary economy: government, don't spend so much. The idea of a macro-economy as something to be measured and manipulated is a very new thing under the sun.
OR: You wrote an exceptional book about that period of time -- i.e., before the “economy” existed -- called The Forgotten Depression. Could you explain what happened in 1920-21 and what was done about it?
Grant: World War I gave rise to a terrific inflation, which lasted through 1919. It destroyed currencies that had been not only as good as gold, but were gold. The German currency among them, and the French franc. Those it didn't destroy, it severely wounded. This was followed by a violent deflation and the titular depression, which took the form of a twenty-odd percent decline in industrial production. Unemployment rates -- not then measured -- almost certainly reached the double digits. Stock prices were sawed in half. Commodity prices were down more than 40 percent, faster and more violently than they even were in the 1929 and 1933 depressions.
So what did the authorities do about it? Essentially nothing.
The government balanced the budget with no thought of fiscal stimulus (that concept was not invented). The Federal Reserve actually raised rates. If you listen to the weather reports on the radio, you're likely to hear something called the real-feel temperature: the temperature adjusted for the force of the wind. The real-feel interest rate, adjusted for falling commodity prices or falling prices generally, was much higher than even the seven percent rate the Fed imposed in 1920. Closer to 15 percent or even 20 percent. A terrifically contractionary set of policies, as we would now describe them.
So how did we get out of it? Because prices moved more or less freely. Prices collapsed but wages also fell enough to restore the profit margins of businesses. If wages had stayed where they were and selling prices had gone down, businesses would have been unprofitable and millions left insolvent. There were a number of bankruptcies anyway. Harry Truman's haberdashery in Kansas City failed. But because prices and wages were allowed to be flexible through the downside as well as the upside, the economy righted itself. Money came into the country in the shape of gold. Labor was cheap, assets were cheap. Equities, real estate: all beaten down. People seeking their own best interests organized themselves in the form of a prosperity brigade. By the time of the automobile in 1921, there were labor shortages in Detroit.
James Grant, financial journalist and historian, is the founder and editor of Grant’s Interest Rate Observer. His most recent book is The Forgotten Depression, 1921: the Crash That Cured Itself.