June 12, 2012 Reading Time: 8 minutes

By James Grant

Bailouts, bear markets and joblessness will surely put capitalism on the November ballot. How do you like your enterprise, Mr. and Ms. American Voter—free or stifled or a little something in between?

The 2012 election promises a clear ideological divide. Mitt Romney may be no Ron Paul, but neither is there any mistaking him for Barack Obama. The former private-equity titan will likely take his stand with a kind of almost-free-enterprise—the welfare state as we knew it before ObamaCare, so-called quantitative easing and the enterprise-thwarting dread that someone in Washington is dreaming up even costlier experiments than the ones that have already failed.

“Capitalism” is the epithet that 19th-century collectivists foisted on the economic system of private property and the invisible hand. It’s a name that wins no friends for the cause of enterprise. A socialist, supposedly, cares for society. A capitalist ostensibly loves only his stocks and steel mills and strikebreakers. The PR battle was almost lost at the naming.

Books upholding capitalism or denouncing it are as old as the printing press—as to the denunciation, indeed, it is much older. Aristotle and the church fathers condemned the acquisitive spirit. Voltaire and Adam Smith praised it. America’s original WASPs were of two minds. Hard work and enterprise were godly virtues, but the virtuous man, by practicing them, could hardly help getting rich. Which is when the trouble started. “Religion begot prosperity,” lamented Cotton Mather, “and the daughter devoured the mother.”

As time went by, statism devoured prosperity. Today the American economy sleepwalks. Ultralow interest rates starve the savers and finance the speculators. Unanchored exchange rates fire up talk of “currency wars.” Where have we gone wrong, and what must we do to turn right?

Allan H. Meltzer and Luigi Zingales, free-market economics professors, have some ideas. Each urges more scope for enterprise and less for government, though neither protests against the monetary arrangements that give the government nearly unchecked and arbitrary financial power. “Two Cheers for Capitalism” was the title of Irving Kristol’s qualified endorsement of American enterprise published in 1978. Messrs. Meltzer and Zingales seem prepared to award most of a third cheer—providing we adopt their simple suggestions.

Mr. Zingales prefaces his sometimes wonky policy prescriptions with a personal plea. “I came here in 1988 from Italy because I was trying to escape a system that was fundamentally unfair,” he writes. Statism, Italian-style, was that system. “I would gently suggest,” he addresses his American readers, “that you have no idea what it’s like to live in a country where there is virtually no meritocracy and competition is considered a sin.”


Well, maybe you do have an inkling, Mr. Zingales reconsiders, as he enumerates the ways in which Silvio Berlusconi’s Italy seems to have followed him across the Atlantic. He attacks the notion that some banks are too big to fail, and he excoriates the individuals who exploit this cozy arrangement. He names, for instance, Jim Johnson, a former CEO of Fannie Mae and still a director of Goldman Sachs, and Robert Rubin, the one-time Treasury secretary and famously inattentive director of Citigroup who admitted in 2007 that he had had “no familiarity at all with CDOs,” the mortgage securities that blew a hole in the bank that was paying him $17 million a year. On and off Wall Street, Mr. Zingales contends, crony capitalism is displacing fair and free competition.

What to do about it? A chaired professor at the University of Chicago’s Booth School of Business, Mr. Zingales is out to rebuild the American meritocracy. He wants to shame Washington lobbyists, to empower the American health-care consumer and to make corporate directors truly accountable to the shareholders. As for business schools, they “should stand up for what they think is the individual responsibility of a good capitalist.”

In regulation, Mr. Zingales demands simplicity. Let us have three focused federal regulatory agencies, not the chaos of competing bureaus that now confuse the situation. One of these entities would stand guard against inflation, another would protect the consumer and a third would keep the banks off the rocks by heading off financial crises before they come to pass (this one will hire clairvoyants).

And then, he adds, let us hold the functionaries’ feet to the fire. We can grade the price-stability agency by watching inflation expectations (the Treasury’s inflation-protected securities provide a handy guide). The consumer-protection agency will succeed or fail according to the level of public trust in American financial institutions (surveys will elicit that information). And we will know all we have to know about the competence of the panic-prevention board by monitoring the cost of insuring the big lumbering banks against insolvency (the market in credit-default swaps will sound the alarm).

“Why Capitalism?” asks Allan H. Meltzer, star professor at Carnegie Mellon University, and he sensibly answers: because it works. Kristol regretted the absence of a capitalist moral compass. None, really, is to be had, Mr. Meltzer says. He quotes Immanuel Kant: “Out of timber so crooked as that from which man is made, nothing entirely straight can ever be carved.”

For the distracted, part-time observer of our economic and financial affairs, Mr. Meltzer’s slim volume may fill the bill. In less than 150 pages of text, he takes on the welfare state, bank regulators, America’s fiscal mess and foreign aid. Generally speaking, the author believes that that government is best which governs least and that the price mechanism allocates resources better than the White House does. But he made a better case for the redeeming power of markets in the first fat volume of his two-volume chronicle of the Fed, “A History of the Federal Reserve” (2003). The relevant section deals with a depression that miraculously cured itself.

Between January 1920 and August 1921, the unemployment rate in the United States jumped to 14% or so from about 2% (as it was then inexactly measured); wholesale prices plunged by more than 40%; and industrial production fell by 23%. The farm economy reeled, and there were waves of business failures—in Kansas City, the firm of Truman & Jacobson, a men’s-wear retailer, went bankrupt, though the first named partner would recover his courage and later win the presidency. “Ain’t we got fun?” is the mordant rhetorical question posed by the title of the hit tune of 1921.

The administration of Warren G. Harding responded to this macroeconomic disaster by running a budgetary surplus. The Fed didn’t lower interest rates but raised them. In response to this bitter medicine, or perhaps despite it, the economy staged the kind of bounce-back that the Obama administration can only pine for. In 1922, the first full year of recovery, industrial production leapt by 27.3%. By 1923, joblessness was back to 3%.

Mr. Meltzer, a monetarist, takes due note of the fact that, from the peak to the trough of the 1920-21 business cycle, the sum of checking accounts and currency fell by 10.9%. Such a collapse, nowadays, would call forth a gust of Federal Reserve intervention. Absent radical money printing—”QE” was not even a gleam in the central bank’s eye at this point—how did the American economy right itself? How did the banking system survive?

One part of the answer, Mr. Meltzer says, was that gold rushed into the country. Because gold was money (governments acknowledged it as such), the inflow delivered a monetary pick-me-up. There was no mystery why funds moved to these shores: America was on the bargain counter. Stocks, bonds and commodities had taken a beating. Value-minded foreigners seized the opportunity to buy them. No central banker had to lead investors by the hand.

The plunge in prices meant that the dollar bills in American wallets went further, too. Mr. Meltzer calls this rise in the purchasing power of money the “real balances” effect. “The public used its increase in money balances to purchase goods and assets,” he writes. “Judging from stock market prices, after July 1921 asset prices rose absolutely and relative to prices of new production, stimulating the demand for new production. The change in relative prices and real wealth more than offset the negative effect of high real interest rates on spending.” As for American banking, the biggest casualty was the little First National Bank of Cleburne, Texas, with deposits of $2.8 million. No bank was designated “too big to fail” in those days—and not one big bank did.

For all the talking that Fed Chairman Ben Bernanke does about the Great Depression of the 1930s, he has nothing to say about the not-great depression of the 1920s. It was ugly and sharp, but it ended 18 months after it began. And in the course of it ending, the Treasury reduced the public debt to $22.9 billion from $24.3 billion. According to 21st-century doctrine, producers and consumers are incapable of climbing out of a deflationary hole without a government-provided fiscal and monetary ladder. Nonetheless, in this particular unsung depression, individuals managed the trick, which suggests that markets work if only we let them.

“In 1920-21,” relates Benjamin Anderson, a bank economist who witnessed the goings-on, “we took our losses, we readjusted our financial structure, we endured our depression, and in Aug. 1921 we started up again.” At any rate, the Harding depression presents a provocative comparison to the Hoover-and-Roosevelt depression that began in 1929 and didn’t end, as Robert Higgs persuasively argues in his 2006 book, “Depression, War and Cold War,” until 1946.

Neither Mr. Meltzer nor Mr. Zingales is a fan of the Federal Reserve—Mr. Meltzer is an especially withering critic—but neither makes a fundamental case against the pure paper dollar, the Fed’s stock in trade. Mr. Meltzer declares that the principal alternative to fiat money, the gold standard, has no place in a modern economy “because democratic governments, reflecting voters’ concerns, prefer now to keep unemployment rates low rather than stabilize prices via the price of gold.” The alleged trade-off between stable prices and unemployment under a gold standard, however, he asserts but does not prove. Nor does he pause to note that, under the Bernanke standard, America’s unemployment rate has topped 8% for 3½ years running. For no potential employer is uncertainty as to the timing of the next adventure in money printing a confidence-builder.

Mr. Meltzer, a devotee of Milton Friedman, one of the 20th century’s pre-eminent apologists for fiat money, is true to the monetarist faith. For Mr. Zingales, however, I have high hopes—perhaps in his next book. As he detests statism, so may he come to recoil from modern monetary methods.

What are these methods? Fixing an interest rate, manipulating the structure of interest rates and goosing the stock market in the name of “stimulating” the economy are prime examples. Many argue that these radical interventions have spared us from another Great Depression. More likely, I think, the same machinations have snuffed out whatever chance we had of dealing with our difficulties as efficiently as our forebears did in the not-great depression of the early 1920s.

Not since 1971 has anyone had the right to exchange a dollar bill at the Treasury for a fixed and statutory weight of gold or silver. Most of us have forgotten that the dollar was ever exchangeable into anything except small coins. We collectively nod in agreement at the dubious proposition that the Fed should have the power to manipulate the value of the money we spend and save, just as it suits the government’s purposes.

Herbert Hoover is not often invoked as an authority on monetary economics, but the memoirs of the 31st president are full of wise words on the relationship between the citizen and his government. The gold-exchange standard of the late 1920s and 1930s, a third-rate version of the classical gold standard in place before World War I, failed as a monetary mechanism. But it did serve a constitutional purpose. Hoover wrote:

Currency convertible into gold of the legal specifications is a vital protection against economic manipulation by the government. As long as currencies are convertible, governments cannot easily tamper with the price of goods, and therefore the wage standards of the country. They cannot easily confiscate the savings of the people by manipulation of inflation and deflation. . . . Once free of convertible standards, the executives of every “managed-currency” country had gone on a spree of government spending, and the people thereby lost control of the public purse—their first defense against tyranny.

Mr. Meltzer and Mr. Zingales—and Mr. Romney, too—pledge their fealty to the ideal of the free market. But each accepts a monetary system that replaces a fixed and objective standard of value with a changeable and subjective one. Do you wonder how to restore monetary power in the people and put a spring back in the step of the capitalists? “The True Gold Standard,” by Lewis E. Lehrman, published in 2011, is available on Amazon.

—Mr. Grant is the editor of Grant’s Interest Rate Observer.

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