Today’s Federal Open Market Committee (FOMC) meeting comes two weeks after the U.S. Treasury prodded major banks to create a $60-$100 billion structured credit facility to shore up the asset-backed commercial paper market. Treasury’s decision was another attempt to mollify the markets, after the FOMC had already slashed the federal funds rate by 50 basis points to 4.75 percent. So far, it hasn’t worked, and U.S. interest-rate futures suggest that the Fed may today cut its target rate by another 25 basis points.

Given the current panoply of worries—the housing crunch, rising oil prices, decreased consumer spending, depressed corporate profits, and slowing growth in Japan and Europe—most economists appear to welcome such a move. Harvard’s Martin Feldstein summed up the conventional wisdom last month when he said the federal funds rate should drop to 4.25 percent or less in order to prevent a significant economic downturn.

Not so fast. While it is true that substantial housing crises have often presaged a recession, the U.S. economy still has considerable strengths and solid growth prospects. What matters now is that monetary policy be oriented toward sustainable economic growth—which is to say, we need a policy that acknowledges the long-term linkage between sound money and solid, sustainable growth. Financial markets—and economic agents—are highly efficient at discounting the future into the present, and they will react positively if the Fed moves to defend the dollar’s value and stability.

Adam Smith described the factors conducive to wealth creation as those consistent with the institutions found in a free-market, limited-government society, and history has proven him right. The hallmark of a capitalist economy is the institutional framework that guarantees human progress: private ownership of the means of production, which ensures the accumulation of capital; specialization and the division of labor, which support entrepreneurship; exchange on markets guided by the price system, which effectively allocates scarce resources; and a stable monetary system, as money permits indirect exchange and economic calculation.  

It is interesting to note that all of these factors boost labor productivity, which is the sine qua non of wealth creation. But it is also important to understand the centrality of sound money within this framework.

Exchange can be either direct, via barter, or indirect, via money, which serves as a medium of exchange and a unit of calculation. Because indirect exchange is so much more efficient than barter, the use of money radically intensifies the division of labor, fueling further specialization and growth in the productivity of labor. Additionally, stable money permits effective calculation of both retrospective profit and loss and prospective financial planning, which aids in both resource allocation and capital formation.

For these reasons, economists from Ludwig von Mises to Milton Friedman have held that sound money is crucial to economic growth. And, while Karl Marx’s notion that money would disappear in a socialist society showed a poor understanding of its economic role, Lenin inadvertently swerved into the truth when he (allegedly) said that the best way to destroy a capitalist economy is to debauch the currency. This is a reality that, over the long run, discredits the Phillips Curve, the alleged inverse relationship between inflation and unemployment. Instead, long-term monetary stability permits efficient exchange and calculation, which drives economic growth and employment. Indeed, there is a significant relationship between price stability and economic growth in market economies.

In order to promote monetary stability, the Fed must make the crucial distinction between defending liquidity and bailing out insolvency.

Inflation, on the other hand, is the scourge of a market economy. It punishes fixed-income recipients, who face higher prices; transfers wealth from creditors to debtors; discourages capital formation and long-term planning, due to the vagaries of future valuation; and distorts relative prices throughout the economy—all of which harm trade and disturb the efficient allocation of resources.

Given the nexus between sound money and economic growth, how should we evaluate recent Fed policy and the wisdom of another rate cut? The Fed is technically governed by the Full Employment Act of 1946 and the Humphrey-Hawkins Act of 1978, which call for promotion of full employment, economic growth, moderate long-term interest rates, and stable prices. As Friedman repeatedly observed, these objectives are neither mutually compatible nor directly accessible to policy instruments, and such conflicting goals have turned Fed policy into a random walk. Even worse, they have led the Fed to cause, rather than ameliorate, cyclical downturns.

Consider the present environment. From late 2001 to 2004—in the wake of a global recession, terrorist attacks, and war—U.S. monetary policy pursued a dramatic reduction in short-term interest rates. Indeed, for much of that period the real federal funds rate was negative. When interest rates are artificially held below their natural level, investors get false signals, particularly in interest-sensitive capital goods sectors, such as housing and construction, which experience a boom. The falsified interest rates induce a flurry of lending and investment in capital goods, and hiring and spending increase in these sectors. Conversely, financial institutions, which now have an excess of reserves to lend due to the Fed’s expansionary policy, seek out borrowers of dubious credit. For several quarters, or even years, a general economic boom occurs.

But the housing and capital goods booms—along with the loans to marginal borrowers—are not based on real savings. Rather, they are based on a spike in fiduciary credit triggered by Fed policies that inject reserves into the banking system to cut interest rates and fuel the boom. As such, some increases in spending and employment are unsustainable, and marginal projects undertaken without the backing of real demand may face insolvency.

Eventually the central monetary authority faces a dilemma, which is roughly where we are now. It can compound its errant intervention by accelerating the expansionary policy, keeping interest rates below where they would be otherwise. Or it can allow interest rates to return to their natural levels and thereby cause an economic slowdown, as marginal projects are liquidated, assets are repriced, and labor markets readjust.

As dislocations deepen, postponement usually makes the eventual correction more painful. But a bigger problem with continued monetary ease is the loss of confidence in the Fed’s commitment to protecting a strong American dollar. Given that the dollar serves as a global reserve currency, a flight from dollar-denominated assets abroad could mean a return to 1970s-style inflation and global recession.

Since the Fed’s rate cut on September 18th, there has been predictable fallout. The U.S. dollar has plunged to record lows against the euro and other major currencies. Oil prices have climbed to all-time highs, surpassing $90 per barrel, and the price of gold has also soared. Meanwhile, the U.S. consumer price index is trending upward, and a collapsing dollar will only accelerate this.

It is not difficult to imagine what Friedman would make of the present situation. Toward the end of his life he was worried about a decline in anti-inflation vigilance. Knowing how important sound money is to growth, Friedman understood the challenge posted by a worldwide system of managed fiat currencies run through fractional-reserve banking systems. He also understood the crucial distinction between defending liquidity and bailing out insolvency.

From this viewpoint, the present moment does not call for a further easing of U.S. monetary policy. It calls for a return to the basics. The Fed should control the growth of the monetary base (currency, Fed reserves, and demand deposits) and defend the dollar.

John L. Chapman is an NRI fellow in economics at the American Enterprise Institute.