Winter 2020 Cato Journal in Review: Monetary Policy, International Conflict, U.S. History, and More

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cato journal, cj, monetary policy, phillips curveThe winter 2020 edition of the Cato Journal is now available online! Articles in this issue discuss a range of topics—from the proper size of government, to the relationship between tariffs and monetary policy, to the life and legacy of Frederick Douglass. Below, you’ll find summaries of each article, with links to the full-text versions embedded in the titles.


“Freedom and Authority: ‘Right-Sizing’ Government,”

John Norton Moore, Professor, University of Virginia School of Law

This edition’s inaugural article begins by asking: where should we turn for answers about the proper size, and role, of government? Moore suggests that “individual exchange, or markets,” which he deems an “alternative” to government (not insofar as they are antithetical to government, but insofar as they, too, perform many similar functions essential to human flourishing) serve as “a readily available basis for answering many of the questions about right-sizing government.”

In fact, Moore believes that markets and governments can help one another perform these functions more effectively. This is partly because both are inherently vulnerable to different types of failure. His article elaborates on these, beginning with the reasons for and categories of “market failure”: issues surrounding negative (or positive) externalities; information asymmetries; literal or figurative insurance failures; monopolies; and the inability to meet the needs of disenfranchised members of society. An effective government, therefore, should augment markets “in certain areas where [they] simply will not function efficiently,” such as by providing constitutional structures, legal systems, and institutional checks that facilitate fair competition.

Moore then explores the various causes and classes of “government failure.” He notes that governments are prone to favor certain electoral groups, often at the expense of minorities, the unborn, and individuals below voting age. They also suffer from “time horizon problems” in which officials “seek to reap the benefits of public actions prior to the next election but postpone the costs as long as possible.” Then there are issues with bureaucratic rent-seeking; “overly risk-averse behavior”; the “limited legal accountability” of government institutions; and the tendency to “tax at a federal level and spend at a state level.” (Of course, many of these vulnerabilities have composites within the market. The difference is that corporations are subject to oversight from both government and consumers, who can simply refuse to patronize those firms that act disingenuously or fail to provide the services they desire.)

Just as governments can check or ameliorate the fallout from market failure, markets and citizens have a vital role to play when it comes to reducing government failure. Given the “inherent limitations on government action,” Moore determines that “where markets work it is markets that should be the choice for action rather than government. Markets, however, require government action to provide stable expectations in exchange, and to deal with areas of market failure.”


“The U.S.-China Trade War: Is There an End in Sight?”

Simon Lester, Associate Director of the Herbert A. Stiefel Center for Trade Policy Studies, Cato Institute, and Huan Zhu, Research Associate at the Center

The United States’ tense trade history with China began long before Donald Trump ascended to the office of the presidency. The authors explore this checkered relationship, beginning by establishing a connection between China’s economic liberalization and its status as a trade competitor with the U.S. After implementing a series of free-market reforms, China’s economy surged; and once it joined the World Trade Organization in 2001, it quickly came to rival the U.S. in certain trading markets.

Yet China soon began to flout both the letter and the spirit of its WTO commitments, leading both the Bush and Obama administrations to respond in very different ways. Lester and Zhu attribute the Bush administration’s “sluggish” response to its overly optimistic outlook on China’s continued liberalization; its anxieties over a potential trade war with the country; its desire to protect our corporate interests in China; and its preoccupation with both the war on terror and the global financial crisis. The Obama administration, on the other hand, took a different tack, with President Obama declaring that “other countries should play by the rules that America and our partners set,” and that “the United States, not China, should write [those rules].”

As it happened, the United States did write the rules of the Trans-Pacific Partnership (TPP)—and deliberately excluded China from negotiations. Bolstering commentators’ claims that the thrust of TPP was not so much fair trade as it was China’s “containment” as a global power, the Obama administration also imposed tariffs and brought formal complaints against China. It did, however, try—and fail—to complete “a bilateral investment treaty negotiation” with the nation.

Nor is it clear that the Trump administration will fare much better in its efforts. Thus far, President Trump’s trade war with China has concentrated mainly on the arena of technology transfer, with each side imposing escalating tariffs on the other. Although both remain engaged in bilateral trade negotiations, Lester and Zhu write that these are “focused on a narrow sub-set of issues,” since the sum total of both countries’ complaints are too “difficult to resolve all… at once.” More pointedly, they add, President Trump’s indiscriminate use of tariffs and his “general skepticism about trade liberalization may be undermining his efforts to take on China, which might go better in a coordinated approach with others.” Lester and Zhu suggest that a moderate Democrat might be more effective at concluding our current stalemate with China, first, by ending trade disputes with our allies; and then by collaborating with those allies to incentivize China’s liberalization by “filing WTO complaints against China and negotiating with China in a good faith manner.” Such negotiations, they add, will require the U.S. to at least be “willing to make concessions of our own.”


“Tariffs and Monetary Policy: A Toxic Mix”

Michael D. Bordo, Distinguished Professor at Rutgers University and Distinguished Visiting Scholar at the Hoover Institution, and Mickey D. Levy, Chief Economist for the Americas and Asia at Berenberg Capital Markets

Continuing with the theme of President Trump’s trade war with China, Bordo and Levy consider whether the recent tariffs—and subsequent uncertainties over the future of global trade—had anything to do with Federal Reserve’s repeated (and perhaps unwarranted) decision to lower its interest rate target, bringing the federal funds rate increasingly near the zero lower bound throughout the latter half of 2019. Should the Fed continue cutting rates, Bordo and Levy warn—especially given our record low unemployment rates and the stability of our markets—it will compromise its ability to “implement effective countercyclical policy in response to a future economic downturn.”

President Trump’s tariffs are hastening a global trend toward protectionist trade policy, the authors write. They discuss the monetary and economic consequences of these initial and retaliatory tariffs. Not only have they adversely affected the industries they target, they’ve heightened uncertainties across the economy, depressing overall market performance as a result. Bordo and Levy point to several models that suggest the Trump administration’s preference for tariffs correlates directly with slower worldwide GDP growth, declines in aggregate investment, and dwindling numbers of U.S. real exports. “The negative impacts of tariffs and related uncertainties on exports, industrial production, business investment, and confidence have offset the positive impulses of the Trump administration’s deregulatory and tax reform initiatives,” they write.

They also cite a statement from Federal Reserve Chairman Jerome Powell in which Powell suggests that these same trade uncertainties can shift “the appropriate stance of monetary policy.” Yet the authors warn that adjusting monetary policy in response to anticipated trade policy changes is both dangerous and beyond the proper conduct of monetary policymakers. While our current “trade barriers… impose supply constraints on productive capacity and distort global supply and distribution channels,” these consequences, though unfortunate, “are beyond the scope of monetary policy to remedy.” Any responsibility that our central bankers assume for mitigating the economic effects of a trade war can only backfire: not only is it beyond both the scope of the Federal Reserve’s policy mandate and its administrative powers to reduce the burden of tariffs, trying and then failing to do so will compromise what remains of its public trust and political independence.


“Money Market Turmoil"

Allan M. Malz, Adjunct Associate Professor at Columbia University

This article chronicles the evolution and the effects of post-crisis monetary policy. Much of Malz analysis explores the relationship between the Fed’s new Quantitative Easing (QE) powers, its policy of paying interest on banks’ excess reserves (IOER), its overnight reverse-repo operations (ON-RRPs), and the shocking spike in repo market interest rates that occurred in late 2019. The “repo market” is where banks and other investors procure overnight (or very short-term) loans using securities—such as Treasuries and Mortgage-Backed Securities—as collateral, which the borrowers agree to repurchase at a slightly higher price. Since repo loans are collateralized, they should trade at slightly lower interest rates than the overnight federal funds rate (the average rate that banks charge one another to borrow short-term liquidity). But, from 2017 onward, the repo rate trended higher than the federal funds rate, culminating in an unprecedented September 16, 2019 spike. Malz examines how the Federal Reserve’s new monetary policy regime contributed to this event, critiques its response to date, and suggests how the Fed can avoid similar episodes in the future.

The Fed’s current monetary policy regime, which Malz describes as “ad hoc” and discretionary by design, heightens market uncertainty while providing little in the way of financial stability. Today, the FOMC uses a number of discretionary tools in hopes of pegging both short-term and long-term market interest rates. Particularly concerning are the Fed’s large-scale asset purchases (another name for its QE programs), which Malz writes have “aimed, not to influence short-term rates, which… were loosely governed by interest on excess reserves (IOER), but to push down long-term interest rates.” IOER, for its part, was how the Fed attempted to avoid a commensurate crash in short-term lending after flooding the market with reserves, by enticing banks to hold some of those excess reserves in exchange for marginal interest payments. This served to sterilize large increases in base money.

By itself, however, IOER proved ineffective at “anchoring” the federal funds rate toward its target. This prompted the Fed to adopt still another tool: overnight reverse repos, which gave the Fed a new way to participate in repo lending. Combining overnight reverse repos with IOER seemed to help the Fed tighten its grip on the ostensibly market-directed federal funds rate. But even as the federal funds rate trended closer to its very low target, the repo rate spike of 2019 made it clear that the Fed’s new policy regime had created a dangerous disunion between the once-integrated federal funds and repo markets. Although the Federal Reserve had successfully pinned down the federal funds rate, which had formerly trended in a similar direction as the repo rate, it and its tools “had proven ineffective in anchoring rates in both loose and tight money markets.” The repo rate began to climb.

Malz reviews the potential causes of the repo market’s tightening: first, the Fed’s large-scale asset purchases—and its short-lived attempts to sell them back off again—created extreme fluctuations in the Fed’s balance sheet, and in turn, the supply of reserves in the money markets. Yet these fluctuations affected the repo and federal funds markets differently. Whereas the federal funds rate remained relatively steady throughout—mainly due to the cocktail of additional tools the Fed could use to manipulate it—the repo rate tightened, throwing the two formerly “integrated” markets out of alignment. Second, government borrowing has lately accelerated, leading to an influx of T-bills in the market. More significant, however, are the “countervailing… [and] ongoing regulatory and supervisory developments” that are bidding up the repo rate. Post-crisis regulations have placed higher liquidity coverage ratios on banks, who can count both reserves and “high-quality collateral received in a reverse repo as part of the stock of liquid assets they must maintain to satisfy the liquidity coverage ratio.”

The asymmetries in the money markets as well as the uncertainties over how the Fed plans to use unconventional monetary policy going forward are causing the very volatility that the Fed attempted to avoid when it first tightened its grip on market interest rates.  Malz warns that “the impossible attempt to reshape every specific feature of the financial system… has predictably resulted in myriad unanticipated consequences.” He suggests that “higher regulatory capital requirements would be a more efficient approach” to maintaining financial stability and preventing systemic collapse.


“On Targeting the Price of Gold”

George Selgin, Director, Cato Center for Monetary and Financial Alternatives

Just in time for Judy Shelton’s Federal Reserve Board confirmation hearing, Selgin revisits some of her prior comments, which some interpreted as being sympathetic to a gold standard, alongside Fed Chairman Jerome Powell’s remarks that switching to a gold price target would be unsound monetary policy. His article poses three questions: first, are Shelton and Powell referring to similar policies—would reviving the gold standard have a similar effect as implementing a gold price target? He discusses the differences between a gold standard and a gold price target, noting that gold price targeting, which would require the Fed to adjust the money supply to keep the value of paper money on par with the price of gold, amounts to something more like a “pseudo” gold standard, since a real gold standard eliminates the need for a central bank entirely.

Selgin’s second question is whether Shelton herself has ever expressly endorsed either the gold standard or gold price targeting. A review of her comments shows otherwise. Finally, Selgin examines whether targeting the price of gold would be as disastrous as Powell suggests—or how it would differ from our current, interest rate targeting regime. He presents a reduced-form regression analysis of the price of gold on the Fed’s current interest rate target, the federal funds rate, to determine “first, where the fed funds target would have had to be set at any given time to maintain a fixed value of gold and, second, how inflation and output would have responded to that rate setting.” After reviewing some methodological caveats, Selgin concludes that had the Fed tried to target the price of gold “within still-narrower bounds it would have had to tolerate much more dramatic swings in its fed funds target.”


“Real and Pseudo Gold Price Rules”

Richard M. Salsman, Assistant Professor of Political Economy, Duke University and Senior Fellow at the American Institute for Economic Research

Salsman approaches the issue on gold price targeting from a slightly different angle. A gold-price rule, he writes, would indeed require a fundamental restructuring of our central bank’s role in our economy—but that wouldn’t be a bad thing. Over the past half-century, central banks have come increasingly to “finance politics and politicize finance,” a trend that, in the U.S., accelerated after our country abandoned the gold standard. By design, fiat currency regimes render monetary policy more discretionary and increase a central bank’s vulnerability to politicization. The Federal Reserve was no exception, in Salsman’s view. He also associates the Fed’s increasingly political role with its power to monetize debt. Initially, it began doing so in an effort to help finance military expenditures during wartime, but has now become part of its strategy to “moderate long-term interest rates”—the third, and less-well-known, prong of its so-called dual mandate to achieve “maximum employment and price stability.”

Next, Salsman clarifies the distinction between “targets”—the objects of a particular policy or strategy—“tools”—the policies and strategies themselves, or the means through which a target is achieved—and “rules”—specific prescriptions about when and how to use particular tools. While the Federal Reserve certainly has its targets and tools, it lacks a precise system of rules to keep it both independent and accountable. This is problematic for Salsman, who writes: “Targets or tools… are infeasible and ineffective. …Nor do they diminish current central bank power or capriciousness.” A gold price rule, on the other hand, would do so both easily and effectively. Salsman explains that under a gold price rule, the Fed would no longer need to forecast the trajectory of its current, primary target (the federal funds rate); it would also relieve the Fed of any responsibility for planning or regulating market fluctuations (an impossible task anyhow, even under the most restrictive monetary regime). Both of these changes would dramatically constrain the Federal Reserve’s authority and limit its operations, in turn freeing monetary policymakers from political pressure and restoring the natural ebb and flow of the markets. A gold price rule would also open the doorway to currency competition and choice.

Salsman contrasts a gold-price monetary system with a classical “gold standard”-based regime (in which central banks would have to redeem their currencies in physical gold, and the private sector would be prohibited from trading in gold or issuing its own payments media.) He then describes how a gold price-based monetary system would operate today, as well as how it could regulate inflation without compromising natural market processes. Finally, he discusses what a central bank would not do under a gold price rule: it would not engage in additional open-market operations; it would not monetize government debt; and it would not pay interest on excess reserves. It would not, in short, be as vulnerable to politicization and scorn as our central bank is today.


“A Fresh Look at Central Bank Independence”

Paul Wachtel, Professor of Economics at New York University, and Mario I. Blejer, Visiting Professor in the Institute of Global Affairs at the London School of Economics

Over the past century, the concept of central bank independence (which Wachtel and Blejer abbreviate CBI) has evolved considerably. Although we continue to idealize CBI, no country has achieved a truly “independent” monetary policy regime in practice. (There is, moreover, a difference between central bank independence and central banker independence: we tend to conflate the two, but safeguarding the independence of a central bank has nothing to do with allowing central bankers to conduct monetary policy independent of any rules or oversight.)  

The authors write that our present understanding of what CBI is, and our attitude toward it, is the product of four key developments. The first were the inflationary spikes that plagued the U.S. during the 1970s. These contributed to a general sense that monetary policymakers were politically pliable, and measures needed to be taken to separate monetary policy from political expediency. The second was the influx of central banks in newly independent or transitioning countries during the latter half of the twentieth century. Many of these countries saw central bank independence as a hallmark of economic prosperity. The third was the “rational expectations revolution,” which altered the way many central bankers understood the role of monetary policy. The fourth were the increase in empirical studies that showed a correlation between high rates of CBI and low rates of inflation.

Yet CBI is undergoing a conceptual shift today. This owes partly to the global financial crisis and the additional responsibilities that central bankers have assumed for the economic recovery. Wachtel and Blejer discuss how, as a result of these changes and other factors, “CBI is a far more nuanced concept than it seemed 30 years ago.” A more “constrained” view of CBI, they write, suggests that “central banks must often work with or listen to political authorities,” especially with respect to crisis responses, which have a significantly fiscal component. But debates over the precise meaning and merits of CBI are ongoing. Central banks and elected officials have yet to determine how or whether to separate central banks’ monetary policy decisions from “other policy interventions with fiscal and distributional consequences.”


“The Phillips Curve: A Poor Guide for Monetary Policy”

James A. Dorn, Vice President for Monetary Studies and Senior Fellow at the Cato Institute

The Federal Reserve owes much of its current policy approach—and even its “dual mandate” to maintain a level of inflation consistent with maximum employment—to the Phillips curve, which suggests an inverse relationship between price inflation and unemployment. Dorn argues that the Phillips curve has been repeatedly misinterpreted, erroneously applied, and that, even if it were understood correctly, a number of factors make the original Phillips curve “a poor guide” for conducting monetary policy today. When A.W. Phillips first introduced the monetary policy world to his now-famous curve in 1958, he noted that the inverse relationship it stipulated between inflation and unemployment was a short-run correlation only. To this day, no one has demonstrated a long-run or causal relationship between inflation and unemployment. Overlooking this caveat, however, monetary policymakers have used Phillips’ observations “to believe they could fine-tune the economy by choosing a socially optimal point on the Phillips Curve”—somewhere between low employment and low inflation, or high employment and high inflation. Dorn suggests that the two are not tied to one another, but to a third lever: “changes in aggregate demand that cause changes in both unemployment and inflation.”

Furthermore, additional studies suggest that the inverse correlation between inflation and unemployment is only stable “under fixed exchange rates which… anchor inflation expectations.” That the Phillips Curve is an unsuitable barometer for monetary policy has been proven time and time again, Dorn demonstrates; notably, during the “stagflation” episodes of the 1970s, when in Peter Ireland’s words, “the Federal Reserve’s efforts to exploit that Phillips curve led… not to lower employment at the cost of higher inflation but instead to the worst of both worlds: higher unemployment and higher inflation.” Dorn also reviews what Milton Friedman called the three stages of the Phillips curve. The initial, short-run, inverse correlation between inflation and unemployment precedes the second stage, in which the Phillips curve maintains its shape but adjusts its position. That is, “an increase in inflation… temporarily reduces unemployment below its long-run ‘natural level’”. Once workers and employers recognize this higher inflation rate, however, they change their behavior, unemployment returns to its ‘natural’ rate and the Phillips curve adjusts accordingly. This is because, as Alan Meltzer writes, “any influence of nominal variables [e.g., prices] on real variables [e.g., employment] last[s] only as long as it takes markets to learn and adjust.”

The third stage, per Friedman, pertains to the long-run Phillips curve, which by that point ceases to be a curve at all but becomes instead a vertical line—followed by a positively sloped Phillips curve. According to Friedman, sustained inflation, albeit at variable rates, “plants the seeds for higher future unemployment by distorting relative prices and increasing ‘regime uncertainty,”’ which has a chilling effect on economic productivity.

During the Great Moderation, both inflation and unemployment dropped, further throwing into question the validity of the Phillips curve. More likely, as Dorn and other experts suggest, aggregate demand—which may be partly influenced by inflation expectations, and partly by myriad other factors—is a better determinant of unemployment. Yet the Phillips curve remains a tempting distraction for central banks, who continue to use it to determine how to adjust monetary policy according to their economic projections. Dorn suggests revising our present monetary policy framework by replacing the present dual mandate (“which is flawed by assuming a tradeoff between inflation and unemployment”) with a single directive to keep NGDP on a stable path. By doing so, the Fed would cease to gamble its monetary policy decisions on the accuracy of a decades-old model, and in turn, “increase the credibility of monetary policy, reduce regime uncertainty, mitigate business fluctuations, and avoid stop-go monetary policy.”


“The Transportation-Communication Revolution: 50 Years of Dramatic Change in Economic Development”

Joseph Connors, Assistant Professor of Economics at Florida Southern College, James D. Gwartney, Gus A. Stavros Eminent Scholar Chair at Florida State University, and Hugo M. Montesinos, Assistant Professor of Statistics at Ursinus College

While the Industrial Revolution ushered in rapid and unprecedented improvements in technology, the economy, and the lives of millions, its immediate impact was still only felt by a small handful of the world’s population—about 15 percent. Over the past 50 years, however, we have witnessed what Connors, Gwartney, and Montesinos call the “Transportation-Communication Revolution,” marked by far more dramatic—and much further-reaching—changes in global technology, infrastructure, and productivity. The authors review the factors leading to and resulting from this second economic revolution, and compare it favorably—in terms of its scope, impact on trade, and effects on global wealth inequality—to the Industrial Revolution of the 18th and 19th centuries.

The extensive data series that Connors, Gwartney, and Montesinos provide in their article show a dramatic 50-year spike in worldwide income and per capita GDP, which they attribute to the past half century’s “huge reductions in transportation and communication costs.” These have catalyzed four major economic shifts, each of which has had a disproportionately positive impact on developing countries. First, the authors discuss the significant advancements from “large increases in international trade”; second, the “higher rates of entrepreneurship and expanded opportunities [especially for lower-income countries] to borrow successful technologies and business practices from high-income countries”; third, the improvements “in economic freedom”; and finally, “the virtuous cycle of development,” whereby innovation begets further innovation.

The authors’ multiple regressions and empirical analyses show that “measured in real dollars, the size of the international trade sector was 44 times higher in 2017 than it was in 1960.” What’s more, these additions to the international trade sector came mainly from lower-income countries. The advantages of increased and freer trade have brought these lower-income countries’ real per capita GDP up at a rate nearly double that of higher-income countries. The authors contrast this with the Industrial Revolution, which predominately affected countries that were already well-developed or comparatively wealthy. The Transportation-Communication Revolution, on the other hand, has had a much more extensive reach, and its benefits have been most palpable in new or lower-income countries and markets. “As a result,” the authors write, “worldwide income inequality has declined sharply in recent years.” Their data are a testament to the fact that reduced costs and freer trade have exponentially positive effects on the productivity—and the livelihoods—of newer entrants into the global marketplace.


“The Effect of War on Economic Growth”

Clifford F. Thies, Chair of Free Enterprise and Professor of Economics and Finance at Shenandoah University, and Christopher F. Baum, Professor of Economics and Social Work at Boston College and Research Fellow at the German Institute for Economic Research

Conventional wisdom holds that war stimulates economic activity. This perspective comes from the fact that measures of employment and income tend to rise along with weapons and munitions manufacturing. But as Thies and Baum demonstrate, the relationship between “war” (which is itself difficult to qualify) and per capita GDP is not so clear-cut. Although wartime manufacturing can reduce unemployment, it often results in the destruction of both human and material capital. It also stifles trade and can reduce investment in new products and services. To date, no clear-cut method has been developed for measuring the true cost of war on per capita GDP. The authors therefore address the question of how per capita GDP changes, both during and after wartime, conducting an extensive quantitative analysis that uses different data sets’ definitions of war and other violent conflicts. Their panel data measure changes in multiple countries’ GDP per capita over consecutive five-year periods ranging from 1955 to 2015. The results show that high-magnitude wars and coups “lower per capita GDP significantly”; that “political instability [in general] depresses economic growth”; and that “economic freedom… [has] a significant, positive effect on per capita GDP.”

The authors’ findings deviate from prior research in that theirs suggest that war has a negative impact on economic growth. They attribute the originality of these results to the fact that national income accounting “ignores the loss of lives and the destruction of physical and human capital associated with war. Moreover, resources devoted to war are treated [in most studies] as final goods or services instead of as costs of production.” Since “war and other forms of armed conflict should be considered a major impediment to the economic development of low-income countries,” the authors’ conclusion provides an overview of several policy alternatives aimed at conflict resolution.


“Frederick Douglass and the American Dream”

Timothy Sandefur, Vice President for Litigation at the Goldwater Institute and Chair in Constitutional Government

Based on remarks delivered at Reason magazine’s “Reason Weekend” in March 2019, Sandefur’s article gives a compelling account of Frederick Douglass’ life and legacy, concentrating especially on how Douglass’ wisdom bears on contemporary race relations, debates over the meaning of freedom and the validity of the American dream, attitudes toward self-determination, and interpretations of the U.S. Constitution.

Sandefur devotes much of his article to comparing Douglass’ personal and political philosophy—which aimed at the realization and perfection of our constitutional principles—to the philosophies of past and present civil rights advocates, especially Ta-Nehisi Coates and others who disavow America’s founding documents and institutions as inherently racist. Contrary to what these contemporaries—both Douglass’ and our own—suggest, Sandefur argues that Douglass’ life epitomizes the American Dream, and that his achievements provide a stirring testimony to his conviction that America is exceptional precisely because its founding principles necessitated the eventual abolition of slavery and the death of racial injustice. Sandefur concludes by discussing precisely why it remains incumbent upon Americans to share Douglass’ legacy with one another as they confront contemporary questions about civil rights, equality, and the battle between liberty and the false flag of nihilism.