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By Gordon Kerr, on 30 August 11
Warren Buffett is the most successful investor on the planet and a very smart fellow. His core team also gave me a job in October 2000 at GenRe Financial Products, and I have always held him in high regard.
He has invested $5 billion in Bank of America on 25th August. But was the Wall Street Journal correct to headline the deal a “Vote of Confidence” in the bank?
My analysis is based purely on the facts presented in this weekend’s WSJ.
In return for his $5bn cheque, Buffett will receive:
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Preference shares bearing a ‘coupon’ of 6%. Technically, preference coupons are dividends; the payment can only be made out of profits. Allow me nonetheless to use the term ‘coupon’ in order to compare the risks and returns of this deal with a bank deposit. The structure here is as close to a coupon as preference share terms allow. Even if the bank experiences a choppy ride, so long as it survives and returns to profit at some future point, any unpaid dividends in loss making years are payable under a contractual cumulation provision.
- Warrants (these are options to buy shares at a pre-agreed price) over 700 million shares of BofA common stock at a strike price very close to Thursday’s share price. The WSJ values these warrants at about $3 billion. Assuming that is correct, Mr. Buffett could either sell them for $3 billion or retain them as he sees fit.
- The deal is not even Tier 1 equity for BofA and is considered expensive ‘bridge financing’ . However, Mr Buffett has secured a 5% penalty charge ($250 million) should BofA redeem the preference shares.
Short term deposit rates are 1% or less in US banks. On this basis, the deal can be characterised as a net investment of $2bn at a coupon of 15% (5/2x 6%). This equates to about 15 times the return on cash short term deposit accounts. Similarly, the redemption premium becomes not 5% but 12.5% of net invested funds.
Let us consider the ranking of the investment in a potential liquidation of BofA. Secured creditors of the bank take precedence over depositors. Preference Shares rank below depositors but above common equity. And yet banks have pledged so many assets to each other via repo and “failed sale” transactions that who can tell how much quality collateral could be viewed as actually supporting the deposit base?
Bearing in mind the recent history of western Bailouts, consider the following range of possible outcomes:
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BofA survives and thrives. Happy days for all stakeholders, excellent return for Mr. Buffett;
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BofA fails. Either there are enough assets in liquidation to redeem deposits or depositors are rescued by a possible Heurta De Soto or Baxendale plan or fresh taxpayer bailout;
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BofA fails and (2) above extends to pay off unsecured creditors but not preference shares;
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BofA fails and preference shareholders are covered by (2) above;
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BofA fails and (2) above extends to protect common shareholders.
Politicians have rarely breathed the words “moral hazard” and “perverse incentives” when they are actually engaged in formulating the bailout package, so outcomes (4) and (5) cannot be completely dismissed, but surely they are unlikely.
But how likely are outcomes (2) and (3)? I just cannot see how governments can attempt a second bailout given that Ireland is now on its fifth. But I don’t know. I suspect Mr Buffett does not know either.
Mr Buffett, like the rest of us, knows that the banking system is in a critical state. Yet like many of us he has a problem: we all need to keep some cash in banks. When you have the quantum of funds under management that he has, you can forget about deposit insurance.
What a smart deal he appears to me to have made. A good chunk of the cash element of his investment portfolio can be parked at a fixed coupon of 15% for the foreseeable future.
Either paper money collapses, in which case all of his cash funds are in turmoil, or there will be another rescue attempt, or hyperinflation, or QE 3,4,and 5 or some ‘unknown unknown’ attempt to prop up the banking system. It is possible that a future rescue might specifically wipe out common and preference equity, and so Mr Buffett’s is seeking a huge upside against the risk of that specific downside.
So what of the headline? I concede that he picked BofA rather than another US megabank, but it is still rather a stretch to term this a “Vote of Confidence” in BofA.
By Toby Baxendale, on 29 August 11
Exciting news from Mises.org:
The great debate between Keynesians and Austrians enters the digital age with the Mises Academy’s first ever online formal debate, between economists Karl Smith and Robert P. Murphy.
Resolved: Government Spending Can Play an Important Role in Boosting Economic Growth
Smith will argue in favor of this resolution, and Murphy will argue against.
The debate will be held by Webex, and costs $20. It will take place Friday, September 2nd at 1pm UK time, but will be recorded for later viewing.
See here for more details.
By Steven Baker MP, on 27 August 11
Via Honesty is best policy | The Jewish Chronicle, I set out MA, the Austrian measure of the money supply developed by Dr Anthony J Evans and Toby Baxendale:
Ask economists how much money there is and you will get many answers. You know money is what you can exchange for real goods and services, but economists often include things like time deposits, which cannot be spent because they have fixed terms. Money is one half of every transaction, so its supply really matters. According to my colleague Dr Anthony J Evans of Kaleidic Economics, the Bank of England’s preferred measures, “Narrow Money” and “Broad Money”, are either too narrow or too broad. From the perspective of the Austrian School of Economics, Anthony, together with entrepreneur Toby Baxendale, chairman of The Cobden Centre, has established and now publishes a different measure which they call “MA”. A chart (see above) of the growth of MA shows a pattern that is not visible in the Bank of England’s measures.
Given a good measure of the money supply, we shouldn’t be surprised that our economic and financial troubles continue.
Please see the full article for more and Kaleidic Economics for the data and explanation.
By Robert Thorpe, on 26 August 11
Recently, Paul Krugman claimed that the threat of an invasion by space aliens could bring the US economy out of recession in eighteen months. I expect many readers of this site found that both funny and worrying. It reminded me of an excellent science fiction novel I read years ago, “The Forever War” by Joe Haldeman.
Most political movements try to present themselves as positive about humanity. But privately their supporters often admit to seeing “noble lies” and social engineering more positively than they would publicly say. I don’t think libertarians or classical liberals are completely immune to this. In “The Forever War” a leftist author criticises conservatives, but also allows himself to think through the consequences of the ideas of American leftists.
Novels about interstellar war are often quite macho and conservative. “The Forever War” was seen as a response to one of those books, “Starship Troopers” by Robert Heinlein. It begins with an attack by aliens on starships travelling from earth to colonize other planets. It then follows a soldier, Private Mandella, through the ensuing war against the aliens. It becomes clear much later that the start of the war had been a mistake by jumpy humans, not a hostile alien attack. That is rather like the “Gulf of Tonkin Incident” in the Vietnam war. Haldeman wrote “The Forever War” in the early 70s after his own service in Vietnam; the interstellar war he describes is eerily similar to the Vietnam war and clearly a commentary on it.
When the soldiers first return to earth an army captain comes to meet them, he says:
“I’m twenty-three, so I was still in diapers when you people left for Aleph … to begin with, how many of you are homosexual?” Nobody. “That doesn’t really surprise me. I am, of course. I guess about a third of everybody in Europe and America is.
“Most governments encourage homosexuality – the United Nations is neutral, leaves it up to the individual countries – they encourage homolife because it’s the one sure method of birth control.”
Over the course of the book that policy becomes stricter and heterosexuality comes to be seen as a mental illness. It’s interesting to consider if future governments will try strategies like this. As the story progresses it hints that governments have encouraged recreational drug use too for the same reason.
The captain continues:
“… the population of the world is nine billion. It’s more than doubled since you were drafted. And nearly two-thirds of those people get out of school only to go on relief”.
“Relief”, it turns out, is the dole. Here we have the “Gloomy Keynesian” idea that as technology progresses unemployment becomes much greater. It turns out that jobs are rationed and only certain people are eligible so there is a thriving black market in faking this eligibility. Haldeman supposes that the war provides the Keynesian solution to this problem: producing the technology to fight the war creates employment and stimulates output.
Haldeman writes:
The main effect of the war on the home front was economic, unemotional – more taxes but more jobs as well. After twenty-two years, only twenty-seven returned veterans, not enough to make a decent parade. The most important fact about the war to most people was that if it ended suddenly, Earth’s economy would collapse.
And at the very end of the book when some ancient history is discussed:
… the old soldiers were still around, and many of them were in positions of power. They virtually ran the United Nations Exploratory an Colonization Group, that was taking advantage of the newly discovered Collapsar jump to explore interstellar space.
Many of the early ships met with accidents and disappeared. The ex-military men were suspicious. They armed the colonizing vessels, and the first time they met a Tauran ship they blasted it.
They dusted off their medals and the rest was going to be history.
You couldn’t blame it all on the military though. The evidence they presented for the Taurans having been responsible for the early causalities was laughably thin. The few people who pointed this out were ignored.
The fact was, Earth’s economy needed a war, and this one was ideal. It gave a nice hole to throw buckets of money into, but would unify humanity rather than dividing it.
Here we see the problems many leftists have with their own ideas. If Keynes is right about economics or if Malthus is right about population [1] then that has dark implications. Of course there’s nothing wrong with an idea that leads us to a dark place if that idea is right, but there’s no need to worry if it’s wrong.
Writing about the recent earthquake in Virginia, Steve Horwitz gave a very clear criticism of this kind of thinking:
… the problem with the ‘disasters are good for the economy’ nonsense, and GDP more generally, is that it confuses a flow with a stock. GDP measures a flow of activity, not a stock of wealth. Destroying things and then rebuilding them might increase economic activity in the area affected (by drawing resources from elsewhere), but leaves us with less wealth than we would have had without the disaster. That is the real meaning of the Broken Window Fallacy.
It’s a mistake to think that Keynesians want to waste resources in order to increase employment. Their argument is that it isn’t very important how efficient a spending project is during a recession. They would prefer it if the output of a project were useful because if it were, that would clearly be beneficial. But, they don’t require a project to be efficient; their view is that if no good spending projects are politically feasible, then bad ones will do. They believe that during a recession there are great spin-off benefits to spending on output. They believe that it will stimulate production and employment and make society wealthier in the long run.
Keynesian commentators often seem to believe that the level of GDP output proves that a certain amount of capital wealth exists to be used, so when GDP increases that means society is richer. GDP is certainly an indicator of wealth; output can only be produced because capital and labour exist to produce it. But, many different levels of output are possible with the same capital. The amount of existing stocks of goods that are processed into new outputs depends on the demand for those new outputs.
In the recent controversy over the Virginia earthquake some Keynesian commentators I’ve read have expressed the view that it’s all about “crowding out”. Crowding out is a macroeconomic idea often put forward by critics of the Keynesians. In its simplest form, the argument is that every pound the government tax from someone, or borrow from someone, is a pound that would have been spent on private sector output. So, according to this argument “stimulus” policies will have no beneficial effect. I agree with this idea to some extent. The problem with it is that the private sector doesn’t only sell GDP output; existing assets are also for sale, including financial assets such as bonds and share. That means a person may receive income and spend it on things that aren’t output. Also, once the seller of an asset receives the proceeds he may not spend them on output either; he may buy another asset. Eventually somebody in the chain will spend on output, though that may take a long time. This means a government could increase output by taxing people who are likely to spend their money on assets and using the proceeds to buy output goods.
I don’t think the crowding out explanation helps us very much. As Horwitz says, the important issue isn’t whether output falls, everybody know output falls during a recession. The important question is: what does a fall in output mean?
One possibility is that investors and businesses are being irrationally cautious. Instead of investing in new projects which could earn profits in the future for them and increase output to the benefit of everyone they rush into relatively secure investments such as money, bonds, blue chip stocks and gold. Keynesians are fond of the idea of the irrationality of the market because it supports this view (they aren’t particularly interested in disputing Austrian Business Cycle Theory as a cause of recessions). I think this possibility is a distraction; to the degree that markets can be irrational it’s close to impossible to say in which direction they’re being irrational [2].
There is an alternative view, though: investors may be making a sensible decision to avoid investing in new projects because the risk/reward ratio is too poor to make it worth their while. That decision may certainly reduce employment in the short-run, but that doesn’t show that it reduces society’s overall wealth. It may well be that this decision isn’t only sensible for investors. The processing of existing resources into new goods doesn’t necessarily add value from anyone’s point of view. Keynesian economists often assume that it’s always worthwhile to convert existing resources into output at the same rate that prevailed before a recession. There is no reason to think this is true.
[1] – Those interested in the history of economic thought will notice the influence of Malthus. Thomas Malthus was good at coming to unsettling conclusions. He suggested that real wages will fall in the long-run to the minimum necessary for subsistence, consigning the human race to poverty in the long term. Malthus also proposed a macroeconomic theory similar to Keynes’s, long before him.
[2] – This is the weakest form of the Efficient Markets Hypothesis.
By Jonathan Catalán, on 25 August 11
Banking theory remains one of the most heatedly debated areas of economics within Austrian circles, with two camps sitting opposite each other: full reservists and free bankers. The naming of the two groups may prove a bit misleading, since both sides support a free market in banking. The difference is that full reservists believe that either fractional reserve banking should be considered a form of fraud or that the perceived inherent instability of fiduciary expansion will force banks to maintain full reserves against their clients’ deposits. The term free banker usually refers to those who believe that a form of fractional reserve banking would be prevalent on the free market.
The case for free banking has been best laid out in George Selgin’s The Theory of Free Banking.[1] It is a microeconomic theory of banking which suggests that fractional reserves will arise out of two different factors,
- Over time, “inside money” — banknotes (money substitute) — will replace “outside money” — the original commodity money — as the predominate form of currency in circulation. As the demand for outside money falls and the demand for inside money rises, banks will be given the opportunity to shed unnecessary reserves of commodity money. In other words, the less bank clients demand outside money, the less outside money a bank actually has to hold.
- A rise in the demand to hold inside money will lead to a reduction in the volume of banknotes in circulation, in turn leading to a reduction of the volume of banknotes returning to issuing banks. This gives the issuing banks an opportunity to issue more fiduciary media. Inversely, when the demand for money falls, banks must reduce the quantity of banknotes issued (by, for example, having a loan repaid and not reissuing that money substitute).
Free bankers have been quick to tout a number of supposed macroeconomic advantages of Selgin’s model of fractional reserve banking. One is greater economic growth, since free bankers suppose that a rise in the demand for money should be considered the same thing as an increase in real savings. Thus, within this framework, fractional reserve banking capitalizes on a greater amount of savings than would a full reserve banking system.
Another supposed advantage is that of monetary equilibrium. An increase in the demand for money, without an equal increase in the supply of money, will cause a general fall in prices. This deflation will lead to a reduction in productivity, as producers suffer from a mismatch between input and output prices. As Leland Yeager writes, “the rot can snowball”, as an increase in uncertainty leads to a greater increase in the demand for money. This can all be avoided if the supply of money rises in accordance with the demand for money (thus, why free-bankers and quasi-monetarists generally agree with a central bank policy which commits to some form of income targeting).[2]
Monetary (dis)equilibrium theory is not new, nor does it originate with the free bankers. The concept finds its roots in the work of David Hume[3] and was later developed in the United States during the first half of the 20th Century.[4] The theory saw a more recent revival with the work of Leland Yeager, Axel Leijonhufvud, and Robert Clower.[5] The integration of monetary disequilibrium theory with the microeconomic theory of free banking is an attempt at harmonizing the two bodies of theory.[6] If a free banking system can meet the demand for money, then a central bank is unnecessary to maintain monetary stability.
The integration of the macro theory of monetary disequilibrium into the micro theory of free banking, however, should be considered more of a blemish than an accomplishment. It has unnecessarily drawn attention away from the merits of fractional reserve banking and instead muddled the free bankers’ case. Neither is it an accurate or useful macroeconomic theory of industrial misbalances or fluctuations.[7]
The Nature of Price Fluctuations
The argument that deflation resulting from an increase in the demand for money can lead to a harmful reduction in industrial productivity is based on the concept of sticky prices. If all prices do not immediately adjust to changes in the demand for money then a mismatch between the prices of output and inputs goods may cause a dramatic reduction in profitability. This fall in profitability may, in turn, lead to the bankruptcy of relevant industries, potentially spiraling into a general industrial fluctuation. Since price stickiness is assumed to be an existing factor, monetary equilibrium is necessary to avoid necessitating a readjustment of individual prices.
Since price inflexibility plays such a central role in monetary disequilibrium, it is worth exploring the nature of this inflexibility — why are prices sticky? The more popular explanation blames stickiness on an entrepreneurial unwillingness to adjust prices. Those who are taking the hit rather suffer from a lower income later than now.[8] Wage stickiness is also oftentimes blamed on the existence of long-term contracts, which prohibit downward wage adjustments.[9]
Austrians can supply an alternative, or at least complimentary, explanation for price stickiness.[10] If equilibrium is explained as the flawless convergence of every single action during a specific moment in time, Austrians recognize that an economy shrouded in uncertainty is never in equilibrium. Prices are set by businessmen looking to maximize profits by best estimating consumer demand. As such, individual prices are likely to move around, as consumer demand and entrepreneurial expectations change. This type of “inflexibility” is not only present during downward adjustments, but also during upward adjustments. It is “stickiness” inherent in a money-based market process beset by uncertainty.
It is true that government interventionism oftentimes makes prices more inflexible than they would be otherwise. Examples of this are wage floors (minimum wage), labor laws, and other legislation which makes redrawing labor contracts much more difficult. These types of labor laws handicap the employer’s ability to adjust his employees’ wages in the face of falling profit margins. Wages are not the only prices which suffer from government-induced inflexibility. It is not uncommon for government to fix the prices of goods and services on the market; the most well-known case is possibly the price fixing scheme which caused the 1973–74 oil crisis. There is a bevy of policies which can be enacted by government as a means of congesting the pricing process.
But, let us assume away government and instead focus on the type of price rigidity which exists on the market. That is, the flexibility of prices and the proximity of the actual price to the theoretical market clearing price is dependent on the entrepreneur. As long as we are dealing with a world of uncertainty and imperfect information, the pricing process too will be imperfect.
Price rigidity is not an issue only during monetary disequilibrium, however. In our dynamic market, where consumer preferences are constantly changing and re-arranging themselves, prices will have to fluctuate in accordance with these changes. Consumers may reduce demand for one product and raise demand for another, and these industries will have to change their prices accordingly: some prices will fall and others will rise. The ability for entrepreneurs to survive these price fluctuations depends on their ability to estimate consumer preferences for their products. It is all part of the coordination process which characterizes the market.
The point is that if price rigidity is “almost inherent in the very concept of money”,[11] then why are price fluctuations potentially harmful in one case but not in the other? That is, why do entrepreneurs who face a reduction in demand originating from a change in preferences not suffer from the same consequences as those who face a reduction in demand resulting from an increase in the demand for money?
Price Discoordination and Entrepreneurship
In an effort to illustrate the problems of an excess demand for money, some have likened the problem to an oversupply of fiduciary media. The problem of an oversupply of money in the loanable funds market is that it leads to a reduction in the rate of interest without a corresponding increase in real savings. This leads to changes in the prices between goods of different orders, which send profit signals to entrepreneurs. The structure of production becomes more capital intensive, but without the necessary increase in the quantity of capital goods. This is the quintessential Austrian example of discoordination.
In a sense, an excess demand for money is the opposite problem. There is too little money circulating in the economy, leading to a general glut.[12] Austrian monetary disequilibrium theorists have tried to frame it within the same context of discoordination. An increase in the demand for money leads to a withdrawal of that amount of money from circulation, forcing a downward adjustment of prices.
But there is an important difference between the two. In the first case, the oversupply of fiduciary media is largely exogenous to the individual money holders. In other words, the increase in the supply of money is a result of central policy (either by part of the central bank or of government). Theoretically, an oversupply of fiduciary media could also be caused by a bank in a completely free industry but it would still be artificial in the sense that it does not reflect any particular preference of the consumer. Instead, it represents a miscalculation by part of the central banker, bureaucrat, or bank manager. In fact, this is the reason behind the intertemporal discoordination — the changing profit signals do not reflect an underlying change in the “real” economy.
This is not the issue when regarding an excess demand for money. Here, consumers are purposefully holding on to money, preferring to increase their cash balances instead of making immediate purchases. The decision to hold money represents a preference. Thus, the decision to reduce effective demand also represents a preference. The fall in prices which may result from an increase in the demand for money all represent changes in preferences. Entrepreneurs will have to foresee or respond to these changes just like they do to any other.[13] That some businessmen may miscalculate changes in preference is one thing, but there can be no accusation of price-induced discoordination.
The comparison between an insufficient supply of money and an oversupply of fiduciary media would only be valid if the reduction in the money supply was the product of central policy, or a credit contraction by part of the banking system which did not reflect a change in consumer preferences. But, in monetary disequilibrium theory this is not the case.
None of this, however, says anything about the consequences of deflation on industrial productivity. Will a rise in demand for money lead falling profit margins, in turn causing bankruptcies and a general period of economic decline?
Whether or not an industry survives a change in demands depends on the accuracy of entrepreneurial foresight. If an entrepreneur expects a fall in demand for the relevant product, then investment into the production of that product will fall. A fall in investment for this product will lead to a fall in demand for the capital goods necessary to produce it, and of all the capital goods which make up the production processes of this particular industry. This will cause a decline in the prices of the relevant capital goods, meaning that a fall in the price of the consumer good usually follows a fall in the price of the precedent capital goods.[14] Thus, entrepreneurs who correctly predict changes in preference will be able to avoid the worst part of a fall in demand.
Even if a rise in the demand for money does not lead to the catastrophic consequences envisioned by some monetary disequilibrium theorists, can an injection of fiduciary media make possible the complete avoidance of these price adjustments? This is, after all, the idea behind monetary growth in response to an increase in demand for money. Theoretically, maintaining monetary equilibrium will lead to a stabilization of the price level.
This view, however, is the result of an overly aggregated analysis of prices. It ignores the microeconomic price movements which will occur with or without further monetary injections. Money is a medium of exchange, and as a result it targets specific goods. An increase in the demand for money will withdraw currency from this bidding process of the present, reducing the prices of the goods which it would have otherwise been bid against. Newly injected fiduciary media, maintaining monetary equilibrium, is being granted to completely different individuals (through the loanable funds market). This means that the businesses originally affected by an increase in the demand for money will still suffer from falling prices, while other businesses may see a rise in the price of their goods. It is only in a superfluous sense that there is “price stability”, because individual prices are still undergoing the changes they would have otherwise gone.
So, even if the price movements caused by changes in the demand for money were disruptive — and we have established that they are not — the fact remains that monetary injections in response to these changes in demand are insufficient for the maintenance of price stability.
Implications for Free Banking
To a very limited degree, free banking theory does rely on some aspects of monetary disequilibrium. The ability to extend fiduciary media depends on the volume of returning liabilities; a rise in the demand for money will give banks the opportunity to increase the supply of banknotes. However, the complete integration of monetary disequilibrium theory does not represent theoretical advancement — if anything, it has confused the free bankers’ position and unnecessarily contributed to the ongoing theoretical debate between full reservists (many of which reject the supposed macroeconomic benefits of free banking) and free bankers.
We know that an increase in the demand for money will not lead to industrial fluctuations, nor does it produce any type of price discoordination. Like any other movement in demand, it reflects the preferences of the consumers which drive the economy. We also know that monetary injections cannot achieve price stability in any relevant sense. Thus, the relevancy of the macroeconomic theory of monetary disequilibrium is brought into question. Free banking theory would be better off without it.
This suggests, though, that a rejection of monetary disequilibrium is not the same as a rejection of fractional reserve banking. It could be the case that a free banking industry capitalizes on an increase in savings much more efficiently than a full reserve banking system. Or, it could be that the macroeconomic benefits of fractional reserve banking are completely different from those already theorized, or even that there are no macroeconomic benefits at all — it may purely be a microeconomic theory of the banking firm and industry. These aspects of free banking are still up for debate.
[1] George A. Selgin, The Theory of Free Banking: Money Supply under Competitive Note Issue (Totowa, New Jersey: Rowman & Littlefield, 1988). Also see George A. Selgin, Bank Deregulation and Monetary Order (Oxon, United Kingdom: Routledge, 1996); Larry J. Sechrest, Free Banking: Theory, History, and a Laissez-Faire Model (Auburn, Alabama: Ludwig von Mises Institute, 2008); Lawrence H. White, Competition and Currency (New York City: New York University Press, 1989).
[2] Leland B. Yeager, The Fluttering Veil: Essays on Monetary Disequilibrium (Indianapolis, Indiana: Liberty Fund, 1997), pp. 218–219.
[3] Ibid., p. 218.
[4] Clark Warburton, “Monetary Disequilibrium Theory in the First Half of the Twentieth Century,” History of Political Economy 13, 2 (1981); Clark Warburton, “The Monetary Disequilibrium Hypothesis,” American Journal of Economics and Sociology 10, 1 (1950).
[5] Peter Howitt (ed.), et. al., Money, Markets and Method: Essays in Honour of Robert W. Clower (United Kingdom: Edward Elgar Publishing, 1999).
[6] Steven Horwitz, Microfoundations and Macroeconomics: An Austrian Perspective (United Kingdom: Routledge, 2000).
[7] Some of the criticisms presented here have already been laid out in a forthcoming journal article: Phillip Bagus and David Howden, “Monetary Equilibrium and Price Stickiness: Causes, Consequences, and Remedies,” Review of Austrian Economics. I do not support all of Bagus’ and Howden’s criticisms, nor do I share their general disagreement with free banking theory.
[8] Yeager 1997, pp. 222–223.
[9] Laurence Ball and N. Gregory Mankiw, “A Sticky-Price Manifesto,” NBER Working Paper Series 4677, 1994, pp. 16–17.
[10] Horwitz 2000, pp. 12–13.
[11] Yeager 1997, p. 104.
[12] Yeager 1997, p. 223. Yeager quotes G. Poulett Scrope’s Principles of Political Economy, “A general glut — that is, a general fall in the prices of the mass of commodities below their producing cost — is tantamount to a rise in the general exchangeable value of money; and is proof, not of an excessive supply of goods, but of a deficient supply of money, against which the goods have to be exchange.”
[13] Joseph T. Salerno, Money: Sound & Unsound (Auburn, Alabama: Ludwig von Mises Institute, 2010), pp. 193–196.
[14] This is Menger’s theory of imputation; Carl Menger, Principles of Economics (Auburn, Alabama: Ludwig von Mises Institute, 2007), pp. 149–152.
By Toby Baxendale, on 24 August 11
As a young man, Prof Ebeling witnessed first hand the demise of the Soviet system. The article below is a truly remarkable eye witness account of the 72 hours that changed the world. Pause on that: just 72 hours to move from seemingly unassailable Communist Party rule to the new beginnings of the Russian nation we have today.
As we know, Mises had shown in the early ’20s how it was impossible for a pure socialist system to centrally plan; in the absence of a price system, they could not properly allocate scare resources. In the late ’30s, Hayek showed us how it was impossible that any one group of planners match the interpersonal transactions of hundreds of millions of people, each with their own particular subjective values on each of the specific things they were doing. It took 70 years for the total collapse of the Soviet system. Then 72 hours changed the world.
We see that Soviet-style planing of money still lingers on in the world today. We are not accustomed to thinking that the Bank of England, the Federal Reserve and the European Central Bank are money planning bureaus, but that is what they do: try to plan our money supply . We have 9 wise men in the MPC who do this. In our case, they do this by inflation targeting via interest rate adjustments and their own bond purchases. The money supply needs no more planning than the price of apples does, yet we still cling to this notion.
To all policy makers, those 72 hours Ebeling writes about are a stark reminder that when confidence blows in something, and people lose faith in the status quo, things can change very quickly indeed!
The credit-induced boom of the central banks, with their private sector mints, the private banks, lending recklessly during the noughties, led to catastrophe by 2007/08. The policy response of our dear leader Gordon Brown involved the socialisation of banking losses. Having assumed the liabilities of the banks, national governments across the Western world are now crisis. Like the cartoon character who runs off the edge of the cliff with his legs still spinning, suspended in mid air, it may be the sudden awareness of an untenable position that brings the paper money system crashing back down to earth. Are we due for our own 72 hours of reckoning?
Twenty years ago, on August 22, 1991, I stood amid a vast cheering crowd of tens of thousands of people outside the Russian parliament building in Moscow, the capital of the Soviet Union. They were celebrating the failure by diehard Soviet leaders to undertake a political and military coup d’état meant to maintain dictatorial communist rule in the Union of Soviet Socialist Republics.
Four days earlier, on August 19th, a band of hard-line Soviet political and military leaders had initiated the coup attempt against the leadership of Mikhail Gorbachev, the General Secretary of the Communist Party of the U.S.S.R, and Boris Yeltsin, president of the Russian Soviet Federated Socialist Republic, the largest of the constituent republics of the Soviet Union.
Fearful that the political and economic reforms that had been introduced by Gorbachev shortly after his ascendency to the top leadership position in the Soviet Communist Party in 1986 were now threatening to bring about the disintegration of the Soviet Union, the hard-line conspirators were determined to preserve intact what remained of Soviet power in their own country.
Gorbachev’s Attempt to Save Socialism
Gorbachev believed that the Soviet Union had taken several serious wrong turns in the past. But he was not an opponent of socialism or its Marxist-Leninist foundations. He wanted a new “socialism-with-a-human-face.” His goal was a “kinder and gentler” communist ideology, so to speak. He truly believed that the Soviet Union could be saved, and with it a more humane collectivist alternative to Western capitalism.
To achieve this end, Gorbachev had introduced to two reform agendas: First, perestroika, a series of economic changes meant to admit the mistakes of heavy handed central planning. State enterprise managers were to be more accountable, small private businesses would be permitted and fostered, and Soviet companies would be allowed to form joint ventures with selected Western corporations. Flexibility and adaptability would create a new and better socialist economy.
Second, glasnost, political “openness” under which the follies of the past would be admitted and the formerly “blank pages” of Soviet history – especially about the “crimes of Stalin” – would be filled in. Greater historical and political honesty, it was said, would revive the moribund Soviet ideology and renew the Soviet people’s enthusiastic support for the redesigned bright socialist future.
The more hard-line and “conservative” members of the Soviet leadership considered all such reforms as opening a Pandora’s Box of uncontrollable forces that would undermine the Soviet system. They had already seen this happen in the outer ring of the Soviet Empire in Eastern Europe.
The Beginning of the End in Eastern Europe
In 1989 Gorbachev had stood by as the Berlin Wall, the symbol of Soviet imperial power in the heart of Europe, had come tumbling down, and the Soviet “captive nations” of Eastern Europe – East Germany, Poland, Czechoslovakia, Hungary, Romania and Bulgaria – that Stalin had claimed as conquered booty at the end of the Second World War, began to free themselves from communist control and Soviet domination.
The Soviet hard-liners were now convinced that a new political treaty that Gorbachev was planning to sign with Russian president Yeltsin and Nursultan Nazarbayev, president of the Soviet republic of Kazakhstan, would mean the end of the Soviet Union, itself.
Already, the small Baltic republics of Estonia, Latvia, and Lithuania were reasserting the national independence they had lost in 1939-1940, as a result of Stalin and Hitler’s division of Eastern Europe. Violent and murderous Soviet military crackdowns in Lithuania and in Latvia in January 1991 had failed to crush the budding democratic movements in those countries. Military methods had also been employed, to no avail, to keep in line the Soviet republics of Georgia and Azerbaijan.
Communist Conspirators for Soviet Power
On August 18th, the hard-line conspirators tried to persuade Gorbachev to reverse his planned political arrangements with the Russian Federation and Soviet Kazakhstan. When he refused he was held by force in a summer home he was vacationing at in the Crimea on the Black Sea.
Early on the morning of August 19th, the conspirators issued a declaration announcing their takeover of the Soviet government. A plan to capture and possibly kill Boris Yeltsin failed. Yeltsin eluded the kidnappers and made his way to the Russian parliament building from his home outside Moscow. Military units loyal to the conspirators ringed the city with tanks on every bridge leading into the city and along every main thoroughfare in the center of Moscow. Tank units had surrounded the Russian parliament, as well.
But Yeltsin soon was rallying the people of Moscow and the Russian population in general to defend Russia’s own emerging democracy. People all around the world saw Yeltsin stand atop an army tank outside the parliament building asking Muscovites to resist this attempt to return to the dark days of communist rule.
The Western media made much at the time of the apparent poor planning during the seventy-two hour coup attempt during August 19th to the 21st. The world press focused on and mocked the nervousness and confusion shown by some of the coup leaders during a press conference. The conspirators were ridiculed for their Keystone cop-like behavior in missing their chance to kidnap Yeltsin or delaying their seizure of the Russian parliament building; or leaving international telephone lines open and not even jamming foreign news broadcasts that were reporting the events as they happened to the entire Soviet Union.
The Dangers If the Hard-liners had Won
Regardless of the poor planning on the part of the coup leaders, however, the fact remains that if they had succeeded the consequences might have been catastrophic. I have a photocopy of the arrest warrant form that had been prepared for the Moscow region and signed by the Moscow military commander, Marshal Kalinin.
It gave the military and the KGB, the Soviet secret police, the authority to arrest anyone. It had a “fill-in-the-blank,” where the victim’s name would be written in. Almost 500,000 of these arrest warrant forms had been prepared. In other words, upwards of a half-million people might have been imprisoned in Moscow, alone. The day before the coup began, the KGB had received a consignment of 250,000 pairs of handcuffs. And the Russian press later reported that some of the prison camps in Siberia had been clandestinely reopened. If the coup had succeeded, possibly as many as three to four million people in the Soviet Union would have been sent to the GULAG, the notorious Soviet labor camp system.
Another document published in the Russian press after the coup failed had the instructions for the military authorities in various regions around the country. They were to begin tighter surveillance of the people in the areas under their jurisdiction. They were to keep watch on the words and actions of everyone. Foreigners were to be even more carefully followed and watched. And their reports to the coup leaders in Moscow were to be filed every four hours. Indeed, when the coup was in progress, the KGB began to close down commercial joint ventures with Western companies in Moscow, accusing them of being “nests of spies,” and arrested some of the Russian participants in these enterprises.
Fear Underneath the Surrealism of Calm
During the coup attempt Moscow had a surrealistic quality. On the streets around the city it seemed as if nothing were happening – except for the clusters of Soviet tank units strategically positioned at central intersections and at the bridges crossing the Moscow River. Taxi cabs patrolled the avenues looking for passengers; the population seemed to go about its business walking to and from work, or waiting in long lines for the meager supplies of everyday essentials at the government retail stores; and motorists were as usual also lined up at the government owned gasoline stations. Even with the clearly marked foreign license plates on my rented car, I was never stopped as I drove around the center of Moscow.
The only signs that these were extraordinary days were the grimmer than usual looks on the faces of many; and that in the food stores many people would silently huddle around radios after completing their purchases. However, the appearance of near normality could not hide the fact that the future of the country was hanging in the balance.
Russians Run the Risk for Freedom
During the three days of that fateful week, Russians of various walks of life had to ask themselves what price they put on freedom. And thousands concluded that risking their lives to prevent a return to communist despotism was price they were willing to pay. Those thousands appeared at the Russian parliament in response to Boris Yeltsin’s appeal to the people. They built makeshift barricades, and prepared to offer themselves as unarmed human shields against Soviet tanks and troops, if they had attacked. My future wife, Anna, and I were among those friends of freedom who stood vigil during most of those three days facing the barrels of Soviet tanks.
Among those thousands, three groups were most noticeable in having chosen to fight for freedom: First, young people in their teens and twenties who had been living in a freer environment during the previous six years since Gorbachev had come to power, and who did not want to live under the terror and tyranny their parents had known in the past. Second, new Russian businessmen, who realized that without a free political order their emerging economic liberties would be crushed. And, third, veterans of the Soviet war in Afghanistan, who had been conscripted into the service of Soviet imperialism and were now determined to prevent its return.
The bankruptcy of the Soviet system was demonstrated not only by the courage of those thousands defending the Russian parliament, but also by the unwillingness of the Soviet military to obey the orders of the coup leaders. It is true that only a handful of military units actually went over immediately to Yeltsin’s side in Moscow. But hundreds of Russian babushkas – grandmothers – went up to the young soldiers and officers manning the Soviet tanks, and asked them, “Are you going to shoot their mother, your father, your grandmother? We are your own people.” The final act of the coup came when these military units refused to obey orders and seize the Russian parliament building, at the possible cost of hundreds or thousands of lives.
Freedom! Freedom! Freedom!
On that clear, warm Thursday of August 22th, that huge mass of humanity that had assembled in a large plaza behind the Russian parliament stood and listened as Boris Yeltsin told them that that area would now be known as the Square of Russian Freedom. The multitude replied in unison: Svaboda! Svaboda! Svaboda! – “Freedom! Freedom, Freedom!”
A huge flag of pre-communist Russia, with its colors of white, blue and red, draped the entire length of the parliament building. The crowd looked up and watched as the Soviet red flag, with its yellow hammer and sickle in the upper left corner, was lowered from the flagpole atop the parliament, and the Russian colors were raised for the first time in its place. And again the people chanted: “Freedom! Freedom! Freedom!”
Not too far away from the parliament building in Moscow, that same day, a large crowd had formed at Lubyanka Square at the headquarters of the KGB. With the help of a crane, these Muscovites pulled down a large statue of Felix Dzerzhinsky, the founder of the Soviet secret police that stood near the entrance to the KGB building. In a small park across from the KGB headquarters, in a corner of which rests a small monument to the victims of the Soviet prison and labor camps, an anti-communist rally was held. A young man in an old Czarist Russian military uniform burned a Soviet flag, while the crowd cheered him on.
The seventy-five-year nightmare of communist tyranny and terror was coming to an end. The people of Russia were hoping for freedom, and they were basking in the imagined joy of it.
Freedom’s Hope and Post-Communist Reality
The demise of the Communist Party and the Soviet system was one of the momentous events in modern history. That it came about with a relatively small amount of bloodshed during those seventy-two hours of the hard-line coup attempt was nothing short of miraculous – only a handful of people lost their lives.
The last twenty years have not turned out how many of the friends of freedom in Russia had hoped. Indeed, post-communist Russia saw a contradictory, poorly organized, and corrupted privatization of Soviet industry, plus a high and damaging inflation in 1992-1994; a severe financial crisis in 1998; a return to authoritarian political rule following Vladimir Putin’s rise to power in 1999; two bloody and destructive wars in the attempted breakaway region of Chechnya; wide spread and pervasive corruption at all levels of government; state controlled and manipulated markets, investment, and commerce; assassinations and imprisonments of political opponents of the regime; and significant nostalgia among too many in the country for “great power” status and the “firm hand” of the infamous Stalinist era.
Nonetheless, for those of us who were fortunate enough to be in Moscow in August 1991, it remains in our minds as an unforgettable historical moment when the first and longest-lived of the 20th century’s totalitarian states was brought to the doorstep of its end.
Dr. Richard M. Ebeling is Professor of Economics at Northwood University. This article was first published at the NU blog, In Defense of Capitalism & Human Progress on the 18th of August
By Dr Tim Evans, on 23 August 11
Over recent months, TCC’s media profile has gone from strength to strength – with this list of media hits just scratching the surface.
Today, the organisation and its network of voices (board members, senior fellows and advisory board members) are increasingly to be found on the BBC or in such newspapers as the Wall Street Journal, the Financial Times and the Daily Telegraph. As TCC’s scholarly reputation grows so does its media profile and impact.
This is why I have no doubt that our voices will soon be heard not only in more specialised and esoteric outlets but importantly in ones with much greater mass appeal. If TCC’s media strategy was a motorcar then in recent months it has transitioned from second to third gear. If things go as planned next year will see us move into fourth. In this context, I say: BBC Newsnight, Daily Mail and the Mirror – bring it on!
By Gerardo Coco, on 23 August 11
The advent of a European Union with a single currency was hailed by Nobel laureate Robert A. Mundell as
a great step forward, because it will bring forth new and for once meaningful ideas about reform of the international financial architecture. The euro promises to be a catalyst for international monetary reform.
Unfortunately, by underwriting member countries’ financial risk with impunity, the EU made the euro the catalyst of unsound monetary policies that are now leading the Union into an economic maelstrom. Still less has euroization set the pace for an international reform of the monetary machinery.
Milton Friedman was more cautious about this super currency. The euro’s real Achilles heel, he said, would prove to be political: a system under different governments subject to very different political pressures could not endure a common currency. Without political integration, the tension and friction of the national institutional systems would condemn it to failure. Indeed the problem is always political, but not in the sense meant by Friedman. Regardless of the degree of political integration, governments’ spending and dissipation, which are unalterable tendencies of any political organism, make irredeemable paper monies act as transmission belts for financial and economic disruptions.
At the outset of the 2010 Greek crisis that triggered the European domino effect, Professor Mundell pointed out that there was nothing inherently bad in the euro as such; the problem lay in the country’s public debt spiralling out of control. However, being a strong advocate of financial and monetary “architectures” as means for pursuing monetary and non monetary ends, he should have acknowledged that irredeemable currencies cannot be examined independently of the political framework in which they are embedded, because politics inevitably extends the role of money beyond its original function as a medium of exchange, making it trespass into the field of “economic policies”. Official theory does not see money as a neutral device, but as an instrument of policy for purposing ends which conflict with its primary goal: to retain the value of the monetary unit. Failing this primary goal, monetary architectures no matter how they are framed make for economic devastation.
Is a monetary order a constitution?
Robert Mundell’s assertion — that a monetary order is to a monetary system what a constitution is to a political or electoral system — unintentionally sheds light on the authoritarian nature of today’s irredeemable money governance and its fraudulent practices. Where is the flaw in this catching parallel? The flaw is that if a monetary order stands for a constitution, i.e. a democratic framework of laws and regulations, it does not provide for a separation of powers. The money order as a legislative system coincides with the executive power, the money system, embracing the range of practices and policies pursued for monetary and non monetary ends. Moreover, the judicial system is concentrated in the same hands because monetary authorities are not accountable to anyone. With the exception of governments that, being their source of power, may be considered “ghost writers” of monetary constitutions, no one else can influence money legislation. In other words, in this framework there is no room for an “electorate” (producers and consumers). What basic law regulates the relationships between individuals and their monetary orders by guaranteeing fundamental rights?
The basic law of the gold standard was the free convertibility of currencies, allowing individuals to redeem paper into gold on demand. This acted as protection against money misuse by banks or governments. Convertibility was for producers and consumers the means to express their vote on the degree of money reliability. Money was an instrument of saving. Paper money, or fiduciary circulation, as opposed to the banknote which was a title of credit, could be issued too but it had to comply with the law of gold circulation whereby the total volume of currency, coins, banknotes and paper notes had to correspond exactly to the quantity of metallic money necessary to allow economic exchanges. This being the purpose of the monetary system, banks, to avoid insolvency risks and gold reserves outflow had to adjust, through the discount rate policy, the issue of fiduciary papers to the real needs of economy.
Therefore gold was a barrier against the use of money as an instrument of power. Its value was fixed on the world market where gold was always in demand. Gold then had the same value in each country, and that’s why it was a stable international means of payment. Finally exchange rates were stable, not because they were arbitrarily controlled by government but because they were always gravitating towards the gold parity, the rate at which currencies were exchanged, and this was determined by their respective gold content. Roughly stated, the gold standard was an order providing for a separation of powers: the fundamental law of metallic circulation was the constitution, the banking system was the executive power which was controlled by producers and consumers representing the judicial power to sanction abuses. In today’s monetary order, producers and consumers have become legally disarmed victims of monetary legislation, deprived of the weapon of defence against money manipulation.
A trail of broken monetary arrangements
Central banks are the pillars of the monetary order because they are the source of the world’s supply and they regulate it. They control circulation, expand and restrict credit, stabilize prices and, above all they act as instruments of State finances. They are both “anvil and hammer”, trying to adapt the system to all occasions, remedying abuse by a still greater abuse, and considering themselves immune from the consequences. For these reasons, the leading architects of the world financial order should explain how the very same institutions that are pursuing unsound policies domestically might realistically think to establish a sound monetary order at a higher level.
The most important architecture, after the Second World War, was the Bretton Woods Agreement (1944). A “managed” form of gold standard was designed to give a stable word monetary order by a fixed exchange rate system with the dollar as the key currency, redeemable in gold only to central banks, and with member countries’ currencies pegged to the dollar at fixed rates and indirectly redeemable in gold. But the huge balance of payments deficit and high inflation in the US should have made gold rise against the dollar. A crisis of confidence in the reserve currency pushed foreign countries’ central banks to demand conversion into the metal, panicking the US, which promptly closed the gold window.
After the end of Bretton Woods in 1971, fiat currencies began to rule the world
The Smithsonian Agreement (1971-1973) which followed Bretton Woods was hailed by President Nixon as the “greatest monetary agreement in the history of the world” (!). It was an order based on fixed exchange rates fluctuating within a narrow margin, but without the backing of gold. Again, countries were expected to buy an irredeemable dollar at an overvalued rate. The system ended after two years.
Within the West European block, fixed exchange rates remained, but floating within a band against dollar. “The snake”, as the arrangement was called, died in 1976. Major shocks, including the 1973 oil price spike and the 1974 commodity boom, caused a series of currency crises, repeatedly forcing countries out of the arrangement. But this did not persuade them to abandon the dream of intra-European currency stability. The snake was replaced in 1979 by the European Monetary System (EMS) with its basket of arbitrarily fixed-but-adjustable exchange rates floating within a small band and pegged to the European currency unit (ecu), the precursor of euro.
Yet the arrangement ultimately failed, again due to a series of severe shocks (a global recession, German economic and monetary unification, liberalization of capital controls). Rather than abandoning the system, European governments adopted much wider fluctuation bands, reaffirming their commitment to an order based on fixed rates and irredeemable currencies.
So we arrive at an arrangement without historical precedent: sovereign nations with a single legal tender issued by a common central bank — the Euro entered into function in 1999. The stated aims of the single currency were noble: to facilitate trade and freedom of movement, providing for a market large enough to give each country better insulation against external shocks. Unfortunately, it couldn’t provide the member states with a system of defence against the internal shocks inherent to any irredeemable currency.
History confirms that currencies cannot rest on stability pacts and similar restrictions. Mainstream economists have long argued that the euro crisis has arisen from the lack of common social and fiscal policies, but the architects of the European currency were also well aware of this. Their aim was always to forge a European people, and a socialist European superstate, on the back of the euro. They had not the patience for a European state to naturally emerge in the same manner as the US, from a population sharing the same culture and language. “Europe of the people and for the people” was a misleading disguise to give an economic prison the honest appearance of a democratic and liberal project.
So in the end, Euroland has been working as a hybrid framework of institutions to which members countries delegate some of their national sovereignty in exchange for access to a larger market, capital, and low interest rates. But they entered an region of anti-competitive practices, antitrust regulations, redistributive policies, lavish subsidies, and faux egalitarianism — a perfect economic environment in which to run astronomical debts. The euro system represents one of the most significant attempts to place a currency at the service of political and social objectives, and it is for this reason that it will remain a source of problems.
Descent into the maelstrom
Today’s monetary orders are shaped to pursue what Rothbard has called the economics of violent intervention in the market. They are, in essence, based on a socialist idea of money. Accordingly they make for a framework of laws, conventions, and regulations fitting the interests of the rulers. In this framework it is the public debt that has utmost importance. Indeed, it is the monetary order that has developed the concept of debt in the modern sense. Because the management of public finances have become the supreme direction of economic policy, treasuries are now in charge of the national economies. Through the incestuous relationships they maintain with central banks, they are able to create the ideal monetary conditions in which to borrow ad libitum. Purely monetary considerations such as providing a stable currency are disregarded. Political, fiscal and social ends prevail over everything else.
In the last eighty years, monetary orders have allowed an abnormal increase in finance, banking, debt, and speculation completely unrelated to a development of sound economic activity and wealth production, but due instead to government’s overloading of central banking responsibilities. Unfortunately, the outcome is the de facto insolvency of the world monetary order. The ensuing adverse effects may be still delayed with the aid of various measures, interventions and expedients, but not much time is left. The stormy sea of debt has already produced a whirlpool that will be sucking major economies into a maelstrom, and the larger they are, the more rapid will be their descent. It remain to be seen what shape they will take after the shipwreck. Gloomy as the situation may appear, it is not hopeless because such an event might be the sole opportunity to cause a decisive change. It might be that instead of resuming the art of monetary expedients to create irredeemable money, governments and banks let them fade into oblivion. This would allow people to take their monetary destiny back into their own hands.
By Dr Tim Evans, on 22 August 11
Mark Seddon is the former United Nations Correspondent and New York Bureau Chief for Al-Jazeera English TV. He has reported from over twenty countries, including the United States, North Korea, China, Haiti, Syria, Libya, Yemen, Ethiopia and the Democratic Republic of Congo. He has interviewed, amongst others, Ban Ki-Moon, Lech Walesa, Tony Blair, Hans Blix, Michael Foot, Mia Farrow, and George Clooney.
In a journalistic career spanning over twenty years, Mark has been Editor of Tribune and an elected member of the UK Labour Party’s National Executive Committee. He has written for most British newspapers and many magazines, including the Guardian, the Independent, the Daily Mail, The Times, the Spectator, New Statesman, Private Eye, British Journalism Review and Country Life Magazine. For a number of years he was a Diarist at the London Evening Standard, and has also reported for, amongst others, the BBC and Sky TV. He lives in Buckingham, England.
He is a passionate believer in the radical English dissenting tradition, as best represented through Thomas Rainsborough, a Republican officer who served in Parliament’s army and navy; as a Leveller, he clashed with Ireton and Cromwell and died under suspicious circumstances whilst on active service.
By Toby Baxendale, on 22 August 11
Back in the ’30s, at the time of the original Keynes-Hayek debate, Hayek had a solid methodological system that could explain the causes of the recession of the late ’20s and early ’30s, and it’s subsequent gyrations, up and down.
The root cause was excessive credit creation by the world’s main central banks, and their fractional reserve private sector mints, the banks. This bank credit was loaned out to businesses who bought extra kit to produce goods and services more efficiently. The boom in producer sectors bid up relative prices for their resources. Higher wages for labour meant more consumption, boosting consumer sectors. This in turn pushed up relative prices in those sectors. Competition for resources bid up prices until no one believed the prices were sustainable — pop goes the mega bubble, and boom turns to bust. This is called the Austrian Theory of the Business Cycle.
At the BBC LSE Hayek v Keynes debate, Lord Skidelsky told us that everyone knew it was excess credit that caused this boom, and that this was called the “Treasury View.”
This of course is not true; the noble Lord is misinformed. The Treasury View was advanced by members of the Chancellor’s department saying, in short, that for every increase in public expenditure advocated by Keynesian types to alleviate the Great Depression effects, there would be an equivalent reduction in private sector expenditure that would mean that the net effect in the economy is zero.
Whilst I hold that this is a valid view, it is not one that gives us the theoretical tools to understand why boom and bust happen in the first place. Mises and Hayek gave us these tools with the Austrian Theory of the Business Cycle.
Neither the Treasury View, as expounded by the likes of Ralph Hawtrey, nor the Keynesian view were based on a series of logical deductions from root causes. The best Keynes could offer as an explanation for boom and bust was “animal spirits”. He is Theory Lite in this respect.
Unfazed by his shaky foundation, Keynes confidently prescribed how to correct an animal-spirit-induced bust. We are told to spend when the private sector is not spending. Who does this? The government on our behalf. The Treasury View makes clear that it’s futile to tax the private sector in order to spend, so we have the cries from modern day Keynesians to carry on borrowing and spending in order to force a correction . If you haven’t got the correction you desire, you have not borrowed enough! So say the likes of Krugman and Skidelsky, drunk on the intoxicating work of Keynes.
The faulty logic than runs underneath this way of thinking is called the “Circular Flow of Income.” This is now bread and butter in any economics text book. One person’s income, when spent on goods and services, becomes another person’s income. Cut one and you cut all. Therefore, a series of cuts or austerity measures is exactly what you should not be doing at a time of bust; you need to keep everyone’s income up.
Hayek held that relative prices and income where what mattered, not gross aggregates . If a man has an income of £100 and costs of £90, we can say he has a profit of £10. Then recession hits and he has an income of £85 and still costs of £90, so he is sunk by £5. Thus the aim of the man in question, with income of £85 is to get his costs down to under £75 and restore his profitability. As this is done, the foundations for recovery are laid. Even better, if he can get costs to £74, on lower income and a lower costs base, he is in fact more profitable than in the glorious boom times!
In the 5 mins each speaker had in this debate to present their case, some of this came across and some of it did not. Jamie Whyte and George Selgin did a fantastic job at putting forward the case for Hayek. Skidelsky sadly did not represent Keynes very truthfully, for the reasons I have outlined above. Selgin picked him up on various other errors and misrepresentations.
This debate is very relevant for today as no doubt we will be told the current market corrections are “Animal Spirits”, and that the answer is further government intervention.
The BBC tell us the debate had over 1 million listeners and was in their top 5 podcasts. In all my years studying at the LSE and as a donor to it, I have never seen three lecture theatres full of public and students alike. Not even for visiting Heads of State!
This is the debate of our times.
I am delighted to say that the program will be re-run, and they expect another 1.5 millions viewers. Our friend at the Mises Institute, Stephan Kinsella, has blogged all the details here. If you want to educate yourself a little more on these matters, or even if you think you are very familiar with all of the issues, the debate is definitely worth a listen. If you can’t wait for the next BBC broadcast, you can find it online as an MP3.
Since the original broadcast, the debate has continued online. On the 3rd of August, PrimeEconomics published a list of eight alleged fallacies in the Keynes/Hayek debate, drawing a number of responses, including some from George Selgin. On the same day, Selgin posted his own account of the debate at FreeBanking.org. More recently, on the 18th of August, Selgin took up Skidelsky’s suggestion that “no government has ever achieved a speedy recovery from a recession by clamping down on its spending or reducing its indebtedness”, citing the US recovery from a deep recession in 1920. The following day, Skidelsky published his account of the Keynes-Hayek rematch at Project Syndicate, declaring
Except to Hayekian fanatics, it seems obvious that the coordinated global stimulus of 2009 stopped the slide into another Great Depression.
You can read Selgin’s response at FreeBanking.org.
Personally, I look forward to the day when Paul Krugman will come and stand on that same stage where Hayek delivered his famous Prices and Production lectures, and engage in serious debate with Austrian economists. How many lecture theatres would that fill? What global TV audience would it draw?
For those at the BBC and for those at the LSE, I think my next Distinguished Hayek Fellowship Teaching Programme event the LSE should be just this debate, and I would be happy to support and fund whatever I can. I repeat, this is the debate of our times. Only someone of the stature of Krugman can represent Keynes, we need to move this debate up and along now.
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