Deflating the Inflation Myth

[Editor’s Note; this interview, with Cobden Centre contributor Jesus Huerta de Soto, was by Malte Fischer of Handelsblatt]

Professor Huerta de Soto, the inflation rate in the euro zone is now only 0.4 percent. Is deflation threatening us, as many experts maintain?

Deflation means that the money supply is shrinking. This is not the case in the euro zone. The M3, the broadly defined supply of money, is growing by about two percent, while the more narrowly defined money supply, M1, by more than six percent. Although the inflation rate in the euro zone is below the European Central Bank’s target of barely two percent, that’s no reason to stir up fears of deflation like some central bankers are doing.

By doing so, they are suggesting that lowering prices is something bad. That is wrong. Price deflation is not a catastrophe, but rather a blessing.

You’ll have to explain that.

Take my homeland, Spain. At the moment, the consumer prices there are decreasing. At the same time, the economy is growing by around two percent on a yearly basis. Some 275,000 new jobs were created in 2013 and unemployment fell from 26 to 23 percent. The facts contradict the horror scenarios of deflation.

Does that mean we should be happy about deflation?

Certainly. It is particularly beneficial when it results from an interplay of a stable money supply and increasing productivity. A fine example is the gold standard in the 19th century. Back then, the money supply only grew by one to two percent per year. At the same time, industrial societies generated the greatest increase in prosperity in history. That is why the ECB should use the gold standard as an example and lower the target for the growth of the M3 money supply from 4.5 to around 2.0 percent.

If the euro economy were to grow by about three percent – which it is capable of doing if it were freed from the shackles of state regulations – prices would decrease by about one percent per annum.

If deflation is so beneficial, why are people afraid of it?

I don’t believe that the average person is frightened by falling prices. It is the representatives of mainstream economics fomenting a deflation phobia. They argue that deflation allows the actual debt burden to increase, and thus strangles the overall economic demand. The deflation alarmists fail to mention that creditors benefit from deflation, which stimulates demand.

Isn’t there a danger consumers will roll back their spending if everything is cheaper tomorrow?

That is an abstruse argument you hear again and again. Look at how fast the latest smartphones sell, although consumers know that the phones will be sold at a lower cost a few months afterwards. America was dominated by deflation for decades after the Civil War. In spite of that, consumption increased. If people were to put off buying because of lower prices, they ultimately would starve to death.

But lowering prices drives down sales figures and lessens the willingness of companies to invest. Do you want to ignore that?

Sales figures are not crucial for companies, but rather their earnings, meaning the difference between revenues and costs. Sinking sales prices increase pressure to reduce costs. The companies, therefore, replace manpower with machines. That means more machines need to be produced, which increases the demand for manpower in the capital goods sector. In this way, workers who lost their jobs in the wake of price deflation find new work in the capital goods sector. The capital stock grows without resulting in mass unemployment.

Aren’t you making that too easy for yourself ? In reality, the gap between the qualifications of the unemployed and the needs of companies is, at times, quite large.

I’m not claiming the market is perfect. That means it’s crucial that the labor market is flexible enough to offer incentives for creative employers to hire new workers.

What role does politics play?

The problem is that politicians have a short time horizon. That is why we need a monetary policy framework that holds both politicians and unions in check. The euro has this job in Europe. The common currency has removed the option of governments to devalue the currency to cover for their misguided economic policies. Economic policy mistakes are seen directly in the affected country’s loss of competitiveness, which forces politicians to make harsh reforms. Two governments in Spain within one and half years have implemented reforms that I hadn’t even dared to dream of. Now, the economic situation is improving and Spain is reaping the harvest of the reforms.

You may be right in the matter of Spain, but there have been no signs of fundamental reforms in Italy and France…

Which is why conditions there will first have to get worse before reforms come. We have learned from experience that the more miserable the economic situation, the stronger the pressure to reform. The reform successes that Spain and other euro countries have achieved increase the pressure on Paris and Rome. High unemployment in Spain had pushed down labor costs. At an average of €20, or $24.90, per hour, they are now half the rate as in France. That is why the French cannot avoid a drastic economic policy cure, even if the people oppose it. Germany should hold to its budgetary consolidation to keep up pressure on France and Italy.

The ECB is coming under increasing pressure to open the monetary floodgates and devalue the euro. The pressure is coming from academics, financial markets and politicians.

The economic mainstream of Keynesianism and monetarism explains the Great Depression of the 1930s with a shortage of money, which allowed an anti-deflation mentality to develop among academics. Politicians use the academic sounding board to pressure the ECB to reinflate the economy. Governments love inflation because it gives them the opportunity to live beyond their means and pile up huge mountains of debt that the central bank devaluates through inflation. It is no wonder it just happens to be the opponents of austerity policies who warn about deflation and demonize the euro’s set of stability policy regulations. They are afraid of presenting the true costs of the welfare state to the electorate.

The head of the ECB, Mario Draghi, succumbed to the pressure with his promise to save the euro if needs be by firing up the money printing presses. A mistake?

Careful. Until now, Mr. Draghi has been mainly making promises, but has barely acted. Although the ECB has initiated generous money lending transactions, and lowered the prime lending rate, the actual yield for 10-year government bonds of ailing euro zone members is above those in America. Measured on the balance sheet totals, the ECB has done less than other Western central banks. As long as the guardians of the euro are only talking but not acting, the pressure will remain on Italy and France to reform. That is why it is crucial the ECB resists the pressure of the governments and the Anglo-Saxon financial world and buys no state bonds.

What role do the Anglo-Saxon financial markets play?

The Anglo-Saxon press and the financial markets are ostentatiously conducting a crusade against the euro and the austerity policy in continental Europe necessitated by it. I am really no believer in conspiracy theories, but the out-and-out attacks against the euro by Washington and London suggest a hidden agenda. The Americans are afraid that the days of the dollar as a global currency are numbered if the euro survives as a hard currency.

Can the euro survive without political union?

A political union will not draw majority support in the population. It also isn’t desirable because it reduces the pressure for fiscal austerity. The best monetary regime for a free society is the gold standard, with all deposits covered by full reserves and without state central banks. As long as we don’t have that, we should defend the euro because it deprives governments of access to the money printing presses and forces them to consolidate their budgets and make reforms. In a certain way, it has the effect of the gold standard.


In memoriam: James M. Buchanan

It was with great sadness that I heard, on the morning of the 9th of January, that James McGill Buchanan, winner of the Nobel Prize in Economics, had passed away at the age of 93.  I owe Buchanan a great debt of gratitude.  Though he was not a full-fledged member of the Austrian school of economics, from the time of my first international lectures (always from the Austrian perspective) nearly thirty years ago, until now, Buchanan never ceased to respect my talks (often imbued with the excessive passion characteristic of young academics and to which I am so prone) and what is more, to support them in public with all the prestige of his great wisdom and personality.  For example, it particularly surprised and moved me when, at the 1994 general meeting of the Mont Pelerin Society in Rio de Janeiro, Buchanan patiently waited his turn in line for the floor with the sole purpose of objecting because the chair, the Argentine Benegas Lynch, had taken the floor from me when, as Buchanan pointed out:

Professor Huerta de Soto was presenting perhaps one of the most important arguments of the entire conference, the institutional link between the credit expansion made possible by fractional-reserve banking against general legal principles (which require a 100-percent reserve on demand deposits) and economic crises and recessions.

Nor can I forget his kind words of correction on occasion, such as when I launched a comprehensive, supported attack on Maurice Allais and his 1947 article in which he conveys a belief in the possibility of socialist economic calculation.  Buchanan clarified that during those years, Allais shared the general opinion of those in our profession and that he had not yet been able to completely digest Mises’s and Hayek’s contributions on the matter.

In any case, Buchanan’s sympathy with the Austrians was well-known, and his popular collection of essays, LSE Essays on Costs, echoes the essentially Austrian argument that the mistaken neoclassical belief in the possibility of socialist economic calculation had its origin in neoclassical economists’ inability to grasp the true, subjective, entrepreneurial, and creative nature of costs.

At any rate, I have always felt that, despite his sympathy with the Austrians, Buchanan was too heavily influenced by the neoclassical, maximizing spirit of the Chicago school, both in his very remarkable contributions which demonstrate the flaws in the “public choice” of voters, interest groups, bureaucrats, and politicians, and especially in the development of his theory of constitutional contractualism (which I view as one of his most debatable contributions, apart from the principle of unanimity, which he adopted from Wicksell, and which has always seemed quite healthy to me).

It is interesting to note that from a young age, Buchanan valued the Mediterranean academic mentality, particularly the realist, sociological approach of the Italian theory of public finance.  Perhaps for that reason, I think he always liked me and was amused by a young Spanish economist who, in every forum, continually and determinedly stressed the Hispanic origin of the school of Mises and Hayek, and the importance of the scholastics of the Spanish Golden Age.  At least that is what he told me on various occasions – at Madrid’s Jockey restaurant, now no longer in existence – over his favorite Spanish dish, baby eels, amply washed down with Rioja, a meal he never failed to taste on his numerous visits to Spain.

Fortunately, barely four months ago, I had the opportunity to pay my last public tribute to Buchanan, at the opening session of the general meeting of the Mont Pelerin Society, which took place September 3, 2012 in Prague.  There, before the President of the Czech Republic, Vaclav Klaus, and over 500 people who attended the meeting, I expressly mentioned the intellectual victory Buchanan had finally won when various European countries, led by Spain, had at last been obliged to modify their constitutions, compelled by the discipline of the euro, to include the anti-Keynesian principle of budget stability and equilibrium …

May this great libertarian economist rest in peace.


Socialism and decivilization

On pages 33–35 of my book Socialism, Economic Calculation, and Entrepreneurship, I examine the process by which the division of practical entrepreneurial knowledge deepens “vertically” and expands “horizontally,” a process that permits (and at the same time requires) an increase in population, fosters prosperity and general well-being, and brings about the advancement of civilization. As I indicate there, this process is based on

  1. the specialization of entrepreneurial creativity in increasingly narrow and more specific fields, and in increasing detail and depth;
  2. the recognition of the private-property rights of the creative entrepreneur to the fruits of his creative activity in each of these areas;
  3. the free, voluntary exchange of the fruits of each human being’s specialization, an exchange that is always mutually beneficial for all who participate in the market process; and
  4. constant growth in the human population, which makes it possible to entrepreneurially “occupy” and cultivate a rising number of new fields of creative entrepreneurial knowledge, which enriches everyone.

According to this analysis, anything that guarantees the private ownership of what each person creates and contributes to the production process, that defends the peaceful possession of what each person conceives or discovers, and that facilitates (or does not impede) voluntary exchanges (which are always mutually satisfactory in the sense that they mean an improvement for each party) generates prosperity, increases the population, and furthers the quantitative and qualitative advancement of civilization. Likewise, any attack on the peaceful possession of goods and on the property rights that pertain to them, any coercive manipulation of the free process of voluntary exchange, in short, any state intervention in a free market economy always brings about undesired effects, stifles individual initiative, corrupts moral and responsible behavior habits, makes the masses childish and irresponsible, hastens the decline of the social fabric, consumes accumulated wealth, and blocks the expansion of human population and the advancement of civilization, while everywhere increasing poverty.

As an illustration, let us consider the process of decline and disappearance of classical Roman civilization. Though its basic landmarks are easily extrapolated to many circumstances of our contemporary world, unfortunately most people have now forgotten or are completely unaware of that important history lesson; and as a result they fail to see the grave risks now facing our civilization. In fact, as I explain in detail in my classes (and summarize in a video of one of them, on the fall of the Roman Empire [La Caída del Imperio Romano], which to my surprise has already been viewed on the Internet by almost 400,000 people in a little over a year), and according to prior studies by authors like Rostovtzeff (The Social and Economic History of the Roman Empire) and Mises (Human Action), “what brought about the decline of the [Roman] empire and the decay of its civilization was the disintegration of this economic interconnectedness, not the barbarian invasions” (op. cit., p. 767).

To be precise, Rome was the victim of an involution in the specialization and division of the trading process, as authorities systematically hindered or prevented voluntary exchanges at free-market prices, in the midst of rampant growth in subsidies, in public spending on consumption (“panem et circenses”), and in state control of prices. It is easy to grasp the logic behind these events. Chiefly beginning in the 3rd century, the buying of votes and popularity spread food subsidies (“panem”) financed by the public treasury via the “annona,” as well as the continual organization of the most lavish public games (“circenses”). As a result, not only were Italian farm owners eventually ruined, but the population of Rome did not cease to grow until it stood at nearly 1 million inhabitants. (Why take on the toil of working one’s land when its products cannot be sold at profitable prices, since the state distributes them almost for free in Rome?)

The obvious course of action was to leave the Italian countryside and move to the city, to live off the Roman welfare state, the cost of which could not be borne by the public treasury, and could only be covered by reducing the precious-metal content in the currency (that is, inflation). The outcome was inescapable: an uncontrolled drop in the purchasing power of money, i.e., an upward revolution in prices, to which the authorities responded by decreeing that prices were to remain fixed at their prior levels and imposing extremely harsh sentences on offenders. The establishment of these price ceilings led to widespread shortages (since at the low prices set, it was no longer profitable to produce and seek creative solutions to the problem of scarcity, while at the same time consumption and waste were still being artificially encouraged). Cities gradually began to run out of provisions, and the population began to leave and return to the countryside, to live in much poorer conditions in an autarchy, at mere subsistence level, a regime that laid the foundation for what would later be feudalism.

This decivilization process, which arose from the demagogic socialist ideology typical of the welfare state and of government interventionism in the economy, can be illustrated in a simplified, graphic manner by the reverse of the graphic explanation on page 34 of my aforementioned book, Socialism, Economic Calculation, and Entrepreneurship, in which I describe the process by which the division of labor (or rather, the specialization of knowledge) deepens and civilization advances.

Let us begin at the stage represented by the top line in the chart (T1), which reflects the advanced level of development spontaneously achieved by the Roman market process as early as the 1st century, and which, as Peter Temin has shown (“The Economy of the Early Roman Empire,” Journal of Economic Perspectives, vol. 20, no. 1, winter 2006, pp. 133–151), was characterized by a remarkable degree of institutional legal respect for private property (Roman law), and by the specialization and spread of exchanges in all sectors and factor markets (particularly the labor market, since, as Temin has demonstrated, the effect of slavery was much more modest that has been believed up to now). As a result, the Roman economy of the period reached a level of prosperity, economic development, urbanization, and culture that would not be seen again in the world until well into the 18th century.

The capital letters under each person in figure 1 indicate the ends each actor specializes in and devotes himself to. He then exchanges the fruits of his entrepreneurial effort and creativity (represented by the bulb that “lights up”) for those of other actors, and all benefit from each exchange. However, when state intervention in the economy increases (e.g., via price control), exchanges are hindered and decrease, and people find themselves in the stage depicted by the middle line in the chart. They are obliged to reduce the sphere of their specialization by abandoning, for example, ends G and H and concentrating on ends AB, CD, and EF, all with less division of labor, fewer exchanges, and hence a smaller degree of specialization, which requires greater replication and an excess of effort. The obvious result is a drop in the final production of the entire social process, and thus a rise in poverty.

The maximum point of economic decline and recession occurs in the stage shown by the bottom line in the chart (T3), where, when faced with mounting interventionist pressure from the state, continual tax increases, and stifling regulations, people are forced, in order to survive (even if at a level of poverty previously inconceivable), to almost completely abandon the prior division of labor and the exchange process that constitutes the market, to leave the city and return to the countryside to tend livestock and grow their own food, to tan their own leather and build their own shacks, and each person needlessly duplicates the minimum ends and activities required for survival (which we have marked ABCD in the chart). As is logical, productivity falls sharply, and all sorts of shortages occur that reduce the population due to a lack of resources: thus the process of deurbanization and decivilization reaches completion.

As Mises indicates,

With the system of maximum prices the practice of debasement completely paralyzed both the production and the marketing of the vital foodstuffs and disintegrated society’s economic organization.… To avoid starving, people deserted the cities, settled on the countryside, and tried to grow grain, oil, wine, and other necessities for themselves.… The economic function of the cities, of commerce, trade, and urban handicrafts, shrank. Italy and the provinces of the empire returned to a less advanced state of the social division of labor. The highly developed economic structure of ancient civilization retrograded to what is now known as the manorial organization of the Middle Ages.… [The emperors’] counteraction was futile as it did not affect the root of the evil. The compulsion and coercion to which they resorted could not reverse the trend toward social disintegration which, on the contrary, was caused precisely by too much compulsion and coercion [on the part of the state]. No Roman was aware of the fact that the process was induced by the government’s interference with prices and by currency debasement. (op. cit., pp. 768–769)

Mises concludes,

A social order is doomed if the actions which its normal functioning requires are rejected by the standards of morality, are declared illegal by the laws of the country, and are prosecuted as criminal by the courts and the police. The Roman Empire crumbled to dust because it lacked the spirit of liberalism and free enterprise. The policy of interventionism and its political corollary, the Fuhrer principle, decomposed the mighty empire as they will by necessity always disintegrate and destroy any social entity. (op. cit., p. 769, italics added)

Mises’s analysis has invariably been confirmed, not only in many specific historical instances (processes of decline and decivilizing involution, e.g., in the north and other parts of Africa; the crisis in Portugal following the “Carnation Revolution”; the chronic social illness that affects Argentina, which became one of the richest countries in the world before World War II, but which today, instead of receiving immigrants, loses population continually; similar processes that are ravaging Venezuela and other populist regimes in Latin America, etc.), but also, and above all, by the experiment of real socialism, which until the fall of the Berlin Wall steeped hundreds of millions of people in suffering and despair.

Also, today, in a fully globalized world market, the decivilizing forces of the welfare state, of syndicalism, of central banks’ financial and monetary manipulation, of economic interventionism, of the increasing tax burden and regulations, and of the lack of control in the public accounts threaten even those economies that until now had been considered the most prosperous (the United States and Europe). Now at a historic crossroads, these economies are struggling to rid themselves of the decivilizing forces of political demagogy and union power, as they attempt to return to the path of monetary rigor, budget control, tax reduction, and the dismantling of the tangled web of subsidies, intervention, and regulations that choke the entrepreneurial spirit and infantilize and demoralize the masses. Their success or failure in this endeavor will determine their future destiny, and specifically, whether or not they will continue to lead the advance of civilization as they have until now, or whether, in the case of failure, they will leave the leadership of civilization to other societies that, like the Sino-Asian society, fervently and unapologetically seek to become the key players in the new globalized world market.

It is obvious that Roman civilization did not fall as a result of the barbarian invasions: rather, the barbarians easily capitalized on a social process that was already, for purely endogenous reasons, in marked decline and breaking down.

Mises expresses it this way:

The alien aggressors merely took advantage of an opportunity which the internal weakness of the empire offered to them. From a military point of view the tribes which invaded the empire in the fourth and fifth centuries were not more formidable than the armies which the legions had easily defeated in earlier times. But the empire had changed. Its economic and social structure was already medieval. (op. cit., pp. 767–768)

Furthermore, the empire’s degree of regulation, statism, and tax pressure became so great that Roman citizens themselves often submitted to the barbarian invaders as a lesser evil, when they did not actually receive these invaders with open arms. Lactantius, in his treatise, On the Deaths of the Persecutors, written in the year 314-315 AD, states,

There began to be fewer men who paid taxes than there were who received wages; so that the means of the husbandmen being exhausted by enormous impositions, the farms were abandoned, cultivated grounds became woodland … And many presidents and a multitude of inferior officers lay heavy on each territory, and almost on each city. There were also many stewards of different degrees, and deputies of presidents. Very few civil causes came before them: but there were condemnations daily, and forfeitures frequently inflicted; taxes on numberless commodities, and those not only often repeated, but perpetual, and, in exacting them, intolerable wrongs. (cited by Antonio Aparicio Pérez, La Fiscalidad en la Historia de España: Época Antigua, años 753 a.C. a 476 d.C., Madrid: Instituto de Estudios Fiscales, 2008, p. 313)

Clearly, this situation closely parallels the current one in many ways, and a legion of writers have already shown that the present level of subsidies and regulations places a demoralizing, intolerable burden on the increasingly harassed productive sector of society. In fact, a few authors, like Alberto Recarte, have had the courage to call for a reduction in “the number of public employees, particularly those whose job it is to regulate, oversee, and inspect all economic activity by imposing costly and extremely interventionist legal requirements” (El Desmoronamiento de España, Madrid: La Esfera de los Libros, 2010, p. 126). We must remember that we all depend on the output of private economic activity.

In De Gubernatione Dei (IV, VI, 30), Salvian of Marseilles writes,

Meanwhile the poor are being robbed, widows groan, orphans are trodden down, so that many, even persons of good birth, who have enjoyed a liberal education, seek refuge with the enemy to escape death under the trials of the general persecution. They seek among the barbarians the Roman mercy, since they cannot endure the barbarous mercilessness they find among the Romans. Although these men differ in customs and language from those with whom they have taken refuge, and are unaccustomed too, if I may say so, to the nauseous odor of the bodies and clothing of the barbarians, yet they prefer the strange life they find there to the injustice rife among the Romans. So you find men passing over everywhere, now to the Goths, now to the Bagaudae, or whatever other barbarians have established their power anywhere, and they do not repent of their expatriation, for they would rather live as free men, though in seeming captivity, than as captives in seeming liberty. (cited in ibid., pp. 314–315)

Finally, in his Seven Books against the Pagans (Madrid: Gredos, VII, 41-7), the historian Orosius concludes,

The barbarians came to detest their swords, betook themselves to the plough, and are affectionately treating the rest of the Romans as comrades and friends, so that now among them there may be found some Romans who, living with the barbarians, prefer freedom with poverty to tribute-paying with anxiety among their own people. (italics added)

We do not know whether in the future Western civilization, which until now has thrived, will be replaced by that of another people whom even today we might consider “barbarians.” However, we must be certain of two things: first, in the midst of the severest recession to ravage the Western world since the Great Depression of 1929, if we fail to apply the essential measures, i.e., deregulation, especially in the labor market, a reduction in taxes and economic interventionism, and control of public spending and the elimination of subsidies, we risk much more than, for instance, the mere preservation of the euro (or for Americans, of the dollar as an international currency);[1] and second, if we lose the battle of competitiveness in the globalized world market once and for all, and we fall into marked and chronic decline, it will, without a doubt, not be due to exogenous factors, but to our own errors, faults, and moral deficiencies.

Despite the above, I would like to end on an optimistic note. Recessions are painful, and they are often used as a pretext for criticizing the free-market system and increasing regulation and interventionism, thus making matters even worse. Nevertheless, recessions are also the phase in which society gets back on a sound footing, the errors committed are revealed, and everyone is put in his proper place. Recessions are the stage in which the foundation is laid for recovery and an unavoidable return is made to the essential principles that permit society to advance.

It is true that we face many challenges, and that we could very easily become disheartened, and that freedom’s foes lurk everywhere. But it is no less true that, in contrast with the culture of subsidies, irresponsibility, the lack of morals, and dependence on the state for everything, there is, surging from the ashes among many young people (and also among some of us who are no longer so young) the culture of entrepreneurial freedom, of creativity and risk taking, of behavior based on moral principles, and, in short, of maturity and responsibility (as opposed to the infantilism our authorities and politicians would restrict us to in order to make us increasingly servile and dependent). To me it is clear who has the best intellectual and moral weapons, and hence, who holds the future. That is why I am an optimist.

[1] The social process cannot survive or develop without an institutional framework that disciplines and restricts politicians, unions, and privileged interest groups. Though certainly our authorities were unaware of what they were getting into when they advanced the creation of the euro, under the current circumstances, the euro is fortunately playing that “disciplining” role, at least in Europe’s periphery countries, which for the first time in their history, are now forced to take structural measures of economic liberalization in an environment in which the infeasibility and deception that lie at the base of the present welfare state have become evident. In the United States the situation is more dubious. Although sporadic efforts are made to limit the public deficit by movements like the Tea Party and others, the nature of the dollar as the international reserve currency leaves a lot of room for the extravagance of politicians and for unbridled spending.

This article was previously published at


In defence of the euro: an Austrian perspective

With a Critique of the Errors of the ECB and the Interventionism of Brussels

1. Introduction: The Ideal Monetary System

Theorists of the Austrian school have focused considerable effort on elucidating the ideal monetary system for a market economy. On a theoretical level, they have developed an entire theory of the business cycle which explains how credit expansion unbacked by real saving and orchestrated by central banks via a fractional-reserve banking system repetitively generates economic cycles. On a historical level, they have described the spontaneous evolution of money and how coercive state intervention encouraged by powerful interest groups has distanced from the market and corrupted the natural evolution of banking institutions. On an ethical level, they have revealed the general legal requirements and principles of property rights with respect to banking contracts, principles which arise from the market economy itself and which, in turn, are essential to its proper functioning.[1]

All of the above theoretical analysis yields the conclusion that the current monetary and banking system is incompatible with a true free-enterprise economy, that it contains all of the defects identified by the theorem of the impossibility of socialism, and that it is a continual source of financial instability and economic disturbances. Hence, it becomes indispensable to profoundly redesign the world financial and monetary system, to get to the root of the problems that beset us and to solve them. This undertaking should rest on the following three reforms: (a) the re-establishment of a 100-percent reserve requirement as an essential principle of private property rights with respect to every demand deposit of money and its equivalents; (b) the abolition of all central banks (which become unnecessary as lenders of last resort if reform (a) above is implemented, and which as true financial central-planning agencies are a constant source of instability) and the revocation of legal-tender laws and the always-changing tangle of government regulations that derive from them; and (c) a return to a classic gold standard, as the only world monetary standard that would provide a money supply which public authorities could not manipulate and which could restrict and discipline the inflationary yearnings of the different economic agents.[2]

As we have stated, the above prescriptions would enable us to solve all our problems at the root, while fostering sustainable economic and social development the likes of which have never been seen in history. Furthermore, these measures can both indicate which incremental reforms would be a step in the right direction, and permit a more sound judgement about the different economic-policy alternatives in the real world. It is from this strictly circumstantial and possibilistic perspective alone that the reader should view the Austrian analysis in relative “support” of the euro which we aim to develop in the present paper.

2. The Austrian Tradition of Support for Fixed Exchange Rates versus Monetary Nationalism and Flexible Exchange Rates

Traditionally, members of the Austrian school of economics have felt that as long as the ideal monetary system is not achieved, many economists, especially those of the Chicago school, commit a grave error of economic theory and political praxis when they defend flexible exchange rates in a context of monetary nationalism, as if both were somehow more suited to a market economy. In contrast, Austrians believe that until central banks are abolished and the classic gold standard is re-established along with a 100-percent reserve requirement in banking, we must make every attempt to bring the existing monetary system closer to the ideal, both in terms of its operation and its results. This means limiting monetary nationalism as far as possible, eliminating the possibility that each country could develop its own monetary policy, and restricting inflationary policies of credit expansion as much as we can, by creating a monetary framework that disciplines as far as possible economic, political, and social agents, and especially, labour unions and other pressure groups, politicians, and central banks.

It is only in this context that we should interpret the position of such eminent Austrian economists (and distinguished members of the Mont Pèlerin Society) as Mises and Hayek. For example, there is the remarkable and devastating analysis against monetary nationalism and flexible exchange rates which Hayek began to develop in 1937 in his particularly outstanding book, Monetary Nationalism and International Stability.[3] In this book, Hayek demonstrates that flexible exchange rates preclude an efficient allocation of resources on an international level, as they immediately hinder and distort real flows of consumption and investment. Moreover, they make it inevitable that the necessary real downward adjustments in costs take place via a rise in all other nominal prices, in a chaotic environment of competitive devaluations, credit expansion, and inflation, which also encourages and supports all sorts of irresponsible behaviours from unions, by inciting continual wage and labour demands which can only be satisfied without increasing unemployment if inflation is pushed up even further. Thirty-eight years later, in 1975, Hayek summarized his argument as follows:

“It is, I believe, undeniable that the demand for flexible rates of exchange originated wholly from countries such as Great Britain, some of whose economists wanted a wider margin for inflationary expansion (called ‘full employment policy’). They later received support, unfortunately, from other economists[4] who were not inspired by the desire for inflation, but who seem to have overlooked the strongest argument in favour of fixed rates of exchange, that they constitute the practically irreplaceable curb we need to compel the politicians, and the monetary authorities responsible to them, to maintain a stable currency” [italics added].

To clarify his argument yet further, Hayek adds:

“The maintenance of the value of money and the avoidance of inflation constantly demand from the politician highly unpopular measures. Only by showing that government is compelled to take these measures can the politician justify them to people adversely affected. So long as the preservation of the external value of the national currency is regarded as an indisputable necessity, as it is with fixed exchange rates, politicians can resist the constant demands for cheaper credits, for avoidance of a rise in interest rates, for more expenditure on ‘public works,’ and so on. With fixed exchange rates, a fall in the foreign value of the currency, or an outflow of gold or foreign exchange reserves acts as a signal requiring prompt government action.[5] With flexible exchange rates, the effect of an increase in the quantity of money on the internal price level is much too slow to be generally apparent or to be charged to those ultimately responsible for it. Moreover, the inflation of prices is usually preceded by a welcome increase in employment; it may therefore even be welcomed because its harmful effects are not visible until later.”

Hayek concludes:

“I do not believe we shall regain a system of international stability without returning to a system of fixed exchange rates, which imposes upon the national central banks the restraint essential for successfully resisting the pressure of the advocates of inflation in their countries — usually including ministers of finance” (Hayek 1979 [1975], 9-10).

With respect to Ludwig von Mises, it is well known that he distanced himself from his valued disciple Fritz Machlup when in 1961 Machlup began to defend flexible exchange rates in the Mont Pèlerin Society. In fact, according to R.M. Hartwell, who was the official historian of the Mont Pèlerin Society,

“Machlup’s support of floating exchange rates led von Mises to not speak to him for something like three years” (Hartwell 1995, 119).

Mises could understand how macroeconomists with no academic training in capital theory, like Friedman and his Chicago colleagues, and also Keynesians in general, could defend flexible rates and the inflationism invariably implicit in them, but he was not willing to overlook the error of someone who, like Machlup, had been his disciple and therefore really knew about economics, and yet allowed himself to be carried away by the pragmatism and passing fashions of political correctness. Indeed, Mises even remarked to his wife on the reason he was unable to forgive Machlup:

“He was in my seminar in Vienna; he understands everything. He knows more than most of them and he knows exactly what he is doing” (Margit von Mises 1984, 146).

Mises’s defence of fixed exchange rates parallels his defence of the gold standard as the ideal monetary system on an international level. For instance, in 1944, in his book Omnipotent Government, Mises wrote:

“The gold standard put a check on governmental plans for easy money. It was impossible to indulge in credit expansion and yet cling to the gold parity permanently fixed by law. Governments had to choose between the gold standard and their — in the long run disastrous — policy of credit expansion. The gold standard did not collapse. The governments destroyed it. It was incompatible with etatism as was free trade. The various governments went off the gold standard because they were eager to make domestic prices and wages rise above the world market level, and because they wanted to stimulate exports and to hinder imports. Stability of foreign exchange rates was in their eyes a mischief, not a blessing. Such is the essence of the monetary teachings of Lord Keynes. The Keynesian school passionately advocates instability of foreign exchange rates” [italics added].[6]

Furthermore, it comes as no surprise that Mises scorned the Chicago theorists when in this area, as in others, they ended up falling into the trap of the crudest Keynesianism. In addition, Mises maintained that it would be relatively simple to re-establish the gold standard and return to fixed exchange rates:

“The only condition required is the abandonment of an easy money policy and of the endeavors to combat imports by devaluation.”

Moreover, Mises held that only fixed exchange rates are compatible with a genuine democracy, and that the inflationism behind flexible exchange rates is essentially antidemocratic:

“Inflation is essentially antidemocratic. Democratic control is budgetary control. The government has but one source of revenue — taxes. No taxation is legal without parliamentary consent. But if the government has other sources of income it can free itself from their control” (Mises 1969, 251-253).

Only when exchange rates are fixed are governments obliged to tell citizens the truth. Hence, the temptation to rely on inflation and flexible rates to avoid the political cost of unpopular tax increases is so strong and so destructive. So, even if there is not a gold standard, fixed rates restrict and discipline the arbitrariness of politicians:

“Even in the absence of a pure gold standard, fixed exchange rates provide some insurance against inflation which is not forthcoming from the flexible system. Under fixity, if one country inflates, it falls victim to a balance of payment crisis. If and when it runs out of foreign exchange holdings, it must devalue, a relatively difficult process, fraught with danger for the political leaders involved. Under flexibility, in contrast, inflation brings about no balance of payment crisis, nor any need for a politically embarrassing devaluation. Instead, there is a relatively painless depreciation of the home (or inflationary) currency against its foreign counterparts” (Block 1999, 19, italics added).

3. The Euro as a “Proxy” for the Gold Standard (or Why Champions of Free Enterprise and the Free Market Should Support the Euro While the Only Alternative Is a Return to Monetary Nationalism)

As we have seen, Austrian economists defend the gold standard because it curbs and limits the arbitrary decisions of politicians and authorities. It disciplines the behaviour of all the agents who participate in the democratic process. It promotes moral habits of human behaviour. In short, it checks lies and demagogy; it facilitates and spreads transparency and truth in social relationships. No more and no less. Perhaps Ludwig von Mises said it best:

“The gold standard makes the determination of money’s purchasing power independent of the changing ambitions and doctrines of political parties and pressure groups. This is not a defect of the gold standard, it is its main excellence” (Mises 1966, 474).

The introduction of the euro in 1999 and its culmination beginning in 2002 meant the disappearance of monetary nationalism and flexible exchange rates in most of continental Europe. Later we will consider the errors committed by the European Central Bank. Now what interests us is to note that the different member states of the monetary union completely relinquished and lost their monetary autonomy, that is, the possibility of manipulating their local currency by placing it at the service of the political needs of the moment. In this sense, at least with respect to the countries in the euro zone, the euro began to act and continues to act very much like the gold standard did in its day. Thus, we must view the euro as a clear, true, even if imperfect, step toward the gold standard. Moreover, the arrival of the Great Recession of 2008 has even further revealed to everyone the disciplinary nature of the euro: for the first time, the countries of the monetary union have had to face a deep economic recession without monetary policy autonomy. Up until the adoption of the euro, when a crisis hit, governments and central banks invariably acted in the same way: they injected all the necessary liquidity, allowed the local currency to float downward and depreciated it, and indefinitely postponed the painful structural reforms that were needed and which involve economic liberalization, deregulation, increased flexibility in prices and markets (especially the labour market), a reduction in public spending, and the withdrawal and dismantling of union power and the welfare state. With the euro, despite all the errors, weaknesses, and concessions we will discuss later, this type of irresponsible behaviour and forward escape has no longer been possible.

For instance, in Spain, in just one year, two consecutive governments have been literally forced to take a series of measures which, though still quite insufficient, up to now would have been labelled as politically impossible and utopian, even by the most optimistic observers:

  1. article 135 of the Constitution has been amended to include the anti-Keynesian principle of budget stability and equilibrium for the central government, the autonomous communities, and the municipalities;
  2. all of the projects that imply increases in public spending, vote purchasing, and subsidies, projects upon which politicians regularly based their action and popularity, have been suddenly suspended;
  3. the salaries of all public servants have been reduced by 5 percent and then frozen, while their work schedule has been expanded;
  4. social security pensions have been frozen de facto;
  5. the standard retirement age has been raised across the board from 65 to 67;
  6. the total budgeted public expenditure has decreased by over 15 percent; and
  7. significant liberalization has occurred in the labour market, business hours, and in general, the tangle of economic regulation.[7]

Furthermore, what has happened in Spain is also taking place in Ireland, Portugal, Italy, and even in countries which, like Greece, until now represented the paradigm of social laxity, the lack of budget rigour, and political demagogy.[8] What is more, the political leaders of these five countries, now no longer able to manipulate monetary policy to keep citizens in the dark about the true cost of their policies, have been summarily thrown out of their respective governments. And states which, like Belgium and especially France and Holland, until now have appeared unaffected by the drive to reform, are also starting to be forced to reconsider the very grounds for the volume of their public spending and for the structure of their bloated welfare state. This is all undeniably due to the new monetary framework introduced with the euro, and thus it should be viewed with excited and hopeful rejoicing by all champions of the free-enterprise economy and the limitation of government powers. For it is hard to conceive of any of these measures being taken in a context of a national currency and flexible exchange rates: whenever they can, politicians eschew unpopular reforms, and citizens everything that involves sacrifice and discipline. Hence, in the absence of the euro, authorities would again have taken what up to now has been the usual path, i.e. a forward escape consisting of more inflation, the depreciation of the currency to recover “full employment” and gain competitiveness in the short term (covering their backs and concealing the grave responsibility of labour unions as true generators of unemployment), and in short, the indefinite postponement of the necessary structural reforms.

Let us now focus on two significant ways the euro is unique. We will contrast it both with the system of national currencies linked together by fixed exchange rates, and with the gold standard itself, beginning with the latter. We must note that abandoning the euro is much more difficult than going off the gold standard was in its day. In fact, the currencies linked with gold kept their local denomination (the franc, the pound, etc.), and thus it was relatively easy, throughout the 1930s, to unanchor them from gold, insofar as economic agents, as indicated in the monetary regression theorem Mises formulated in 1912 (Mises 2009 [1912], 111-123), continued without interruption to use the national currency, which was no longer exchangeable for gold, relying on the purchasing power of the currency right before the reform. Today this possibility does not exist for those countries that wish, or are obliged, to abandon the euro. Since it is the only unit of currency shared by all the countries in the monetary union, its abandonment requires the introduction of a new local currency, with unknown and much less purchasing power, and includes the emergence of the immense disturbances that the change would entail for all the economic agents in the market: debtors, creditors, investors, entrepreneurs, and workers.[9] At least in this specific sense, and from the standpoint of Austrian theorists, we must admit that the euro surpasses the gold standard, and that it would have been very useful for mankind if in the 1930s the different countries involved had been obliged to stay on the gold standard, because as is the case today with the euro, any other alternative was nearly impossible to put into practice and would have affected citizens in a much more damaging, painful, and obvious way.

Hence, to a certain extent it is amusing (and also pathetic) to note that the legion of social engineers and interventionist politicians who, led at the time by Jacques Delors, designed the single currency as one more tool for use in their grandiose projects to achieve a European political union, now regard with despair something they never seem to have been able to predict: that the euro has ended up acting de facto as the gold standard, disciplining citizens, politicians, and authorities, tying the hands of demagogues and exposing pressure groups (headed by the unfailingly privileged unions), and even questioning the sustainability and the very foundations of the welfare state.[10] According to the Austrian school, this is precisely the main comparative advantage of the euro as a monetary standard in general, and against monetary nationalism in particular; this and not the more prosaic arguments, like “the reduction of transaction costs” or “the elimination of exchange risk,” which were deployed at the time by the invariably short-sighted social engineers of the moment.

Now let us consider the difference between the euro and a system of fixed exchange rates, with respect to the adjustment process which takes place when different degrees of credit expansion and intervention arise between the different countries. Obviously, in a fixed-rate system, these differences manifest themselves in considerable exchange-rate tensions that eventually culminate in explicit devaluations and the high cost in terms of lost prestige which, fortunately, these entail for the corresponding political authorities. In the case of a single currency, like the euro, such tensions manifest themselves in a general loss of competitiveness, which can only be recovered with the introduction of the structural reforms necessary to guarantee market flexibility, along with the deregulation of all sectors and the reductions and adjustments necessary in the structure of relative prices. Moreover, the above ends up affecting the revenues of each public sector, and thus, of its credit rating. In fact, under the present circumstances, in the euro area, the current value in the financial markets of each country’s sovereign public debt has come to reflect the tensions which typically revealed themselves in exchange-rate crises, when rates were more or less fixed in an environment of monetary nationalism. Therefore, at this time, the leading role is not played by foreign-currency speculators, but by the rating agencies, and especially, by international investors, who, by purchasing sovereign debt or not, are healthily setting the pace of reform while also disciplining and determining the fate of each country. This process may be called “undemocratic,” but it is actually the exact opposite. In the past, democracy suffered chronically and was corrupted by irresponsible political actions based on monetary manipulation and inflation, a veritable tax of devastating consequences, which is imposed outside of parliament on all citizens in a gradual, concealed, and devious way. Today, with the euro, the recourse to an inflationary tax has been blocked, at least at the local level of each country, and politicians have suddenly been exposed, and have been obliged to tell the truth and accept the corresponding loss of support. Democracy, if it is to work, requires a framework which disciplines the agents who participate in it. And today in continental Europe that role is being played by the euro. Hence, the successive fall of the governments of Ireland, Greece, Portugal, Italy, Spain and France, far from revealing a democracy deficit, manifests the increasing degree of rigor, budget transparency, and democratic health which the euro is encouraging in its respective societies.

4. The Diverse and Motley “Anti-euro Coalition”

As it would be interesting and highly illustrative, we should now, if only briefly, comment on the diverse and motley amalgam formed by the euro’s enemies. This group includes in its ranks such disparate elements as doctrinaires of the far left and right; nostalgic or unyielding Keynesians like Krugman and Stiglitz, dogmatic monetarists in support of flexible exchange rates, like Barro and others; naive advocates of Mundell’s theory of optimum currency areas; terrified dollar (and pound) chauvinists; and in short, the legion of confused defeatists who “in the face of the imminent disappearance of the euro” propose the “solution” of blowing it up and abolishing it as soon as possible.[11]

Perhaps the clearest illustration (or rather, the most convincing piece of evidence) of the fact that Mises was entirely correct in his analysis of the disciplining effect of fixed exchange rates, and especially of the gold standard, on political and union demagogy lies in the way in which the leaders of leftist political parties, union members, “progressive” opinion makers, anti-system “indignados,” far-right politicians, and in general, all fans of public spending, state subsidies, and interventionism openly and directly rebel against the discipline the euro imposes, and specifically, against the loss of autonomy in each country’s monetary policy, and what that implies: the much-reviled dependence on markets, speculators, and international investors when it comes to being able (or not) to sell the growing sovereign public debt required to finance continual public deficits. One need only glance at the editorials in the most leftist newspapers[12], or read the statements of the most demagogic politicians[13], or of leading unionists, to observe that this is so, and that nowadays, just like in the 1930s with the gold standard, the enemies of the market and the defenders of socialism, the welfare state, and union demagogy are protesting in unison, both in public and in private, against “the rigid discipline the euro and the financial markets are imposing on us,” and they are demanding the immediate monetization of all the public debt necessary, without any countermeasure in the form of budget austerity or reforms that boost competitiveness.

In the more academic sphere, but also with ample coverage in the media, contemporary Keynesian theorists are mounting a major offensive against the euro, again with a belligerence only comparable to that Keynes himself showed against the gold standard in the 1930s. Especially paradigmatic is the case of Krugman[14], who as a syndicated columnist, tells the same old story almost every week about how the euro means a “straitjacket” for employment recovery, and he even goes so far as to criticize the profligate American government for not being expansionary enough and for having fallen short in its (huge) fiscal stimulus packages.[15] More intelligent and highbrow, though no less mistaken, is the opinion of Skidelsky, since he at least explains that the Austrian business cycle theory[16] offers the only alternative to his beloved Keynes and clearly recognizes that the current situation actually involves a repeat of the duel between Hayek and Keynes during the 1930s.[17]

Stranger yet is the stance taken on flexible exchange rates by neoclassical theorists in general, and by monetarists and members of the Chicago school in particular.[18] It appears that this group’s interest in flexible exchange rates and monetary nationalism predominates over their (we presume sincere) desire to encourage economic liberalization reforms. Indeed, their primary goal is to maintain monetary policy autonomy and be able to devalue (or depreciate) the local currency to “recover competitiveness” and absorb unemployment as soon as possible, and only then, eventually, do they focus on trying to foster flexibility and free market reforms. Their naivete is extreme, and we referred to it in our discussion of the reasons for the disagreement between Mises, on the side of the Austrian school, and Friedman, on the side of the Chicago theorists, in the debate on fixed versus flexible exchange rates. Mises always saw very clearly that politicians are not likely to take steps in the right direction if they are not literally obligated to do so, and that flexible rates and monetary nationalism remove practically every incentive capable of disciplining politicians and doing away with “downward rigidity” in wages (which thus becomes a sort of self-fulfilling assumption that monetarists and Keynesians wholeheartedly accept) and with the privileges enjoyed by unions and all other pressure groups. Mises also observed that as a result, in the long run, and even in spite of themselves, monetarists end up becoming fellow travelers of the old Keynesian doctrines: once “competitiveness” has been “recovered,” reforms are postponed, and what is even worse, unionists become accustomed to having the destructive effects of their restrictionist policies continually masked by successive devaluations.

This latent contradiction between defending the free market and supporting monetary nationalism and manipulation via “flexible” exchange rates is also evident in many proponents of the most widespread interpretation of Robert A. Mundell’s theory of “optimum currency areas.”[19] Such areas would be those in which, to begin with, all productive factors were highly mobile, because if that is not the case, it would be better to compartmentalize them with currencies of a smaller scope, to permit the use of an autonomous monetary policy in the event of any “external shock.” However, we should ask ourselves: Is this reasoning sound? Not at all: the main source of rigidity in labour and factor markets actually lies in, and is sanctioned by, intervention and state regulation of the markets, so it is absurd to think states and their governments are going to commit harakiri first, thus relinquishing their power and betraying their political clientele, in order to adopt a common currency afterward. Instead, the exact opposite is true: only when politicians have joined a common currency (the euro in our case) have they been forced to implement reforms which until very recently it would have been inconceivable for them to adopt. In the words of Walter Block:

“… government is the main or only source of factor immobility. The state, with its regulations … is the prime reason why factors of production are less mobile than they would otherwise be. In a bygone era the costs of transportation would have been the chief explanation, but with all the technological progress achieved here, this is far less important in our modern ‘shrinking world.’ If this is so, then under laissez-faire capitalism, there would be virtually no factor immobility. Given even the approximate truth of these assumptions the Mundellian region then becomes the entire globe — precisely as it would be under the gold standard–.”[20]

This conclusion of Block’s is equally applicable to the euro area, to the extent that the euro acts, as we have already indicated, as a “proxy” for the gold standard which disciplines and limits the arbitrary power of the politicians of the member states.

We must not fail to stress that Keynesians, monetarists, and Mundellians are all mistaken because they reason exclusively in terms of macroeconomic aggregates, and hence they propose, with slight differences, the same sort of adjustment via monetary and fiscal manipulation, “fine tuning,” and flexible exchange rates. They believe that all of the effort it takes to overcome the crisis should therefore be guided by macroeconomic models and social engineering. Thus, they completely disregard the profound microeconomic distortion that monetary (and fiscal) manipulation generate in the structure of relative prices and in the capital-goods structure. A forced devaluation (or depreciation) is “one size fits all,” i.e. it entails a sudden linear percentage drop in the price of consumer goods and services and productive factors, a drop which is the same for everyone. Although in the short term this gives the impression of an intense recovery of economic activity and of a rapid absorption of unemployment, it actually completely distorts the structure of relative prices (since without monetary manipulation, some prices would have fallen more, others less, and others would not have fallen at all and might even have risen), leads to a widespread poor allocation of productive resources, and causes a major trauma which any economy would take years to process and recover from.[21] This is the microeconomic analysis centered on relative prices and the productive structure which Austrian theorists have characteristically developed[22] and which, in contrast, is entirely missing from the analytical toolbox of the assortment of economic theorists who oppose the euro.

Finally, outside the purely academic sphere, the tiresome insistence with which Anglo-Saxon economists, investors, and financial analysts attempt to discredit the euro by foretelling the bleakest future for it is to a certain extent suspicious. This impression is reinforced by the hypocritical position of the different US administrations (and also, to a lesser extent, the British government) in wishing (half-heartedly) that the euro zone would “get its economy in order,” and yet self-interestedly omitting to mention that the financial crisis originated on the other side of the Atlantic, i.e. in the recklessness and the expansionary policies pursued by the Federal Reserve for years, and the effects of which spread to the rest of the world via the dollar, as it is still used as the international reserve currency. Furthermore, there is almost unbearable pressure for the euro zone to introduce monetary policies at least as expansionary and irresponsible (“quantitative easing”) as those adopted in the United States, and this pressure is doubly hypocritical, since such an occurrence would undoubtedly deliver the coup de grace to the single European currency.

Might not this stance in the Anglo-Saxon political, economic, and financial world be hiding a buried fear that the dollar’s future as the international reserve currency may be threatened if the euro survives and is capable of effectively competing with the dollar in a not-too-distant future? All indications suggest that this question is becoming more and more pertinent, and though today it does not appear very politically correct, it pours salt on the wound that is most painful for analysts and authorities in the Anglo-Saxon world: the euro is emerging as an enormously powerful potential rival to the dollar on an international level.[23]

As we can see, the anti-euro coalition brings together quite varied and powerful interests. Each distrusts the euro for a different reason. However, they all share a common denominator: the arguments which form the basis of their opposition to the euro would be exactly the same, and they might well repeat and word them even more emphatically, if instead of the single European currency, they had to come to grips with the classic gold standard as the international monetary system. In fact, there is a large degree of similarity between the forces which joined in an alliance in the 1930s to compel the abandonment of the gold standard and those which today seek (up to now unsuccessfully) to reintroduce old, outdated monetary nationalism in Europe. As we have already indicated, technically it was much easier to abandon the gold standard than it would be today for any country to leave the monetary union. In this context, it should come as no surprise that members of the anti-euro coalition often even fall back on the most shameless defeatism: they predict a disaster and the impossibility of maintaining the monetary union, and then right afterward, they propose the “solution” of dismantling it immediately. They even go so far as to hold international contests (– where else — in England, Keynes’s home and that of monetary nationalism) in which hundreds of “experts” and crackpots participate, each with his own proposals for the best and most innocuous way to blow up the European monetary union.[24]

5. The True Cardinal Sins of Europe and the Fatal Error of the European Central Bank[25]

No one can deny that the European Union chronically suffers from a number of serious economic and social problems. Nevertheless, the maligned euro is not one of them. Rather, the opposite is true: the euro is acting as a powerful catalyst which reveals the severity of Europe’s true problems and hastens or “precipitates” the implementation of the measures necessary to solve them. In fact, today, the euro is helping spread more than ever the awareness that the bloated European welfare state is unsustainable and needs to be substantially reformed.[26] The same can be said for the all-encompassing aid and subsidy programs, among which the Common Agricultural Policy occupies a key position, both in terms of its very damaging effects and its total lack of economic rationality.[27] Most of all, it can be said for the culture of social engineering and oppressive regulation which, on the pretext of harmonizing the legislation of the different countries, fossilizes the single European market and prevents it from being a genuine free market.[28] Now more than ever, the true cost of all these structural flaws is becoming apparent in the euro area: without an autonomous monetary policy, the different governments are being literally forced to reconsider (and when applicable, to reduce) all their public expenditure items, and to attempt to recover and gain international competitiveness by deregulating and increasing as far as possible the flexibility of their markets (especially the labour market, which has traditionally been very rigid in many countries of the monetary union).

In addition to the above cardinal sins of the European economy, we must add another which is perhaps even graver, due to its peculiar, devious nature. We are referring to the great ease with which European institutions, many times because of a lack of vision, leadership, or conviction about their own project, allow themselves to become entangled in policies that in the long run are incompatible with the demands of a single currency and of a true free single market.

First, it is surprising to note the increasing regularity with which the burgeoning and stifling new regulatory measures are introduced into Europe from the Anglo-Saxon academic and political world, specifically the United States[29], and often when such measures have already proven ineffective or extremely disruptive. This unhealthy influence is a long-established tradition. (Let us recall that agricultural subsidies, the antitrust legislation, and regulations concerning “corporate social responsibility” have actually originated, like many other failed interventions, in the United States.) Nowadays such regulatory measures crop up repeatedly and are reinforced at every step, for example with respect to the so called “fair market value” and the rest of the International Accounting Standards, or to the (until now, fortunately, failed) attempts to implement the so-called agreements of Basel III for the banking sector and Solvency II for the insurance sector, both of which suffer from insurmountable and fundamental theoretical deficiencies as well as serious problems in relation to their practical application.[30]

A second example of the unhealthy Anglo-Saxon influence can be found in the European Economic Recovery Plan, which the European Commission launched at the end of 2008 under the auspices of the Washington Summit, with the leadership of Keynesian politicians like Barack Obama and Gordon Brown, and on the advice of economic theorists who are enemies of the euro, like Krugman and others.[31] The plan recommended to member countries an expansion of public spending of around 1.5 percent of GDP (some 200 billion euros on an aggregate level). Though some countries, like Spain, made the error of expanding their budgets, the plan, thank God and the euro, and much to the despair of Keynesians and their acolytes[32], soon came to nothing, once it became clear that it only served to increase the deficits, preclude the achievement of the Maastricht Treaty objectives, and severely destabilize the sovereign debt markets of the countries of the euro zone. Again, the euro provided a disciplinary framework and an early curb on the deficit, in contrast to the budget recklessness of countries that are victims of monetary nationalism, and specifically, the United States and especially England, which closed with a public deficit of 10.1 percent of GDP in 2010 and 8.8 percent in 2011, which on a worldwide scale was only exceeded by Greece and Egypt. Despite such bloated deficits and fiscal stimulus packages, unemployment in England and the United States remains at record (or very high) levels, and their respective economies are just not getting off the ground.

Third, and above all, there is mounting pressure for a complete European political union, which some suggest as the only “solution” that could enable the survival of the euro in the long term. Apart from the “Eurofanatics,” who always defend any excuse that might justify greater power and centralism for Brussels, two groups coincide in their support for political union. One group consists, paradoxically, of the euro’s enemies, particularly those of Anglo-Saxon origin: there are the Americans, who, dazzled by the centralized power of Washington and aware that it could not possibly be duplicated in Europe, know that with their proposal they are injecting a divisive virus deadly to the euro; and there are the British, who make the euro an (unjustified) scapegoat upon which to vent their (totally justified) frustrations in view of the growing interventionism of Brussels. The other group consists of all those theorists and thinkers who believe that only the discipline imposed by a central government agency can guarantee the deficit and public-debt objectives established in Maastricht. This is an erroneous belief. The very mechanism of the monetary union guarantees, just like the gold standard, that those countries which abandon budget rigor and stability will see their solvency at risk and be forced to take urgent measures to re-establish the sustainability of their public finances if they do not wish to suspend payments.

Despite the above, the most serious problem does not lie in the threat of an impossible political union, but in the unquestionable fact that a policy of credit expansion carried out in a sustained manner by the European Central Bank during a period of apparent economic prosperity is capable of canceling, at least temporarily, the disciplinary effect exerted by the euro on the economic agents of each country. Thus, the fatal error of the European Central Bank consists of not having managed to isolate and protect Europe from the great expansion of credit orchestrated on a worldwide scale by the US Federal Reserve beginning in 2001. Over several years, in a blatant failure to comply with the Maastricht Treaty, the European Central Bank allowed M3 to grow by even more than 9 percent per year, which far exceeds the objective of 4.5 percent growth in the money supply, an aim originally set by the ECB itself.[33] Furthermore, even though this increase was appreciably less reckless than that brought about by the US Federal Reserve, the money was not distributed uniformly among the countries of the monetary union, and it had a disproportionate impact on the periphery countries (Spain, Portugal, Ireland, and Greece), which saw their monetary aggregates grow at a pace far more rapid, between three and four times more, than France or Germany. Various reasons can be given to explain this phenomenon, from the pressure applied by France and Germany, both of which sought a monetary policy that during those years would not be too restrictive for them, to the extreme short-sightedness of the periphery countries, which did not wish to admit they were in the middle of a speculative bubble, as is the case with Spain, and thus were also unable to give categorical instructions to their representatives in the ECB council to make an important issue of strict compliance with the monetary-growth objectives established by the European Central Bank itself. In fact, during the years prior to the crisis, all of these countries, except Greece[34], easily observed the 3-percent deficit limits, and some, like Spain and Ireland, even closed their public accounts with large surpluses.[35] Hence, though the heart of the European Union was kept out of the American process of irrational exuberance, the process was repeated with intense virulence in the European periphery countries, and no one, or very few people, correctly diagnosed the grave danger in what was happening.[36] If academics and political authorities from both the affected countries and the European Central Bank, instead of using macroeconomic and monetarist analytical tools imported from the Anglo-Saxon world, had used those of the Austrian business cycle theory[37] — which after all is a product of the most genuine continental economic thought — they would have managed to detect in time the largely artificial nature of the prosperity of those years, the unsustainability of many of the investments (especially with respect to real estate development) that were being launched due to the great easing of credit, and in short, that the surprising influx of rising public revenue would be of very short duration. Still, fortunately, though in the most recent cycle the European Central Bank has fallen short of the standards European citizens had a right to expect, and we could even call its policy a “grave tragedy,” the logic of the euro as a single currency has prevailed, thus clearly exposing the errors committed and obliging everyone to return to the path of control and austerity. In the next section, we will briefly touch on the specific way the European Central Bank formulated its policy during the crisis and how and on what points this policy differs from that followed by the central banks of the United States and United Kingdom.

6. The Euro vs. the Dollar (and the Pound) and Germany vs. the USA (and the UK)

One of the most striking characteristics of the last cycle, which ended in the Great Recession of 2008, has undoubtedly been the differing behaviour of the monetary and fiscal policies of the Anglo-Saxon area, based on monetary nationalism, and those pursued by the member countries of the European monetary union. Indeed, from the time the financial crisis and economic recession hit in 2007-2008, both the Federal Reserve and the Bank of England have adopted monetary policies which have consisted of reducing the interest rate to almost zero; injecting huge quantities of money into the economy (euphemistically known as “quantitative easing”); and continuously, directly, and unabashedly monetizing the sovereign public debt on a massive scale.[38] To this extremely lax monetary policy (in which the recommendations of monetarists and Keynesians concur) is added the strong fiscal stimulus involved in maintaining, both in the United States and in England, budget deficits close to 10 percent of the respective GDPs (which, nevertheless, at least the most recalcitrant Keynesians, like Krugman and others, do not consider anywhere near sufficient).

In contrast with the situation of the dollar and the pound, in the euro area, fortunately, money cannot so easily be injected into the economy, nor can budget recklessness be indefinitely maintained with such impunity. At least in theory, the European Central Bank lacks authority to monetize the European public debt, and though it has accepted it as collateral for its huge loans to the banking system, and beginning in the summer of 2010 even sporadically made direct purchases of the bonds of the most threatened periphery countries (Greece, Portugal, Ireland, Italy and Spain), there is certainly a fundamental economic difference between the behaviour of the United States and United Kingdom, and the policy continental Europe is following: while monetary aggression and budget recklessness are deliberately, unabashedly, and without reservation undertaken in the Anglo-Saxon world, in Europe such policies are carried out reluctantly, and in many cases after numerous, consecutive and endless “summits.” They are the result of lengthy and difficult negotiations between many parties, negotiations in which countries with very different interests must reach an agreement. Furthermore, what is even more important, when money is injected into the economy and support is provided to the debt of countries that are having difficulties, such actions are always balanced with, and taken in exchange for, reforms based on budget austerity (and not on fiscal stimulus packages) and on the introduction of supply-side policies which encourage market liberalization and competitiveness.[39] Moreover, though it would have been better had it happened much sooner, the “de facto” suspension of payments by the Greek state, which has given a nearly 75-percent “haircut” to the private investors who mistakenly trusted in Greek sovereign debt holdings, has clearly signalled to markets that the other countries in trouble have no other alternative than to firmly, rigorously, and without delay carry out all necessary reforms. As we have already seen, even states like France, which until now appeared untouchable and comfortably nestled in a bloated welfare state, have lost the highest credit rating on their debt, seen its differential with the German bund rise, and found themselves increasingly doomed to introduce austerity and liberalization reforms to avoid jeopardizing what has always been their indisputable membership among the euro zone hardliners.[40]

From the political standpoint, it is quite obvious that Germany (and particularly the chancellor Angela Merkel) has the leading role in urging forward this whole process of rehabilitation and austerity (and opposing all sorts of awkward proposals which, like the issuance of “European bonds,” would remove the incentives the different countries now have to act with rigor). Many times Germany must swim upstream. For on the one hand, there is constant international political pressure for fiscal stimulus measures, especially from the US Obama administration, which is using the “crisis of the euro” as a smokescreen to hide the failure of its own policies. And on the other hand, Germany has to contend with rejection and a lack of understanding from all those who wish to remain in the euro solely for the advantages it offers them, while at the same time they violently rebel against the bitter discipline that the European single currency imposes on all of us, and especially on the most demagogic politicians and the most irresponsible privileged interest groups.

In any case, and as an illustration which will understandably exasperate Keynesians and monetarists, we must highlight the very unequal results which until now have been achieved with American fiscal-stimulus policies and monetary “quantitative easing,” in comparison with German supply-side policies and fiscal austerity in the monetary environment of the euro: public deficit, in Germany, 1%, in the United States, over 8.20%; unemployment, in Germany, 5.9%, in the United States, close to 9%; inflation, in Germany, 2.5%, in the United States, over 3.17%; growth, in Germany, 3%, in the United States, 1.7%. (The figures for United Kingdom are even worse than those for the US.) The clash of paradigms and the contrast in results could not be more striking.[41]

7. Conclusion: Hayek versus Keynes

Just as with the gold standard in its day, today a legion of people criticize and despise the euro for what is precisely its main virtue: its capacity to discipline extravagant politicians and pressure groups. Plainly, the euro in no way constitutes the ideal monetary standard, which, as we saw in the first section, could only be found in the classic gold standard, with a 100-percent reserve requirement on demand deposits, and the abolition of the central bank. Hence, it is quite possible that once a certain amount of time has passed and the historical memory of recent monetary and financial events has faded, the European Central Bank may go back to committing the grave errors of the past, and promote and accommodate a new bubble of credit expansion.[42] However, let us remember that the sins of the Federal Reserve and the Bank of England have been much worse still and that, at least in continental Europe, the euro has ended monetary nationalism, and for the states in the monetary union, it is acting, even if only timidly, as a “proxy” for the gold standard, by encouraging budget rigor and reforms aimed at improving competitiveness, and by putting a stop to the abuses of the welfare state and of political demagogy.

In any case, we must recognize that we stand at a historic cross-roads.[43] The euro must survive if all of Europe is to internalize and adopt as its own the traditional German monetary stability, which in practice is the only and the essential disciplinary framework from which, in the short and medium term, European Union competitiveness and growth can be further stimulated. On a worldwide scale, the survival and consolidation of the euro will permit, for the first time since World War II, the emergence of a currency capable of effectively competing with the monopoly of the dollar as the international reserve currency, and therefore capable of disciplining the American ability to provoke additional systemic financial crises which, like that of 2007, constantly endanger the world economic order.

Just over eighty years ago, in a historical context very similar to ours, the world was torn between maintaining the gold standard, and with it budget austerity, labour flexibility, and free and peaceful trade; or abandoning the gold standard, and thus everywhere spreading monetary nationalism, inflationary policies, labour rigidity, interventionism, “economic fascism,” and trade protectionism. Hayek, and the Austrian theorists led by Mises, made a titanic intellectual effort to analyze, explain, and defend the advantages of the gold standard and free trade, in opposition to the theorists who, led by Keynes and the monetarists, opted to blow up the monetary and fiscal foundations of the laissez-faire economy which until then had fueled the Industrial Revolution and the progress of civilization.[44] On that occasion, economic thought ended up taking a very different route from that favored by Mises and Hayek, and we are all familiar with the economic, political, and social consequences that followed. As a result, today, well into the twenty-first century, incredibly, the world is still afflicted by financial instability, the lack of budget rigor, and political demagogy. For all these reasons, but mainly because the world economy urgently needs it, on this new occasion[45], Mises and Hayek deserve to finally triumph, and the euro (at least provisionally, and until it is replaced once and for all by the gold standard) deserves to survive.[46]


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[1] The main authors and theoretical formulations can be consulted in Huerta de Soto 2012 [1998].

[2] Ibid., chapter 9.

[3] F.A. Hayek 1971 [1937].

[4] Though Hayek does not expressly name them, he is referring to the theorists of the Chicago school, led by Milton Friedman, who in this and other areas shake hands with the Keynesians.

[5] Later we will see how, with a single currency like the euro, the disciplinary role of fixed exchange rates is taken on by the current market value of each country’s sovereign and corporate debt.

[6] To underline Mises’s argument even more clearly, I should indicate that there is no way to justifiably attribute to the gold standard the error Churchill committed following World War I, when he fixed the gold parity without taking into account the serious inflation of pound sterling banknotes issued to finance the war. This event has nothing to do with the current situation of the euro, which is freely floating in international markets, nor with those problems which affect countries in the euro zone’s periphery and which stem from the loss in real competitiveness suffered by their economies during the bubble (Huerta de Soto 2012 [1998], 447, 622-623 in the English edition).

[7] In Spain, different Austrian economists, including me, had for decades been clamoring unsuccessfully for the introduction of these (and many other) reforms which only now have become politically feasible, and have done so suddenly, with surprising urgency, and due to the euro. Two observations: first, the measures which constitute a step in the right direction have been sullied by the increase in taxes, especially on income, movable capital earnings and wealth (see the manifesto against the tax increase which I and fifty other academics signed in February 2012); second, the principles of budget stability and equilibrium are a necessary, but not a sufficient, condition for a return to the path toward a sustainable economy, since in the event of another episode of credit expansion, only a huge surplus during the prosperous years would make it possible, once the inevitable recession hit, to avoid the grave problems that now affect us.

[8] For the first time, and thanks to the euro, Greece is facing up to the challenges its own future poses. Though blasé monetarists and recalcitrant Keynesians do not wish to recognize it, internal deflation is possible and does not involve any “perverse” cycle if accompanied by major reforms to liberalize the economy and regain competitiveness. It is true that Greece has received and is receiving substantial aid, but it is no less true that it has the historic responsibility to refute the predictions of all those prophets of doom who, for different reasons, are determined to see the failure of the Greek effort so they can retain in their models the very stale (and self-interested) hypothesis that prices (and wages) are downwardly rigid (see also our remarks in footnote 9 about the disastrous effects of Argentina’s highly praised devaluation of 2001). For the first time, the traditionally bankrupt and corrupt Greek state has taken a drastic remedy. In two years (2010-2011) the public deficit has dropped 8 percentage points; the salaries of public servants have been cut by 15 percent initially and another 20 percent after that, and their number has been reduced by over 80,000 employees and the number of town councils by almost half; the retirement age has been raised; the minimum wage has been lowered, etc. (Vidal-Folch 2012). This “heroic” reconstruction contrasts with the economic and social decomposition of Argentina, which took the opposite (Keynesian and monetarist) road of monetary nationalism, devaluation, and inflation.

[9] Therefore, fortunately, we are “chained to the euro,” to use Cabrillo’s apt expression (Cabrillo 2012). Perhaps the most hackneyed contemporary example Keynesians and monetarists offer to illustrate the “merits” of a devaluation and of the abandonment of a fixed rate is the case of Argentina following the bank freeze (“corralito”) that took place beginning in December of 2001. This example is seriously erroneous for two reasons. First, at most, the bank freeze is simply an illustration of the fact that a fractional-reserve banking system cannot possibly function without a lender of last resort (Huerta de Soto 2012 [1998], 785-786). Second, following the highly praised devaluation, Argentina’s per capita GDP fell from 7,726 dollars in 2000 to 2,767 dollars in 2002, thus losing two-thirds of its value. This 65-percent drop in Argentinian income and wealth should give serious pause to all those who nowadays are clumsily and violently demonstrating, for example in Greece, to protest the relatively much smaller sacrifices and drops in prices involved in the healthy and inevitable internal deflation which the discipline of the euro is requiring. Furthermore, all the patter about Argentina’s “impressive” growth rates, of over 8 percent per year beginning in 2003, should impress us very little if at all, when we consider the very low starting point after the devaluation, as well as the poverty, paralysis, and chaotic nature of the Argentinian economy, where one-third of the population has ended up depending on subsidies and government aid, the real rate of inflation exceeds 30 percent, and scarcity, restrictions, regulations, demagogy, the lack of reforms, and government control (and recklessness) have become a matter of course (Gallo 2012). Along the same lines, Pierpaolo Barbieri states: “I find truly incredible that serious commentators like economist Nouriel Roubini are offering Argentina as a role model for Greece” (Barbieri 2012).

[10] Even the President of the ECB, Mario Draghi, has gone so far as to expressly state that the “continent’s social model is ‘gone'” (Blackstone, Karnitschnig, and Thomson 2012).

[11] I do not include here the analysis of my esteemed disciple and colleague Philipp Bagus (The Tragedy of the Euro, Ludwig von Mises Institute, Auburn, Alabama, USA 2010), since from Germany’s point of view, the manipulation to which the European Central Bank is subjecting the euro threatens the monetary stability Germany traditionally enjoyed with the mark. Nevertheless, his argument that the euro has fostered irresponsible policies via a typical tragedy-of-the-commons effect seems weaker to me, because during the bubble stage, most of the countries that are now having problems, with the only possible exception of Greece, were sporting a surplus in their public accounts (or were very close to one). Thus, I believe Bagus would have been more accurate if he had titled his otherwise excellent book The Tragedy of the European Central Bank (and not of the euro), particularly in light of the grave errors committed by the European Central Bank during the bubble stage, errors we will remark on in a later section of this article (thanks to Juan Ramón Rallo for suggesting this idea to me).

[12] The editorial line of the defunct Spanish newspaper Público was paradigmatic in this sense. (See also, for example, the case of Estefanía 2011, and of his criticism of the aforementioned reform of article 135 of the Spanish Constitution to establish the “anti-Keynesian” principle of budget stability and equilibrium.)

[13] See, for example, the statements of the socialist candidate for the French presidency, for whom “the path of austerity is ineffective, deadly, and dangerous” (Hollande 2012), or those of the far-right candidate, Marine Le Pen, who believes the French “should return to the franc and bring the euro period to a close once and for all” (Martín Ferrand 2012).

[14] One example among many articles is Krugman 2012; see also Stiglitz 2012.

[15] The US public deficit has stood at between 8.2 and 10 % over the last three years, in sharp contrast with German deficit, which stood at only 1% in 2011.

[16] An up-to-date explanation of the Austrian theory of the cycle can be found in Huerta de Soto 2012 [1998], chapter 5.

[17] Skidelsky 2011.

[18] A legion of economists belong to this group, and most of them (surprise, surprise!) come from the dollar-pound area. Among others in the group, I could mention, for example, Robert Barro (2012), Martin Feldstein (2011), and President Barack Obama’s adviser, Austan Goolsbee (2011). In Spain, though for different reasons, I should cite such eminent economists as Pedro Schwartz, Francisco Cabrillo, and Alberto Recarte.

[19] Mundell 1961.

[20] Block 1999, 21.

[21] See Whyte’s (2011) excellent analysis of the serious harm the depreciation of the pound is causing in United Kingdom; and with respect to the United States, see Laperriere 2012.

[22] Huerta de Soto 2012 [1998].

[23] “The euro, as the currency of an economic zone that exports more than the United States, has well-developed financial markets, and is supported by a world class central bank, is in many aspects the obvious alternative to the dollar. While currently it is fashionable to couch all discussions of the euro in doom and gloom, the fact is that the euro accounts for 37 percent of all foreign exchange market turn over. It accounts for 31 percent of all international bond issues. It represents 28 percent of the foreign exchange reserves whose currency composition is divulged by central banks” (Eichengreen 2011, 130). Guy Sorman, for his part, has commented on “the ambiguous attitude of US financial experts and actors. They have never liked the euro, because by definition, the euro competes with the dollar: following orders, American so-called experts explained to us that the euro could not survive without a central economic government and a single fiscal system” (Sorman 2011). In short, it is clear that champions of competition between currencies should direct their efforts against the monopoly of the dollar (for example, by supporting the euro), rather than advocate the reintroduction of, and competition between, “little local currencies” of minor importance (the drachma, escudo, peseta, lira, pound, franc, and even the mark).

[24] Such is the case with, for example, the contest held in the United Kingdom by Lord Wolfson, the owner of Next stores. Up to now, this contest has attracted no fewer than 650 “experts” and crackpots. Were it not for the crass and obvious hypocrisy involved in such initiatives, which are always held outside the euro area (and especially in the Anglo-Saxon world, by those who fear, hate, or scorn the euro), we should commend the great effort and interest shown in the fate of a currency which, after all, is not their own.

[25] It might be worth noting that the author of these lines is a “Eurosceptic” who maintains that the function of the European Union should be limited exclusively to guaranteeing the free circulation of people, capital, and goods in the context of a single currency (if possible the gold standard).

[26] I have already mentioned, for instance, the recent legislative changes that have delayed the retirement age to 67 (and even indexed it with respect to future trends in life expectancy), changes already introduced or on the way in Germany, France, Italy, Spain, Portugal, and Greece. I could also cite the establishment of a “copayment” and increasing areas of privatization in connection with health care. These are small steps in the right direction, which, because of their high political cost, would not have been taken without the euro. They also contrast with the opposite trend indicated by Barack Obama’s health-care reform, and with the obvious resistance to change when it comes to tackling the inevitable reform of the British National Health Service.

[27] O’Caithnia 2011.

[28] Booth 2011.

[29] See, for example, “United States’ Economy: Over-regulated America: The home of laissez-faire is being suffocated by excessive and badly written regulation,” The Economist, February 18, 2012, p. 8, and the examples there cited.

[30] Huerta de Soto 2003 and 2009.

[31] On the hysterical support for the grandiose fiscal stimulus packages of this period, see Fernando Ulrich 2011.

[32] Krugman 2012, Stiglitz 2012.

[33] Specifically, the average rise in M3 in the euro zone from 2000 to 2011 exceeded 6.3%, and we should highlight the increases that occurred during the bubble years 2005 (from 7% to 8%), 2006 (from 8% to 10%), and 2007 (from 10% to 12%). The above data show that, as has already been indicated, the goal of a zero deficit, though commendable, is merely a necessary, though not a sufficient, condition for stability: during the expansionary phase of a cycle induced by credit expansion, public-spending commitments may be made based on the false tranquility which surpluses generate, yet later, when the inevitable recession hits, these commitments are completely unsustainable. This demonstrates that the objective of a zero deficit also requires an economy that is not subject to the ups and downs of credit expansion, or at least that the budgets be closed out with much larger surpluses during the expansionary years.

[34] Therefore, Greece would be the only case to which we could apply the “tragedy of the commons” argument Bagus (2010) develops concerning the euro. In light of the reasoning I have presented in the text, and as I have already mentioned, I believe a more apt title for Bagus’s remarkable book, The Tragedy of the Euro, would have been The Tragedy of the European Central Bank.

[35] The surpluses in Spain were as follows: 0.96%, 2.02%, and 1.90% in 2005, 2006, and 2007 respectively. Those of Ireland were: 0.42%, 1.40%, 1.64%, 2.90%, and 0.67% in 2003, 2004, 2005, 2006, and 2007 respectively.

[36] The author of these lines could be cited as an exception (Huerta de Soto 2012 [1998], xxxvii).

[37] Ibid.

[38] At this time (2011-2012), the Federal Reserve is directly purchasing at least 40 percent of the newly issued American public debt. A similar statement can be made regarding the Bank of England, which is the direct holder of 25 percent of all the sovereign public debt of the United Kingdom. In comparison with these figures, the (direct and indirect) monetization carried out by the European Central Bank seems like innocent “child’s play.”

[39] Luskin and Roche Kelly have even referred to “Europe’s Supply-Side Revolution” (Luskin and Roche Kelly 2012). Also highly significant is “A Plan for Growth in Europe,” which was urged February 20, 2012 by the leaders of twelve countries in the European Union (including Italy, Spain, the Netherlands, Finland, Ireland, and Poland), a plan which comprises only supply-side policies and does not mention any fiscal stimulus measure. There is also the manifesto “Initiative for a Free and Prospering Europe” (IFPE) signed in Bratislava in January 2012 by, among others, the author of these lines. In short, a change of models seems a priority in countries which, like Spain, must move from a speculative, “hot” economy based on credit expansion to a “cold” economy based on competitiveness. Indeed, as soon as prices decline (“internal deflation”) and the structure of relative prices is readjusted in an environment of economic liberalization and structural reforms, numerous opportunities for entrepreneurial profit will arise in sustainable investments, which in a monetary area as extensive as the euro area are sure to attract financing. This is how to bring about the necessary rehabilitation and ensure the longed-for recovery in our economies, a recovery which again should be cold, sustainable, and based on competitiveness.

[40] In this context, and as I explained in the section devoted to the “Motley Anti-euro Coalition,” we should not be surprised by the statements of the candidates to the French presidency, which are mentioned in footnote 13.

[41] Estimated data as of December 31, 2011.

[42] Elsewhere I have mentioned the incremental reforms which, like the radical separation between commercial and investment banking (as in the Glass Steagall Act), could improve the euro somewhat. At the same time, it is in United Kingdom where, paradoxically (or not, in light of the devastating social damage that has resulted from its banking crisis), my proposals have aroused the most interest, to the point that a bill was even presented in the British Parliament to complete Peel’s Bank Charter Act of 1844 (curiously, still in effect) by extending the 100-percent reserve requirement to demand deposits. The consensus reached there to separate commercial and investment banking should be considered a (very small) step in the right direction (Huerta de Soto 2010 and 2011).

[43] My uncle by marriage, the entrepreneur Javier Vidal Sario from Navarre, who remains perfectly lucid and active at the age of ninety-three, assures me that in all his life, he had never, not even during the years of the Stabilization Plan of 1959, witnessed in Spain a collective effort at institutional and budget discipline and economic rehabilitation comparable to the current one. Also historically significant is the fact that this effort is not taking place in just one country (for example, Spain), nor in relation to one local currency (for example, the old peseta), but rather is spread throughout all of Europe, and is being made by hundreds of millions of people in the framework of a common monetary unit (the euro).

[44] As early as 1924, the great American economist Benjamin M. Anderson wrote the following: “Economical living, prudent financial policy, debt reduction rather than debt creation — all these things are imperative if Europe is to be restored. And all these are consistent with a greatly improved standard of living in Europe, if real activity be set going once more. The gold standard, together with natural discount and interest rates, can supply the most solid possible foundation for such a course of events in Europe.” Clearly, once again, history is repeating itself (Anderson 1924). I am grateful to my colleague Antonio Zanella for having called my attention to this excerpt.

[45] Moreover, this historic situation is now being revisited in all its severity upon China, the economy of which is at this time on the brink of expansionary and inflationary collapse. See “Keynes versus Hayek in China,” The Economist, December 30, 2011.

[46] As we have already seen, Mises, the great defender of the gold standard and 100-percent-reserve free banking, in the 1960s collided head-on with theorists who, led by Friedman, supported flexible exchange rates. Mises decried the behaviour of his disciple Machlup, when the latter abandoned the defense of fixed exchange rates. Now, fifty years later and on account of the euro, history is also repeating itself. On that occasion, the advocates of monetary nationalism and exchange-rate instability won, with consequences we are all familiar with. This time around let us hope that the lesson has been learned and that Mises’s views will prevail. The world needs it and he deserves it.


Economic Recessions, Banking Reform and the Future of Capitalism

The London School of Economics and Political Science

Hayek Memorial Lecture

October 28, 2010

It is a great honor for me to have been invited by the London School of Economics to deliver this Hayek Memorial Lecture. To begin, I would like to thank the school and especially Professor Timothy Besley for inviting me, Professor Philip Booth and the Institute of Economic Affairs for allowing me to also use this as an opportunity to introduce my most recent book entitled “Socialism, Economic Calculation and Entrepreneurship,” and finally Toby Baxendale for making this whole event possible.

Today I will concentrate on the recent financial crisis and the current worldwide economic recession, which I consider to be the most challenging problem we as economists must now face.

The Fatal Error of Peel’s Bank Act

I would like to start off by stressing the following important idea: all the financial and economic problems we are struggling with today are the result, in one way or another, of something that happened precisely in this country on July 19, 1844… What happened on that fateful day that has conditioned up to the present time the financial and economic evolution of the whole world? On that date, Peel’s Bank Act was enacted after years of debate between Banking and Currency School Theorists on the true causes of the artificial economic booms and the subsequent financial crises that had been affecting England especially since the beginning of the Industrial Revolution.

The Bank Charter Act of 1844 successfully incorporated the sound monetary theoretical insights of the Currency School. This school was able to correctly discern that the origin of the boom and bust cycles lay in the artificial credit expansions orchestrated by private banks and financed not by the prior or genuine savings of citizens, but through the issue of huge doses of fiduciary media (in those days mainly paper banknotes, or certificates of demand deposits issued by banks for a much greater amount than the gold originally deposited in their vaults). So, the requirement by Peel’s Bank Act of a 100 percent reserve on the banknotes issued was not only in full accordance with the most elementary general principles of Roman Law regarding the need to prevent the forgery or the over-issue of deposit certificates, but also was a first and positive step in the right direction to avoid endlessly recurring cycles of booms and depressions.

However Peel’s bank Act, not withstanding the good intentions behind it, and its sound theoretical foundations, was a huge failure. Why? Because it stopped short of extending the 100 percent reserve requirement to demand deposits also (Mises 1980, 446-448). Unfortunately, by Peel’s day, some ideas originally hit upon by the Scholastics of the Spanish Golden Century had been entirely forgotten. The Scholastics had discovered at least three hundred years earlier that demand deposits (which they called in Latin “chirographis pecuniarium,” or money created only by the entries in banks’ accounting books) were part of the money supply (Huerta de Soto 2009, 606). They had also realized that from a legal standpoint, neglecting to maintain a 100 percent reserve on demand deposits is a mortal sin and a crime not of forgery, as is the case with the over-issue of banknotes, but of misappropriation.

This error of Peel’s Bank Act, or rather, of most economists of that period, who were ignorant of something already discovered much earlier by the Spanish Scholastics, proved to be a fatal error: after 1844 bankers did continue to keep fractional reserves, not on banknotes of course, because it was forbidden by the Bank Charter Act, but on demand deposits. In other words, banks redirected their activity from the business of over-issuing banknotes to that of issuing demand deposits not backed by a 100 percent reserve, which from an economic point of view is exactly the same business. So, artificial credit expansions and economic booms did continue, financial crises and economic recessions were not avoided, and despite all the hopes and good intentions originally put into Peel’s Bank Act, this piece of legislation soon lost all of its credibility and popular support. Not only that, but the failure of the Bank Act conditioned the evolution of financial matters up to the present time and fully explains the faulty institutional design that afflicts the financial and monetary system of the so-called free market economies, and the dreadful economic consequences we are currently suffering.

When we consider the failure of Peel’s Bank Act, the evolution of events up to now makes perfect sense: bubbles did continue to form, financial crises and economic recessions were not avoided, bank bailouts were regularly demanded, the lender of last resort or central bank was created precisely to bail out banks and to permit the creation of the necessary liquidity in moments of crisis, gold was abandoned and legal tender laws and a purely fiduciary system were introduced all over the world. So as we can see, the outcome of this historical process sheds light on the faulty institutional design and financial mess that incredibly is still affecting the world at the beginning of the second decade of the 21st century!

The healthy process of capital accumulation based on true savings

Now it is important that we quickly review the specifics of the economic processes through which artificial credit expansions created by a fractional-reserve banking system under the direction of a Central Bank entirely distort the real productive structure, and thus generate bubbles, induce unwise investments and finally trigger a financial crisis and a deep economic recession. But before that, and in honor of Hayek, we must remember the fundamental rudiments of capital theory which up to the present time and at least since the Keynesian revolution, have been almost entirely absent from the syllabus of most university courses on economic theory. In other words, we are first going to explain the specific entrepreneurial, spontaneous and microeconomic processes that in an unhampered free market tend to correctly invest all funds previously saved by economic agents. This is important, because only this knowledge will permit us to understand the huge differences with respect to what happens if investment is financed not by true savings, but by the mere creation out of thin air of new demand deposits which only materialize in the entries of banks’ accounting books. What we are going to explain now is nothing more and nothing less than why the so-called “paradox of saving” is entirely wrong from the standpoint of economic theory (Hayek 1975, 199-263). Unfortunately this is something very few students of economic theory know even when they finish their studies and leave the university. Nevertheless this knowledge applies without any doubt to one of the most important spontaneous market processes that every economist should be highly familiar with.

In order to understand what will follow, we must visualize the real productive structure of the market as a temporal process composed of many  very complex temporal stages in which most labor, capital goods and productive resources are not devoted to producing consumer goods maturing this year, but consumer goods and services that will mature, and eventually be demanded by consumers, two, three, four, or even many more years from now… For instance, a period of several years elapses between the time engineers begin to imagine and design a new car, and the time the iron ore has already been mined and converted into steel, the different parts of the car have been produced, everything has been assembled in the auto factory, and the new cars are distributed, marketed and sold. This period comprises a very complex set of successive temporal productive stages. So, what happens if the subjective time preference of economic agents suddenly decreases and as a result the current consumption of this year decreases, for example, by ten percent? If this happens, three key spontaneous microeconomic processes are triggered and tend to guarantee the correct investment of the newly saved consumer goods.

The first effect is the new disparity in profits between the different productive stages: immediate sales in current consumer goods industries will fall and profits will decrease and stagnate compared with the profits in other sectors further away in time from current consumption. I am referring to industries which produce consumer goods maturing two, three, five or more years from now, their profitability not being affected by the negative evolution of short term current consumption. Entrepreneurial profits are the key signal that moves entrepreneurs in their investment decisions, and the relatively superior profit behavior of capital goods industries which help to produce consumer goods that will mature in the long term tells entrepreneurs all around the productive structure that they must redirect their efforts and investments from the less profitable industries closer to consumption to the more profitable capital goods industries situated further away in time from consumption.

The second effect of the new increase in savings is the decrease in the interest rate and the way it influences the market price of capital goods situated further away in time from consumption: as the interest rate is used to discount the present value of the expected future returns of each capital good, a decrease in the interest rate increases the market price of capital goods, and this increase in price is greater the longer the capital good takes to reach maturity as a consumer good. This significant increase in the market prices of capital goods compared with the relatively lower prices of the less demanded consumer goods (due to the increase in savings) is a second very powerful microeconomic effect that signals all around the market that entrepreneurs must redirect their efforts and invest less in consumer goods industries and more in capital goods industries further from consumption.

Finally, and third, we should mention what Hayek called The Ricardo Effect (Hayek 1948, 220-254; 1978, 165-178), which refers to the impact on real wages of any increase in savings: whenever savings increase, sales and market prices of immediate consumer goods relatively stagnate or even decrease. If factor incomes remain the same, this means higher real wages, and the corresponding reaction of entrepreneurs, who will try in the margin to substitute the now relatively cheaper capital goods for labor. What the Ricardo Effect explains is that it is perfectly possible to earn profits even when sales (of consumer goods) go down, if costs decrease even more via the replacement of labor, which has become more expensive, with machines and computers, for instance. Who produces these machines, computers, and capital goods that are newly demanded? Precisely the workers who have been dismissed by the stagnating consumer goods industries and who have relocated to the more distant capital goods industries, where there is new demand for them to produce the newly demanded capital goods. This third effect, the Ricardo Effect, along with the other two mentioned above, promotes a longer productive process with more stages, which are further away from current consumption. And this new, more capital-intensive productive structure is fully sustainable, since it is fully backed by prior, genuine real savings. Furthermore, it can also significantly increase, in the future, the final production of consumer goods and the real income of all economic agents. These three combined effects all work in the same direction; they are the most elementary teachings of capital theory; and they explain the secular tendency of the unhampered free market to correctly invest new savings and constantly promote capital accumulation and the corresponding sustainable increase in economic welfare and development.

The unsustainable nature of the Bubbles induced by artificial credit expansions created by the fractional-reserve banking industry.

We are now in a position to fully understand, by contrast with the above process of healthy capital accumulation, what happens if investments are financed not by prior genuine savings but by a process of artificial credit expansion, orchestrated by fractional-reserve banks and directed by the lender of last resort or Central Bank.

Unilateral credit expansion means that new loans are provided by banks and recorded on the asset side of their balance sheets, against new demand deposits that are created out of thin air as collateral for the new loans, and are automatically recorded on the liability side of banks’ balance sheets. So new money, or I should say new “virtual money” because it only “materializes” in bank accounting book entries, is constantly created through this process of artificial credit expansion. And in fact roughly only around ten percent of the money supply of most important economies is in the form of cash (paper bills and coins), while the remaining 90 percent of the money supply is this kind of virtual money that only exists as written entries in banks’ accounting books. (This is precisely what the Spanish Scholastics termed, over 400 years ago, “chirographis pecuniarum” or virtual money that only exists in writing in an accounting book.)

It is easy to understand why credit expansions are so tempting and popular and the way in which they entirely corrupt the behavior of  economic agents and deeply demoralize society at all levels. To begin with, entrepreneurs are usually very happy with expansions of credit, because they make it seem as if any investment project, no matter how crazy it would appear in other situations, could easily get financing at very low interest rates. The money created through credit expansions is used by entrepreneurs to demand factors of production, which they employ mainly in capital goods industries more distant from consumption. As the process has not been triggered by an increase in savings, no productive resources are liberated from consumer industries, and the prices of commodities, factors of production, capital goods and the securities that represent them in stock markets tend to grow substantially and create a market bubble. Everyone is happy, especially because it appears it would be possible to increase one’s wealth very easily without any sacrifice in the form of prior saving and honest hard individual work. The so-called “virtuous circle of the new economy” in which recessions seemed to have been avoided forever, cheats all economic agents: investors are very happy looking at stock market quotes that grow day after day; consumer goods industries are able to sell everything they carry to the market at ever increasing prices; restaurants are always full with long waiting lists just to get a table; workers and their unions see how desperately entrepreneurs demand their services in an environment of full employment, wage increases and immigration; political leaders benefit from what appears to be an exceptionally good economic and social climate that they invariably sell to the electorate as the direct result of their leadership and good economic policies; state budget bureaucrats are astonished to find that every year public income increases at double digit figures, particularly the proceeds from Value Added tax, which, though in the end is paid by the final consumer, is advanced by the entrepreneurs of the early stages newly created and artificially financed by credit expansion.

But we may now ask ourselves: how long can this party last? How long can there continue to be a huge discoordination between the behavior of consumers (who do not wish to increase their savings) and that of investors (who continually increase their investments financed by banks’ artificial creation of virtual money and not by citizens’ prior genuine savings)? How long can this illusion that everybody can get whatever he wants without any sacrifice last?

The unhampered market is a very dynamically efficient process (Huerta de Soto 2010a, 1-30). Sooner or later it inevitably discovers (and tries to correct) the huge errors committed. Six spontaneous microeconomic reactions always occur to halt and revert the negative effects of the bubble years financed by artificial bank credit expansion.

The spontaneous reaction of the market against the effects of credit expansions: first the financial crisis and second the deep economic recession.

In my book on Money, Bank Credit and Economic Cycles (Huerta de Soto 2009, 361-384) I study in detail the six spontaneous and inevitable microeconomic causes of the reversal of the artificial boom that the aggression of bank credit expansion invariably triggers in the market. Let us summarize these six factors briefly:

1st The rise in the price of the original means of production (mainly labor, natural resources, and commodities). This factor appears when these resources have not been liberated from consumer goods industries (because savings have not increased) and the entrepreneurs of the different stages in the production process compete with each other in demanding the original means of production with the newly created loans they have received from the banking system.

2nd The subsequent rise in the price of consumer goods at an even quicker pace than that of the rise in the price of the factors of production. This happens when time preference remains stable and the new money created by banks reaches the pockets of the consumers in an environment in which entrepreneurs are frantically trying to produce more for distant consumption and less for immediate consumption of all kinds of goods. This also explains the 3rd factor which is

3rd The substantial relative increase in the accounting profits of companies closest to final consumption, especially compared with the profits of capital goods industries which begin to stagnate when their costs rise more rapidly than their turn over.

4th “The Ricardo Effect” which exerts an impact which is exactly opposite to the one it exerted when there was an increase in voluntary saving. Now the relative rise in the prices of consumer goods (or of consumer industries’ turnover in an environment of increased productivity) with respect to the increase in original-factor income begins to drive down real wages, motivating entrepreneurs to substitute cheaper labor for machinery, which lessens the demand for capital goods and further reduces the profits of companies operating in the stages furthest from consumption.

5th The increase in the loan rate of interest even exceeding pre-credit expansion levels. This happens when the pace of credit expansion stops accelerating, something that sooner or later always occurs. Interest rates significantly increase due to the higher purchasing power and risk premiums demanded by the lenders. Furthermore, entrepreneurs involved in malinvestments start a “fight to the death” to obtain additional financing to try to complete their investment projects (Hayek 1937).

These five factors provoke the following sixth combined effect:

6th Companies which operate in the stages relatively more distant from consumption begin to discover they are incurring heavy accounting losses. These accounting losses, when compared with the relative profits generated in the stages closest to consumption, finally reveal beyond a doubt that serious entrepreneurial errors have been committed and that there is an urgent need to correct them by paralyzing and liquidating the investment projects mistakenly launched during the boom years.

The financial crisis begins the moment the market, which as I have said is very dynamically efficient (Huerta de Soto 2010a, 1-30), discovers that the true market value of the loans granted by banks during the boom is only a fraction of what was originally thought. In other words, the market discovers that the value of bank assets is much lower than previously thought and, as bank liabilities (which are the deposits created during the boom) remain constant, the market discovers the banks are in fact bankrupt, and were it not for the desperate action of the lender of last resort in bailing out the banks, the whole financial and monetary system would collapse. In any case, it is important to understand that the financial and banking crisis is not the cause of the economic recession but one of its most important first symptoms.

Economic recessions begin when the market discovers that many investment projects launched during the boom years are not profitable. And   then consumers demand liquidation of these malinvestments (which, it is now discovered, were planned to mature in a too-distant future considering the true wishes of consumers). The recession marks the beginning of the painful readjustment of the productive structure, which consists of withdrawing productive resources from the stages furthest from consumption and transferring them back to those closest to it.

Both the financial crisis and the economic recession are always unavoidable once credit expansion has begun, because the market sooner or later discovers that investment projects financed by banks during the boom period were too ambitious due to a lack of the real saved resources that would be needed to complete them. In other words, bank credit expansion during the boom period encourages entrepreneurs to act as if savings had increased when in fact this is not the case. A generalized error of economic calculation has been committed and sooner or later it will be discovered and corrected spontaneously by the market. In fact all the Hayekian theory of economic cycles is a particular case of the theorem of the impossibility of economic calculation under socialism discovered by Ludwig von Mises, which is also fully applicable to the current wrongly designed and heavily regulated banking system.

The specific features of the 2008 Financial Crisis and the current economic recession.

The expansionary cycle which has now come to a close was set in motion when the American economy emerged from its last recession in 2001 and the Federal Reserve embarked again on a major artificial expansion of credit and investment, an expansion unbacked by a parallel increase in voluntary household saving.  In fact, for several years the money supply in the form of banknotes and deposits has been growing at an average rate of over ten percent per year (which means that every seven years the total volume of money circulating in the world has doubled).  The media of exchange originating from this severe fiduciary inflation have been placed on the market by the banking system as newly-created loans granted at extremely low (and even negative in real terms) interest rates.  This fueled a speculative bubble in the shape of a substantial rise in the prices of capital goods, real estate assets, and the securities which represent them and are exchanged on the stock market, where indexes soared.

Curiously enough, like in the “roaring” years prior to the Great Depression of 1929, the shock of monetary growth has not significantly influenced the unit prices of the subset of consumer goods and services (which are only approximately one third of the total number of goods that are exchanged in the market).  The last decade, like the 1920s, has seen a remarkable increase in productivity as a result of the introduction, on a massive scale, of new technologies and significant entrepreneurial innovations which, were it not for the “money and credit injection,” would have given rise to a healthy and sustained reduction in the unit price of the goods and services all citizens consume.  Moreover, the full incorporation of the economies of China and India into the globalized market has gradually raised the real productivity of consumer goods and services even further.  The absence of a healthy “deflation” in the prices of consumer goods in a stage of such considerable growth in productivity as that of recent years provides the main evidence that the monetary shock has seriously disturbed the whole economic process. And let us remember the “Antideflationist Hysteria” of those who, even during the years of the bubble, used the slightest symptoms of this healthy deflation, to justify even greater doses of credit expansion.

As we have already seen, artificial credit expansion and the (fiduciary) inflation of media of exchange offer no shortcut to stable and sustained economic development, no way of avoiding the necessary sacrifice and discipline behind all high rates of voluntary saving.  (In fact, before the crisis and particularly in the United States, voluntary saving not only failed to increase, but even fell to a negative rate for several years.)

The specific factors that trigger the end of the euphoric monetary “binge” and the beginning of the recessionary “hangover” are many, and they can vary from one cycle to another.  In this crisis, the most obvious triggers were first, the rise in the price of commodities and raw materials, particularly oil, second, the subprime mortgage crisis in the United States, and finally, the failure of important banking institutions when it became clear in the market that the value of their debts exceeded that of their assets (mainly mortgage loans erroneously granted).

If we consider the level of past credit expansion and the quality and volume of malinvestment produced by it, we could say that very probably in this cycle the economies of the European Monetary Union are in comparison in a somewhat less poor state (if we do not consider the relatively greater Continental European rigidities, particularly in the labor market, which tend to make recessions in Europe longer and more painful).  The expansionary policy of the European Central Bank, though not free of grave errors, has been somewhat less irresponsible than that of the Federal Reserve.  Furthermore, fulfillment of the convergence criteria for the monetary union involved at the time a healthy and significant rehabilitation of the chief European economies.  Only some countries on the periphery, like Ireland and Spain, were immersed in considerable credit expansion from the time they initiated their processes of convergence.

The case of Spain is paradigmatic.  The Spanish economy underwent an economic boom which, in part, was due to real causes (like the liberalizing structural reforms which originated with José María Aznar’s administration).  Nevertheless, the boom was also largely fueled by an artificial expansion of money and credit, which grew at a rate nearly three times the corresponding rates in France and Germany.

Spanish economic agents essentially interpreted the decrease in interest rates which resulted from the convergence process in the easy-money terms traditional in Spain:  a greater availability of easy money and mass requests for loans from Spanish banks (mainly to finance real estate speculation), loans which Spanish banks granted by creating the money ex nihilo while European central bankers looked on unperturbed. Once the crisis hit Spain the readjustment was quick and efficient: In less than a year more than 150,000 companies -mainly related with the building sector- have disappeared, almost five million workers who were employed in the wrong sectors have been dismissed, and nowadays we can conclude that although still very weak, the economic body of Spain has been already healed. We will later come back to the subject of what economic policy is most appropriate to the current circumstances. But before that, let us make some comments on the influence of the new accounting rules on the current economic and financial crisis.

The negative influence of the new accounting rules.

We must not forget that a central feature of the long past period of artificial expansion was a gradual corruption, on the American continent as well as in Europe, of the traditional principles of accounting as practiced globally for centuries.

To be specific, acceptance of the international accounting standards (IAS) and their incorporation into law in most countries have meant the abandonment of the traditional principle of prudence and its replacement by the principle of “fair value” in the assessment of the value of balance sheet assets, particularly financial assets.

In fact, during the years of the “speculative bubble,” this process was characterized by a feedback loop:  rising stock-market values were immediately entered into the books, and then such accounting entries were sought as justification for further artificial increases in the prices of financial assets listed on the stock market.

It is easy to realize that the new accounting rules act in a pro-cyclic manner by heightening volatility and erroneously biasing business management:  in times of prosperity, they create a false “wealth effect” which prompts people to take disproportionate “risks”;  when, from one day to the next, the errors committed come to light, the loss in the value of assets immediately decapitalizes companies, which are obliged to sell assets and attempt to recapitalize at the worst moment, when assets are worth the least and financial markets dry up.  Clearly, accounting principles which have proven so disturbing must be abandoned as soon as possible, and the recent accounting reforms recently enacted, must be reversed.  This is so not only because these reforms mean a dead end in a period of financial crisis and recession, but especially because it is vital that in periods of prosperity we stick to the principle of prudence in valuation, a principle which has shaped all accounting systems from the time of Luca Pacioli at the beginning of the fifteenth century till the adoption of the false idol of the International Accounting Rules.

It must be emphasized that the purpose of accounting is not to reflect supposed “real” values (which in any case are subjective and which are determined and vary daily in the corresponding markets) under the pretext of attaining a (poorly understood) “accounting transparency.”  Instead, the purpose of accounting is to permit the prudent management of each company and to prevent capital consumption, as Hayek already established as early as 1934 in his article “The Maintenance of Capital” (Hayek 1934). This requires the application of strict standards of accounting conservatism (based on the prudence principle and the recording of either historical cost or market value, whichever is lower), standards which ensure at all times that distributable profits come from a safe surplus which can be distributed without in any way endangering the future viability and capitalization of each company.

Who is responsible for the current situation?

Of course the spontaneous order of the unhampered market is not responsible for the current situation. And one of the most typical consequences of every past crisis and of course of this current one, is how many people are blaming the market and firmly believing that the recession is a “market failure” that requires more government intervention. The market is a process that spontaneously reacts in the way we have seen against the monetary aggression of the bubble years, which consisted of a huge credit expansion that was not only allowed but even orchestrated and directed by central Banks, which are the institutions truly responsible for all the economic sufferings from the crisis and recession that are affecting the world. And paradoxically central banks have been able to present themselves to the general public not only as indignant victims of the list of ad hoc scapegoats they have been able to put together (stupid private bankers, greedy managers receiving exorbitant bonuses, etc.), but also as the only institutions which, by bailing out the banking system as a last resort, have avoided a much greater tragedy.

In any case, it is crystal clear that the world monetary and banking system has chronically suffered from wrong institutional design at least  since Peel’s Bank Act of 1844. There is no free market in the monetary and banking system but just the opposite: private money has been nationalized, legal tender rules introduced, a huge mess of administrative regulations enacted, the interest rate manipulated and most importantly, everything is directed by a monetary central-planning agency: The Central Bank.

In other words, real socialism, represented by state money, Central banks and financial administrative regulations, is still in force in the monetary and credit sectors of the so-called free market economies.

As a result of this fact we experience regularly in the area of money and credit all the negative consequences established by the Theorem of the Impossibility of Socialism discovered by those distinguished members of the Austrian School of Economics: Ludwig von Mises and Friedrich Hayek.

Specifically, the central planners of state money are unable to know, to follow and to control the changes in both the demand for and supply of money. Furthermore, as we have seen, the whole financial system is based on the legal privilege given by the state to private bankers, who can use a fractional-reserve ratio with respect to the demand deposits they receive from their customers. As a result of this privilege, private bankers are not true financial intermediaries, but are mainly creators of deposits materializing in credit expansions that inevitably end in crisis and recession.

The most rigorous economic analysis and the coolest, most balanced interpretation of past and recent economic and financial events lead inexorably to the conclusion that central banks (which, again, are true financial central-planning agencies) cannot possibly succeed in finding the most convenient monetary policy at every moment.  This is exactly the kind of problem that became evident in the case of the failed attempts to plan the former Soviet economy from above.

To put it another way, the theorem of the economic impossibility of socialism, which the Austrian economists Ludwig von Mises and Friedrich A. Hayek discovered, is fully applicable to central banks in general, and to the Federal Reserve and (at one time) Alan Greenspan and (currently) Ben Bernanke in particular.  According to this theorem, it is impossible to organize any area of the economy and especially the financial sector, via coercive commands issued by a planning agency, since such a body can never obtain the information it needs to infuse its commands with a coordinating nature. This is precisely what I analyze in Chapter 3 of my book on Socialism, Economic Calculation and Entrepreneurship, which has been published by Edward Elgar in association with the Institute of Economic Affairs, and which we present today (Huerta de Soto, 2010b).

Indeed, nothing is more dangerous than to indulge in the “fatal conceit” – to use Hayek’s useful expression (Hayek, 1990) – of believing oneself omniscient or at least wise and powerful enough to be able to keep the most suitable monetary policy fine-tuned at all times.  Hence, rather than softening the most violent ups and downs of the economic cycle, the Federal Reserve and, to a lesser extent, the European Central Bank, have been their main architects and the culprits in their worsening.

Therefore, the dilemma facing Ben Bernanke and his Federal Reserve Board, as well as the other central banks (beginning with the European Central Bank), is not at all comfortable.  For years they have shirked their monetary responsibility, and now they find themselves up a blind alley.  They can either allow the recessionary process to follow its course, and with it the healthy and painful readjustment, or they can escape forward toward a “renewed inflationist” cure.  With the latter, the chances of an even more severe recession (even stagflation) in the not-too-distant future increase dramatically.  (This was precisely the error committed following the stock market crash of 1987, an error which led to the inflation at the end of the 1980s and concluded with the sharp recession of 1990-1992.)

Furthermore, the reintroduction of the artificially cheap-credit policy at this stage could only hinder the necessary liquidation of unprofitable investments and company reconversion.  It could even wind up prolonging the recession indefinitely, as happened in the case of the Japanese economy, which, though all possible interventions have been tried, has ceased to respond to any stimulus involving either monetarist credit expansions or Keynesian methods.

It is in this context of “financial schizophrenia” that we must interpret the “shots in the dark” fired in the last two years by the monetary authorities (who have two totally contradictory responsibilities:  both to control inflation and to inject all the liquidity necessary into the financial system to prevent its collapse).  Thus, one day the Fed rescues Bear Stearns, AIG, Fannie Mae, Freddie Mac or City Group, and the next it allows Lehman Brothers to fail, under the amply justified pretext of “teaching a lesson” and refusing to fuel moral hazard.  Finally, in light of the way events were unfolding, the US and European governments launched multi-billion-dollar plans to purchase illiquid (that is, worthless) assets from the banking system, or to monetize the public debt, or even to buy bank shares, totally or partially nationalizing the private banking system. And considering all that we have seen, which are now the possible future scenarios?

Possible future scenarios and the most appropriate economic policy.

Theoretically, under the wrongly designed current financial system, once the crisis has hit we can think of four possible scenarios:

The first scenario is the catastrophic one in which the whole banking system based on a fractional reserve collapses. This scenario seems to have been avoided by central banks which, acting as lenders of last resort, are bailing out private banks whenever it is necessary.

The second scenario is just the opposite of the first one but equally tragic: it consist of an “inflationist cure” so intense, that a new bubble is created. This forward escape would only temporarily postpone the solution of the problems at the cost of making them far more serious later (this is precisely what happened in the crisis of 2001).

The third scenario is what I have called the “japanization” of the economy: it happens when the reintroduction of the cheap-credit policy together with all conceivable government interventions entirely blocks the spontaneous market process of liquidation of unprofitable investments and company reconversion. As a result, the recession is prolonged indefinitely and the economy does not recover and ceases to respond to any stimulus involving monetarist credit expansions or Keynesian methods.

The fourth and final scenario is currently the most probable one: It happens when the spontaneous order of the market, against all odds and despite all government interventions, is finally able to complete the microeconomic readjustment of the whole economy, and the necessary reallocation of labor and the other factors of production toward profitable lines based on sustainable new investment projects.

In any case, after a financial crisis and an economic recession have hit it is necessary to avoid any additional credit expansion (apart from the minimum monetary injection strictly necessary to avoid the collapse of the whole fractional-reserve banking system). And the most appropriate policy would be to liberalize the economy at all levels (especially in the labor market) to permit the rapid reallocation of productive factors (particularly labor) to profitable sectors.  Likewise, it is essential to reduce public spending and taxes, in order to increase the available income of heavily-indebted economic agents who need to repay their loans as soon as possible.  Economic agents in general and companies in particular can only rehabilitate their finances by cutting costs (especially labor costs) and paying off loans.  Essential to this aim are a very flexible labor market and a much more austere public sector.  These measures are fundamental if the market is to reveal as quickly as possible the real value of the investment goods produced in error and thus lay the foundation for a healthy, sustainable economic recovery.

However, once the economy recovers (and in a sense the recovery begins with the crisis and the recession themselves which mark the discovery by the market of the errors committed and the beginning of the necessary microeconomic readjustment), I am afraid that, as has happened in the past again and again, no matter how careful central banks may be in the future (can we expect them to have learned their lesson? For how long will they remember what happened?), nor how many new regulations are enacted (as in the past all of them and especially Basel II and III have attacked only the symptoms but not the true causes), sooner or later new cycles of credit expansion, artificial economic boom, financial crisis and economic recession will inevitably continue affecting us until the world financial and banking systems are entirely redesigned according to the general principles of private property law that are the essential foundation of the capitalist system and that require a 100 percent reserve for any demand deposit contract.


I began this lecture with Peel’s Bank Act, and I will also finish with it. On June 13 and 24, 1844 Robert Peel pointed out in the House of Commons that in each one of the previous monetary crises “there was an increase in the issues of country bank paper” and that “currency without a basis (…) only creates fictitious value, and when the bubble bursts, it spreads ruin over the country and deranges all commercial transactions”.

Today, 166 years later, we are still suffering from the problems that were already correctly diagnosed by Robert Peel. And in order to solve them and finally reach the only truly free and stable financial and monetary system that is compatible with a free market economy in this 21st century, it will be necessary to take the following three steps:

First, to develop and culminate the basic concept of Peel’s Bank Act by also extending the prescription of a 100 percent reserve requirement to demand deposits and equivalents. Hayek states that this radical solution would prevent all future crises (Hayek 1984, 29) as no credit expansions would be possible without a prior increase in real genuine saving, making investments sustainable and fully matched with prior voluntary savings. And I would add to Hayek’s statement the most important fact that 100 percent banking is the only system compatible with the general principles of the law of property rights that are indispensable for the capitalist system to work: there is no reason to treat deposits of money differently from any other deposit of a fungible good, such as wheat or oil in which nobody doubts the need to keep the 100 percent reserve requirement.

In relation to this first step of the proposed reform it is most encouraging to see how two Tory MPs, Douglas Carswell and Steve Baker, were able to introduce in the British Parliament on September the 15th and under the 10 minute rule the first reading of a Bill to reform the banking system extending the prescriptions of Peel’s Bank Act to demand deposits. This “customer Choice Disclosure and Protection Bill” will be discussed in its second reading, three weeks from now, on November the 19th, and has two goals: first to fully and effectively defend citizens’ right of ownership over money they have deposited in checking accounts at banks; and second, to once and for all put an end to the recurrent cycles of artificial boom, financial crisis and economic recession. Of course this first draft of the bill still needs to be completed with some important details, for instance the time period (let us say a month) under which all deposits should be considered demand deposits for storage and not for investment, and any contract that guarantees full availability of its nominal value at any moment should be considered at all effects a demand deposit for storage. But the mere discussion of these matters in the British Parliament and by the public at large is, in itself, of huge importance. In any case it is exciting that a handful of MPs have taken this step against the tangle of vested interests related to the current privileged fractional-reserve banking system. If they are successful in their fight against what we could call the current “financial slavery” that grips the world they will go down in history like William Wilberforce –with the abolition of the slave trade- and other outstanding British figures to which the whole world owes so much.

Second, if we wish to culminate the fall of the Berlin wall and get rid of the real socialism that still remains in the monetary and credit sector, a priority would be the elimination of Central Banks, which would be rendered unnecessary as lenders of last resort if the above 100 percent reserve reform is introduced, and harmful if they insist on continuing to act as financial central-planning agencies.

And third, who will issue the monetary base? Maurice Allais, the French Nobel Prize winner who passed away two weeks ago, proposed that a Public Agency print the public paper money at a rate of increase of 2 percent per year. I personally do not trust this solution as any emergency situation in the state budget would be used, as in the past, as a pretext for issuing additional doses of fiduciary media. For this reason, and this is probably my most controversial proposal, in order to put an end to any future manipulation of our money by the authorities, what is required is the full privatization of the current, monopolistic, and fiduciary state-issued paper base money, and its replacement with a classic pure gold standard.

There is an old Spanish saying: “A grandes males, grandes remedios”. In English, “great problems require radical solutions”. And though of course any step toward these three measures would significantly improve our current economic system, it must be understood that the reforms proposed and taken by governments up to now (including Basel II and III) are only nervously attacking the symptoms but not the real roots of the problem, and precisely for that reason they will again miserably fail in the future.

Meanwhile, it is encouraging to see how a growing number of scholars and private institutions like the “Cobden Centre” under the leadership of Toby Baxendale, are studying again not only the radical reforms required by a truly honest private money, but also very interesting proposals for a suitable transition to a new banking system, like the one I develop in chapter 9 of my book on Money, Bank Credit and Economic Cycles. By the way, in this chapter I also explain a most interesting by-product of the proposed reform, namely the possibility it offers of paying off, without any cost nor inflationary effects, most of the existing public debt which in the current circumstances is a very worrying and increasingly heavy burden in most countries.

Briefly outlined, what I propose and the Cobden Centre has developed in more detail for the specific case of the United Kingdom, is to print the paper banknotes necessary to consolidate the volume of demand deposits that the public decides to keep in the banks. In any case, the printing of this new money would not be inflationary, as it would be handed to banks and kept entirely sterilized, so to speak, as 100 percent asset collateral of bank liabilities in the form of demand deposits. In this way, the basket of bank assets (loans, investments, etc.) that are currently backing the demand deposits would be “freed”, and what I propose is to include these “freed” assets in mutual funds, swapping their units at their market value for  outstanding treasury bonds. In any case, an important warning must be given: naturally, and one must never tire of repeating it, the solution proposed is only valid in the context of an irrevocable decision to re-establish a free-banking system subject to a 100 percent reserve requirement on demand deposits. However, no matter how important this possibility is considered under the current circumstances, we must not forget it is only a by-product (of “secondary” importance) compared to the major reform of the banking system we have outlined.

And now to conclude, should in this 21st century a new Robert Peel be able to successfully push for all these proposed reforms, this great country of the United Kingdom would again render an invaluable service not only  to itself but also to the rest of the world.

Thank you very much.


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