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By Toby Baxendale, on 3 February 12
On Wednesday, I talked about the forgotten wisdom embodied in Say’s Law. Today, we reprint the chapter called “Keynes vs. Say’s Law” from Henry Hazlitt’s The Failure of the “New Economics” which is a quick read and sheds more light on what the classical economists did and did not think with regards to Say’s law, whilst exposing some very poor scholarship from Keynes and revealing a startling contradiction in his work.
This is very relevant to today, when we have shops and factories stuffed full of goods that they can’t sell. This is a situation generally called a recession whose cure, according to conventional wisdom, is more Keynesian style spending, be it by way of deficit spending, increased taxation and spending, or the minting up of new money and spending.
A full copy of Hazlitt’s book can be downloaded here (with thanks to our friends at Mises.org).
KEYNES vs. SAY’S LAW
1. Keynes’s “Greatest Achievement”
We come now to Keynes’s famous ”refutation” of Say’s Law of Markets. All that it is necessary to say about this ”refutation” has already been said by Benjamin M. Anderson, Jr.,[1] and Ludwig von Mises.[2] Keynes himself takes the matter so cavalierly that all he requires to “refute” Say’s Law to his own satisfaction is less than four pages.
Yet some of his admirers regard this as alone securing his title to fame:
Historians fifty years from now may record that Keynes’ greatest achievement was the liberation of Anglo-American economics from a tyrannical dogma, and they may even conclude that this was essentially a work of negation unmatched by comparable positive achievements. Even, however, if Keynes were to receive credit for nothing else . . . his title to fame would be secure .. . [Yet] the Keynesian attacks, though they appear to be directed against a variety of specific theories, all fall to the ground if the validity of Say’s Law is assumed.[3]
I think I am justified, therefore, in devoting a special chapter to the subject.
It is important to realize, to begin with, as Mises [4] has pointed out, that what is called Say’s Law was not originally designed as an integral part of classical economics but as a preliminary—as a refutation of a fallacy that long preceded the development of economics as a recognized special branch of knowledge. Whenever business was bad, the average merchant had two explanations at hand: the evil was caused by a scarcity of money and by general overproduction. Adam Smith, in a famous passage in The Wealth of Nations [5] exploded the first of these myths. Say devoted himself to a refutation of the second.
For a modern statement of Say’s Law, I turn to B. M. Anderson:
“The central theoretical issue involved in the problem of postwar economic adjustment, and in the problem of full employment in the postwar period, is the issue between the equilibrium doctrine and the purchasing power doctrine.
Those who advocate vast governmental expenditures and deficit financing after the war as the only means of getting full employment, separate production and purchasing power sharply. Purchasing power must be kept above production if production is to expand, in their view. If purchasing power falls off, production will fall off.
The prevailing view among economists, on the other hand, has long been that purchasing power grows out of production. The great producing countries are the great consuming countries. The twentieth-century world consumes vastly more than the eighteenth-century world because it produces vastly more. Supply of wheat gives rise to demand for automobiles, silks, shoes, cotton goods, and other things that the wheat producer wants. Supply of shoes gives rise to demand for wheat, for silks, for automobiles, and for other things that the shoe producer wants. Supply and demand in the aggregate are thus not merely equal, but they are identical, since every commodity may be looked upon either as supply of its own kind or as demand for other things. But this doctrine is subject to the great qualification that the proportions must be right; that there must be equilibrium.” [6]
Keynes’s “refutation” of Say’s Law consists in simply ignoring this qualification.
He takes as his first target a passage from John Stuart Mill:
“What constitutes the means of payment for commodities is simply commodities. Each person’s means of paying for the production of other people consist of those which he himself possesses. All sellers are inevitably, and by the meaning of the word, buyers. Could we suddenly double the productive powers of the country, we should double the supply of commodities in every market; but we should, by the same stroke, double the purchasing power. Everybody would bring a double demand as well as supply; everybody would be able to buy twice as much, because every one would have twice as much to offer in exchange.” [7]
By itself, this passage from Mill, as B. M. Anderson [8] has pointed out, does not present the essentials of the modern version of Say’s Law:
“If we doubled the productive power of the country, we should not double the supply of commodities in every market, and if we did, we should not clear the markets of the double supply in every market. If we doubled the supply in the salt market, for example, we should have an appalling glut of salt. The great increases would come in the items where demand is elastic. We should change very radically the proportions in which we produced commodities.”
But as Anderson goes on to point out, it is unfair to Mill to take this brief passage out of its context and present it as if it were the heart of Say’s Law. If Keynes had quoted only the three sentences immediately following, he would have introduced us to the conception of balance and proportion and equilibrium which is the heart of the doctrine—a conception which Keynes nowhere considers in his General Theory.
Mill’s next few lines, immediately following the passage torn from its context, quoted above, are as follows:
“It is probable, indeed, that there would now be a superfluity of certain things. Although the community would willingly double its aggregate consumption, it may already have as much as it desires of some commodities, and it may prefer to do more than double its consumption of others, or to exercise its increased purchasing power on some new thing. If so, the supply will adapt itself accordingly, and the values of things will continue to conform to their cost of production.”
The doctrine that supply creates its own demand, in other words, is based on the assumption that a proper equilibrium exists among the different kinds of production, and among prices of different products and services. And it of course assumes proper relationships between prices and costs, between prices and wage-rates. It assumes the existence of competition and free and fluid markets by which these proportions, price relations, and other equilibria will be brought about.
No important economist, to my knowledge, ever made the absurd assumption (of which Keynes by implication accuses the whole classical school) that thanks to Say’s Law depressions and unemployment were impossible, and that everything produced would automatically find a ready market at a profitable price. Say’s Law, to repeat, was, contrary to the assertions of the Keynesians, not the cornerstone on which the great edifice of the positive doctrines of the classical economists was based. It was itself merely a refutation of an absurd belief prevailing prior to its formulation.
To resume the quotation from Mill:
“At any rate, it is a sheer absurdity that all things should fall in value, and that all producers should, in consequence, be insufficiently remunerated. If values remain the same, what becomes of prices is immaterial, since the remuneration of producers does not depend on how much money, but on how much of consumable articles, they obtain for their goods. Besides, money is a commodity; and if all commodities are supposed to be doubled in quantity, we must suppose money to be doubled too, and then prices would no more fall than values would.”
In sum, Say’s Law was merely the denial of the possibility of a general overproduction of all goods and services.
If you had presented the classical economists with “the Keynesian case”—if you had asked them, in other words, what they thought would happen in the event of a fall in the price of commodities, if money wage-rates, as a result of union monopoly protected and insured by law, remained rigid or rising—they would have undoubtedly replied that sufficient markets could not be found for goods produced at such economically unjustified costs of production and that great and prolonged unemployment would result. Certainly this is what any modern subjective-value theorist would reply.
2. Ricardo’s Statement
We might rest the case here. But such a hullabaloo has been raised about Keynes’s alleged “refutation” of Say’s Law that it seems desirable to pursue the subject further. One writer [9] has distinguished “the four essential meanings of Say’s Law, as developed by Say and, more fully, by [James] Mill and Ricardo.” It may be profitable to take her formulation as a basis of discussion. The four meanings as she phrases them are:
(1) Supply creates its own demand; hence, aggregate overproduction or a ”general glut” is impossible.
(2) Since goods exchange against goods, money is but a “veil” and plays no independent role.
(3) In the case of partial overproduction, which necessarily implies a balancing underproduction elsewhere, equilibrium is restored by competition, that is, by the price mechanism and the mobility of capital.
(4) Because aggregate demand and supply are necessarily equal, and because of the equilibrating mechanism, output can be increased indefinitely and the accumulation of capital proceed without limit.
I shall contend that of these four versions, 1, 3 and 4 are correct, properly interpreted and understood; that only version 2 is false as stated, and that even this is capable of being stated in a form that is correct.
Now Ricardo clearly stated the doctrine in versions 1, 3, and 4; and though he implied it also in version 2, his statement even of this can be interpreted in a sense that would be correct:
“M. Say has . . . most satisfactorily shown that there is no amount of capital which may not be employed in a country, because a demand is only limited by production. No man produces but with a view to consume or sell, and he never sells but with an intention to purchase some other commodity, which may be immediately useful to him, or which may contribute to future production. By producing, then, he necessarily becomes either the consumer of his own goods, or the purchaser and consumer of the goods of some other person. It is not to be supposed that he should, for any length of time, be ill-informed of the commodities which he can most advantageously produce, to attain the object which he has in view, namely, the possession of other goods; and, therefore, it is not probable that he will continually produce a commodity for which there is no demand.
There cannot, then, be accumulated in a country any amount of capital which cannot be employed productively until wages rise so high in consequence of the rise of necessaries, and so little consequently remains for the profits of stock, that the motive for accumulation ceases. While the profits of stock are high, men will have a motive to accumulate. Whilst a man has any wished-for gratification unsupplied, he will have a demand for more commodities; and it will be an effectual demand while he has any new value to offer in exchange for them. . . .
Productions are always bought by productions, or by services; money is only the medium by which the exchange is effected. Too much of a particular commodity may be produced, of which there may be such a glut in the market as not to repay the capital expended on it; but this cannot be the case with respect to all commodities.” [10]
The italics above are my own, intended to bring out the fact that Ricardo by no means denied the possibility of gluts, but merely of their indefinite prolongation.[11] In his Notes on Malthus, in fact, Ricardo wrote:
“Mistakes may be made, and commodities not suited to the demand may be produced—of these there may be a glut; they may not sell at their usual price; but then this is owing to the mistake, and not to the want of demand for productions.” [12]
The whole of Ricardo’s comment on this phase of Malthus’s thought will repay study. “I have been thus particular in examining this question [Say's Law]/’ wrote Ricardo, “as it forms by far the most important topic of discussion in Mr. Malthus’ work.” [13] i.e., Malthus’s Principles of Political Economy.
It was Malthus who, in 1820, more than a century before Keynes, set himself to “refuting” Say’s Law. Ricardo’s answer (most of which was not discovered or available until recent years) is devastating. If it had been earlier available in full, it would have buried Malthus’s fallacious “refutation” forever. Even as it was, it prevented its exhumation until Keynes’s time.
Ricardo’s answer was, it is true, weak or incomplete at certain points. Thus he did not address himself to the problem of what happens in a crisis of confidence, when for a time even the commodities that are relatively underproduced may not sell at existing price levels, because consumers, even though they have the purchasing power and the desire to buy those commodities, do not trust existing prices and expect them to go still lower. But the basic truth of Say’s Law (and Say’s Law was only intended as a basic or ultimate truth) is not invalidated but merely concealed by a temporary abnormal situation of this kind. This situation is possible only in those periods when a substantial number of consumers and businessmen remain unconvinced that “bottom” has been reached in wages and prices, or feel that their job or solvency may still be in danger. And this is likely to happen precisely when wage-rates are artificially forced or held above the equilibrium level of marginal labor productivity.
Again, it is true that Ricardo declares at one point (already quoted) that “Money is only the medium by which the exchange is effected.” If this is interpreted to mean, as Bernice Shoul interprets it, that money “plays no independent role,” then of course it is not true. But if it is interpreted to mean: “If we, for the moment, abstract from money, we can see that in the ultimate analysis goods exchange against goods,” then it is both true and methodologically valid.
Having recognized this truth, of course, we must in the solution of any dynamic problem put money back into our equation or “model” and recognize that in the modern world the exchange of goods is practically always through the medium of money, and that the interrelationship of goods and money-prices must be right for Say’s Law to be valid. But this is merely to return to the qualification of correct price relationships and equilibrium that has always been implicit in the statement of Say’s Law by the leading classical economists.
3. The Answer of Haberler
Before leaving this subject it may be important to address ourselves to some of the confusions about it, not of Keynes himself, but of the “post-Keynesians.” Prof. Gottfried Haberler has been by no means uncritical of Keynes [14], but his discussion of Keynes’s discussion of Say’s Law is peculiar. He presents part of the quotation I have already presented from Ricardo (on pp. 37-38) but does so in truncated form, and ends with the sentence: “Money is only the medium by which the exchange is effected.” He then declares: “The meaning of this original formulation of this law seems to me quite clear: It states that income received is always spent on consumption or investment; in other words, money is never hoarded. . . .” [15]
Now the meaning of Ricardo’s formulation of Say’s Law is already quite clear, particularly when it is given in full. It does not require any exegesis by Haberler or anyone else, and certainly no paraphrase that quite changes its meaning. Not only did Ricardo never explicitly assert the proposition that Haberler attributes to him; there is every reason to suppose that he would have repudiated it. At several points he actually describes what we today might call money hoarding and its effects. At many points in his Notes on Malthus he writes, regarding some view that Malthus attributes to him: “Where did I ever say this?” [16]. We may be confident that he would have written the same regarding this Haberler “interpretation.”
“Our conclusion, thus [Haberler goes on] is that there is no place and no need for Say’s Law in modern economic theory and that it has been completely abandoned by neo-classical economists in their actual theoretical and practical work on money and the business cycle. . . . Summing up, we may say that there was no need for Keynes to rid neo-classical economics of Say’s Law in the original, straightforward sense, for it had been completely abandoned long ago.” [17]
The short answer to this is that there is still need and place to assert Say’s Law whenever anybody is foolish enough to deny it. It is itself, to repeat, essentially a negative rather than a positive proposition. It is essentially a rejection of a fallacy. It states that a general overproduction of all commodities is not possible. And that is all, basically, that it is intended to assert.
Haberler is right insofar as he denies the belief of Keynes (and such disciples as Sweezy) that Say’s Law “still underlies the whole classical theory, which would collapse without it” (General Theory, p. 19). It is true that Say’s Law is not explicitly needed in the solution of specific economic problems if its truth is tacitly taken for granted. Mathematicians seldom stop to assert that two and two do not make five. They do not explicitly build elaborate solutions of complicated problems upon this negative truth. But when someone asserts that two and two make five, or that an existing depression is the result of a general overproduction of everything, it is necessary to remind him of the error.
There is still another line of attack on Say’s Law, which Haberler among others seems to adopt, and this is to assert that in the sense in which Say’s Law is true it is “mere tautology.” If it is tautological, it is so in the same sense in which basic logical and mathematical propositions are tautological: “Things that are equal to the same thing are equal to each other.” One does not need to say this as long as one does not forget it.
To sum up, Keynes’s “refutation” of Say’s Law, even if it had been successful, would not have been original: it does not go an inch beyond Malthus’s attempted refutation more than a century before him. Keynes ”refuted” Say’s Law only in a sense in which no important economist ever held it.
4. To Save Is to Spend
Risking the accusation of beating a dead horse, I should like to address myself to one more effort by Keynes to disprove Say’s Law, or what he calls “a corollary of the same doctrine” (p. 19). “It has been supposed,” he writes, “that any individual act of abstaining from consumption necessarily leads to, and amounts to the same thing as, causing the labor and commodities thus released from supplying consumption to be invested in the production of capital wealth” (p. 19). And he quotes the following passage from Alfred Marshall’s Pure Theory of Domestic Values (p. 34) in illustration:
“The whole of a man’s income is expended in the purchase of services and of commodities. It is indeed commonly said that a man spends some portion of his income and saves another. But it is a familiar economic axiom that a man purchases labor and commodities with that portion of his income which he saves just as much as he does with that he is said to spend. He is said to spend when he seeks to obtain present enjoyment from the services and commodities which he purchases. He is said to save when he causes the labor and the commodities which he purchases to be devoted to the production of wealth from which he expects to derive the means of enjoyment in the future.”
This doctrine, of course, goes much further back than Marshall. Keynes could have quoted his bête noir, Ricardo, to the same effect. “Mr. Malthus,” wrote Ricardo, “never appears to remember that to save is to spend, as surely as what he exclusively calls spending.” [18] Ricardo went much further than this, and in answering Malthus answered one of Keynes’s chief contentions in advance: “I deny that the wants of consumers generally are diminished by parsimony —they are transferred with the power to consume to another set of consumers.” [19]
And on still another occasion Ricardo wrote directly to Malthus: “We agree too that effectual demand consists of two elements, the power and the will to purchase; but I think the will is very seldom wanting where the power exists, for the desire of accumulation [i.e., saving] will occasion demand just as effectually as a desire to consume; it will only change the objects on which the demand will exercise itself.” [20]
For the present, however, it may be sufficient merely to note Keynes’s contention on this point rather than to try to analyze it in full. There will be plenty of opportunity for that later. As we shall see, Keynes himself alternates constantly between two mutually contradictory contentions: (1) that saving and investment are “necessarily equal,” and “merely different aspects of the same thing” (p. 74), and (2) that saving and investment are “two essentially different activities” without even a “nexus” (p. 21), so that saving not only can exceed investment but chronically tends to do so. The second is the view which he chooses to support at this point. We shall have occasion to analyze both views later. For the present it is sufficient merely to note the presence of this deep-seated contradiction in Keynes’s thought.[21]
Notes
1 Economics and the Public Welfare, (New York: Van Nostrand, 1949), pp. 390-393.
2 Planning for Freedom. (South Holland, 111.: Libertarian Press, 1952), pp. 64-71.
3 Paul M. Sweezy in The New Economics, ed. by Seymour E. Harris, (New York: Alfred Knopf, 1947), p. 105.
4 Op. cit., pp. 64-65.
5 Vol. I, Book IV, Chap. I, (Edwin Cannon edition, 1904), p. 404 ff. 6 Economics and the Public Welfare, p. 390.
7 Principles of Political Economy, Book III, Chap. xiv. Sect. 2.
8 Op. cit., p. 392.
9 Bernice Shoul, “Karl Marx and Say’s Law,” The Quarterly Journal of Economics, Nov., 1957, p. 615.
10 David Ricardo, The Principles of Political Economy and Taxation, (Everyman ed., New York), pp. 193-194.
11 The phrase “effectual demand,” however, was italicized merely to bring out here the fact that Keynes did not invent this phrase. Ricardo even uses the phrase “effective demand” in his Notes on Malthus (Sraffa edition, Cambridge University Press, p. 234). The term “effectual demand” was actually introduced by Adam Smith in The Wealth of Nations (Book I, Chap. 7). John Stuart Mill explains. “Writers have . . . defined [demand as] the wish to possess, combined with the power of purchasing. To distinguish demand in this technical sense, from the demand which is synonymous with desire, they call the former effectual demand.” Principles of Political Economy, 1848, Book III, Chap. II, § 3.
12 Sraffa edition, Cambridge University Press, p. 305.
13 Op. cit.} pp. 306-307.
14 Haberler’s comments on the General Theory in Chap. 8 of the third edition of his Prosperity and Depression (Geneva: League of Nations, 1941) contain many penetrating observations.
15 The New Economics, ed. by Seymour E. Harris, p. 174.
16 See, e.g., Sraffa edition, p. 424.
17 Op. cit., pp. 175-176.
18 David Ricardo, Notes on Malthus (Sraffa edition), p. 449.
19 Ibid.,p.3O9.
20 Letters of Ricardo to Malthus, ed. by Bonar (1887). Letter of Sept. 16, 1814, p. 43.
21 Supplementing the present chapter, the reader is referred to the remarkable statement and defense of Say’s Law by John Stuart Mill, quoted at length on pp. 364-371.
By Toby Baxendale, on 2 February 12
In yesterday’s article I emphasised that it is profit that is beneficial, not revenue.
I’ve just read an excellent article (H/T Sean Corrigan) by Jerry L. Jordan, past president of the Federal Reserve Bank of Cleveland. He makes the same point, with particular reference to government “investment” and national accounting.
He opens with an analogy to warm the hearts of American readers:
It is tempting to think that the Soviets perfected negative-value-added investment — the stuff produced is worth less than the value of the resources to produce it. However, most families have experienced this first hand.
It usually surfaces with an entrepreneurial adolescent deciding it would be a good idea to sell lemonade at the curbside to passersby
Parents, wanting to encourage the idea that working and making money is a good idea, drive around to buy the lemon, sugar, designer bottled water, cups, spoons, napkins, a sign or two, and probably a paper table cloth.
Aside from time and gas, the outing adds up to something north of $10. At the opening of business the next day, the kids find business is slow to nonexistent at $1 per cup. So, they start to learn about market demand and find that business becomes so brisk at only 10 cents per cup that they are sold out by noon, having served 70 cups of lemonade and hauled in $7.
The excited lunch-time conversation is about expanding the business. A stand across the street to catch traffic going the opposite direction; maybe one around the corner for the cross-street traffic. The kids see growing revenue; the “investors” see mounting losses.
There is a strand of economics, we’ll call it the K-brand, that sees all this as worthwhile. They add together the $10 spent by the parents to back the venture and the $7 spent by the customers and conclude that an additional $17 of spending is clearly a good thing. Surely, the neighborhood economy has been stimulated.
To the family it is a loss, chalked up as a form of consumption. If this were a business enterprise it would be a write-off. In classical economics it is a “mal-investment.”
But of course the government “invests” on a much larger scale:
To K-brand economics, such “investing” is better done by the government because there never has to be a write-down for bad ideas. So, Japan spent a couple of decades “investing” in airports few people fly to, highways few people drive on and bullet trains that not enough people ride on. All the expenditures were recorded as investment and were additions to national output, never recognizing that the value of what was produced is less than the value of the resources needed to produce it — negative-value-added. Surely it is clear that Japan was made poorer by lots of bad “investments.”
The U.S. recorded a great amount of “residential investment spending” in the central valleys of California that added to national output, only to have the houses bulldozed because there were no buyers. Subsequently, the homebuilders incurred losses, reducing business income, thus shrinking national output.
Nevertheless, the national accounts will never be revised to reflect that the “investment spending” of a few years earlier was all “mal-investment” and should have been recorded as a form of business consumption. Such “investment” actually made us poorer.
The irony of this example is the expenditures incurred to bulldoze the vacant houses is recorded as “stimulus” to the economy. Thanks for that to K-brand economics. They now want California to “invest” in a Japanese-style bullet train that is negative-value-added economics.
I recommend the whole article.
By Toby Baxendale, on 1 February 12
At times of recession, like we have today, a range of dodgy economic ideas that have been refuted several times over during the last 200 years are recycled with fresh enthusiasm, requiring us to refute them once again.
Chimera 1: prosperity through stealing and spending
Our political masters follow the lead of the economists. Recently we heard this statement from our Culture Secretary, the Rt Hon. Jeremy Hunt MP,
There are people who say that doing a project like this is a massive Keynesian boost to the economy. That is definitely the case, in terms of money being spent.
The message is clear: if we spend money, we will end up getting wealthier. That’s nice and simple then. What are we waiting for? If £39bn of spending is going to create more than £39bn of wealth, we should not be shy! Why not spend £339bn? In fact, choose any number!
It is remarkable that an educated man like Hunt cannot see that if we extract £39bn in taxes from the private sector and give it to the Olympic development people to spend, we have just moved money that people would otherwise have spent on goods and services they actually want, and directed it instead to the government’s preferred expenditure? The net gain is zero, at best.
This was clear enough to Jean-Baptiste Say in 1803, when he wrote A Treatise on Political Economy:
But this advantage is to be derived from real production alone, and not from a forced circulation of products; for a value once created is not augmented in its passage from one hand to another, nor by being seized and expended by the government, instead of by an individual. The man, that lives upon the productions of other people, originates no demand for those productions; he merely puts himself in the place of the producer, to the great injury of production, as we shall presently see.
Say had a great letter exchange with his English contemporary Malthus. Like Hunt today, Malthus believed public expenditure was essential to keeping the economy going. He argued that the payroll of the state — in modern terms, the army of teachers, nurses, civil servants, and quango staff — should be maintained across the economy, for the benefit of all.
Say pointed out that if no extractions were made from the private sector, the public labour force would soon get redeployed. If the tax collector did not collect, no-one would struggle to find better ways to spend their money!
In his letters to Mr Malthus, Say reminds us that spending is only half of the equation. Value must be traded for value, and production must precede consumption:
When I advance that produce opens a vent for produce; that the means of industry, whatever they may be, when unshackled, always apply themselves to the objects most necessary to nations, and that these necessary objects create at once new populations and new enjoyments for those populations, all appearances are not against me. Let us only look back two hundred years and suppose that a trader had carried a rich cargo to the places where New York and Philadelphia now stand; could he have sold it? Let us suppose even, that he had succeeded in founding there an agricultural or manufacturing establishment; could he have there sold a single article of his produce? No, undoubtedly. He must have consumed them himself. Why do we now see the contrary? Why is the merchandize carried to, or made at Philadelphia or New York, sure to be sold at the current price? It seems to me evident that it is because the cultivators, the traders, and now even the manufacturers of New York, Philadelphia, and the adjacent provinces, create, or send there, some productions, by means of which they purchase what is brought to them from other quarters.
We produce in order to support our own demand for goods and services. We can’t produce just anything. We must be focused on producing things our fellow citizens want. This happens naturally in an unhampered market economy. If we consume without producing, we will eventually burn through all our capital and have no ability to demand anything further in the future. Spending alone is never the solution. The key is prior production.
So much for the Rt Hon. Jeremy Hunt’s plan to boost wealth by stealing and spending.
Chimera 2: prosperity through printing and spending
A more senior political master, the Chancellor, acquiesces to his Governor of the Bank of England: they will make more money units, freshly minted digital ones, specifically to create a Keynesian stimulus! The letter from the Governor to the Chancellor laying this proposition out concludes
the Committee judged that it was necessary to inject further monetary stimulus into the economy.
I have spent 22 years in devotion to satisfying consumer demands, and thus creating wealth. It is done as follows:
- As an entrepreneur you look for the most urgent needs of consumers.
- You work out how to fulfill those needs.
- Painfully, at the beginning of your enterprise, sometimes to pay more to your staff, you go without wages yourself and refrain from consumption — in short you save.
- Thus you deploy your savings or borrow the savings of others to take command over the various factors of production — land, labour and capital — and mix them into better and more capital-intensive combinations to provide the goods and services that the customers want.
- More capital deployed in the right intensity creates more productivity, allowing cheaper goods and services.
- This takes place over time.
More money units may create the illusion of wealth, leading to temporary euphoria, but when reality bites, you rapidly go back to square one, perhaps having made some unwise decisions along the way.
We are currently experiencing a money deflation, which the authorities are attempting to counteract by putting more money units in circulation. All stops have been pulled to prevent prices from falling into line with what consumers want. The money printers are obsessed with aggregate spending, when they should be concerned about profits.
If you had a company with £1m of capital invested in the capital structure, with revenues of £10m p.a. and profits of £250k and by dumping low-margin, loss-making work, you could move to a £1m capital intensive enterprise with £8m revenues and £500k of profit, would this not be better? The capital deployed would now be generating twice as much. I often give this analogy to people who have consumption spending fetishes, showing that it is not the top line, but the bottom line that we should all focus on.
Another analogy I give is of the salesman who reports to you that he has sold £1m of kit and does not mention at what net margin. How does he compare to the one who says he has sold £1m of kit at 10% net margin? It will almost be apodictic that the latter will have sold for more profit while the former, not concentrating on the bottom line and not even mentioning it, will have sold for less profit. Profit (in cash terms) is the only thing that matters at the end of the year.
Crudely put, the mass of Keynesians relate GDP, which measures largely the consumption side of the economy (ignoring the larger production side), as the revenue of goods and services sold for money in a particular period (usually a year). There are many problems with this, but for now note that a lowering of prices means a lowering of GDP. If prices fall thanks to productivity improvements we have the basis for a recovery, but GDP-obsessed planners will instead see disaster.
Attempts to prop up GDP by printing more money units will not increase real wealth, but they will cause further distortions to an economy that’s already out-of-sync with consumer preferences, and stoke new asset bubbles. The injections of cash will not address any of the causes of monetary deflation.
Over the last two decades, credit has been created to the extent that our money supply has tripled and asset prices have soared. These prices need to come down. When they come down, people will start to pick up bargains and start spending again. Companies will then invest to satisfy the renewed demand.
No politician will allow this painful adjustment to happen. They are in thrall to the circular flow of income fallacy.
What would Say say?
Say pointed out, as we have seen in the examples above, that it is production that allows you to trade for other goods and services. Production and consumption can’t be out of sync in an unhampered free market. Why do we have recessions like today’s, with shops and factories with too much to sell and too little demand? The only answer can only be that prices are too high. These goods and services, and indeed the factors of production that create these goods and services, are offered for too much money. Prices need to come down.
Prices were a subject of lively debate in the letters between Say and Malthus. Malthus, wedded to the erroneous Labour Theory of Value, alleged that if prices fell too low, wages would not be paid and the problem would get worse as labour would become idle, there would be less spending, and we would spiral into the abyss. This is what virtually all economists tell us today.
Here’s what Say had to say, in 1821:
Give me some just ideas on the price of things?
If you wish to form just ideas on this subject you must never confound the nominal price with the real price of things.
What do you call the nominal price of things?
The price we pay for a thing in money or in coin.
What do you call its real price?
The value we have given to obtain the money with which we purchase this thing.
Give me an example.
A potter is in want of a loaf of bread, which sells for a shilling: he is obliged, in order to obtain it, to sell a vase which is worth a shilling. If the price of the loaf should rise to two shillings; and if the potter is obliged to sell two vases in order to obtain these two shillings, which he must pay for the loaf, the dearness of the bread is real. If the potter can obtain these two shillings by the sale of a single vase, the dearness of the bread is only nominal. He has in both cases exchanged only one vase against one loaf, whatever may have been the denomination of the intermediate value. It is the value of the money which is depreciated, that of the bread has remained the same.
Is it not a real dearness to a man whose income arises from lands which are let, or from a capital lent at interest, when the loaf has risen from one to two shillings?
No: that which is real is the depreciation which has taken place in the value of the merchandise in which his income is stipulated to be paid: that is, in the fall of the money. He who pays the income, by acquiring at less expense this merchandise, gains in this case what the other loses.
You have said that if, when I am obliged to give two shillings to buy a loaf, I am able to obtain these two shillings, on the same terms that I before obtained one, the loaf has not become dearer; but if to obtain two shillings, that is, the price of one loaf, I am obliged to give two vases instead of one, then the bread will have really become dearer?
No; not if the vases as well as the money have fallen to half their value.
How can I tell whether they have fallen to half their value or not?
They have fallen if they can be obtained for half the expenses of production: that is, if means have been found to create, at the same charge of production (which consists as we know of the workmanship, interest of capital and profit) two vases instead of one.
It is then the lowering the charges of production which causes the real fall in the price of products?
Just so. Then whatever may be the value with which a product is purchased, this product, which has fallen one half, is obtained for one half less expense of production.
Explain that by an example.
If, by means of a knitting frame, I can make a pair of stockings for three shillings, instead of expending six shillings on them, he who grows wheat can obtain a pair of stockings for one half the quantity of wheat which he had before been accustomed to give for them. That is, if he was before obliged to sell thirty-six pounds of wheat in order to obtain a pair of stockings, he would now sell but eighteen. But the eighteen pounds have required on his part only one half the expenses of production which the thirty-six pounds would have required.
It is the same whatever is the production with which we are occupied. It may be said, that when an article really falls in price, not only those who produce it, but every body else, obtains it at the price of the reduced charge of production.
You have said besides that the riches of society is composed of the sum total of the values which it possesses: it appears to me to follow, that the fall of a product, stockings for example, by diminishing the sum of the values belonging to society, diminishes the mass of its riches.
The sum of the riches of society does not fall on that account. Two pairs of stockings are produced instead of one; and two pairs at three shillings are worth as much as one pair at six shillings. The income of society remains the same, for the maker gains as much on two pairs at three shillings, as he did on one pair at six shillings.
But, when the income remains the same, and the products fall, the society is really enriched. If the same fall takes place on all products at once, which is not absolutely impossible, society by obtaining all the objects of its consumption at half price, without having lost any part of its income, would really be twice as rich as before, and could buy twice as many things.
This does not generally happen, but it has happened to a great number of products, which have fallen from the price they were formerly at, some a tenth, some a fourth, a half, three-fourths, as silver, and even in a greater proportion as silks, and probably many other articles.
To what cause is that to be attributed?
To many causes: but principally to the progress of intelligence and industry. It is to their progress that we owe, both the discovery of countries in which there is a greater abundance of products, and also a means of transporting them less hazardous and more economical. To that progress also we are indebted for processes more simple and more expeditious, the use of machinery, and in general a better adaptation of the productive faculties of nature.
Are there any products which have really become dearer?
There are some, but very few, and only those the demand for which has increased in consequence of the progress of civilization, without the means of production having increased in the same proportion. Such as butchers’ meat and poultry, and almost all the useful animals which are raised at less expense in less civilized countries.
Are there not variations in value which are not the consequence of the charges of production?
The errors, the fears or the passions of men, or unforeseen events, cause disorder and confusion in values which are merely relative: that is, when any merchandise rises or falls with respect to others, in consequence of circumstances foreign to its production. Late frosts increase the price of the last years wines, whatever may have been the charges of their production.
Does such a dearness increase the national wealth?
No: for in exchanging another product for one which has become dearer, one must give more to receive less: he who buys, loses on his merchandise, precisely as much as the seller gains on his goods.
When the wine doubles its price, he, who, to purchase a piece of wine is obliged to sell six bushels of wheat instead of three, which should have purchased a piece of wine is poorer by all that the wine merchant is richer.
Thus these kinds of variation, which sometimes overturn private fortunes, do not affect the general riches
The key thing to note is that a rise in productivity means the same goods are produced at a lower cost, and profits go up, allowing more demand to be expressed in the economy. Productivity rises can be facilitated by allowing taxpayers to retain more of their wealth. Adding more money units simply creates asset bubbles.
Over the next few days I will post copies of some of the best refutations of Keynes’s supposed refutation of Say’s Law. The wisdom of the older economists is in short supply, and we will do our bit to promote that wisdom.
By Detlev Schlichter, on 31 January 12
“All within the state, nothing outside the state, nothing against the state.” Benito Mussolini
Those who have eyes to see and ears to hear will have noticed the accelerating trend towards interventionist policies and assertive state action all around us. This is not a conspiracy theory circulating on the internet. It is a phenomenon that is now so blatantly obvious that it makes the headlines in the highbrow pro-establishment media: The Economist and the Financial Times are talking openly about the trend towards “repression” and “national capitalism” as if it was simply the latest fashion in crisis management. A century ago, Randolph Bourne pointed out that “war is the health of the state”. It turns out that so is economic crisis.
Politicians, bureaucrats and many of their claqueurs in the media have drawn conclusions that are conveniently in their own interests: to them the crisis is evidence that things cannot be left to the markets, to consumers, to greedy bankers, and the spontaneous interaction of the public. If the state does not regulate and control everything, chaos ensues. We need more government. More control. More regulation. More oversight. Politicians and bureaucrats need more power.
Conveniently, the public believes it was greedy bankers and ‘unfettered capitalism’ that brought us down. But cheap credit through state fiat money and the systematic subsidization of the housing market are not features of the free market but of politics. The present mess is the result of decades of institutionalized monetary debasement and the accumulation of public debt. These policies have left us with bankrupt welfare states and overstretched banks, yet none of this has diminished the enthusiasm of politicians and bureaucrats to give us more of their medicine.
Let’s not forget that it was politicians and their central bankers, with the intellectual support of ambitious but misguided economists, who got rid of the gold standard. They considered the gold standard an inconvenient monetary straitjacket that was best replaced with a system of limitless fiat money under central bank control. Limitless money allowed unrestricted bank credit creation and state deficit spending. Once that system was in place, it was politicians who accumulated all that public debt and issued the deluge of unfunded and unkeepable promises that pit large sections of society against one another. And it is the central bankers who happily funded this gigantic debt bubble for decades with cheap credit.
After 40 years of fiat money the world is in a deep and deepening financial crisis. Excess levels of debt, weak and overstretched banks and distorted asset markets – all of this marks the inevitable endgame of a system based on persistent monetary debasement. But politicians and central bankers are merrily undeterred. “Nothing that cannot be papered over with more paper money!”
Authoritarianism needs ever more authorities
So the problem is not with the policy establishment but with us, the masses. We need to be controlled better. Mr. Martin Wheatley, inaugural head of the UK’s new Financial Conduct Authority, told the Financial Times last week that his agency will “step into the footprints of investors – who cannot be counted on making rational choices.” Apparently, we, the consumers and savers, cannot be trusted with our own money. We need someone to tell us what we should or should not buy. But don’t worry. Mr. Wheatley assures us that his interventions into our financial affairs are based on the latest insights of science, namely the latest research in “behavioural economics.”
Part and parcel of this trend is the global fight against cash. Authorities want to monitor and record ALL your transactions. They don’t want you to use cash. Ever more countries restrict the amount of cash you can take across borders (noticed the signs at airports?), and in Italy and Spain, proposals are being discussed to limit the amount of cash citizens can use for individual transactions. “Cash has been a problem for a long time” the UK’s top taxman, Dave Hartnett, told The Daily Telegraph last week. Hartnett wants the citizenry to stop giving cash to their cleaners, gardeners, and to small tradesmen and other potential tax cheats and economic criminals so that they can no longer avoid paying taxes. Hartnett’s vision of Britain is a society of snoops and denunciators. “Households have a duty to ensure that other people do not evade paying their share of tax. The people who are worried about it should use our whistle-blowing line to tell us. We are getting better and better at finding people who receive cash.” Nice touch. A tinge of the former GDR’s Stasi culture for the British way of life?
The beauty of a big state is apparent to Mr. Hartnett: “Tax provides the funding to run the country.” Really? No, I don’t think so. It is rather Mr. Wheatley’s irrational savers and Mr. Hartnett’s tax-avoiding cleaners, gardeners and shopkeepers who are running whatever is still functioning in this country, the productive, independent middle class, who are able to and do look after themselves and their children, but who are also forced to fund the largely parasitic class of self-deluded authoritarians with their wasteful government projects.
Decent citizens don’t use cash. Cash is used by tax-cheats, terrorists, drug-dealers and child pornographers. Once this is established it will be a short step to severely restricting or even banning the withdrawal of cash from bank accounts. As all banks will soon anyway be mere branches of the ever-expanding central bank, which prints the money to keep the nominally private banks alive, all transactions will then be just electronic bookkeeping adjustments at the state central bank. All financial transactions will then be entirely transparent to the authorities. “Irrational” behaviour can be identified early and – eliminated.
Whatever you may think of Julian Assange’s Wikileaks, it is deeply troubling how quickly and easily this organization was crippled by Visa and Mastercard cutting it off from its donors. This gives you a taste for where we are going.
Fiat money and central banking are incompatible with free banking, with a system in which banks are independent capitalist enterprises. But more than that, fiat money and central banking are incompatible with capitalism and a free society. Central banking is central planning.
Hey, who is boss?
The bureaucracy is annoyed. The public is not giving it enough credit for its excellent management of the economy. The public is still pessimistic and concerned about banks and the overall direction of the equity market. Okay. So the government just stops them from acting on that pessimism. Show them who is boss:
In France, Spain and Belgium the government has ruled that shares of financial companies cannot be shorted. In Italy you are banned from shorting any stocks. Shorts on stock indices are banned in Italy, France, Belgium and Spain. Is this arbitrary? Of course it is. But the real measure of power is if you can use it arbitrarily. Make it clear to people what you, the government, likes or dislikes. Then you ban what you don’t like.
Government is not voluntary association, contractual cooperation and trade. “Government is essentially the negation of liberty” (Ludwig von Mises). “Everything a government does rests on the use of force. No law actually is a law unless it is backed by the threat of force.” (George Reisman). And a government that is digging itself an every deeper economic hole will, in its growing desperation, apply force ever more readily. Count on it.
But what does the sovereign do, the democratic masses? Well, they obey. Like obedient sheep they stand patiently in line at airports in the UK, the USA, and elsewhere, calmly watching their six-year olds being padded down by security personnel. And they happily pay their Starbucks Coffee and the pack of cigarettes (as long as we are still allowed to smoke somewhere) at Tescos with their debit cards, or buy everything on the internet, leaving for whatever they do a perfect paper trail, a seamless record kept forever. “It is so convenient. And I have nothing to hide.”
And, naturally: “the government is here to help, so why not cooperate with the government? After all it is still a democratic state.” Every four to five years each of us has an opportunity to cast a vote of infinitesimally small importance to decide which of two gangs will get almost unlimited power over the ever growing state apparatus, and this, it seems, is to many sufficient compensation for handing over control of their lives and property to others. Stimmviehvolk is how an incredibly prescient Friedrich Nietzsche described them more than a hundred years ago: voting cattle.
Prosperity through money printing
The persistent debasement of money in the modern state fiat money system is an obstacle to the smooth operation of the market, the production of wealth and the growth in prosperity. It keeps the middle class in bondage as its efforts to save and gain financial independence are constantly undermined by the official policy of inflationism. But the central planners and central bankers and their apologists among journalists and economists tell us that it is exactly the other way round: “Prosperity through monetary debasement” is Big Brother’s slogan, and he has spokespeople with outstanding academic credentials to explain this absurdity to the masses. In November 2010, MIT and Princeton man Ben Bernanke, the U.S. government’s money-printer-in-chief, wrote this in the Washington Post when explaining to the less educated why creating $600 billion out of thin air and massaging yields on government debt down was a clever policy:
Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
Well, that was 14 months ago. As it turns out, manipulating the economy by artificially lowering rates (lowering rates not by saving but by simply printing money) has not started a virtuous circle. Such manipulations come with nasty unintended consequences, and after a few decades of such a policy the accumulated unintended consequences far outweigh whatever short–lived growth blip money debasement may have manufactured otherwise. None of this has anything to do with healthy growth and a functioning free market economy.
But it is important that those in positions of authority do not admit that they are clueless. They never make mistakes. Their policy is never wrong. They simply need to do more of the same – and then even more. As I write this, the Fed is, of course, preparing another round of quantitative easing, and so is the Bank of England. And the ‘economists’ on Wall Street and the City of London cheer them on.
The debasement of paper money certainly continues.
By Toby Baxendale, on 30 January 12
A challenge for 2012 – part one was to read The Theory of Money and Credit by Mises on its 100th year anniversary. The 1934 preface was sadly so pertinent to today that we reproduced it as an enticement to read the whole book.
My second challenge for 2012 is to read a book written 86 years later by Jesús Huerta de Soto in its English translation called Money, Bank Credit, and Economic Cycles, which can be downloaded here.
Like The Theory of Money and Credit in its day, this book is the most comprehensive economic text on money, capital theory, business cycles and entrepreneurship written by a modern Austrian.
Here is the preface to the second English edition, written by Huerta de Soto in November 2008.
I am happy to present the second English edition of Money, Bank Credit, and Economic Cycles. Its appearance is particularly timely, given that the severe financial crisis and resulting worldwide economic recession I have been forecasting, since the first edition of this book came out ten years ago, are now unleashing their fury.
The policy of artificial credit expansion central banks have permitted and orchestrated over the last fifteen years could not have ended in any other way. The expansionary cycle which has now come to a close began gathering momentum when the American economy emerged from its last recession (fleeting and repressed though it was) in 2001 and the Federal Reserve reembarked on the major artificial expansion of credit and investment initiated in 1992. This credit expansion was not backed by a parallel increase in voluntary household saving. For many years, the money supply in the form of bank notes and deposits has grown at an average rate of over 10 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 newlycreated loans granted at very low (and even negative in real terms) interest rates. The above 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, like in the “roaring” years prior to the Great Depression of 1929, the shock of monetary growth has not significantly influenced the prices of the subset of consumer goods and services (approximately only one third of all goods). 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 injection of money and credit, would have given rise to a healthy and sustained reduction in the unit price of consumer goods and services. Moreover, the full incorporation of the economies of China and India into the globalized market has boosted 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 economic process. I analyze this phenomenon in detail in chapter 6, section 9.
As I explain in the book, artificial credit expansion and the (fiduciary) inflation of media of exchange offer no short cut to stable and sustained economic development, no way of avoiding the necessary sacrifice and discipline behind all high rates of voluntary saving. (In fact, particularly in the United States, voluntary saving has not only failed to increase in recent years, but at times has even fallen to a negative rate.) Indeed, the artificial expansion of credit and money is never more than a short-term solution, and that at best. In fact, today there is no doubt about the recessionary quality the monetary shock always has in the long run: newly-created loans (of money citizens have not first saved) immediately provide entrepreneurs with purchasing power they use in overly ambitious investment projects (in recent years, especially in the building sector and real estate development). In other words, entrepreneurs act as if citizens had increased their saving, when they have not actually done so. Widespread discoordination in the economic system results: the financial bubble (“irrational exuberance”) exerts a harmful effect on the real economy, and sooner or later the process reverses in the form of an economic recession, which marks the beginning of the painful and necessary readjustment. This readjustment invariably requires the reconversion of every real productive structure inflation has distorted. The specific triggers of 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 the current circumstances, the most obvious triggers have been the rise in the price of raw materials, particularly oil, 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 liabilities exceeded that of their assets (mortgage loans granted).
At present, numerous self-interested voices are demanding further reductions in interest rates and new injections of money which permit those who desire it to complete their investment projects without suffering losses. Nevertheless, this escape forward would only temporarily postpone problems at the cost of making them far more serious later. The crisis has hit because the profits of capital-goods companies (especially in the building sector and in real-estate development) have disappeared due to the entrepreneurial errors provoked by cheap credit, and because the prices of consumer goods have begun to perform relatively less poorly than those of capital goods. At this point, a painful, inevitable readjustment begins, and in addition to a decrease in production and an increase in unemployment, we are now still seeing a harmful rise in the prices of consumer goods (stagflation).
The most rigorous economic analysis and the coolest, most balanced interpretation of recent economic and financial events support the conclusion that central banks (which are true financial central-planning agencies) cannot possibly succeed in finding the most advantageous monetary policy at every moment. This is exactly what became clear 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—(at one time) Alan Greenspan and (currently) Ben Bernanke—in particular. According to this theorem, it is impossible to organize society, in terms of economics, based on 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. Indeed, nothing is more dangerous than to indulge in the “fatal conceit”—to use Hayek’s useful expression—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 soften the most violent ups and downs of the economic cycle, the Federal Reserve and, to some lesser extent, the European Central Bank, have most likely 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 in a blind alley. They can either allow the recessionary process to begin now, and with it the healthy and painful readjustment, or they can escape forward toward a “hair of the dog” cure. With the latter, the chances of even more severe stagflation in the not-too-distant future increase exponentially. (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 a 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 has occurred in Japan in recent years: though all possible interventions have been tried, the Japanese economy has ceased to respond to any monietarist stimulus involving credit expansion or Keynesian methods. It is in this context of “financial schizophrenia” that we must interpret the latest “shots in the dark” fired 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 Federal Reserve rescues Bear Stearns, AIG, Fannie Mae, and Freddie Mac or Citigroup, and the next it allows Lehman Brothers to fail, under the amply justified pretext of “teaching a lesson” and refusing to fuel moral hazard. Then, in light of the way events were unfolding, a 700-billion-dollar plan to purchase the euphemistically named “toxic” or “illiquid” (i.e., worthless) assets from the banking system was approved. If the plan is financed by taxes (and not more inflation), it will mean a heavy tax burden on households, precisely when they are least able to bear it. Finally, in view of doubts about whether such a plan could have any effect, the choice was made to inject public money directly into banks, and even to “guarantee” the total amount of their deposits, decreasing interest rates to almost zero percent.
In comparison, the economies of the European Union are in a somewhat less poor state (if we do not consider the expansionary effect of the policy of deliberately depreciating the dollar, and the relatively greater 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 involved at the time a healthy and significant rehabilitation of the chief European economies. Only the countries on the periphery, like Ireland and particularly 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 (liberalizing structural reforms which originated with José María Aznar’s administration in 1996). Nevertheless, the boom was also largely fueled by an artificial expansion of money and credit, which grew at a rate nearly three times that of 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 realestate speculation), loans which these banks have granted by creating the money ex nihilo while European central bankers looked on unperturbed. When faced with the rise in prices, the European Central Bank has remained faithful to its mandate and has tried to maintain interest rates as long as possible, despite the difficulties of those members of the Monetary Union which, like Spain, are now discovering that much of their investment in real estate was in error and are heading for a lengthy and painful reorganization of their real economy.
Under these circumstances, 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 factors 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, sustained economic recovery in a future which, for the good of all, I hope is not long in coming.
We must not forget that a central feature of the recent 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 different countries (in Spain via the new General Accounting Plan, in effect as of January 1, 2008) 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 this abandonment of the traditional principle of prudence, a highly influential role has been played by brokerages, investment banks (which are now on their way to extinction), and in general, all parties interested in “inflating” book values in order to bring them closer to supposedly more “objective” stockmarket values, which in the past rose continually in an economic process of financial euphoria. 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.
In this wild race to abandon traditional accounting principles and replace them with others more “in line with the times,” it became common to evaluate companies based on unorthodox suppositions and purely subjective criteria which in the new standards replace the only truly objective criterion (that of historical cost). Now, the collapse of financial markets and economic agents’ widespread loss of faith in banks and their accounting practices have revealed the serious error involved in yielding to the IAS and their abandonment of traditional accounting principles based on prudence, the error of indulging in the vices of creative, fair-value accounting.
It is in this context that we must view the recent measures taken in the United States and the European Union to “soften” (i.e., to partially reverse) the impact of fair-value accounting for financial institutions. This is a step in the right direction, but it falls short and is taken for the wrong reasons. Indeed, those in charge at financial institutions are attempting to “shut the barn door when the horse is bolting”; that is, when the dramatic fall in the value of “toxic” or “illiquid” assets has endangered the solvency of their institutions. However, these people were delighted with the new IAS during the preceding years of “irrational exuberance,” in which increasing and excessive values in the stock and financial markets graced their balance sheets with staggering figures corresponding to their own profits and net worth, figures which in turn encouraged them to run risks (or better, uncertainties) with practically no thought of danger. Hence, we see that the IAS 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, i.e., when assets are worth the least and financial markets dry up. Clearly, accounting principles which, like those of the IAS, have proven so disturbing must be abandoned as soon as possible, and all of the accounting reforms recently enacted, specifically the Spanish one, which came into effect January 1, 2008, 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 to the adoption of the false idol of the IAS.
In short, the greatest error of the accounting reform recently introduced worldwide is that it scraps centuries of accounting experience and business management when it replaces the prudence principle, as the highest ranking among all traditional accounting principles, with the “fair value” principle, which is simply the introduction of the volatile market value for an entire set of assets, particularly financial assets. This Copernican turn is extremely harmful and threatens the very foundations of the market economy for several reasons. First, to violate the traditional principle of prudence and require that accounting entries reflect market values is to provoke, depending upon the conditions of the economic cycle, an inflation of book values with surpluses which have not materialized and which, in many cases, may never materialize. The artificial “wealth effect” this can produce, especially during the boom phase of each economic cycle, leads to the allocation of paper (or merely temporary) profits, the acceptance of disproportionate risks, and in short, the commission of systematic entrepreneurial errors and the consumption of the nation’s capital, to the detriment of its healthy productive structure and its capacity for long-term growth. Second, I must emphasize 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, by applying strict standards of accounting conservatism (based on the prudence principle and the recording of either historical cost or market value, whichever is less), 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 the company. Third, we must bear in mind that in the market there are no equilibrium prices a third party can objectively determine. Quite the opposite is true; market values arise from subjective assessments and fluctuate sharply, and hence their use in accounting eliminates much of the clarity, certainty, and information balance sheets contained in the past. Today, balance sheets have become largely unintelligible and useless to economic agents. Furthermore, the volatility inherent in market values, particularly over the economic cycle, robs accounting based on the “new principles” of much of its potential as a guide for action for company managers and leads them to systematically commit major errors in management, errors which have been on the verge of provoking the severest financial crisis to ravage the world since 1929.
In chapter 9 of this book (pages 789–803), I design a process of transition toward the only world financial order which, being fully compatible with the free-enterprise system, can eliminate the financial crises and economic recessions which cyclically affect the world’s economies. The proposal the book contains for international financial reform has acquired extreme relevance at the present time (November 2008), in which the disconcerted governments of Europe and America have organized a world conference to reform the international monetary system in order to avoid in the future such severe financial and banking crises as the one that currently grips the entire western world. As is explained in detail over the nine chapters of this book, any future reform will fail as miserably as past reforms unless it strikes at the very root of the present problems and rests on the following principles: (1) the reestablishment of a 100-percent reserve requirement on all bank demand deposits and equivalents; (2) the elimination of central banks as lenders of last resort (which will be unnecessary if the preceding principle is applied, and harmful if they continue to act as financial central-planning agencies); and (3) the privatization of the current, monopolistic, and fiduciary state-issued money and its replacement with a classic pure gold standard. This radical, definitive reform would essentially mark the culmination of the 1989 fall of the Berlin Wall and real socialism, since the reform would mean the application of the same principles of liberalization and private property to the only sphere, that of finance and banking, which has until now remained mired in central planning (by “central” banks), extreme interventionism (the fixing of interest rates, the tangled web of government regulations), and state monopoly (legal tender laws which require the acceptance of the current, state-issued fiduciary money), circumstances with very negative and dramatic consequences, as we have seen.
I should point out that the transition process designed in the last chapter of this book could also permit from the outset the bailing out of the current banking system, thus preventing its rapid collapse, and with it the sudden monetary squeeze which would be inevitable if, in an environment of widespread broken trust among depositors, a significant volume of bank deposits were to disappear. This short-term goal, which at present, western governments are desperately striving for with the most varied plans (the massive purchases of “toxic” bank assets, the ad hominem guarantee of all deposits, or simply the partial or total nationalization of the private banking system), could be reached much faster and more effectively, and in a manner much less harmful to the market economy, if the first step in the proposed reform (pages 791–98) were immediately taken: to back the total amount of current bank deposits (demand deposits and equivalents) with cash, bills to be turned over to banks, which from then on would maintain a 100-percent reserve with respect to deposits. As illustrated in chart IX-2 of chapter 9, which shows the consolidated balance sheet for the banking system following this step, the issuance of these banknotes would in no way be inflationary (since the new money would be “sterilized,” so to speak, by its purpose as backing to satisfy any sudden deposit withdrawals). Furthermore, this step would free up all banking assets (“toxic” or not) which currently appear as backing for demand deposits (and equivalents) on the balance sheets of private banks. On the assumption that the transition to the new financial system would take place under “normal” circumstances, and not in the midst of a financial crisis as acute as the current one, I proposed in chapter 9 that the “freed” assets be transferred to a set of mutual funds created ad hoc and managed by the banking system, and that the shares in these funds be exchanged for outstanding treasury bonds and for the implicit liabilities connected with the public social-security system (pp. 796–97). Nevertheless, in the current climate of severe financial and economic crisis, we have another alternative: apart from canceling “toxic” assets with these funds, we could devote a portion of the rest, if desired, to enabling savers (not depositors, since their deposits would already be backed 100 percent) to recover a large part of the value lost in their investments (particularly in loans to commercial banks, investment banks, and holding companies). These measures would immediately restore confidence and would leave a significant remainder to be exchanged, once and for all and at no cost, for a sizeable portion of the national debt, our initial aim. In any case, an important warning must be given: naturally, and I must never tire of repeating it, the solution proposed is only valid in the context of an irrevocable decision to reestablish a free-banking system subject to a 100-percent reserve requirement on demand deposits. Any of the reforms noted above, if adopted in the absence of a prior, firm conviction and decision to change the international financial and banking system as indicated, would be simply disastrous: a private banking system which continued to operate with a fractional reserve (orchestrated by the corresponding central banks), would generate, in a cascading effect, and based on the cash created to back deposits, an inflationary expansion like none other in history, one which would eventually finish off our entire economic system.
The above considerations are crucially important and reveal how very relevant this treatise has now become in light of the critical state of the international financial system (though I would definitely have preferred to write the preface to this new edition under very different economic circumstances). Nevertheless, while it is tragic that we have arrived at the current situation, it is even more tragic, if possible, that there exists a widespread lack of understanding regarding the causes of the phenomena that plague us, and especially an atmosphere of confusion and uncertainty prevalent among experts, analysts, and most economic theorists. In this area at least, I can hope the successive editions of this book which are being published all over the world may contribute to the theoretical training of readers, to the intellectual rearmament of new generations, and eventually, to the sorely needed institutional redesign of the entire monetary and financial system of current market economies. If this hope is fulfilled, I will not only view the effort made as worthwhile, but will also deem it a great honor to have contributed, even in a very small way, to movement in the right direction.
Jesús Huerta de Soto Madrid November 13, 2008
By Dr Tim Evans, on 29 January 12
When Labour peer Maurice Glasman recently went on BBC Radio 4 with TCC’s Detlev Schlichter I was disappointed and a little taken aback to learn of his Lordship’s ignorance when it came to the Austrian School of Economics. While towards the end of the interview he accepted the need for honest – backed – money, he went on to demonstrate his ignorance when he implied that free marketeers have a prescriptive attitude to ownership philosophies and organisational models. I was really saddened by this not least because like so many other Austro-libertarians I have spent years pointing out that genuine markets would encourage more open and diverse forms of ownership including mutuals.
When I was fifteen I avidly watched this excellent BBC documentary on the Mondragon Experiment which sparked a life long interest in mutuals, friendly societies and co-operatives. Later, as a university student I went on to study a wide range of radical dissenters including a wide range of anti-statists. Indeed, it is with this history in mind that I find it ironic that away from the naïveté of Lord Glasman, it is Conservative Prime Minister David Cameron who is planning to introduce a Parliamentary bill promoting co-operative forms of ownership and doing so in key areas such as education and healthcare.
Thirty-two years on from the BBC’s film on the Mondragon Experiment, maybe opinion formers are finally rediscovering the libertarian tradition of collective forms of organisation and self-help without the state. As much a part of a market as any other form of non-coerced organisation or ownership philosophy, I do hope Lord Glasman and his Purple Book friends take note.
By Alasdair Macleod, on 29 January 12
Both the US Federal Reserve and the European Central Bank are now offering limitless quantities of new money – the ECB to support the banks, and the Fed for reasons (despite explanations) that are not entirely clear. The Fed in its press release announced that it expected interest rates to “warrant exceptionally low levels for the Federal Funds Rate at least through late 2014.” The fact that the central banks governing the two most important currencies in the world are issuing money to all-comers at very little interest cost for up three years has not been lost on gold and silver, whose prices shot up in response to the Fed’s announcement.
The Fed has effectively extended its zero interest rate policy (ZIRP) for another 18 months. The reason stated is “low rates of resource utilisation and a subdued outlook for inflation in the medium run”. More important perhaps and unsaid is the presidential election due later this year and the need to finance a deficit that seems impossible to cut.
The Fed is running huge risks with its extended ZIRP, principally with monetary inflation morphing into price inflation. To help achieve its low inflation target the Fed uses the Personal Consumption Expenditures Price Index (PCEPI), which assumes that consumers switch spending from higher priced goods to those that are stable or falling. The result is that this index rises at about one-third less than the Consumer Price Index, which itself rises at less than half the CPI calculated on the more honest methodology used before 1980. The upshot is that the Fed uses inflation targets that are so heavily adjusted that they are effectively meaningless.
To the Keynesians at the Fed, subdued inflation is linked with a sluggish economy, and here the Fed is very selective in its approach. It admits that employment is picking up, and household spending “continues to advance”; but instead chooses to worry over slowing fixed investment and a depressed housing sector. Surely, whatever your views, there are enough signs of economic stabilisation to justify sitting on the fence, instead of committing to ZIRP for an extra 18 months.
I take the view that Gross Domestic Product is likely to surprise on the upside, as I wrote in an article for GoldMoney on 10 January. In that article I gave concrete reasons why, and suggested that money will begin to flow from capital markets into the economy. This is important, because GDP is only a money quantity and can rise without any underlying economic progression – the difference being reflected in the prices of goods and services. So GDP can actually rise with no underlying improvement in economic activity, it merely reflecting higher prices.
Changes in the prices of goods and services are actually impossible to measure and so cannot be quantified. Under-reporting price increases by using an index approximation such as the GDP deflator, which represents price inflation similarly to the PCEPI, artificially inflates real GDP. It will be interesting to hear what excuse the Fed comes up with then for the continuing for even longer with ZIRP. The reality is that the Fed and other central bankers are cornered and have only one tool left: issue as much paper money as it takes to prevent systemic financial calamity. This realisation is only just dawning on individuals with savings to protect, which is why precious metals were right to rise so sharply.
This article was previously published at GoldMoney.com.
By Tim Price, on 28 January 12
“The reality.. is that banks.. support a thick layer of second tier executives, as well as legions of pen-pushing, meeting-loving, middle- and back-office workers who are paid multiples of their worth and contribution, especially compared with other industries.”
- Financial Times Lex column, January 19th, 2012.
“Stephen [Hester, CEO of RBS] is being urged by a number of people to accept the bonus and I think he will”.. This person [an unnamed senior banker] added that if [Hester] turned down his bonus, it would “demoralise” staff members and would send a signal that they now effectively “worked for an arm of the civil service or a utility, rather than for a bank.”
- Unnamed banker, playing the world’s smallest violin on behalf of Stephen Hester.
Erik Schatzker (Bloomberg News): “$1.6 billion in compensation [at Goldman Sachs] is still a lot of money.”
Nassim Taleb: “Anything above zero is too much money.”
Erik Schatzker: “Why zero ?”
Nassim Taleb: “Because it is a utility. Anything you bail out, you should not be earning more than a civil servant of corresponding rank. Period.”
- Nassim Taleb on Bloomberg News, Oct 18th, 2011.
Contender for leading meme of our time is the idea, fast becoming conventional wisdom, that capitalism is somehow experiencing a crisis. UK Prime Minister David Cameron (or his speechwriter) suggested last week that it is now the time to use the “crisis of capitalism to improve markets, not undermine them.”
If we draw a straight line back in time from the current financial crisis to the dawn of the same crisis, few would dispute that it was, and is, banks carrying the smoking gun. It was banks that made questionable loans to flaky borrowers – sovereign as well as individual – and it is banks that required extraordinary levels of involuntary taxpayer support to keep them “in business”, that is to say, keep their senior executives in the manner to which they have become accustomed. Unfortunately, in saving the banks from themselves, sovereign governments have now largely destroyed their own balance sheets.
There is not, and never was, a free or fair market for banks. A free market would have allowed insolvent banks to fail. A free market, for that matter, would have no need of a central bank dictating monetary policy: the genius of the market is that it is perfectly capable of pricing money and interest rates in the same way it makes a price, every day, without fail, for the value of Tesco plc, crude oil or wheat. If the Prime Minister were capable of framing the problem correctly, he would have said that it was now the time to use the “crisis of statism to introduce markets”.
Instead, career politicians in the coalition, with no practical experience of any world other than the political, have been busily urging the rest of Britain to become “a John Lewis economy” of motivated employee shareholders. As Martin Vander Weyer asked archly in The Spectator, “Have you wondered why there’s only one John Lewis Partnership, Mr Clegg ?” But then criticising the Lib Dems (official financial policy: join the euro zone) for economic confusion is like criticising David Blunkett for being blind.
Having said that, the ‘sex-tips-from-virgins’ unsolicited economic advice from Mr Clegg did inadvertently stumble upon a broader truth about the financial crisis: in large part, it does come down to ownership. Example: the two largest Swiss banks, UBS and Credit Suisse, have not exactly covered themselves with glory during the financial crisis. They’ve covered themselves with something, but it doesn’t smell like glory. Credit Suisse stock between the start of 2007 and the end of 2011 has delivered a total return to shareholders of some minus 70%. UBS stock over the same period has done even worse: a total return of minus 82.6% (and that includes dividends).
By their very nature it’s difficult to comment about how genuinely private Swiss banks have performed during the crisis, but since they’re not beholden to a widely diversified (read: essentially powerless) shareholder base, they can concentrate on customer service rather than on filling their boots and extracting value from shareholders. And as hedge fund manager Kyle Bass has pointed out, having unlimited liability as a partner in such a bank gives those employees a particular interest in ensuring that they don’t entertain reckless malinvestments. For this reason alone, private banking groups have a higher likelihood of outliving their publicly listed competitors.
The phrase ‘market failure’ also crops up in David Swensen’s guide for individual investors, ‘Unconventional success’. The title is an allusion to Keynes’ famous observation that fund managers, courtesy of endemic groupthink, tend to prefer (and to deliver) conventional failure over unconventional success. Swensen himself is famous for steering the Yale endowment through many years of impressive investment returns.
He uses ‘market failure’ in the context of a managed fund industry that involves the
interaction between sophisticated, profit-seeking providers of financial services and naive, return- seeking consumers of investment products. The drive for profits by Wall Street and the mutual fund industry overwhelms the concept of fiduciary responsibility, leading to an all too predictable outcome: except in an inconsequential number of cases where individuals succeed through unusual skill or unreliable luck, the powerful financial services industry exploits vulnerable individual investors.
To Swensen,
The ownership structure of a fund management company plays a role in determining the likelihood of investor success. Mutual fund investors face the greatest challenge with investment management companies that provide returns to public shareholders or that funnel profits to a corporate parent – situations that place the conflict between profit generation and fiduciary responsibility in high relief. When a funds management subsidiary reports to a multiline financial services company, the scope for abuse of investor capital broadens dramatically. In contrast, private for-profit investment management organizations enjoy the option of playing the role of a benevolent capitalist, mitigating the drive for profits with concern for investor returns.
The financial crisis of 2007- ..? has taken the role of giant vampiric money-squids masquerading as investment banks to new levels of surrealism quite beyond the realm of satire. Not content with ripping the faces off clients, banks – not limited in the scope of their operations to pure investment banking – have now shown themselves quite adept at ripping the faces off taxpayers too. If deficit exists, it is not in free market terms, because as we have seen, no such free market exists. The deficit is a political and regulatory one.
In The Puritan Gift, the Hopper brothers identify the proximate cause for the crisis as
an excess of borrowing by government, businesses and individuals.. Increasingly, reckless lending and borrowing – two sides of the same coin – have characterized most aspects of American society for the last thirty years..
This abuse of credit across the whole of society coincided with, and could not have occurred without, a deterioration in corporate culture occurring in the last third of the twentieth century. In the Golden Age of Management (1920 – 1970), executives had learned the craft of management ‘on the job’ from more senior colleagues. As they progressed up the ladder of promotion, they would also absorb ‘domain knowledge’ about the activity for which they were responsible – to borrow a term favoured by Jeff Immelt, chairman and chief executive of General Electric. Starting in the late 1960s, however, a new concept appeared on the corporate scene: that management was a profession like medicine, dentistry or the law, which people were ‘licensed’ to practise at the highest level if they had studied the subject in an academic setting. Business school graduates and accountants set the pattern of behaviour; others would follow in their footsteps. In 2001 a ‘professional’ manager entered the Oval Office of the White House to take charge of the nation.
Whether considering the managers of listed businesses or the managers of discretionary funds, investors should be well served by identifying those conforming to a moral as opposed to a purely self-interested approach. Decent moral behaviour is to a degree subjective, but as Justice Potter Stewart famously said of pornography, we know it when we see it. Reforming banking sector pay will only be the start of an overdue cleansing of the Augean stables. When banks compete properly for business and run the risk of genuine failure in so doing, the market will be on its way to being fixed.
But as things stand, banks in collusion with central banks are distorting the term structure of debt markets (and through inflationism, all other asset markets too) and giving investors a delusional sense of safety with regard to sovereign bonds. Both financial signals and financial signalling are all wrong. When monetary policy rates and supposedly market-led interest rates are as low as they currently are (5 year US Treasuries yield less than 1% and 5 year Gilts barely that), it is not a sign of confidence, Messrs Cameron and Osborne, but a reflection of absolute terror on the part of the crippled banks that have been buying them in preference to any form of more constructive lending.
Again, this is not a crisis of capitalism, but of state-controlled capital.
This article was previously published at The price of everything.
By Jan Skoyles, on 27 January 12
Taking the title from a recent Guardian article, Jan Skoyles looks at the arguments made by Thomas Frank, in his new book ‘Pity the Billionaire’ , against the Republican nominees’ demands for less regulation. Mr Frank believes that the on-going financial crisis demonstrated the need for more regulation. She looks at the reasons against government regulation and argues that it should be down to the markets.
The Republican candidates’ views on the economy, Wall St and regulation are hot topics, understandably so given the current financial climate.
This is something which Thomas Frank, in his new book, ‘Pity the Billionaire’, is particularly vocal on. In his book, he states that ‘[Republican nominees’] ideas, if implemented, would crash the economy, wreck the regulatory state, [and] exacerbate the already outrageous gap between the rich and everybody else.’
Sounds extreme. But it also sounds just like the America we already have.
The biggest issue Mr Frank takes against the party’s candidates is that the most promising nominees have ‘sworn to liberate banks and financial institutions from government supervision.’
Mr Frank believes the financial crisis happened as a result of failed regulation by government. He is incredulous that a real-life presidential candidate, in the midst of a crisis, could advocate a market free of regulation.
He criticises those who fight for true capitalism, free-markets and minimal government involvement for presenting their ideas in an ‘economy in ruins thanks to complex, unregulated financial derivatives. Monopolies and oligopolies were everywhere. Hourly wages had been falling for decades.’
The state is involved in the economy already…but that’s because it has to be. A completely free market would be a disaster, something not even the business community itself wants to try.
Yes, the financial system did collapse due to complex, badly managed financial markets and yes, big companies do get bigger, and we definitely agree that hourly wages have been falling for a long time. But we do not agree that the Republicans are wrong to fight for less government intervention and financial regulation.
To argue against government regulation does not mean one is arguing against standards. It also does not mean that you are against regulation per se, just government-led regulation.
Mr Frank asks us to look at the backdrop in which the Republicans state their cause. We ask him to look at backdrop of this financial crisis – decades of government regulation and intervention.
The current financial crisis snowballed out of an already highly regulated environment. Whilst some of us see this as proof that heavy regulation is the wrong path, Keynesians believe it is proof that the regulators are either inefficient or do not have enough powers.
Why is that individuals such as Mr Frank and Paul Krugman believe that the best way to deal with a costly situation, such as a country’s debt or banking system, is to spend government resources on it? Why do they never consider that the answer may be to spend less money on it and step back from the scene of the crime, rather than contaminate it further?
Standards do matter and regulation, in some cases and to some extent, is important. However, it has consistently been shown (and what better example than the current crisis) that government regulation is inefficient and leads to poor standards.
Has government regulation improved standards?
Prior to regulatory bodies, the rule of law kept businesses in line – as it does today in many private industries. Arguments for regulation were based on the belief that there was no law which would cover one industry. The first regulatory board in the US was set up in 1887 to regulate railroads. They set rates and fares amongst other things. It led to a cartel-based service, driving many competing firms out of business. Since 1887 several regulatory bodies have followed, including food agencies, pharmaceutical agencies and, of course, financial bodies.
Has ever-increasing government intervention improved matters? Not according to Bill Bonner:
We’ve already seen how in the US, the health care, education and defense industries have been thoroughly zombified. Huge amounts of money have been “invested” in these industries over the last four decades. Despite all the money, people are statistically no healthier…and no better educated.
If it’s so useless why do we have it?
William L. Anderson relates regulation nicely to inflation:
Regulation is like inflation; both are portrayed as bad things, both are products of the state, yet they persist. And they persist because at least some influential individuals are benefiting from them. Thus, those who gain are going to make sure that these issues are portrayed in the most favorable light.
As is noted in the several models below, as produced by Mr Devlin Cooper, governments and businesses can, and do, benefit from regulation. They demonstrate the regulatory capture which occurs in government regulation.
(1) The Public Interest Theory—Government regulation is required to resolve market failures (including asymmetric information, externalities, market power, natural monopolies).
(2) The Capture Theory—Producers have a demand for regulation in order to try to capture greater market shares themselves.
(3) The Stigler Model—The government has the power to coerce, and interest groups want to convince the government to exercise their coercive power in order to benefit the interest groups.
(4) The Pelzman Extension of the Stigler Model—Pelzman mainly extended Stigler’s theory by noting that legislators want to stay in office, and they are willing to offer favorable legislation to interest groups in return for political support.
(5) The Becker Model—You might see greater regulation in areas where there are market failures because in instances of severe market failures, there may be more to gain by regulation.
Market failure is, of course, whatever the government wants it to be. A voluntary transaction between parties can usually be labelled a ‘market failure’ if it does not serve the interests of some particular group.
If it is damaging to an individual or group then this should be managed by civil law.
It is interesting to note that, according to William L. Anderson, in the century following the founding of the United States there was virtually no regulation in comparison to today. That was the system which provided the foundation for the world’s (once) most powerful country. Regulation came about in the late 19th Century around the same time the American Constitution was turned on its head as governments and central banks became more entwined and interventionist.
Anti-competitive
Government regulation, wrongly, makes us think competition is a bad thing. But competition is a good thing for an economy. A business which has competition knows it must work to attract and retain customers. It will not set unfair prices or charges as it knows that the customer will vote with his feet and go to the competition.
Of course banks, and other businesses, will seek to maximise profits (it is part of the human mindset) but customers, in return, will always seek value. These interests interact in a free, unregulated market as Anthony W.Hager explains:
These interests combine in a free market, making astute businesses profitable while rewarding prudent customers with quality services, all at an agreeable price. Government interference upsets that balance, imposing undesirable results on everyone
The existence of regulatory bodies campaigned for and organised by governments, but supported by business, means markets are now victims to a comprehensive program of government intervention. Business is no longer democratic. Governments are now able to ‘buy’ businesses’ votes and businesses are able to organise regulation to suit them. Understandably, big businesses embrace regulation because it reduces the competitive threat.
Common sense
Ron Paul, a Republican nominee and campaigner to ‘End the Fed’, states that he ‘shudders’ every time he hears someone call for more government regulation as a result of the crisis. For Dr Paul, it is this regulation which drives businesses to behave recklessly. He argues:
- Regulatory agents are not omniscient, they cannot watch and predict everything.
- Heavy regulation favours big business; they can afford to hire lawyers to identify loopholes.
- Regulation is a moral hazard. Knowing an industry is regulated, we place all of our trust in it. We question very little. Hence why we stopped asking where our money was going. We trusted the regulators.
- “Nothing should take the place of common sense”
Ignoring the fundamentals
Of course it is only fair to posit that financial regulation has only come into being due to the fiat monetary system. As noted above, regulation has grown and compounded over the last one-hundred years. This is the same period in which our money has been distanced further and further from a sound monetary system. This perceived need for regulation stems from the issue of fiat money which has no intrinsic value and can be created at will by both governments and banks.
Governments respond to calls to fix our banking system by increasing the control over the system. But they already have control over our monetary system, the system which led us to this mess. They, or Mr Frank, do not stop to look at the fundamentals which have led people to demand yet more regulation.
It would be strange to not wish for high standards in areas such as health, banking and education. But it is not strange to want to remove the state’s role in establishing and enforcing these standards.
When governments become involved in the setting of rules in the market, they are imposed uniformly. This creates uniform errors, or even crises (as we have seen), when something goes wrong.
Libertarians believe that good regulation must be born of the market, ‘…a bottom up approach,’ as described by Dr Tim Evans. This method would not create these uniform rules which we see today, but would allow a ‘polycentric’ approach to the setting of standards. This would be led by consumers.
Consumers seek value, not votes. These complex systems of banking and health should not be under the control of a group who have an ulterior motive in the market place. Dr Tim Evans explains, ‘The more complex and dangerous something is, the more it has to be born of real people in real and open markets.’
Government regulation, like fiat money, represents government interference in the market. Both have had disastrous consequences.
By Dr Tim Evans, on 27 January 12
I am not joking. It has finally happened. And I want to see it. As reported by Bloomberg, ‘Euro Crash! The Musical’ is coming to town. According to this report this spectacular and timely production “transposes the single-currency story to a deep dark forest. Mark and Gilda can’t find their way out. They are lured into the gingerbread Euroland house, where Papa Kohl and Madame Mitterrand run a school of fiscal discipline attended by some wayward pupils – personified nation states like Callum of Ireland and Stavros of Greece”. The show’s numbers include “a chorus praising the virtues of the Bundesbank and former U.K. Chancellor of the Exchequer Norman Lamont singing “Our currency’s gone down the plughole” in the shower”.
“EuroCrash!” is showing in at the Cockpit Theatre in London from 8 to 11 February 2012 and I am definitely going to see it. For more information and to book your ticket(s) just click here.
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