Austrians, Fractional Reserves, and the Money Multiplier

[Editor's note: this article, by Robert Batemarco, first appeared at]

John Tamny recently wrote a piece at Forbes titled, “The Closing of the Austrian School’s Economic Mind” in which he critiqued certain claims made in Frank Hollenbeck’s Mises Daily article, “Confusing Capitalism with Fractional Reserve Banking.”

Tamny goes far beyond taking Hollenbeck to task, asserting that many modern Austrian economists have certain views of monetary policy that are at odds with much of the rest of the contribution of the Austrian School. Tamny’s biggest point of disagreement with Austrians is over the low regard with which many Austrians hold the practice of fractional reserve banking. In so doing, he makes several arguments which cannot stand up to critical scrutiny.

The crux of the Austrian position is that the practice of fractional reserve banking gives ownership claims to the same funds to more than one person. The person depositing the funds clearly has a property claim to those funds. Yet when a loan is made from those funds, the borrower now has a claim to the same funds. Two or more people owning the same funds is what makes bank runs possible. The existence of deposit insurance since the 1930s has minimized the number of these runs, in which multiple owners sought to claim their funds at the same time. The deposit insurance that prevents bank runs really amounts to a pre-emptive bailout of the banks. As this is a special privilege, rather than a natural development of the market, it follows that restrictions on fractional reserve banking would be a libertarian validation of the market rather than the statist interference that Tamny claims it to be.

His inability to see that fractional reserves lead to two or more people having claim to the same funds at the same time leads him to deny the logic of the money multiplier. To quote him:

The problem is that the very notion of a “money multiplier” is a logical impossibility; one that dies of its illogic rather quickly if analyzed in the lightest of ways. … To the Austrians, money can be multiplied. Bank A takes in $1,000, lends $900 to Bank B, then Bank B lends $810 to Bank C, only for Bank C to lend $729 to Bank D, etc. Pretty soon $1,000 has been “multiplied” many times over as the credit is passed around.

The notion of the money multiplier is by no means uniquely Austrian. I learned it forty years ago from the Paul Samuelson textbook and from the Fed publication Modern Money Mechanics. It is also the centerpiece of the monetary system chapter of virtually every textbook right up to Paul Krugman’s most recent edition. Indeed, the nature of the process is one of the most uncontroversial propositions in economics — a good definition of an uncontroversial economic proposition being one on which both Murray Rothbard and Paul Krugman are in substantive agreement. Indeed, if there were no money multiplier, one would be at a loss to explain why, until QE1 in 2008, M1 was a 1.6 times size of the monetary base, having historically been even higher. Nor would the required reserve ratio, a tool of monetary policy that became too powerful to be used after 1937, have any effect on the money supply in the absence of the money multiplier effect.

What is controversial about the money multiplier is not its existence, but whether or not it creates distortions in the economy. The distortions introduced into the economy by fractional reserve banking, and to an even greater extent by central banking, comprise the central element of Austrian business cycle theory. The basic idea is that the creation of money (which is also credit, since that new money is loaned into existence) increases the supply of loanable funds and lowers market interest rates without increasing the supply of voluntary saving. This misleads investors into believing that more resources have been made available by savers for investment projects than actually have been made available. Thus, projects are started on too big a scale since many investors try to exercise a claim on the same productive resources. In so doing, they will bid up the resource prices, slashing the profitability of many of these investment projects. This is the real goods sector counterpart of bank runs in the monetary sector. Since there is no real goods sector counterpart to deposit insurance, firms will run short of the resources necessary to profitably complete their investment projects, exposing them as malinvestments and turning boom to bust.

Tamny disputes the above claims, largely on the basis of what seems to me an idiosyncratic definition of credit. He states that, “credit can’t be multiplied. Period. For every individual who attains credit successfully, there must be a saver willing to give up near-term access to the economy’s resources.” This statement is informed by the valuable insight that lending money to those who wish to buy goods they could not otherwise afford does not create additional goods. Where the equivocation arises is in his use of the word credit to describe the goods that credit permits one to buy. I believe this eccentric use of that word is what leads to many of Tamny’s disagreements with the Austrians. Here is Exhibit A:

Perhaps another logical response to this line of thinking is the housing boom that took place in the 2000s. Wasn’t the latter most certainly a function of easy credit? Let’s be serious. To believe it was, that low rates set by the Fed were what made housing credit easy is to believe that rent control renders apartments abundant. But it doesn’t, nor were low rates decreed by the Fed the driver of the housing boom.

Austrians agree that making loans more available than the market would make them does not make more goods available. But there is the illusion of more resources in the short run because the credit-creation process does initially commandeer resources from those whose money decreases in value through the Cantillon Effect. Unfortunately, many entrepreneurs seeking to expand their operations act on this illusion. Only when the new money reaches those whose money lost its value initially and they re-assert their demand, does the inability of new credit to create new goods become obvious.

The last critique Tamny makes that I will discuss here is his implication that Austrian support for 100 percent reserves on demand deposits would make it impossible for borrowers to borrow from savers in order to lend those savings out. This is wrong. Austrians have no problem with savers buying the bonds of a firm seeking additional financing, nor with their buying stock, either directly from the company or its investment bank through an IPO or on the secondary market where it helps keep the market liquid, nor with their buying a bank CD or time deposit knowing that they will not have a claim on the funds they have entrusted to the bank until maturity. In all of these cases, intermediaries are borrowing from savers in order to lend those savings out (this is not exactly a loan in the case of stocks). What Austrians object to is banks telling depositors they still have an instantaneous claim on the funds deposited when they have given someone else a claim on the same funds.

Under the elimination of fractional reserve banking, investment spending would be reduced, not to zero, but to a more sustainable level. This would not eliminate entrepreneurial errors, which are part and parcel of having to act in the face of uncertainty, but it would eliminate the cluster of errors generated by the inconsistent plans that would be made on the basis of falsified market signals of interest rates below their natural rate, thus moderating, or in the best-case scenario, eliminating the business cycle.


Has Fractional-Reserve Banking Really Passed the Market Test?

[Editor's note: the following piece was originally published by World Dollar at]

In 2003, Jörg Guido Hülsmann, a senior fellow of the Mises Institute, published the essay “Has Fractional-Reserve Banking Really Passed the Market Test?” in a Winter edition of The Independent Review. The key conclusion drawn was that it is the obfuscation of the difference between fractional-reserve IOUs and genuine money titles which preserves the the practice of fractional-reserve banking.

It is the belief of this author that this essay has not received the acclaim that it so richly deserves. Indeed, its implications for the future of money and banking are monumentous. If those who advance the Austrian School of economics, the Mises Institute and Zero Hedge most prominently among them, were to grant its ideas a great renaissance, the worldwide return to sound money may happen far sooner than most could have believed possible.

J.G. Hülsmann 
explains why “in a free market with proper product differentiation, fractional-reserve banking would play virtually no monetary role” (p.403). The incisive reason given is that genuine money titles are valued at par with money proper, while fractional-reserve IOUs + RP (Redemption Promise) would be valued below par, due to default risk.

Here is the deductive argument being made:

1.    Debt (IOUs + RP) is promised money.
2.    A promise has the risk of not being kept (default risk).
3.    Therefore, promised money, debt (IOUs + RP), is less valuable than genuine money titles (/money proper).

J.G. Hülsmann goes on to explain why the mispricing of fractional-reserve debt (IOUs + RP) persists. The reasons given include the outlawing of genuine money titles and deceptive language (“deposits”).  This author would like to add one more reason, namely the myth that the government could actually “guarantee” deposits in the event of a systemic run. Systemic runs mean, by definition, most if not all money proper exiting the fractional reserve banking system, meaning the money proper with which the “guarantees” could be fulfilled doesn’t exist, short of unprecedented levels of new money printing and financial repression. This point is acknowledged on p.22 of the otherwise unexceptional “The Chicago Plan Revisited” by Jaromir Benes and Michael Kumhof.

The history of fractional reserve banking is, then, defined by informational inefficiency. Market participants have failed to reflect the price differential between fractional reserve debt (IOUs + RP) and genuine money titles.

Let us now extend the deductive argument:

4.    Therefore, an arbitrage opportunity exists. All holders of Debt (IOUs + RP) have an economic incentive to make the redemption request for genuine money titles (/money proper).

Mervyn King, ex-governor of the Bank of England, once claimed that it is irrational to start a bank run, but rational to participate in one once it has started. While the second part of the claim is correct, the first is not. It is irrational not to start a bank run, due to the arbitrage opportunity that exists.

This, of course, holds the assumption that the market will become informationally efficient, and will therefore capitalise on the mispricing. But the holding of this assumption is only credible if this idea is spread. We live in a time with an unprecedented level of competing voices wanting to be heard, the unfortunate consequence of which is that we drown out the voices that are truly exceptional. It is no exaggeration to say that “Has Fractional-Reserve Banking Really Passed the Market Test?” may prove to be the most revolutionary essay in the history of monetary economics and banking, if only it  receives the level of appraisal and promotion it deserves.

On this matter, the reasons given for the persistence of the mispricing of fractional-reserve debt (IOUs + RP) are unsustainable in the long run. The lack of legal protection for genuine money titles is no more than a technicality, for there is nothing in practice that can sustainably prevent the existence of full reserve banks. Awareness that “deposits” are not actually money being held for safekeeping is a matter of educating the public, as is awareness that government’s deposit “guarantees” are not actually credible in the event of a systemic run.

If we assume, then, that fractional-reserve banking will come to its logical ending, there is good reason to believe that the shock will herald the endgame for fiat money. It is in fact the case that all fiat money is the liability of the central bank, which also carries the risk of non-repayment (default risk). This, again, means an arbitrage opportunity for market participants to withdraw the fiat money from the fiat money banking system. This confirms that the original basis for fiat money is destroyed, for its repayment to the central bank is not credible.

Finally, at long last, we have a worldwide return to sound money. Will there be a new 21st century Gold Standard? Will we recourse to cryptocurrencies such as Bitcoin? Will we see the rise of the Equal Opportunity Standard, with everyone in the world being issued once with an equal amount of World dollars? Or will there be another innovation to come? What we must defend, as proud advocates of freedom, is that the free market will decide. That governments finally learn to stop their oppressive, damaging interference with the monetary system.


Money demand and banking – some challenges for the “Free Bankers”

Within the Austrian School of Economics there has long been disagreement and therefore occasionally fierce debate about the nature and consequences of fractional-reserve banking, from here on called simply FRB. FRB denotes the practice by banks of issuing, as part of their lending activities, claims against themselves, either in the form of banknotes or demand deposits (fiduciary media), that are instantly redeemable in money proper (such as gold or state fiat money, depending on the prevailing monetary system) but that are not fully backed by money proper. To the extent that the public accepts these claims and uses them side by side with money proper, gold or state fiat money, as has been the case throughout most of banking history, the banks add to the supply of what the public uses as money in the wider sense.

Very broadly speaking, and at the risk of oversimplifying things, we can identify two camps. There is the 100-percent reserve group, which considers FRB either outright fraud or at least some kind of scam, and tends to advocate its ban. As an outright ban is difficult for an otherwise libertarian group of intellectuals to advocate – who would ban it if there were no state? – certain ideas have taken hold among members of this group. There is the notion that without state support – which, at present, is everywhere substantial – the public would not participate in it, and therefore it would not exist, or that it constitutes a fundamental violation of property rights, and that it would thus be in conflict with libertarian law in a free society. This position is most strongly associated with Murray Rothbard, and has, to various degrees and with different shadings, been advocated by Hans-Hermann Hoppe, Jesus Huerta de Soto, and Jörg Guido Hülsmann.

The opposing view within the Austrian tradition is mainly associated with George Selgin and Larry White, although there are other notable members of this group, such as Steve Horwitz. This camp has assumed the label “free bankers” and it defends FRB against accusations of fraud and misrepresentation, maintains that FRB is a normal feature of a free society, and that no property rights violations occur in the normal conduct of it. But this group takes the defence of banking practices further, as it also maintains that FRB is not a disruptive influence on the economy, a position that may put the free bankers in conflict with the Austrian Business Cycle Theory, although the free bankers deny this. This point is different from saying that FRB is not fraudulent or suspect. We should always consider the possibility that otherwise perfectly legitimate activities could still be the cause of economic imbalances, even in a free market. If we did find that to be the case, we might still not follow from this that state intervention or bans are justified.

But the free bankers go even further than this. Not only is FRB not problematic, either on grounds of property rights nor on economic stability, FRB is even beneficial as it tends to maintain what the free bankers call short term monetary equilibrium, that is, through FRB the banks tend to adjust the supply of money (by issuing or withdrawing deposit money on the margin) in response to discretionary changes in money demand in such a way that disruptions would not occur that otherwise seem unavoidable under inelastic forms of money when changes in money demand would have to be absorbed by changes in nominal prices. FRB is thus not just legitimate, it is highly beneficial.

Purpose of this essay

As I said before, this is an old debate. Why should we reheat it? – Before I answer this question, I should briefly state my position: I am not fully in agreement with either camp. I do believe that the free bankers’ defence of FRB is largely successful but that their claims as to it being entirely innocuous and certainly their claims as to its efficiency in flexibly meeting changes in money demand are overstated. In my view, their attempts to support these claims fail.

FRB is, in principle and usually, neither fraud nor a scam, and the question to what extent the depositing public fully grasps how FRB works is not even material in settling this issue. In their 1996-paper ‘In defense of fiduciary media’, Selgin and White argue that the type of money that FRB brings into circulation has to be distinguished from fiat money; they explain that FRB is not fraudulent and that it does not necessarily involve a violation of property rights; third party effects, that is any potentially adverse effects that FRB may have on those who do not participate in it, are not materially different from adverse effects that may emanate from other legitimate market activity, and thus provide no reason for banning FRB; furthermore, Selgin and White claim that FRB is popular and that it would occur in a free market. I agree with all these points. There is no basis for banning FRB, so it should not be banned. This position is, in my view, correct, and it also happens to be obviously libertarian. I may add that I believe it is also almost impossible to ban FRB, or something like FRB, completely. We could ban FRB as practiced by banks today but in a developed financial system it is still likely that other market participants may from time to time succeed in bringing highly liquid near-money instruments into circulation, and that may cause all the problems that the 100-percent-reserve crowd associates with traditional FRB. The question is now the following: do these problems with FRB exist? The free bankers say no. FRB, in a free market, is not only not a source of instability, it is a source of stability as it manages to satisfy changes in money demand smoothly. These positive claims as to the power of FRB are the topic of this essay. I do not believe that these claims hold up to scrutiny.

Why is this relevant?

At first it does not appear to be relevant. Selgin and White declare in their 1996 paper, and I assume their position on this has not changed, that they are opposed to state fiat money and central banking. This sounds similar to the conclusions that I develop in my book, Paper Money Collapse. I advocate the strict separation of money and state. No central bank and no state fiat money. I think it is extremely likely that an entirely uninhibited free market in money and banking would again chose some kind of inflexible commodity – a natural commodity with a long tradition as a medium of exchange, such as gold, or maybe a new, man-made but scarce commodity, such as the cryptographic commodity Bitcoin, or something similar – as the basis for the financial system, and even if the market were to continue with the established denominations of dollars, yen, and so forth, as the public is, for now at least, still comfortable using them, would somehow link the issuance of these monetary units again to something inelastic that was not under anybody’s discretionary control.

In any case, if we assume that some type of ‘market-gold-standard’ would again resurface, it is very clear that under such purely market-driven, voluntary arrangements and with essentially hard money at its core, any FRB activity would be strictly limited. FRB-practicing banks would not have lender-of-last resort central banks watching their backs. There would be no limitless well of new bank reserves to bail out overstretched banks and to restart new credit cycles whenever the old ones have run their course. There would be no state-administered and tax-payer-guaranteed deposit insurance, or any other arrangement by which the cost of failure in banking could be socialized. Lowering reserve ratios and issuing additional fiduciary media (substitute money, i.e. deposit money) would be legal (the state would abstain from any involvement in monetary affairs, including the banning of any such activities) but it would come with considerable business risk, as it should be.

Would there still be FRB? Certainly. And in my view, the remaining FRB activity, adding as it does to the elasticity of the money supply at the margin and thus potentially distorting interest rate signals, is going to lead to capital misallocations to some degree, and thus initiate the occasional business cycle. That, in my view, is the price we have to pay for having a developed monetary economy and entire freedom in money and banking with all the undeniable advantages such a system brings. Importantly, I believe that these costs are unavoidable. But they are minor due to the absence of FRB-boosting state policy. – No, an entirely free market would not fulfil any dreams of uninterrupted bliss or realise the macroeconomist’s fantasy of everlasting ‘equilibrium’, both notions that Ludwig von Mises frequently rejected and ridiculed, but it would for sure be considerably better, and much more stable, than anything our present elastic monetary system can produce.

In Paper Money Collapse, I argue that inelasticity of supply is a virtue in money. That is why gold is such an excellent monetary asset. Complete inelasticity is unattainable in the real world but something like a proper gold standard is close enough. But for the ‘free bankers’ the remaining elasticity under restricted FRB (restricted by a stable commodity base) would be a boon. It would further stabilize the economy and establish…equilibrium. In my view, these claims are unsupported. But, you may say, why should we argue about the specific features of the post-fiat-money world if we are in agreement that such a post-fiat money world is in any case preferable to the present one?

The reason is simply this: how do we evaluate current policies? On this question I thought that most Austrians, as advocates of gold or something similar, and as critics of fiat money, would still be in broad agreement. But to my initial shock and my lasting amazement I found that some Austrian free bankers frequently cannot bring themselves to reject ‘quantitative easing’ and other heavy-handed central bank intervention on principle, and that they are able to embrace monetarist policy proposals, such as nominal GDP targeting by central banks, as a kind of second-best-solution that will do for as long as our first choice of separation of money and state is not realised. I believe these positions to stand in fundamental conflict with key tenets of the Austrian School of Economics and, apart from that and more importantly, to be simply unjustifiable. I think they are misguided. But it seems to me that the occasional support for them among free bankers originates in certain expectations as to what the equilibrating forces of ‘free banking’ would bring about in a free market in terms of a stable nominal GDP, and the free bankers can thus advocate certain forms of central bank activism if these are bound to generate these same outcomes. Therefore, in order to refute the idea of nominal GDP targeting we have to show that the free bankers’ expectations as to ‘monetary equilibrium’ under free banking lack a convincing analytical foundation. In this essay I want to pose some challenges for the free bankers. In a later article I hope to address NGDP-targeting as such.

Money does not need a producer

Among all goods money has a special place. It is the most liquid good and the only one that is demanded only for its exchange value, that is, its price in other goods and services. Anybody who has demand for money has demand for real money balances, that is, for effective purchasing power in the form of money. Nobody has demand for a specific quantity of the monetary asset per se, like a certain number of paper notes or a particular quantity of gold, but always for the specific purchasing power that these monetary assets convey.

In contrast to all other goods and services, changes in money demand can in theory be met by either producing additional quantities or by withdrawing and eliminating existing quantities of the monetary asset (changing the physical quantity of money), or by allowing the price of money, money’s exchange value, to change in response to the buying and selling of money versus non-money goods by the public (changing money’s purchasing power). Furthermore, it can be argued, as I do in Paper Money Collapse, that the superior market process for bringing demand for and supply of money in balance is the latter, i.e. the market-driven adjustment of nominal prices in response to the public’s buying and selling of money for non-money goods according to money demand. Why? – Well, mainly because the process of adjusting the physical quantity of money does not work. 1) We lack a procedure by which we can detect changes in money demand before they have begun to affect prices, and if prices are already beginning to change then these price changes already constitute the very process that satisfies the new money demand. This makes changing the quantity of money superfluous. 2) We lack a procedure by which we can expand and contract the supply of money without affecting the supply of credit and without changing interest rates. This makes changing the quantity of money dangerous. Money demand and loan demand are different things. Our modern fiat money systems are, in any case, not really designed for occasionally reducing the supply of money but for a continuous expansion of the money supply. As the Austrian Business Cycle Theory explains, expanding the supply of money by expanding bank credit must distort interest rates (artificially depress them) and lead to mismatches between voluntary saving and investment and thus to capital misallocations.

To this analysis the free bankers appear to voice a few objections. Before we look at the differences, however, let’s first stress an important agreement: the free bankers agree that nominal prices can do the adjusting and bring demand for and supply of money in balance. But they introduce an important condition: in the long run. In the short run, they argue, the process is not quite as smooth as many hard-money Austrians portray it to be.

Selgin and White (‘Defence’, 1996):

In the long run, nominal prices will adjust to equate supply and demand for money balances, whatever the nominal quantity of money. It does not follow, however, that each and every change in the supply of or demand for money will lead at once to a new long-run equilibrium, because the required price adjustments take time. They take time because not all agents are instantly and perfectly aware of changes in the money stock or money demand, and because some prices are costly to adjust and therefore “sticky.” It follows that, in the short run (empirically, think “for a number of months”), less than fully anticipated changes to the supply of or demand for money can give rise to monetary disequilibrium.

Thus, the first objection of the free bankers is that the account of the hard-money Austrians about the smooth adjustment of prices in response to changes in money demand is a bit superficial and slick. In the real world, not all prices will respond so quickly. Not all goods and services are being priced and re-priced in a continuous auction process, and when the public reduces money-outlays at the margin in an attempt to increase money-holdings, not every producer of goods and services will quickly adjust the price tags of his wares.

I do think some of this criticism is valid, and I am not excluding myself from it. My own account of the process of adjustment of money’s purchasing power sometimes runs the risk of glossing over the real-life frictions involved. However, to my defence, I acknowledged some of these problems in Paper Money Collapse, although I do not treat them extensively. See page 144-145:

In the absence of a flexible money supply, sudden changes in money demand will have to be fully absorbed by changes’ in money’s purchasing power. One could argue that this, too, has the potential to disrupt the otherwise smooth operation of the economy. Indeed, as we have seen, this phenomenon will also affect the prices of different goods differently. [This refers to the fact that when, for example, people try to raise their money holdings, they will reduce money-outlays on non-money goods or sell non-money goods for money, but they won’t cut every single expenditure item by an equal amount, or liquidate a tiny portion of each of their assets but will always cut the expenditure or sell the asset that is lowest on their present value scale. Downward pressure on prices from rising money demand will thus not be the same for all prices.]…A change in the demand for money will change overall prices but also relative prices and therefore the relative position of economic actors and the allocation of resources in the economy. All of this is true but it must lead to a different question: Is any of this avoidable….?

Is ‘monetary disequilibrium’ a unique phenomenon?

The free bankers are correct to point to these problems but it is also true that every change in the preferences of economic agents leads to similar problems. If consumer tastes change and money-flows are being redirected from certain products to certain other products, this, too, means that nominal spending on some items is being reduced. Profitability will decline in some parts of the economy and increase in others. This, too, will ultimate redirect resources and change the economy but all of these processes “take time because not all agents are instantly and perfectly aware …” of what is going on, and also for other reasons, including the stickiness of some prices. I think agents are never “instantly and perfectly aware” of anything, and that the slickness of economic models is never matched by reality. Accordingly, the real world is constantly in disequilibrium, and as economists we can only explain the underlying processes that tend towards equilibrium without ever reaching it. I wonder, however, if the concerns of the free bankers, valid though they are, are not just examples of the frictions that always exist in the real world, in which tastes and preferences change constantly, and change in an instant, but prices, knowledge, and resource use always move more slowly.

Furthermore, the issue of stickiness of prices should not be overstated. These days many prices do appear rather flexible and tend to adjust rather quickly: not only those of financial assets but also industrial commodities, and even many consumer goods, from used cars to hotel stays to flight tickets to everything on eBay. Discounting in response to a drop in nominal spending is the first of line of defense for almost every entrepreneur, I would guess, and if what the entrepreneur faces is indeed a higher money demand among his clientele, rather than a genuine change in consumption preferences, then sales should stabilize quickly at the lower price.

But I think the main point is this: how can the banks do better? What do the free bankers say to my two points above that changing the quantity of money is not really a viable alternative to allowing changes in nominal prices? Let’s address the first point first:

Point 1) We lack a procedure by which we can detect changes in money demand before they have begun to affect prices, and if prices are already beginning to change then these price changes already constitute the very process that satisfies the new money demand. This makes changing the quantity of money superfluous.

How do banks detect a change in money demand – before it has affected prices?

Banks have no facility to create money and money alone (deposit money, fiduciary media). New money is always a byproduct of banks’ lending operations. Banks can only create money by expanding their balance sheets. Thus, they always create an asset (a new loan) at the same time they create a new liability (the demand deposit in which the bank pays out the loan to the borrower, and which is part of the money supply). Therefore, if you suddenly experience a rise in money demand, if you suddenly feel the urge to hold more of your wealth in the form of the most fungible object (money), the bank can’t help you. Of course, you could go to the bank and borrow the money and then keep it in cash. This is a possibility but I think we all agree – and the free bankers seem to agree as well – that this is very unusual, and that it must be rare. Banks meet loan demand, not money demand, and the two are not only different, they are the opposite of one another. Borrowers do not have a high marginal demand for money; quite to the contrary, they have a high marginal demand for goods and services, i.e. non-money items (that is why they are willing to incur interest expense). The loan is in the form of money but the borrowers usually spend the money right away on whatever they really desire.

Banks are not in the money-creation business (or only in it by default – no pun intended); they are really in the lending business. The idea that rising money demand would articulate itself as higher loan demand at banks is wrong, and the free bankers do not usually make that mistake. They know (and some of them even stress) that money demand articulates itself in the markets for non-money goods and services (including, but not restricted to, financial assets). People reduce or increase spending in order to establish the desired money holdings.

To the extent that, when people experience a higher money demand, they sell financial assets to banks, the banks do indeed directly experience the heightened money demand, and if the banks increase their FRB activities in response and expand their balance sheets accordingly (the financial assets they buy enter the asset side of the balance sheet – they are the new loans – and the new demand deposits the banks issue to pay for them sit on the liability side of the balance sheet), the quantity of money is indeed being expanded in response to money demand. But to the extent that the public does not sell to FRB-practicing banks or that the public reduces other outlays or sells non-financial assets, the banks are not directly involved as counterparties. How can they still detect a rising money demand?

[As an aside, the free bankers sometimes speak of ‘the public having a higher demand for demand deposits or ‘inside money’ ’, and that the banks should be allowed to ‘accommodate’ this. I think these statements are confusing. Depositing physical cash in a bank, or conversely liquidating demand deposits to increase holdings of physical cash, are transactions between various forms of money. In a functioning FRB system, both forms of money, physical cash and bank-produced deposit money, are almost perfect surrogates. Both are used side by side, and both satisfy the demand for money. That is the precondition for FRB to work. The factors that occasionally determine preferences for a specific form of money are fundamentally different from those that affect the demand for money overall. If the public, for example, reduces demand deposits and accumulates physical cash, i.e. switches from ‘inside money’ to ‘outside money’, this may be because it is concerned about the health of the banks, and this is unrelated to the public’s demand for money, which in this case may be unchanged. As an example, in the recent crisis, the demand for physical cash increased in many countries, relative to the demand for bank deposits. At the same time, overall money demand also probably increased. But importantly, both phenomena are fundamentally different.]

The answer is this: if the public, in an attempt to raise money holdings, reduces money spending, this will slow the velocity of money, and to the banks this will be clearly visible. Money doesn’t change hands as quickly as before, and that includes transaction-ready deposit money at banks. Importantly, the slower velocity of money means a reduced risk of money outflows for each bank, in particular the likelihood of transfers to other banks that are a drain on existing bank reserves. Thus, the banks now have more scope to conduct FRB, that is, to reduce their reserve ratios, lower loan rates and issue more loans, and obviously to produce more deposit money in the process.

In the essay mentioned above, ‘In defence of fiduciary media’, this explanation appears in footnote 29, the emphasis here is different and so is the wording but the essence is the same, in my view. Banks increase FRB in response to a drop in money velocity. A rising money demand articulates itself in a lower velocity and thus a tendency for more FRB:

But how can the banks manage to expand their demand deposits, if total bank reserves have not changed? The increased demand to hold demand deposits, relative to income [increased money demand, DS], means that fewer checks are written per year per dollar of account balances. The marginal deposit dollar poses less of a threat to a bank’s reserves. Thus a bank can safely increase its ratio of deposits to reserves, increasing the volume of its deposits to the point where the rising liquidity cost plus interest and other costs of the last dollar of deposits again equals the marginal revenue from a dollar of assets.

I think this explanation is exceedingly clever and accurate. I do not, because I cannot, object to the logic. But does it help us? I have two observations:

1)   Is it really probable that this process is faster and more efficient than the adjustment of nominal prices? The objection of the free bankers was that the adjustment of nominal prices takes time. But so does this process. The bankers will not be “instantly and perfectly aware” of what is happening anymore than the producers of goods and services. When the public reduces spending in order to preserve money balances the effect will be felt as soon by the producers of whatever the public now spends less money on, as by the bankers who see fewer cheques being written. Why would we assume that the bankers respond faster? Sure, prices can be sticky, but does that mean that accelerated FRB will always beat nominal price changes in terms of speed? Will the bankers always expand their loan book faster than the affected producers discount their product? It is not clear to me why this would be the case.

2)   More importantly, the banks will, by definition, give the new deposit money first not to those who have a higher demand for money but to their loan clients who, we just established, have no demand for money but for goods and services, and who will quickly spend the money. From there, the money will circulate and may, finally, reach those who do indeed have a higher demand for money. But there is no escaping the fact that this is a roundabout process. For the very reason that banks can only produce money as a byproduct of their lending business, those who do demand higher money balances can only ever be reached via a detour through other markets, never directly. Bank-produced money has to go through the loan market first, and has to change hands a few times, before it can reach those who originally experienced a high money demand. There is no process as part of which we could ever hear a banker say to any of his customers: you have a higher money demand? Here, have some. – The question is now, what type of frictions or unintended consequences of this procedure of satisfying money demand do we encounter? Are these frictions likely to be smaller or even greater than the frictions inherent in allowing nominal prices to do the adjusting to meet changes in money demand?

Before we address these frictions a few words on a related topic: the free bankers sometimes seem to imply that unwanted fiduciary media (demand deposits, inside money) would return to the banks. This is not correct, or rather, it would only be correct if people wanted to exchange the demand deposit for physical cash but this is a transaction that is, as we have seen, unrelated to money demand. Claims against any specific bank may be unwanted, or demand deposits may be wanted less than physical cash, but this is unrelated to overall money demand. If deposit money is seen as a viable money good, and this is the precondition for FRB to work, any excess holding of money, whether inside money or outside money, whether cash or demand deposit, will not be returned to a bank and exchanged but will be spent! If banks increase their FRB activities and bring new fiduciary media into circulation, this money will circulate until it reaches somebody with genuine money demand. Often – when money demand has not risen simultaneously – this process involves inflation as a lower purchasing power for each monetary unit is required to get the public to voluntarily hold the new monetary units.

Is money demand a form of desired saving?

According to the free bankers, banks respond to a drop in money velocity as a result of rising money demand by engaging in extra FRB. At lower velocity, the risks inherent in FRB are smaller and this encourages banks to reduce their reserve ratios marginally, create extra loans and produce extra money, i.e. new deposit money that is now satisfying at least some of the new money demand. But what about the extra bank credit that also comes into existence? Hasn’t Mises shown that bank credit expansion is a source of economic instability; that bank credit expansion sets off business cycles? If extra loans at lower interest rates are not the result of additional voluntary saving but simply of money printing, and these loans still encourage extra investment and capital spending, then these additional projects will ultimately lack the real resources, resources that only voluntary saving can free up and redirect towards investment, that are needed to see the projects through to conclusion and to sustain them. Extra bank credit is thus bound to upset the market’s process of coordination between saving and investment – coordination that is directed via market interest rates. Would the extra FRB not start a Misesian business cycle? Would the allegedly faster and smoother process of satisfying changed money demand via FRB, via the adjustment in the nominal quantity of money rather than nominal price changes, not create new instabilities as a result of the artificially lower interest rates and the extra bank credit that are the necessary mirror image of new deposit money?

In Austrian theory, desired savings are a function of time preference. A lower time preference means the public attaches a lower importance to consumption in the near future relative to consumption in the more distant future. The discount rate at which future goods are discounted is lowered and the propensity to save rises, i.e. the willingness to reallocate income from meeting present consumption needs to meeting future consumption needs rises. The extra savings are offered on the loan markets at marginally lower rates. This encourages a marginal increase in investment. The marginally lower rates on the loan market thus accurately reflect the marginally lower time preference of the public. But lower rates as a result of credit expansion and FRB can unhinge this process. That is the core message of the Austrian Business Cycle Theory. How can the free bankers get out of this dilemma?

The free bankers counter this point by claiming that an increased demand for money reflects a lower time preference. Holding more money is a form of saving.

Although in the already quoted “Defence of Fiduciary Media”, Selgin and White at some point state that

We agree that time preference and money demand are distinct, and that a change in one does not imply a change in the other.

They also write, and this is more crucial to the case they are making, I believe,

The argument for the equilibrating properties of free banking rests in part on recognizing that an increased demand to hold claims on intermediaries, including claims in the form of banknotes and demand deposits, at the expense of holding additional consumer goods, is equivalent to an increase in desired saving.

In any case, in the examples they provide later, time preference, desired saving, and money demand always move together.

While I agree that accumulating money balances can be a form of saving (I say that much in Paper Money Collapse), it does not have to be the case, and I think it is more helpful to disentangle saving, consumption and money demand. Holding money is non-consuming, as Selgin and White point out, but it is equally non-investing.

If I sell my laptop on e-Bay so I have more readily spendable money (demand deposits) in my bank account so that I can take advantage of any unforeseen spending opportunities during my holiday in Greece, would we say that my time preference has declined, and that this is an act of saving? This is a switch from a consumption good to money, and Selgin and White would label this an act of saving, at least as I understand them. But the laptop would have delivered its use-value to me over a long period of time. Now I hold instantly spendable demand deposits instead. Has my time preference really dropped?

Here is a different example, one where we encounter a switch from investment goods to money, an example that Selgin and White put forward in their paper and where they argue that in such an operation total desired saving remains unchanged. Time preference remains the same. In the example given, the public sells bonds and accumulates cash or demand deposits instead. Both, money and bonds are non-consumption goods and thus saving-instruments in the Selgin and White definition. According to their theory, the banks would now acquire the bonds and issue deposit money against them. By doing this (increased FRB activity), the banks satisfy the demand for more money and keep interest rates from rising – which is appropriate as overall desired savings have not changed and time preference is still the same. – However, has the public’s time preference really not changed? Rather than holding a less liquid, long-term debt instrument the public now holds the most fungible asset (money). Is it fair to say that when people liquidate their bond portfolios that their time preference remains unchanged? – Maybe the public does this precisely for the reason that time preference has increased. The public may spend the money soon on consumption goods, or the public considers market interest rates too low and as no longer representative of the public’s time preference, and a drop in bond prices (rise in yields) is thus warranted to reflect this, and should not be cancelled out by the banks’ accelerated FRB.

The short run versus the long run

Furthermore, I suspect that there is an inconsistency in claiming that, in the long run, nominal price changes do bring the demand for and supply of money in line and then to argue that in the short run, money demand is best – and automatically – met by quantitative changes in the supply of money via FRB. The long run is evidently only a string of short runs, and if changes in money demand have been satisfied in the short run via FRB, how can these changes then still exercise up- or downward pressure on nominal prices in the long run?


The free bankers are correct to point to real-life frictions in the process of satisfying a changed money demand via an adjustment of nominal prices. The process is neither smooth nor instant, but then almost no market process is in reality. Their explanation that a rise in money demand will lead to a drop in money velocity and that this will, on the margin and under normal conditions, encourage additional FRB and thus an expansion of bank-produced money also strikes me as correct. Yet, the free bankers fail, in my view, to show convincingly why this process would be faster and smoother than the adjustment of nominal prices, and in particular, why the extra bank credit that also comes into existence through FRB would not generate the problems that the Austrian School under Mises has explained extensively.

If only a subset of the population, rather than the entire public, experiences a higher money demand – and this must be the more likely scenario by far – and this subset than reduces nominal spending on those goods and services that are relevant to this group, and if this then leads to a marginal drop in the prices of these goods and services, the extra demand of this group for real money balances has been met with potentially fairly limited frictions and side-effects, I would argue. By comparison, FRB can never meet money demand of any group directly. Banks always have to inject the new money into the economy via the loan market, that is, at a point where money demand is low and demand for non-money goods is high. Money demand will always be met in a roundabout way. Furthermore, the lowering of interest rates through the additional FRB activity is only unproblematic if the additional demand for real money balances is identical with desired saving and reflects a reduce time preference. These are rather heroic assumptions indeed.

Ludwig von Mises – The real free banker

The 100-percent-reserve Austrians have stuck – correctly in my view – with one of the most important insights of Austrian monetary theory as developed by the school’s most distinguished 20th century representative, Ludwig von Mises, namely the destabilizing force of credit expansion. Unfortunately, the 100-percent-reserve Austrians have taken the critique of banking too far. Claims of misrepresentation, deception, and fraud as being constituting elements of FRB go too far and remain ultimately unsupported.

The self-styled ‘free bankers’ are correct to reject these claims but they are taking their defense of FRB too far as well. By claiming that FRB could smoothly and quickly satisfy any changes in money demand they assign equilibrating properties to FRB that are ultimately unsupportable. In the process, they risk ignoring some of the most relevant Misesian insights. In particular the free bankers, it seems to me, tend to ignore that in an established FRB system, bank-produced fiduciary media (such as demand deposits) will be seen as near-perfect surrogates for money proper (such as state fiat money or gold). In such an environment the banks can (within limits) expand FRB and thus create more fiduciary media regardless of present money demand. Unwanted money (deposit money) then leads to a rise in money velocity and an upward pressure on nominal prices – it does not lead to the public exchanging deposit money for physical cash, as that would be just a switch from one form of money to another. Therefore, the unwanted bank-produced money – that entered the economy via the bank loan market – does not return to the banks. In my view, the free bankers ignore some of the dangers in FRB and overstate its equilibrating powers.

Both camps refer to Mises as an authority, albeit the ‘free bankers’ generally less so. Selgin and White, in their 1996 paper, quote Mises as a champion of free banking. I do, however, believe that the quote, taken from Human Action, has to be read in the context of Mises’ life-long and unwavering commitment to a proper gold standard. Here is the quote:

Free banking is the only method for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all the information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular – one is tempted to say normal – feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.

Crises and depressions, in Misesian theory, do not come about because of short-term mismatches between money demand and money supply, or frictions in the adjustment of nominal prices, but because of credit expansion. In order to appreciate Mises’s concerns over credit expansion, one does not have to consider bankers fraudsters (or ‘banksters’), and I can see no evidence in Mises’ writing that he saw bankers that way. But in order to agree with him that banks should be as free as all other enterprises – which, importantly, includes the freedom to fail – you do not have to assign them mystical equilibrating powers, either.

Mises’ conclusions were consistent and his recommendations practical: introduce inelastic, inflexible, apolitical money as the basis of the financial system, a hard monetary core, such as in a proper gold standard, and then allow banks the same freedom, under the same laws of corporation, that all other businesses enjoy – no special bans and no special privileges, such as ‘lenders of last resort’ or tax-payer-backed deposit insurance – and you can allow the market to operate. I believe that this should be the policy proposal under which all Austrians can and should unite.

Any deviation from the core Misesian message also occasionally gets ‘Austrians’ into some strange political company. With their damnation of FRB and allegations of fraud, the 100-percent-reserve Austrians seem at times to play into the hands of populist anti-bank fractions that have recently grown in influence since the financial crisis started, and to inadvertently be associated with the statist proposals of organizations such as the UK’s Positive Money or IMF economists Benes and Kumhof, all of whom consider money-creation by private banks – FRB- as the root of all evil and propose full control over the monetary sphere by the state – a proposal that could not be further from Mises’ ideals.

On the other side, the free bankers are in such awe of the assumed equilibrating powers of FRB in a free market that they confidently predict a stable (or at least reasonably stable) nominal GDP – and if we do not have free banking and a free market yet, why not have today’s central banks target nominal GDP to get a similar result under today’s statist monetary infrastructure? Bizarrely, and completely indefensibly, in my view, these Austrians end up joining forces with aggregate-demand-managing Keynesians or money-supply-managing monetarists. This is not only in fundamental conflict with many tenets of the Misesian framework – it is simply misguided, even under considerations of monetary realpolitik, i.e. of what is politically practicable presently but better than the present system.

Banks should be free but can only ever be so within a proper capitalist monetary system, and that is a system with a market-chosen monetary commodity at its core, and most certainly a hard and inelastic one. No new ‘target’ for central bank policy can ever achieve results that mirror the outcome of a properly functioning monetary system and a free banking market. We do not have a gold standard and free banking at present, and under these conditions I would suggest that a central bank that imitates a gold standard as closely as possible – i.e. one that ultimately keeps the monetary base fairly stable – would be, under the circumstances, the second best’, or least worst, solution. But a full treatment of the NGDP-targeting proposal will have to wait for another blog.

In the meantime, the debasement of paper money continues.

This article was previously published at


All power to the state! – money madness at the IMF

You cannot escape an all-pervasive sense of crisis these days. Impending doom does not only announce itself in actual events but also via the proliferation of ever more hair-raising schemes that claim to solve our problems. Maybe it should not surprise us if, at a time when the world’s most powerful central banks keep interest rates at zero for years on end and keep printing quantities of money that are simply outside the facilities of human imagination (trillions? quadrillions?), bravely hoping it will end differently this time, people get the impression that economics holds no certainties, that it is merely an exercise in limitless creativity. In his excellent speech to the New York Fed, Jim Grant reminded us that when the Financial Times first explained to their readers what QE was, back in 2009, one of those readers wrote in a letter to the editor: “I can now understand the term ‘quantitative easing, but . . . realize I can no longer understand the meaning of the word ‘money’.” – This gentleman is not alone. The basics of monetary economics have been tossed out the window and a merry ‘anything goes’ of policy proposals has descended on us. Otherwise sane-looking men and women now propose that, although years of zero interest rates have not solved our problems, everything will change once interest rates are negative. We should all get checks from the central bank with free money to spend, and government bonds at the central bank should be cancelled. Grown men dream of money from helicopters and money buried in bottles in the ground. “Whom the gods would destroy, they first make mad.”

Just when you thought it could not get any madder there comes a policy proposal that sets a new low in monetary policy discussion. Of course, in the current climate it is being hailed as ‘epic’ and ‘revolutionary’. The easily excitable Ambrose Evans-Pritchard, a tireless campaigner for man’s exploration of the unknown in the field of money, could not believe his eyes: “So there is a magic wand after all,” he writes in the Daily Telegraph, “one could eliminate the net public debt of the US at a stroke and, by implication, do the same for Britain, Germany, Italy or Japan.” It gets better all the time. No longer are we confined to debating arduous strategies for crawling slowly back to sustainable growth, no, we can now simply wipe out all our debt.

Harry Potter meets Irving Fisher

The proposal under discussion is the IMF’s Working Paper 12/202 by Jaromir Benes and Michael Kumhof (a link to a PDF version is provided in this article). It is titled “The Chicago Plan Revisited” and presents itself as a restatement of the ideas of Irving Fisher and Henry Simons of the University of Chicago from the 1930s and 40s, and an application of these ideas to the present crisis. It suggests the following:

‘Private money’ creation is the root of all economic evil. Most money today is created by ‘private’ banks through fractional-reserve banking. This means money-creation is linked to loan creation and debt accumulation. A hundred-percent reserve system is to be established by the state and the state will forthwith crack down on any attempt by the private sector to issue liquid financial instruments – near monies – that could be accepted by the public as cash equivalents. Money creation is put under the full control of the state. The new system is to be implemented right away in one big swoop: the banks are forced to borrow the needed reserves from the government (Treasury) to achieve the new 100 percent reserve ratios instantly. The government creates these reserves – as is usual in a fiat money system – out of thin air. In the US, this plan would amount to new reserves to the tune of 184 percent of GDP, according to Benes/Kumhof, which means $27.6 trillion or 15 times the combined size of QE1 and QE2. With the new 100% reserve requirement, this money will not circulate and not allow for further bank credit creation, which – it is expected by the authors – makes this intervention not inflationary. (A portion of the new reserves will also be cancelled in the next step.) The new reserves allow the government/central bank to ultimately transfer ownership of the bank assets to itself.

Importantly, these new reserves are issued in a process very different from how reserves are issued and placed with the banks today, for example through ‘quantitative easing’, and how it was suggested by Irving Fisher in 1935 (“100% Money”), or Milton Friedman in 1960 (“A Program for Monetary Stability”). These more ‘conventional’ procedures do not allow for any large-scale elimination of debt. Central banks acquire bank assets by exchanging them for newly created reserve money, which they issue as a claim against themselves (a liability), and under normal accounting principles, any write-down of the new assets (debt ‘forgiveness’) would necessarily cause the extinction of the bank reserves as well. Writing down debt shortens the balance sheet of the central bank and thus reduces the central bank’s liabilities, which are the banking system’s reserves.

Benes and Kumhof circumvent this by simply claiming that the new fiat reserves are not just a new liability of the central bank but that they are assets as well, Treasury Credit or ‘commonwealth equity’. Through this accounting gimmick, the state can issue new assets, simply as an administrative act. Thus, the new reserve money lengthens the balance sheets of BOTH central bank and ‘private’ banks in a first step, that is, the new reserve money is simultaneously an asset AND a liability for both. This novel approach then allows balance sheet reduction later on and debt forgiveness without elimination of the new reserves that now back bank deposits by 100%. (See model balance sheets on pages 64 to 66 of the Benes/Kumhof paper and compare them to the model balance sheet presented by Irving Fisher on page 57 of “100% Money”, 1935, which is much more conventional.)

At the end of this process, not only has a lot of debt disappeared, the separation of the ‘credit’ and the ‘money’ sphere of the economy is now total, and so is the state’s control over the monetary economy. This, Benes and Kumhof, make perfectly clear, is the ultimately goal of the exercise, and they claim it is to our benefit. Why? Here (very differently from Fisher and Friedman or, for that matter, any monetary theorist) they do not argue as economists, but quote anthropologists and certain monetary historians who claim that 1) money originated not spontaneously from direct exchange but is a creation of the state, or rather the state’s early precursors, such as priests and religious masters of ceremony; this is deemed important because the origin of money determines the “nature of money” (page 12) and therefore determines who should best control its issuance. 2) They argue that thousands of years of monetary history confirm that the state can be trusted fully with the monetary privilege. (If you remember history somewhat differently, then according to Benes and Kumhof you have to rethink. The paper follows a select group of maverick anthropologists and monetary activists that have simply rewritten monetary history. Needless to say, none of this was ever claimed by Irving Fisher or Milton Friedman, and to my knowledge, not even Henry Simons.)

Finally, the paper presents an elaborate econometric model that shows that all of this will work in reality.

In this essay I will do four things: I will put the proposed paper in the context of ‘Austrian ’ and Monetarist monetary theory, and show that it is not only outside these intellectual traditions but that its main argument is not even economic in nature. I will show that the core problem Benes and Kumhof claim to have identified is bogus, and that they do not understand money creation in our economy. I will then look at the paper’s peculiar historical, and non-economic, justification of complete state control of money, and show that this argumentation is highly dubious but also irrelevant. I will then show that the proposal presented relies on unprecedented forms of state intervention and crucially advances the notion that the state can create vast new assets – commonwealth equity – by decree, which allows it to claim to have no net debt and thus engage in loan acquisition and ‘debt forgiveness’.

What this paper is not: it is neither ‘Austrian’ nor Monetarist

Benes and Kumhof, early in their paper, claim that fractional-reserve banking increases the risk of bank runs, causes boom-bust cycles, and that a 100 percent reserve system would ensure greater stability. These observations are, in principle, correct. But this is, sadly, where it stops. Benes and Kumhof do not build on these insights. In fact, for their further argument these insights are completely irrelevant. Their paper does not bother to investigate the full range of effects of bank credit expansion, and ask, for example, if the expansion of base money by the central bank under a 100%-reserve system could not have similar or even the same adverse effects that deposit-money expansion has in a fractional-reserve system.

The Austrian School has provided the most comprehensive analysis of the effects of bank credit expansion and has shown most conclusively why more inelastic (‘harder’) monetary systems offer greater stability. Expanding the money supply always has disruptive effects as the inflow of new money must distort interest rates, and interest rates are crucial for the coordination of investment activity with voluntary saving. The question the ‘Austrians’ ask is not, who should control money creation, but should anybody control money creationShould anybody even create money on an ongoing basis? Once a commodity of reasonably inelastic supply, such as gold, is widely accepted as money, any quantity of this monetary asset – within reasonable limits – is sufficient, and indeed optimal, to satisfy any demand for money. Demand for money is demand for purchasing power in the form of money, and can always be met by allowing the market to adjust the price of the monetary asset relative to non-money goods. No money creation is needed, and any ongoing money creation is in fact disruptive.

‘Austrians’ tend to be critical of fractional-reserve banking but they are equally critical – in fact, even more critical – of fiat money and central banking. The problems they studied would also occur – and are even more likely to occur – if the fractional-reserve-banking system was replaced with one gigantic state central bank.

But Benes and Kumhof did not call their paper ‘The Austrian Plan Revisited’ but ‘The Chicago Plan Revisited’. The approach and the goals of the Chicago School were different. But it is still worth mentioning that in his 1935 book “100% Money” Irving Fisher suggested that his plan could be combined with the gold standard, something that is impossible with the Benes/Kumhof plan and that Benes and Kumhof show no interest in. Here is Fisher, page 16:

Furthermore, a return to the kind of gold standard we had prior to 1933 [before the domestic gold standard was abolished by Roosevelt and private gold confiscated, DS] could, if desired, be just as easily accomplished under the 100% system as now; in fact, under the 100% system, there would be a much better chance that the old-style gold standard, if restored, would operate as intended to operate.

This would indeed be the 100% gold standard that many ‘Austrians’ propose, and a system immeasurably more stable than what we have today. However, it was certainly not Fisher’s primary objective to restore the gold standard. Fisher wanted to maintain the fiat money system and consolidate the control of the central bank over the banking system by eliminating any remaining discretion by ‘private’ banks. Fisher was a big proponent of price index numbers. He believed the purchasing power of money could be measured accurately through statistics – a fallacy that is still widely believed today and still causes confusion and harm – and he was an early advocate of inflation-targeting. (For an Austrian School response to Fisher’s original plan see Ludwig von Mises, Human Action, 1949, Chapter XVII, 12. The Limitation on the Issuance of Fiduciary Media)

25 years later, Fisher’s fellow Chicagoan Milton Friedman also proposed a version of the 100% plan, this time with even less reference to boom-bust cycles or the potential for a gold standard. Friedman was an advocate of central banking because he believed that monetary and economic stability could be achieved by guaranteeing a stable, persistent and moderate expansion of the money supply, which is at the core of Friedman’s Monetarism. In a 100% system the state central bank – so he argued – can make sure that this would happen.

Importantly, both Fisher and Friedman had an asymmetrical view of monetary expansion. The ongoing expansion of the money supply – and therefore persistent injections of new money into the economy – were not considered harmful (quite to the contrary), as long as the money inflow remained moderate, but any contraction of the money supply (shrinking of bank balance sheets and destruction of money) was seen as a major problem and to be avoided at almost all cost. Their plans for full reserve banking was largely motivated by a desire to avoid the destruction of previously created deposit money. Of course, ‘Austrians’ see this very differently. The expansion of money – even if moderate and controlled – must already cause problems (capital misallocations), and when these problems come to the surface they cannot be suppressed with yet more money creation, at least not forever (although this is attempted under Friedman’s proposal for very easy monetary policy in crises).

It should now be clear why the Austrian School is enjoying a revival in the present crisis, not the Chicago School. Fisher and Friedman did not get their 100%- system with complete control over money creation for the central bank but whatever power central banks had in recent decades – and that power was formidable – was used in ways that were strongly influenced by the Chicago School. Fisher and Friedman have shaped modern central bank orthodoxy to this day. As long as inflation is moderate central bankers believe that no monetary problem exists, in line with Fisher. Even in the run-up to the present, spectacular financial crisis, inflation remained moderate in most major countries, at least in the common (and dangerously narrow) CPI definition. And for the past two decades, any crisis that, if left unchecked, could have caused bank balance sheet deleveraging and credit contractions was aggressively fought with low interest rates and base-money injections from the central bank, according to Friedman. In fact, the Bernanke Fed has repeatedly referred to Friedman’s policy descriptions as a blueprint for its own actions. However, none of this has prevented major financial imbalances to build, and these policies have even helped create these imbalances, as Austrian theory would suggest.

But I digress. None of this makes any impression on Benes and Kumhof. In fact, Benes and Kumhof seem decidedly uninterested in monetary theory, business cycle theory, or the Austrian School. There is no mention of Mises or Hayek, and only Carl Menger is mentioned – in a footnote and disapprovingly.

Instead, the paper sets up an entirely new and I believe bogus problem based on the premise that in our monetary system money is supposedly provided ‘privately’, that is, by ‘private’ banks, and ‘state-issued’ money only plays a minor role. From this rather confused observation, the paper derives its key allegation that ‘state-issued money’ ensures stability, while ‘privately-issued money’ leads to instability. This claim is not supported by economic theory and certainly not by anything in the Austrian School or, for that matter in Friedman’s Monetarism or Irving Fisher’s original plan. Monetary theory does not distinguish between ‘state-controlled money’ and ‘privately produced’ money, it is a nonsensical distinction for any monetary theorist. An attempt to give credence to this distinction and its alleged importance is made in a later chapter in the Benes/Kumhof paper but, tellingly, this attempt is not based on monetary theory but on an ambitious, if not to say bizarre, re-writing of the historical record.

Benes and Kumhof create an artificial problem

For any analysis of the present financial system a distinction between state-created money and privately created money is entirely artificial and of no help whatsoever, because in our system money is created in a process in which ‘private’ banks are intimately connected with the state central bank. Any distinction between ‘private’ and ‘state’ is thus arbitrary and for an analysis of the economic consequences of such a system meaningless. Yes, most money in circulation today is deposit money and sits on the balance sheets of nominally ‘private’ banks, but the reserves are state fiat money, only to be created by the state central bank, which the nominally private banks have to have an account with in order to receive a banking license. Fractional-reserve-banks rely crucially on state-sponsored and state-controlled central banks that have a lender-of-last-resort function and that can – in a fiat money system – create bank reserves at will, no cost, and without limit, and are, under normal circumstances willing to do so to backstop the banks. Without this crucial backstop fractional-reserve banking on the scale on which it has been practiced in recent years and decades would be inconceivable. In their description of the present system, Benes and Kumhof take no account of any of this. Frankly, they do not appear to understand it.

Here are two statements from the IMF paper that may at first appear sensible but that on closer inspection reveal the grave misunderstanding of our present system by Benes and Kumhof:

“In a financial system with little or no reserve backing for deposits, and with government-issued cash having a very small role relative to bank deposits, the creation of a nation’s broad monetary aggregates depends almost entirely on banks’ willingness to supply deposits.” (page 5)

But what determines the willingness of the banks to supply deposits? Fractional-reserve banking (supplying deposits) is lucrative but also risky for the banks as the public can demand redemption of deposits in cash or in transfers to other banks, and banks cannot create cash or the reserve money required to facilitate transfers. These forms of money remain the prerogative of the state central bank. It is the certainty, or high probability, under present institutional arrangements that the central bank will support the banks and continue to supply whatever amount of cash and reserves is needed, that allows the banks to supply – very profitably, of course – vast amounts of deposit money on the basis of small reserve money. Should the public demand payment in cash, the central bank can reasonably be expected to stand by the banks and supply the needed cash.

In recent decades, the global banking system found itself on numerous occasions in a position in which it felt that it had taken on too much financial risk and that a deleveraging and a shrinking of its balance sheet was advisable. I would suggest that this was the case in 1987, 1992/3, 1998, 2001/2, and certainly 2007/8. Yet, on each of these occasions, the broader economic fallout from such a de-risking strategy was deemed unwanted or even unacceptable for political reasons, and the central banks offered ample new bank reserves at very low cost in order to discourage money contraction and encourage further money expansion, i.e. additional fractional-reserve banking. It is any wonder that banks continued to produce vast amounts of deposit money – profitably, of course? Can the result really be blamed on ‘private’ initiative?

Fractional-reserve banking on today’s scale requires two things: 1) a state-sponsored central bank that has the monopoly of bank reserve-provision and that has a lender-of-last resort function for the banking industry; 2) the central bank must have complete control over bank reserves and be able to create them at no cost and without limit. In short, the precondition for large-scale fractional-reserve banking is a complete, unrestricted fiat money system. By contrast, the ability of the central bank to create reserves is fundamentally restricted under a gold standard.

The gold standard was abolished and replaced with a system of entirely unconstrained state fiat money through an act of politics. The state established monopolistic central banks that have a lender-of-last-resort function for the banking sector. The state thus created the infrastructure that allows banks to supply vast amounts of deposits, and over the decades has repeatedly subsidized this activity and socialized its risks.

Here is the second statement by Benes and Kumhof:

“The control of credit growth would become much more straightforward because banks would no longer be able, as they are today, to generate their own funding, deposits, in the act of lending, an extraordinary privilege that is not enjoyed by any other type of business.” (page 5)

But what exactly constitutes the privilege? – In a free society, you are, of course, free to issue your own fiduciary media – just issue checks against yourself and have them circulate as money surrogates. You will probably have to convince the public that you will convert these checks into money proper on demand in order to persuade the public to use the checks as money equivalents, and even then you may not succeed. But if the public believes you and your endeavor is successful, you have indeed become a money-producer and can fund your own lending with your checks. In fact, this is pretty much how fractional-reserve-banking originated. So far no privilege. It only becomes a privileged business, and possible on the scale we see it today, once the state supports it. The ‘Austrian’ solution is straightforward: remove the privilege! Without fiat money, central banks and state-sponsored deposit insurance, let us see how much ‘private’ money creation there really is!

No theory but revisionist history

Benes and Kumhof try to argue in a separate part of the paper that the distinction between ‘privately produced’ money and ‘state-produced’ money is meaningful and important.  Here, they completely depart from any traditional analysis of money or even any that could still be called ‘economic’. An economic analysis of money understands money as a useful social institution and thus starts with an inquiry of what money is used for in general, including today by today’s money users (that includes you and me), and tries to explain, based on reasoning, what would therefore make for good money in a general context, including the present one. Benes and Kumhof, however, do not argue conceptually as economic theoreticians but as (re-)interpreters of history. History can tell us what is good money and how it comes about. The anthropologists and monetary historians Benes and Kumhof quote claim that because money originated – supposedly – with the state its issuance is best controlled by the state. Again, no economic – conceptual, logical, theoretical – explanation is given for why that should be the case and why this could be upheld as a general rule. Allegedly, history tells us that the state is a responsible issuer of money and the private sector an irresponsible one. And that’s that.

The interpretation of the historical record that is provided in support of this allegation ranges from the adventurous to the outright bizarre. Instances in which the redeemability of deposit money in gold and silver was abandoned by official decree and vast amounts of fiat money were created to fund wars, revolutions or other state expenditures, such as during the Revolutionary War in America, the Civil War in America, or 1920s Weimar Germany, are reinterpreted to show that the ensuing inflations and outright currency disasters cannot be blamed on the state but are entirely the result of the involvement of ‘private’ money issuers.

“Colonial paper monies issued by individual states were of the greatest economic advantage to the country…The Continental Currency issued during the revolutionary war was crucial for allowing the Continental Congress to finance the war effort. There was no over-issuance by the colonies,… The Greenbacks issued by Lincoln during the Civil War were again a crucial tool for financing the war effort, [Hooray! Another war courtesy of paper money! DS] … The one blemish on the record of government money issuance was deflationary rather than inflationary in nature.”

Really? – The ‘colonials’ that were issued to fund the war with Britain ended up worthless, and to this day there is the idiom “worthless as a continental” in the American language. The period of the Civil War, too, was one of unusually high inflation, and in 1879 the USA decided to go back on a gold standard, at which point a period of considerable growth and rising prosperity set in.

While the enthusiasm for paper-money-funded wars on the part of Benes and Kumhof is already a bit disturbing, what is particularly striking is that Benes and Kumhof, and the ‘historians’ they quote (in particular the activists David Graeber, an anthropologist and leading figure of the Occupy Wall Street movement, and Stephen Zarlenga, founder and director of the American Monetary Institute), try nothing short of a complete re-writing of economic history and suggest conclusions – not only in one instance but throughout ALL of monetary history – that not only fly in the face of the generally accepted historical record but also common sense. The state as a monopoly-issuer of money with no restriction whatsoever becomes a trusted guardian of the common weal – simply by being a state!

Their whole argument gets kooky in the extreme when they address more recent instances of fiat money currency disasters, for which we not only have ample documentation that supports the opposite interpretation but which some of the most distinguished monetary theorists actually lived through themselves and experienced first hand – and which they explained succinctly.

Ludwig von Mises wrote a seminal book on monetary theory in 1912 (Theories des Geldes und der Umlaufmittel), in which he laid the foundations for the Austrian Business Cycle Theory and in which he predicted (!) the European hyperinflations of the 1920s. He lived through the hyperinflation in Austria in 1923, and, as the chief economist of the Vienna Chamber of Commerce, was in direct contact with the key players in government and central bank. He later wrote his memoirs.

Benes and Kumhof now claim that all these accounts are simply wrong. The main culprit was not the state but the private sector. We only have to ask state officials (!) and they can tell us what really happened. Here is the IMF working paper, page 17:

“The Reichsbank president at the time, Hjalmar Schacht, put the record straight on the real causes of that episode in Schacht (1967).”

According to Benes/Kumhof, Schacht blames the inflation on aggressive money creation by the private sector but his account also suggests that this was only possible because the Reichsbank generously redeemed deposit money in Reichsmark, that is, the central bank provided essential support for money expansion. With a generous backstop from the state the private sector will, of course, create money. But does that mean the state had nothing to do with the whole debacle? Kumhof, Benes and their prime source, Zarlenga, seem to not understand the role of central banks and the essential ingredient of state-backing for large-scale fractional-reserve banking. Furthermore, Schacht is a source of a somewhat dubious reliability in this debate. Schacht became a Hitler supporter later on, introduced socialist New-Deal-type policies in Germany, and helped the Nazis with re-armament and plans for German autarky. I am not saying this to discredit Schacht as an economic observer, only to highlight that he had – and this is probably an understatement – a considerable pro-state bias in all his economic views and is hardly an objective observer on the question of whether the state can be trusted with money. (As an aside, all totalitarian ideologies are anti-gold and pro-paper money and central banks. The Socialists, the Communists, the National-Socialists, the Fascists – they all hated to see the state restrained in its manoeuvrability by a gold standard.)

Benes and Kumhof’s case simply ignores the numerous historical accounts that paint a very different picture, such as the work by English historian Adam Ferguson whose seminal book “When Money Dies” has recently found a wide new readership. It ignores the eye-witness reports of one of the most distinguished economists of the 20th century, Ludwig von Mises, or the work of Swiss monetary historian Peter Bernholz.

I am not a historian and I want to be careful in dismissing challenges to the established historical record out of hand, but the account presented here strikes me as simply ridiculous, unscientific, mystical pro-state propaganda. As a scientific argument it is without merit.

But almost the worst aspect of it is this: where are the economics, where is conceptual analysis and reasoning? Even if we accepted – simply for argument’s sake and contrary to the overwhelming evidence to the contrary – that the state has more often than not been a good guardian of the money privilege, what are the explanations for this, what are the theoretical and conceptual arguments that underpin this historical pattern? Could we rely on this always being the case? If it is in the “nature of money” (Benes/Kumhof) to be provided by the state, is it therefore in the “nature of the state” to always provide good money, or would we need specific institutional arrangements, legal frameworks, or some ‘good-money’-culture or tradition for this to be the case? Of course, Benes and Kumhof provide no answers.

This part of the paper is simply unscientific because the argument is essentially mystical. The whole idea that a socially useful institution such as money can only be understood if we understand its “nature”, which does not derive from how people use it (including you and me today) but from how it came into being thousands of years ago, is nothing if not rooted in mysticism.

Money is a tool, and so are hammers. If I asked you to tell me what a hammer is for, what makes for a good hammer and a bad hammer, and what type of hammer I need for a specific purpose, would you tell me that I first have to understand the “nature” of the hammer, and to do so I would have to ask anthropologists how the first hammers came into being and what the first hammers or hammer-like tools were used for?

Mystical assets

Remember what I said above about circulating your own checks as fiduciary media? That is a pretty good description of paper money issuance. The newly circulated paper money is accounted for as a liability on the balance sheet of the paper money creator, and the things he acquires through issuing/spending this new paper money become the corresponding assets. By issuing paper money the money creator lengthens his balance sheet, while those who transact with the money-creator neither lengthen nor shorten their balance sheets but exchange positions on the asset side of their balance sheets, they replace other, previously held assets with new money.

This can also be observed in the creation of base money (extra bank reserves) by central banks today. When the Federal Reserve creates an extra $1 trillion as part of ‘quantitative easing’ and decides to buy mortgage-backed securities from its member-banks, then the Fed’s balance sheet expands by $1 trillion dollars. The new bank reserves are on the liability-side of its balance sheet, while the mortgage-backed securities are on the asset-side. The balance sheets of the banks do not expand as a result of the Fed operation. The banks simply replace mortgages with new reserves. Both are on the asset side of their balance sheets. Their asset-mix has changed. They now have more reserves.

This process could be extended until almost all bank assets have moved to the central bank and the banks are fully reserved and thus cease to be fractional-reserve banks. This was precisely the process that Irving Fisher had in mind when he wrote “100% Money” in 1935 (see page 57), and Milton Friedman when he wrote “A Program For Monetary Stability” in 1960.

At no point did any of these economists suggest, nor does any central bank today suggest, that the creation of new paper money enhances the overall wealth of society, that there is now more property in this society. It is also clear from this process that ‘debt forgiveness’ by the central bank is difficult. The central bank can issue enough reserve money to acquire all bank assets but whenever it writes down the book value of any of these assets it also has to shrink the liability side of its balance sheet, it has to destroy reserve money.

Benes and Kumhof now come up with an entirely novel approach. The state simply declares that its new reserve money is also an asset in its own right. Per decree the state creates wealth: Treasury Credit or commonwealth equity. The central bank books the new reserves on its liability side, just as in a conventional money creation process but now does not book existing assets against it that it acquires from whoever books the new reserves as assets (the banks). The corresponding asset is now ‘Treasury Credit’, which did not exist before but now comes into being per government decree. At this stage, the central bank’s balance sheet lengthens without any acquisition of new assets – the offsetting asset is created simultaneously with the reserve money liability!

The balance sheets of the banks now also lengthen: the banks book the new reserves on their asset side without (at this stage) transferring other assets to the money-issuer. The asset-side of their balance sheets lengthens. The corresponding lengthening of the liability side is achieved by booking ‘Treasury Credit’ as a liability.

It is this slight-of-hand that allows, in the following steps, various bank assets to get written off without a corresponding shrinking of reserve money. Only via the accounting gimmick of creating central bank assets out of thin air (and not just new central bank liabilities) and thus claiming that overall wealth – new assets – have been created administratively by the government can the large-scale debt write-off that is the paper’s allegedly strongest selling point, proceed.

All of this is state intervention in private contracts and property rights on a gigantic scale. The state may have the power to rewrite accounting rules and simply claim the existence of mysterious ‘government wealth’. Stranger things were claimed by governments in the 20th century. But what are the consequences? How will the public react? What confidence will it have in the new 100% state controlled monetary system?

Simply writing off all household debt is a mixed blessing. How would you feel if you worked hard and saved and did pay down your debt to give your family financial security, only to find out that your irresponsible and reckless neighbors, living high on the hog on credit cards, just saw all their debt wiped out by the Benes/Kumhof plan?

All power to the state!

This whole plan is nonsense on the greatest scale. Benes and Kumhof have thoroughly embarrassed themselves. Maybe we should simply look the other way and ignore this ill-conceived rubbish, maybe excuse it as the confused musings of two state-worshipping econometricians who fell under the spell of the New Age historicism of Graeber and Zarlenga, which they saw as a great opportunity for some fancy econometric modeling. But this comes with endorsement from the IMF, a major state-organization. Could it be that those who benefit from the accumulation of more state power feel that all the widespread banker-bashing and the erroneous but skillfully planted notion of the failure of capitalism can be turned even more to their advantage? Even the otherwise intervention-happy Ambrose Evans-Pritchard has his doubts:

Arguably, it would smother freedom and enthrone a Leviathan state. It might be even more irksome in the long run than rule by bankers.

Ambrose, for once I agree.

In the meantime, the debasement of paper money continues.

This article was previously published at


In defence of the euro: an Austrian perspective

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

1. Introduction: The Ideal Monetary System

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

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

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

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

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

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

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

To clarify his argument yet further, Hayek adds:

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

Hayek concludes:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

7. Conclusion: Hayek versus Keynes

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

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

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


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MISES, L. von. 1969. Omnipotent Government: The Rise of Total State and Total War. New Rochelle, New York: Arlington House.

MISES, L. von. 2009. The Theory of Money and Credit. Auburn, Alabama: Ludwig von Mises Institute. [First German edition, 1912.]

MISES, M. von. 1984. My Years with Ludwig von Mises. Iowa, USA: Center for Futures Education.

MUNDELL, R. 1961. “Optimal Currency Areas.” The American Economic Review, vol. 51, September, pp. 657-664.

O’CAITHNIA, B. 2011. “Compounding Agricultural Poverty: How the EU’s Common Agricultural Policy is Strangling European Recovery.” Institutions in Crisis: European Perspectives on the Recession. David Howden, ed. Cheltenham, UK and Northampton, USA: Edward Elgar, pp. 200-228.

SKIDELSKY, R. 2011. “The Keynes-Hayek Rematch.” August 19. La Vanguardia, October 6, p. 21.

SORMAN, G. 2011. “La crisis del euro no va a tener lugar.” ABC, October 30, p. 54.

STIGLITZ, J. 2012. “Después de la austeridad”. El Pais, Negocios, Sunday, May 13, p. 19.

ULRICH, F. 2011. “Fiscal Stimulus, Financial Ruin.” Institutions in Crisis: European Perspectives on the Recession. David Howden, ed. Cheltenham, UK and Northampton, USA: Edward Elgar, pp. 142-163.

VIDAL-FOLCH, X. 2012. “Heroica reconstrucción del estado fallido griego.” El País, Thursday, February 23, p. 21.

WHYTE, J. 2011. “The High Cost of a Cheap Pound.” The Wall Street Journal, May 17.

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

[2] Ibid., chapter 9.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

[17] Skidelsky 2011.

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

[19] Mundell 1961.

[20] Block 1999, 21.

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

[22] Huerta de Soto 2012 [1998].

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

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

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

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

[27] O’Caithnia 2011.

[28] Booth 2011.

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

[30] Huerta de Soto 2003 and 2009.

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

[32] Krugman 2012, Stiglitz 2012.

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

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

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

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

[37] Ibid.

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

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

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

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

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

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

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

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

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


ValueWalk interviews Detlev Schlichter

Reproduced by kind permission of at

Can you tell us a little bit about your background?

I studied economics in my home country, Germany, and joined J.P. Morgan as a trader in Frankfurt in 1990. By 1996 I had become a portfolio manager in J.P. Morgan’s asset management division and moved to London, which I still call my home. I specialized in European and global bond portfolios. From 1998 to 2001 I worked at Merrill Lynch Investment Managers, which has since become part of BlackRock, and in 2001 I joined Western Asset Management, the Pasadena-based bond specialist. For Western I oversaw their London-based investment team and was lead portfolio-manager for all their global strategies. When I left Western in 2009 my team there oversaw roughly $65 billion in assets under management for institutional clients from around the world. I look back on my years in the business with many fond memories. I worked with some interesting people and had some fascinating clients. But by 2009 I had become very pessimistic on our financial system as a result of my study of Austrian School economics and my own experience after almost two decades in the business. The two perspectives combined to form a rather unpleasant outlook. I wanted to step outside the industry, think things through, and write a book about it.

What investing style do you subscribe to?

I am not sure I subscribe to any identifiable style, or that I even consider it particularly desirable to do so. Let me explain. I spent almost 20 years in the institutional asset management business. There is very limited room to develop your own style to begin with. These companies are asset-gathering companies. They need to constantly grow and attract new clients. In order to do that they not only try to establish a decent track record but also a specific house style and a clear and distinguishable process that they can market. They try to create a brand. As a portfolio manager you have to play along and do things in a way that fits the process. Incidentally, that was something I was actually quite good at. Now it so happens that certain styles work for some time and then stop working. Markets constantly change. In the industry, however, whenever somebody has good numbers for a while and a good story about how those numbers have been generated, he is usually in a sweet spot. New clients come rushing in. But I have become very cynical in this regard. That is usually the moment you should sell these firms or money mangers. I accept that my take on the style-question is unusual. But that is how I see it.

The truth is I tried many different things over the years. Only now, that I am out on my own, outside the mainstream industry, can I look at things with an entirely open mind, which is refreshing. I like Doug Casey’s distinction between traders, investors and speculators. Many people call themselves investors when what they really do is trading. This is certainly true of many ‘investors’ in the asset management industry. I would now call myself a speculator. Most of the time you do nothing. Until you spot a major dislocation, or a major event or an opportunity, something that you have a completely different view on from most other people. That’s when you go in and take risk. Example: I am convinced this crisis is misunderstood by most. We are witnessing the failure of our fiat money system. This will get much worse. I try to position myself for it.

What attracted you to the Austrian school of thought?

I came across some writings by F.A. Hayek by chance more than twenty years ago. I can honestly say that I felt immediately that I was reading something special, something that made sense, that was true. I found it exceptionally convincing, and it made a huge impression on me. For the next four years I read everything Hayek wrote. Then, I discovered the other Austrians, Mises, Rothbard, Menger. To sum it up, I would say that it is the methodology that makes the Austrian School so special. Ludwig von Mises, for me, is the unsurpassed master of the Austrian School. He understood better than anybody what economics is about, what it can do and what it cannot do, and how it should go about it. Austrian School Economics starts with the individual actor. Purposeful individual action and human cooperation on markets is the driving force behind all economic phenomena. From the starting point of the individual, the Austrians reconstruct and explain all institutions of the market – from the bottom up, so to speak. By contrast, most modern economists approach economics as if it was a natural science, where we must collect observations, statistical data, and look for patterns. This is the right approach for natural sciences because in nature we can’t perceive of purposeful action. But we do understand the actions of humans in the economy. The approach can be and has to be different. Furthermore, macroeconomists implicitly assume that the statistical aggregates and the large wholes that they work with in their models (consumption, investment, retail spending, aggregate demand, and so forth) are what really interact with one another in the real world. This is a tremendous intellectual error. The economy is ultimately driven by countless individual decision-makers. The Austrians do not lose sight of that.

It is no surprise to me that the Austrian School has such a strong appeal for real-life entrepreneurs and risk-takers. No other school of thought understands entrepreneurship, risk-taking, capital accumulation and capital maintenance, relative prices and the real-life elements of time and error, like the Austrian School does. Of course, politicians, central bankers and state bureaucrats are, by contrast, drawn towards mainstream macroeconomics. It gives them the illusion that the economy can be planned and manipulated from the top down.

What inspired you to write a book?

When you begin to understand Austrian monetary theory you realize that our financial system is built on quicksand – elastic, constantly expanding fiat money to be produced without limit and at full discretion by the central banks. I realized that the growing instabilities and dislocations that I observed in my work-life as a portfolio manager over the past two decades were the inevitable consequence of our monetary infrastructure. What amazed me was that nobody around me saw it that way. Whenever a credit boom threatened to turn into a credit bust – as it sooner or later must – everybody was calling for a monetary stimulus, for lower rates and for policy accommodation to extend the credit boom further. Such a policy may indeed prevent a correction now, but only at the cost of making an even bigger correction necessary in the future. But everybody in financial markets is so indoctrinated with a specific and narrow subset of modern macroeconomics – I would say the most toxic aspects of Keynesianism and Monetarism – that everybody believes any policy to be a good one if it only creates some near-term GDP boost. There is no perception of long-term dislocations and market imbalances, of what the consequences of such a policy of artificially cheap credit must ultimately be. I think a gigantic intellectual bubble exists in which most financial market participants operate. That bubble will probably only get pricked by real events, i.e. the massive crisis that is now unfolding. But I wanted to try and give people a different perspective, to debunk some of the erroneous common wisdom that is readily accepted by so many people in the business.

Can you explain to people what your definition of money is?

Money is the medium of exchange. It is the most fungible good in the economy and therefore most readily facilitates exchange of property. It is neither a consumption good nor an investment good. We hold it not to satisfy any of our consumption needs, nor to generate a return. We have demand for it because it gives us flexibility. To hold money balances means to hold purchasing power in its most readily tradable form.

Capitalism developed on the basis of inelastic, inflexible and apolitical commodity money, such as gold and silver – inelastic in its supply and outside political control. Today we live in a world of entirely elastic paper money under discretion of the state, and for the first time in history, such a system spans the entire globe. Remember also, that today’s fiat money system only came into full bloom on August 15, 1971.

Today, most mainstream economists maintain that the perfect elasticity of the money supply is a plus. My book argues that this is wrong. The relative inelasticity of gold makes gold a superior form of money. Elastic money systems must ultimately collapse. Throughout history they always have.

Can you tell us about the US system pre-Fed era?

I should stress first that I am not a monetary historian, although there is a short chapter on the history of paper money systems in my book – all of these systems collapsed by the way. Understanding monetary systems requires theory. History can illuminate concepts or raise new questions. Only theory can explain.

Prior to the founding of a central bank, the Federal Reserve, in 1913 and the subsequent abandonment of a gold anchor in 1933 (domestically) and 1971 (internationally), the US used, for the most part, commodity money. I say ‘for the most part’ as America conducted some interesting experiments with paper money as well, all of them complete disasters. In fact, one of the first historic examples of a paper money system outside Medieval China, was Massachusetts, which, in 1690 when still a British colony, issued paper money to fund military excursions into French Quebec. Then there were the famous continentals, a paper money issued by the Continental Congress in 1775 to fund the Revolutionary War. These early experiments with paper money ended like they always do – with worthless paper tickets. Then in the early part of the 19th century the dollar was defined as a specific amount of gold. This was proper commodity money, a gold standard. There was no central bank. Gold was money. Commercial banks had to redeem their banknotes in specie, which set tight limits on bank credit creation. But the government couldn’t stop interfering, in particular whenever it needed cheap credit, usually to fund wars. Requirements to redeem in physical gold were lifted on a couple of occasions, so in the wake of the War of 1812, when the US was fighting Britain again, and most famously during the Civil War, when the greenbacks were issued and soon inflated into worthlessness. In 1879, the US joined Britain, and in fact most of the then industrialized world, in what became known as the Classical Gold Standard. After the inflation of the greenback era, a corrective deflation was allowed to unfold (but strong economic growth continued nevertheless), and from 1879 to 1914 there was no meaningful deflation or inflation in the system at all. This was a time of hard, inflexible and stable money. This was a period– in the US and globally – of solid economic growth, rising living standards and growing international trade, and of harmonious economic relationships between countries. The Classical Gold Standard was not perfect but probably the best monetary system we have had so far.

Many people have proposed going back to the gold standard? We had many depressions and recessions while on the gold standard, do you think it would be a good idea?

Yes, we should definitely return to a gold standard — not one that is “managed” by the government, but a proper gold standard with no involvement of the state. I wouldn’t hold my breath, however. As we have seen, governments love fiat money. It gives them control over the economy. We will eventually return to some form of gold standard but only after the complete collapse of the present system in a major crisis.

The elasticity of money – which means periods of money expansion and credit booms followed by periods of monetary stagnation or contraction – is the main cause of business cycles. How did this occur under a gold standard? Answer: the spread of deposit banking and fractional-reserve banking, in particular in the late 19th century. These banking practices introduced an element of elasticity into the money supply. They can be profitable for the banks but they are risky and are destabilizing for the broader economy, even under gold standard conditions. That is why many Austrians argue for a 100-percent gold standard, for 100 percent reserve banking. I am not in that camp. I think fractional-reserve banking should not be banned, cannot be banned, and ultimately does not need to be banned. Many of these issues can be solved in a free market. We may have the occasional recession but the system can cope with that.

However, the Fed was founded in a joined effort by politicians and bankers in order not to restrict and contain fractional-reserve banking but, to the contrary, in order to encourage and subsidize it. Money has since not become less elastic but much more elastic. Of course, credit cycles still occur. They now only get much, much bigger. We had a thirty-year credit boom. We will now get a major credit bust. Compared to what we are facing now, the recessions of the gold standard era will look like a walk in the park.

Why do most policy makers seem to be in the Keynesian school and not the Austrian school of thought?

Please remember my answer to the question above about the appeal of the Austrian School. The methodology of the Austrians is superior, but the methodology of mainstream macroeconomics, and Keynesianism in particular, is appealing to politicians. These schools perceive the economy as an organism that sometimes performs below potential, which then provides a convenient excuse for the politicians to get involved. Keynesianism has popularized the concept of ‘aggregate demand’. A recession is now seen simply as a lack of aggregate demand. So politicians have a pseudo-scientific excuse to run deficits and spend money they don’t have. Strangely, the fact that “lack of aggregate demand” can at best be a symptom but hardly an explanation of the recession does not appear to bother too many people.

Truth is, the recession is the result of imbalances that the economy accumulated during the previous artificial credit boom. Once these dislocations (such as excessive levels of debt, overextended banks and inflated asset markets) exist, the cleansing of a recession is needed and unavoidable. That is not a popular message among politicians.

Greece was forced to implement austerity and the budget deficit as % of GDP went up and unemployment skyrocketed. What are your thoughts on the reason why this occurred?

That is not surprising at all. You have to remember that in today’s world GDP is a very poor measure of economic health. In the EU, 50 percent of recorded economic activity is conducted by the public sector. In my adopted home country, the UK, it is 53 percent. The public sector spends more money than all private individuals and corporations put together. This is more socialism than capitalism.

We don’t have to assume that everything the state does is pure waste. For some of these things there would be a proper demand even in a state-less free market. However, we – and in fact the state bureaucrats as well – have no means of telling what is truly demanded by the buying public and what is of marginal or of no productivity, and what is thus complete waste, because the public sector operates outside of market prices and without the guidance of profit and loss. But whatever the state does enters the GDP statistic just the same.

So whenever the state is being cut back – which hardly ever happens, only in cases of default, which is why I am a big advocate of government defaults – a lot of things drop out of the GDP statistics and unemployment goes up because public sector employees are laid off. This drop in GDP is not a lasting problem. We know that a lot of state activity was at least suboptimal to begin with. Now resources (including labor) are being redirected to the private sector, where they will eventually be employed again, and this will enhance wealth and prosperity in the long run. In my view, Greece should stop paying anything to her creditors, declare full default, and shrink the state drastically. For a short while, the statistics would look dreadful. Then Greece would have a massive and lasting recovery. With no debt, a small state and a free economy it could, after some time, outperform everybody else in Europe.

Taxes went up in the Clinton era and the economy still boomed, do you think slightly increasing taxes will be detrimental to the economy?

I object to taxes for moral and ethical reasons (which are subjective) and economic considerations (which are objective). Taxes are always detrimental to the economy. They were so, too, under Clinton. It so happened that other things outweighed their negative impact. Remember, the mega credit boom that started in the early 80s was still in full swing, the Greenspan put was still operable, the NASDAQ bubble was still being inflated. Some of the growth of those years was genuine, that is, based on entrepreneurship, capital creation and innovation, but a lot of it was also the result of easy money. Under these circumstances the tax hikes were not felt that much, that is all.

Today’s environment is very different. The credit boom has ended, and has ended for good. The state and the financial sector have benefitted most from decades of cheap credit and are now severely overstretched. The economy overall is much weaker. Higher taxes would be detrimental. Also, the idea that the gigantic government deficits could be closed with higher taxes is idiotic. To the US I would give the same advice as I just gave to Greece: default, shrink the state massively, go back to hard money. Alas, they won’t do it.

I am curious what you think about the major currencies; Dollar, Euro, Yen, some of the emerging countries?

They are all locked in a deadly race to the bottom. All these currency-areas face the same problems, which are the typical problems of a fiat money system reaching its endgame: massive public debt, uncontrollable deficits, weak banks, addiction to cheap credit and constant asset price inflation. None of these governments want to face up to the reality that they are broke and that what the economy needs is for the market to be allowed to liquidate unsustainable levels of debt and other economic imbalances. As that is deemed politically unacceptable, they will continue to try and buy time by producing ever more currency units and injecting them into financial markets. Inflation and currency destruction will be the endgame. I would stay away from paper money as much as I can. Buy gold and silver instead, and certain other real assets. To guess which of these paper currencies will hit the bottom first is a mug’s game, in my view.

Is inflation or deflation a bigger threat right now?

Inflation and deflation are both unpleasant but it is wrong to call them both an equal threat right now. Allowing deflation now would have a clear advantage, namely it would bring the economy back to a state of balance and toward more proportionate and sustainable structures. A deflationary correction that would allow the liquidation of market dislocations would be painful but it would ultimately restore the economy to health.

If all market interventions, including cheap money from the Fed, would cease now, we would indeed face a sharp economic contraction and most likely a period of deflation. But this is ultimately unavoidable anyway. Current economic structures are simply unsustainable, and the market has a way of dealing with what is unsustainable: liquidate it. The market is craving a cleansing recession, including drops in certain prices. As I said before, this is deemed politically unacceptable. That is why we will get ever more aggressive monetary policy and ever more money printing. This will not solve our problems but it will lead to inflation and most likely complete currency collapse. My outlook for the coming years is inflation, much higher inflation, not deflation. The reason for that is policy.

Hopefully you won’t consider the following analogy tasteless but to ask what is the bigger threat, inflation or deflation, is a bit like asking a cancer patient what is the bigger threat, death or chemotherapy. Nobody will readily embrace either. But it appears to me that in constantly telling us that we need to avoid deflation at all cost, today’s policy establishment is telling us that we should avoid chemotherapy and accept death by hyperinflation.

What are your opinions on Gold?

Gold is the essential self-defense asset. Whenever fiat money systems enter their endgame and are about to collapse, gold comes back. It is the eternal form of money. As Greenspan once said (and he said it when he was already the head the world’s foremost paper money central bank): In extremis, nobody accepts paper money. Gold will always be accepted.

At its current price of $1,720 an ounce I still consider it cheap. Much more fiat money will be created in coming months and years. You want to own something that is not simultaneously somebody else’s liability (such “money in the bank” on your deposit or savings account) and that cannot be created for political purposes at will and without limit, such as paper dollars.

Don’t trade gold, accumulate it.

QEII, Operation Twist, thoughts?

These operations get ever more extreme. It is just part of the logic of the system. We are in a mess because of the trillions that were created out of thin air in the past. To keep the system going a bit longer, the central banks now have to produce ever more money ever faster. Will it stimulate the economy? Yeah, right.

Like a little hamster in his wheel, Bernanke will have to run ever faster to keep the printing press humming and keep the system from correcting. We will get QE 3 and QE 4, no question. By the way, Operation Twist could already be QE3 in disguise. On the face of it, the Fed is just selling short duration Treasuries and buying long duration Treasuries. But the Fed also promised to keep interbank rates near zero for a long time (meaning: forever), and to achieve that they may be buying back short-term Treasuries pretty soon. Listen, there are no exit strategies. The Fed’s balance sheet will continue to grow. It is already bigger than M1. We will get more and more money……

Flashback to September 2008, what do you think the Government should have done?

Nothing. I like Jim Grant’s term: “constructive inaction”. If you believe that the Fed and the government saved us from another Great Depression with all their bailouts and quantitative easing, think again. All they did was postpone the depression – and to make the final disaster worse. All these imbalances are still with us, many of them are larger and have been moved to the state’s balance sheet. Nothing is fixed.

But if you think that this advice – do nothing – is unrealistic and that the government, after having actively supported the build-up of this credit edifice for decades, cannot simply walk away from it once the house of cards finally unravels, then I would suggest the following: Any actions by the government should have been directed toward sustaining the payment infrastructure and maybe to minimize the fallout for bank depositors, who for a long time have actively be lured into entrusting their savings to an increasingly leveraged, government-supported banking system, which has now checkmated itself. I am not suggesting a debt-funded bailout of the deposit base. But the US government allegedly sits on 260 million ounces of gold, some of it confiscated from its own population. Current market value: $450 billion. That could have been handed back to the banks as a backstop against their deposits. This could have been the first step towards abolishing the Fed and returning the country to a gold standard.

If you were Ben Bernanke what would you do now?

Abdicate. His mandate is contradictory and impossible. He is supposed to provide a stable medium of exchange for the American public, and at the same time provide an unlimited backstop for Wall Street and Washington. Well, it is one or the other. We already know which one he chose.

Same question, Barack Obama?

Abdicate is again a good option.

I am not an American so I am looking at this from a distance. It strikes me that the presidencies of George W. Bush and Barrack Obama were both unmitigated disasters for their country. I don’t even think the two as men are necessarily bad or evil. As individuals they may be decent and have good intentions. But the politics are just shockingly bad. The growth of the state, of government involvement in the economy and in all walks of life, the budget deficits, the ever-growing debt pile, the aggressive monetization of debt and the dependency on cheap credit and ongoing market manipulation – this is a complete shipwreck by any standard but, if I may say so, particularly shameful for a country that for freedom-loving people around the world was once a beacon of liberty, opportunity and capitalism. As a generally pro-American libertarian, I can’t tell you how much it hurts to see this once great country go to bits like this.

What needs to be done? Stop printing money, return the country to a gold standard, default on the debt (it will never be repaid anyway!), shrink the state aggressively, stop all foreign wars – the military is the government’s biggest single expenditure item at close to $1 trillion a year.

If you think this is unrealistic then let me tell you that I think all of this will ultimately happen – but not by choice but by necessity, as a result of a massive crisis.

If you were Angela Merkel or Jean-Claude Trichet?

I think that what I said about Bernanke and Obama broadly applies to Merkel and Trichet as well. At the core, the problems are the same. Europe’s problem is not that many different countries share the same currency. Many more and much more different countries did the same between 1879 and 1914 under the gold standard, and it worked very well. The problem is precisely that they do not share an international, apolitical and inelastic commodity money, but a fully elastic and politicized fiat money that comes with built-in expectations of government and bank bailouts. Stop printing money, return to hard and de-politicized money, preferably a gold standard, and shrink the state – the advice is the same.

Who are you endorsing for US President? Ron Paul?

I think the entire political process, not only in the US, but in all modern mass democracies, has become a most degrading and dispiriting spectacle. I agree with P.J. O’Rourke: Don’t vote. It only encourages the bastards. Politics needs to be thoroughly delegitimized as a problem-solving device. It creates more problems than it solves. So I am not endorsing anybody.

Having said this, Ron Paul is, of course, by far the best choice from my point of view. I don’t think that this will surprise you considering what I said above. He is right about ending the wars, abolishing the Fed, returning to a gold standard, shrinking the state. But I fear that he doesn’t have a snowball’s chance in hell to win the presidency. So the crisis will continue. Don’t bet on politics. Trust your own reason. Be prepared.

This article was originally published at on the 31st of October: Interview with Austrian Economist and Author: Detlev Schlichter

The curse of Babel

A very old and well known story is told in Genesis 11. It is the story of the curse of Babel:

Now the whole world had one language and a common speech. As people moved eastward, they found a plain in Shinar and settled there.

They said to each other, “Come, let’s make bricks and bake them thoroughly.” They used brick instead of stone, and tar for mortar. Then they said, “Come, let us build ourselves a city, with a tower that reaches to the heavens, so that we may make a name for ourselves; otherwise we will be scattered over the face of the whole earth.”

But the LORD came down to see the city and the tower the people were building. The LORD said, “If as one people speaking the same language they have begun to do this, then nothing they plan to do will be impossible for them. Come, let us go down and confuse their language so they will not understand each other.”

So the LORD scattered them from there over all the earth, and they stopped building the city. That is why it was called Babel—because there the LORD confused the language of the whole world. From there the LORD scattered them over the face of the whole earth.

I retell this tale not for the sake of the theology but for the sake of our present debates. In what follows, the names have been omitted in the hope that I may be excused any hint of misrepresentation…

When I first approached a prominent worldwide leader of the Austrian School, in frustration at the pitiful state of economic debate, to ask who were the UK’s best Austrians, with a view to starting a UK-based Austrian-School think tank, things seemed ever so easy. I had mostly read Mises and a touch of Rothbard. I understood the Austrian school and the monetary theory of the trade cycle but I was not broadly read into the scholarly debate over money.

And then I discovered the curse of Babel amongst the monetary scholars of the free-market.

One eminent free-market British academic believes that central banking, fiat money and fractional reserve deposit taking are institutions which have evolved naturally in society and which should be preserved. He believes the Bank of England should be privatised.

Most Monetarists seem to think central banking and fiat money are just fine, together with the Keynesians, some of whom at least think they are free market, but some advocate various forms of full-reserve banking.

Most, perhaps all, Austrians think the central banks are a plain instrument of statism which should be abolished, together with deposit insurance, legal tender laws and various other privileges. They reject fiat money outright, more often than not, as a creature of interventionism and a tool of the enemies of liberty.

But one faction believes that fractional reserve deposit taking is a breach of sound property rights — a thoroughly libertarian concept — and that it emerged out of fraud to be legitimised by the state.

The other faction pay little heed to the theory of property rights in demand deposits, emphasising freedom of contract. They believe fractional reserve deposit taking is a natural and honest phenomenon which enjoys the consent of depositors. They argue that full-reserve deposit taking is only ever a product of the state and deride the full-reservers willingness to restrict freedom.

Amongst all this, the protagonists accuse one another variously of economic or legal ignorance or a misinterpretation of history. All sides have their scholars and their literature.  Both factions claim the term “free banking” as a rejection of central banking. Sometimes they claim the support of the same scholars…

It seems once we go beyond money as the means of exchange, universal agreement stops. Truly, when it comes to the institutional arrangements for money, we are under the curse of Babel.

It is a pity then that money is dying.

Right across the western world and perhaps shortly in China, we see state-supplied money running out of control, with all the distortions and maladjustments that implies, across sectors, regions and time. It seems the state’s response to every setback is more borrowing and more debasement. Unable to sensibly measure the money supply and unsure whether circumstances are inflationary or deflationary, the authorities wrestle to prop up a system damned by its own inadvertent design, a design which emerged out of the failure of Bretton Woods, itself a system condemned to a youthful death.

Five years ago, I would have wondered how the monetary authorities of the Weimar Republic could be so stupid…

At The Cobden Centre, we are agreed that honest money is a product of the market subject to the laws of property and contract, not the will of authority. With Richard Cobden, we agree that the very terms of regulating and managing the currency are an absurdity: the currency should regulate itself. Unfortunately and despite endless study, we seem to be able to agree neither what the proper institutions of such a system would be nor how to get there.

We have previously published an admittedly incomplete list of ten plans for reform. Since I agree with Sir Mervyn King (PDF) in that “of all the many ways of organising banking, the worst is the one we have today”, I could happily accept most of them as a step forward. Perhaps Bagus’ “button-pushing” withdrawal of the state would have disruptive consequences beyond our imagination but it seems mere perseverance with our present system is little more predictable, except in as much as it shall fail.

The original curse of Babel was cast, it seems, to prevent a people speaking as one: for speaking as one, nothing they planned to do would be impossible for them. Perhaps we shall not aspire so high, but we must change if we are to rise above the level of The People’s Front of Judea and win a battle which, it seems, must be won in our lifetimes.


A Note on the Notice of Withdrawal Clause

Regular readers of this site may be aware of a debate relating to the contractual devices that banks might use to ensure that they are solvent. One of the terms that has been used is a “notice of withdrawal clause”, but what is this?

It might be argued that a notice of withdrawal clause (or a “withdrawal clause”) is merely another term for the more often invoked “option clause”. This has received extensive treatment in the “free banking” literature (for example Dowd (1988), Selgin & White (1994, 1997)), and we can use the following definition:

option clauses… give banks the option of deferring redemption of their notes provided that they later pay compensation to the noteholders whose demands for redemption are deferred” (Dowd, 1998, p.319)

The confusion may stem from the fact that in some instances option clauses and withdrawal clauses are used interchangeably. For example Selgin & White (1997) say:

one possible run-proofing device discussed in the literature is an “option clause” or “notice of withdrawal clause” allowing a bank temporarily to suspend the redeemability of some or all of its liabilities (notes or demand deposits) provided the bank pays a pre-specified (penalty) rate of interest on the suspended liabilities

However, I believe there is stronger textual support for the idea that they are distinct devices. In an earlier article Selgin & White (1994) say the following:

a bank might contractually reserve the option to suspend for a limited time the redeemability of its notes or demand deposits, as Scottish banks did with banknotes before 1765 (when the practice was outlawed) and as banks do today when they include “notices of withdrawal” clauses in deposit contracts

My reading is that they are often used interchangeably (or perhaps as though a withdrawal clause is a type of option clause), because they perform the same economic function. But a detailed reading would reveal them to be different.

In my working paper on the sound money debate I define a withdrawal clause as follows:

In addition to the option clause banks might also offer (and historically did offer) a “notice of withdrawal” clause, specifying that their customers were required to give 

30 days notice prior to making a redemption claim. The fact that this clause existed (to protect the bank from a legal point of view if it were ever to suffer a liquidity crisis) does not mean it is always invoked, and banks could routinely not enforce this rule and satisfy immediate redemption requests.

Firstly, note that this is presented as a different clause to the option clause. But secondly, we can see that it differs from the option clause in terms of the default nature of the contract.

Recollect that an option clause allows banks – under certain conditions – to convert a demand deposit into a timed deposit (thus giving them time to generate liquidity whilst avoiding firesale losses). This is seen to be good for the banks (obviously!) but also good for the customers (since it’s better to receive the deposit plus interest at some point in the future than to see the bank being wiped out).

However in the case of the withdrawal clause there is a notice period written into the contract – it is technically a timed deposit (where the notice period serves as a minimum term). But if the bank wanted to offer an instant access account it can simply publicise the fact that it does not routinely enforce this notice period and that it satisfies redemptions on demand.

I suspect the reason withdrawal clauses received less explicit attention in the literature is that unlike the option clause they are not a uniquely “free banking” concept. Indeed, notices of withdrawal are routinely used in contemporary banking. Investopedia define it as follows:

A notice given to a bank by a depositor. As its name implies, a notice of withdrawal states the depositor’s intention to withdraw funds from an account. This notice applies to both time-deposit and NOW accounts

In short, the option clause means that a de jure demand deposit can be treated as a de facto timed deposit. The withdrawal clause means that a de jure timed deposit can be treated as a de facto demand deposit. They are two sides of the same coin – both allow instant access fractional reserve accounts, the only difference is the default position.

So perhaps provisions such as option clauses and withdrawal clauses allow banks to offer fractional reserve accounts that aren’t fraudulent or reliant on legal privilege, but does that make the 100% reserve argument wrong? Not necessarily. The withdrawal clause in particular “works” precisely because it changes the de jure status of the account. A counter argument might be “if a withdrawal clause applies to a timed deposit then you are admitting that fractional reserve banking is irreconcilable with demand deposits”. From the view of legal theory (and depending on your definitions), this may well be correct. However the de facto status of this account is instant access and redeemable “on demand”. In terms of the economic function of the account it exists exactly as “free bankers” envisage.



Horwitz: To the Opponents of Fractional Reserve Banking

Steven Horwitz writes

In some free-market circles fractional reserve banking (FRB) is blamed for everything from business cycles to bad breath. Defenders are seen as apologists for inflation and fraud. Thankfully these views remain a minority because they are gravely mistaken. As I, and other Austrian monetary theorists, such as George Selgin and Larry White, have argued, there’s nothing wrong with FRB that getting rid of a central bank can’t cure. Fractional reserve banking works just fine in a free market.

As you’d expect, his post has kicked off a lively discussion. The debate rolls on.


A third way: instant access by exception

Cross posted at and The Coordination Problem.

Come the Revolution, in a free banking world, where there is at least no lender of last resort, commodity backed money with no possibility of over issuing above that commodity in reserve and no deposit insurance, it would be possible for safe deposit accounts and savings accounts where money is lent to borrowers to exist. Both 100% Reserve Free Bankers and Fractional Reserve Free Bankers would be happy thus far. If an instant access demand deposit is offered that is fractional in nature, we get heated debate within the free banking community; the arguments will be familiar to readers of this site. So I am going to throw in a left field ball and see what comes out in debate about what I see as a potential solution to this. I will remain silent on the thread until all comments are in.

The Third Type of Account (not named yet, will not use 100% or Fractional in the title due to fear of the verbal abuse that will come forth!)

Consider this, a depositor goes into his bank, he is offered a safe deposit account that is safe, but gives no interest, his time preference is such that he wants to earn some interest. The bank worker shows him to his colleague who offers him a savings account. Our depositor loves the rate of interest offered, but notes that he has to put his money away for at least a month, 3,6,9, 18 months, X number of years to get a proceedingly better rate of interest. This does not satisfy our depositor as he wants to have instant access and interest. He wants to have his cake and eat it. He gets taken to see the Third Type of Account manager. This manager says this account is a timed deposit account in nature i.e. your money is locked away for at least a month, 3,6,9 18 months X number of years, but the bank will allow instant access, by exception for the liquidity that it keeps in reserve all the time. However, should there be too much call on liquidity, the bank reserves the right to point out that you the depositor are actually a de jure timed depositor / creditor to the bank for at least a month, 3,6,9 18 months X number of years and are going to he held to the time period you freely signed up to.

This third type of account always allows the bank to be reliant on no legal privilege and no accounting standard that is different to other commercial organisation to keep its current and long term creditors whole at all points in time as the creditor in question is in fact a timed depositor who has instant liquidity by exception and not by demand. The reality is this liquidity would be almost at all times there bar the period of bank runs. In fact, dare I say it (I can feel the avalanche of invective building up already) that this is a robust 100% reserve type account form an accounting an legal point of view, with all the benefits of a fractional reserve account of instant access, with none of the inflationary business cycle inducing consequences hotly alleged by the 100% Reserve Bankers.