The bankruptcy of governments

The following is a transcript of the “Adam Smith Lecture” I gave at a private gathering in London on 19 February.

For a long time governments have been redistributing peoples’ income and wealth in the name of fairness. They provide for the unemployed, the sick, and the elderly. The state provides. You can depend on the state. The result is nearly everyone in all advanced countries now depends on the state.

Unfortunately citizens are running out of accessible wealth. Having run out of our money, Governments are now themselves insolvent. They started printing money in a misguided attempt to manage our affairs for us and now have to print it just to survive. The final and inevitable outcome will be all major paper currencies will become worthless.

To appreciate the scale of these problems, we must understand the errors in economic and monetary policies. I shall start with economics.


Modern economists retreat into two comfort zones: empirical evidence and mathematics. They claim that because something has happened before, it will happen again. The weakness in this approach is to substitute precedence for the vagaries of human nature. We can never be sure of cause and effect. Human action is after all subjective and therefore inherently unpredictable.

The mathematicians like to think that economics is a physical science and is not a slippery social science. Economics is a branch of human psychology. It is plainly nonsensical to apply maths to human psychology.

The result is that much of the good work done by the classical economists like Adam Smith has been destroyed by modern economics. The classical economists explained the benefits of doing away with tariffs and the guilds. This revelation was instrumental to the industrial revolution. Then along came Marx who persuaded people that economics was a class interest, that free market economists were promoting the interests of the bourgeois businessman to the disadvantage of the worker. That became the justification for communism and socialism. Keynes and those that followed him never properly challenged Marxian fallacies. They were never involved in what became known as the socialist calculation debate.

It is not generally appreciated that Keynes was strongly socialistic. In the concluding remarks to his General Theory, Keynes looks forward to the euthanasia of the rentier (or saver) and that the State will eventually supply the resources for capital investment. He wanted the state to control profits.

Keynes was primarily a mathematician. Keynes was no more an economist than Karl Marx, whose beliefs led to the economic destruction of Russia and China; or John Law, who bankrupted France, with similar fallacies to those of Keynes.

The misconceptions of Keynesianism are so many that the great Austrian economist von Mises said that the only true statement to come out of the neo-British Cambridge school was “in the long run we are all dead”.

Let me define economics for you at the simplest level. We divide our labour. Each one of us is a consumer; an entrepreneur whether for wages or profit; and a saver for the future. We invest savings to improve production. Each of us discharges these three functions in the proportions we choose as individuals, we interact with others doing the same thing. We exchange our goods at mutually agreed prices using money to facilitate the exchange. We use money to keep score, and that money has to be sound for our calculations to mean anything. Together we are society itself, each providing things others want and will pay for.

The state has no role in this process. Instead it is a cost to society, because it takes some of our spending and savings to support itself. The more the state takes the greater the burden. It destroys society’s potential wealth. But it has not stopped there. Socialism forces the vast majority of people to give up saving and rely on the state to provide. Governments everywhere are now encumbered with obligations they cannot possibly discharge.


On the money side our mistakes go back to the Bank Charter Act of 1844.

The Bank Charter Act gave the Bank of England a note-issuing monopoly backed by gold and government debt. It failed to stop other banks issuing bank credit. This led to credit-driven business cycles which were socially destabilising, adding fuel to the various brands of communism and socialism that developed in the late nineteenth century.

Gold backing for the Bank of England’s notes was gradually eroded, starting in the late 1890s, with a number of countries, including Britain, abandoning it altogether in the interwar years. A gold-exchange standard was adopted for central banks at Bretton Woods. And finally President Nixon in August 1971 abandoned gold altogether.

Ever since then, the expansion of money supply has been increasing exponentially. Quantitative easing is now required to keep the pace of printing up, lest interest rates begin to rise.

Monetary policy from the 1920s has been used to manage an increasingly unstable global economy. The irony is that this instability has its origins in the expansion of money and credit itself. The growth of money supply and bank credit has as its counterpart debt. Few are the assets not encumbered with this debt. Asset prices need more money and credit to sustain them. It is a finite process that ended with the credit crunch five years ago.

That is the background. Now I shall look at the situation today, five years on from the credit crunch. There are four interlinked problems that cannot be resolved: the economy, the banks, government finances and population demographics.

The economy

The advanced economies have been progressively undermined by government intervention and unsound money. They are taxed and regulated to such a degree that laissez-faire hardly exists anymore.

Government spending typically amounts to 50% of GDP in the advanced economies; sometimes more, sometimes less. For productive businesses it is like running a marathon carrying a bureaucrat on your back who tells you how to run.

The misallocation of economic resources which is the result of decades of increasing government intervention cannot go on indefinitely. Businesses have stopped investing, which is why big business’s cash reserves are so high. Money is no longer being invested in production; it is going into asset bubbles. Dot-coms, residential property, and now on the back of zero interest rates government bonds and equities. These booms have hidden the underlying malaise. There can be no economic recovery. Our bureaucrat-carrying marathon runner is finally collapsing under his burden.

The burden of government is now too great to be sustained.


Banks are geared 25 to 30 times, which is fine if you can grow your way out of problems. That is no longer the case. They are vulnerable to existing but unrecognised bad debts, and now a fall in government bond prices. All that’s needed to trigger a collapse in the banks is absence of economic recovery. If we have a downturn it will be quicker. All that’s needed is a rise in interest rates, to reduce collateral values. All that’s needed is a fall in asset prices.

Then there is the shadow banking system, which the Bank for International Settlements reckoned amounts to over $60 trillion, of which $9 trillion is in the UK. If an investment bank goes under, the shadow banking system could make it virtually impossible to ring-fence the others.

Another area of risk is cross-border exposure. Cross border loans in Europe amount to EUR3.5tr. France is 1.2tr. Italy 700bn. Spain 500bn. These are only the obvious risks. Much of this is cross-border within the eurozone, meaning a default in any of those three is certain to wipe out the European banking system, and then everyone else’s.

For this not to happen requires the central banks to make available unlimited funds in the form of credit and raw money. As Mario Draghi said, whatever it takes. His solution is to print enough fiat currency to save the system.

Government finances.

From the time of the banking crisis, government finances have deteriorated sharply, and their debts rocketed. No country, except some in the Eurozone has managed to cut government spending, and only those which did, did so under extreme financial pressure and because they couldn’t print money. The fact is that everywhere government spending is increasingly mandated into pensions, social services and healthcare, which makes spending cuts extremely difficult.

Until recently it was assumed that economic recovery would generate the taxes to balance the books. That has not happened, nor can it happen. In the Eurozone governments are now taking on average over half of every working man’s income and deploying it unproductively. Take France. Government is 57% of GDP. The population is 66m, of which the employed working population is about 25m, 17m in the productive private sector. The taxes collected on 17m pay for the welfare of 66m. The taxes on 17m pay all government’s finances. The private sector is simply over-burdened and is being strangled.

The interest rates at which governments borrow are entirely artificial, made artificial by their own intervention in the debt markets. They are financing themselves by printing money to buy their own debt. The moment this ends, and it will, money will flow out of bonds, equities and even property priced on the back of low interest rates. The pressure for interest rates to rise will have to be met with yet more money printing, because governments cannot afford to pay higher interest rates, nor can they afford to see private sector asset values fall. Price inflation will create a real crisis, perhaps later this year.

Population demographics

Populations in the US, the UK, Japan and Europe are growing older. This is bad news for government finances. When someone retires, he stops paying income taxes and becomes a cost. High unemployment is also costly, because the unemployed are not funding future liabilities. Professor Kotlikoff of Boston University has calculated that in fiscal 2012 the net present value of the US Government’s future liabilities increased $11 trillion to $212tr. The whole US economy is only $15 trillion. Europe is worse, far worse: Europe has more pensioners as a proportion of the working population, high rates of unemployment and a large government relative to the private sector, which funds it all. The UK, taking these factors into account, is slightly worse off than the US. Japan has worse birth rates and longevity. They sell more nappies for the incontinent than they do for new-borns. The solution already is to issue increasing amounts of unsound currency.


The world’s economic problems have been building for a long time. Economic fallacies have been pursued first by Marx and then by Keynes in the 20th century, and monetary policy first took a wrong turn with the Bank Charter Act of 1844. The progressive replacement of sound money by fiat currency has destroyed economic calculation, and has destroyed private sector wealth. These policies were deliberate. We have now run out of accessible wealth to transfer from private individuals to governments. That is our true condition.

Governments will still seek to save themselves at the continuing expense of their citizens, and in the process destroy what wealth is left.

There can only be one outcome: the bankruptcy of governments. This means that their fiat currencies will inevitably lose all their purchasing power.

How soon? I’m afraid sooner than most people think. Japan is already entering the black hole, with her currency beginning its collapse. The UK is on the precipice and cannot afford further falls in sterling without triggering the rise in inflation that will force a rise in interest rates and a spiral into insolvency. Europe could go at any time. The US is probably the best of a very bad bunch, but even her economy is looking bad.

I do not make these statements because I am gloomy. I make them because I approach economics without emotion and without political bias. I make them because I have considered our true economic and monetary position using as far as I am able sound aprioristic theory applied to our current position.

Thank you.

This transcript was previously published at


AEP and “The Chicago Plan Revisited”

Towards the end of last year, Ambrose Evans-Pritchard discovered the IMF working paper “The Chicago Plan Revisited” (PDF), which “revives the scheme first put forward by professors Henry Simons and Irving Fisher in 1936 during the ferment of creative thinking in the late Depression”.

He was perplexed:

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

Personally, I am a long way from reaching an conclusion in this extraordinary debate. Let it run, and let us all fight until we flush out the arguments.

One thing is sure. The City of London will have great trouble earning its keep if any variant of the Chicago Plan ever gains wide support.

In the spirit of the second paragraph, I intend in this essay to outline a more accurate history of the antecedents of this plan advocated by the Chicago monetarists.  I show the Austrian heritage that predates this, and show how and why the Austrian proposal of Jesus Huerta de Soto is actually freedom-enhancing. On the way, we will also suggest where Ambrose Evans-Prichard may wish to revise his views on the origin of money.

The Austrian School settings of what has become known as the Chicago Plan

I draw to your attention this letter between Prof Jesus Huerta de Soto and the two IMF authors, sent on the 9th of October:

Dear Michael and Jaromir,

After reading the e-mail between my disciple working in the Stability Department of the Bank of Spain Dr. Antonio Pancorbo and Michael Kumhof (August 29 and 31, 2012) I would like to stress the point that the 100 per cent proposal was launched for the first time by Ludwig von Mises in the 1912 first edition of his “Theory of Money and Credit”, as recognized by the Chicago School economists of the 1930’s (see specially Albert G. Hart, “The Chicago Plan of Banking Reform”, Review of Economics Studies 2, 1935, footnote p. 104). Of course, in 1912 the Gold Standard was still in force, but this should not be interpreted as if there should be a necessary link between the 100 per cent proposal and the reintroduction of the Gold Standard. Although Austrian economists generally support both reforms, they would be happy, as a second best, with the 100 per cent proposal for the reasons originally given by Mises in 1912 (specially the need to avoid artificial credit expansions not backed by previous real genuine savings). In my opinion your most interesting paper would be improved in its part dedicated to the history of the 100% proposal with the recognition to the Mises original contribution.

Furthermore, if you should have considered in your model the huge malinvestments induced through each cycle by credit expansions financed by the current fractional reserve banking system (which are analyzed in detail by the Austrian Business Cycle Theory), the introduction of the 100 per cent reserves reform would produce output gains significantly higher than the 10 per cent you mention in your paper.

Finally you probably will be interested to know the growing political and popular debate on the 100 per cent reform that is taking place in Europe. To show this see enclosed the “Hayek Memorial Lecture” I delivered at the London School of Economics in which I mention the piece of legislation proposed by two Tory MP’s at the British Parliament aimed at the establishment of 100 per cent banking for demand deposits, as well as the English version of the movie produced by my department of economics at King Juan Carlos University that was showed at the Spanish TV defending the 100 per cent proposal and which got 7 per cent of total audience (!__english ).

Sincerely yours,

Jesús Huerta de Soto

Catedrático de Economía Política

Universidad Rey Juan Carlos

P.S.: From the methodological point of view I think we should be a little bit more humble regarding both the evaluation of the historical “evidence” (that Michael Kumhof believes shows “unequivocally” a pure fiat money system is far superior to a gold standard) and the “evidence” obtained from your model (that should not be considered more than a “potentially illustrative abstraction”).

A full video and the speech of my 2010 Hayek Lecture at the LSE where Prof Huerta de Soto spoke are available here.

Prof Jesus Huerta de Soto’s 1998 book, translated to English in 2006 as Money, Bank Credit and Economic Cycles, can be downloaded here (PDF).

Chapter 9 discusses all the 20th Century proposals for reform on these lines and the Nobel winners who have supported proposals in this tradition. Huerta de Soto then discuses his proposal and the implications for a free society. Ambrose Evans-Prichard may learn much from these links to serious scholarship.

In short, Huerta de Soto swaps immaterial demand deposits for physical cash. He does not use bonds. The physical cash is a one-off printing of notes by the state in direct exchange for ownership of these bank liabilities (the demand deposits), which it can promptly destroy, thus leaving the banks and their customers owning what they think they own: their own money. And the banks, being liberated from having these current liabilities, now have the asset side of their balance sheet intact with no demand deposit liability. The increase in bank net worth should be able to pay off the national debt, which of course is simply a byproduct of this reform. The real aim is to fix money to gold and abolish the central bank, which would then remove monetary socialism from our system. With stable and honest money, redeemable in a commodity once more, and with governments nowhere near it, freedom and liberties would be massively boosted. However, it is best to read the actual proposal rather than my quick and dirty summary.

Evans-Pritchard’s Telegraph colleague, Daniel Hannan, MEP, asked me to put forward this proposal in no more than 1200 words and offer a reward for anyone who could refute it. I did, the link is here and no one has refuted it. If you read through the comments thread, you will see various attacks and rebuttals and points of clarification.

Fantastical as this all may sound, in the cold light of day it does stack up and it may well be the only solution left to the authorities should the system collapse again. After all, not much good can come from nationalising an already state-dominated money and banking system.

The origins of money

Ambrose Evans-Pritchard has a different view as to the origins of money from myself. He disagrees with the account of Adam Smith and he claims that Aristotle says, in Ethics, that money was fiat and derived its value from the state. I will see if his assertions can withstand scrutiny by going to the texts themselves, and I will take this in chronological order.


The claim:

Anthropological studies show that social fiat currencies began with the dawn of time. The Spartans banned gold coins, replacing them with iron disks of little intrinsic value. The early Romans used bronze tablets. Their worth was entirely determined by law – a doctrine made explicit by Aristotle in his Ethics – like the dollar, the euro, or sterling today.

In all of the works of Aristotle, at best we may find 20-30 pages of economics. I find nothing on the origins of money in Ethics. I am happy to be proved wrong, but I do find the relevant points in his Politics which I reprint in full from “The Complete Works of Aristotle , Vol 2″ – John Barnes (Princeton / Bollingen Series LXX1.2, 1257 a1, Book 1, 9, line 18 to line 10 of 1257b1, pages 1994-1995)

In the first community, indeed, which is the family, this art is obviously of no use, but it begins to be useful when the society increases. For the members of the family originally had all things in common; later, when the family divided into parts, the parts shared in many things, and different parts in different things, which they had to give in exchange for what they wanted, a kind of barter which is still practiced among barbarous nations who exchange with one another the necessaries of life and nothing more; giving and receiving wine, for example, in exchange for coin, and the like. This sort of barter is not part of the wealth-getting art and is not contrary to nature, but is needed for the satisfaction of men’s natural wants.


The other or more complex form of exchange grew, as might have been inferred, out of the simpler. When the inhabitants of one country became more dependent on those of another, and they imported what they needed, and exported what they had too much of, money necessarily came into use. For the various necessaries of life are not easily carried about, and hence men agreed to employ in their dealings with each other something which was intrinsically useful and easily applicable to the purposes of life, for example, iron, silver, and the like. Of this the value was at first measured simply by size and weight, but in process of time they put a stamp upon it, to save the trouble of weighing and to mark the value.

When the use of coin had once been discovered, out of the barter of necessary articles arose the other art of wealth getting, namely, retail trade; which was at first probably a simple matter, but became more complicated as soon as men learned by experience whence and by what exchanges the greatest profit might be made. Originating in the use of coin, the art of getting wealth is generally thought to be chiefly concerned with it, and to be the art which produces riches and wealth; having to consider how they may be accumulated. Indeed, riches is assumed by many to be only a quantity of coin, because the arts of getting wealth and retail trade are concerned with coin.

The natural and spontaneous discovery by man of money, as the final means for complex exchange, that over and above barter, was seemingly explored by Aristotle in Politics and not in Ethics. Also there is no mention of fiat money. There is also the traditional story of the origin of money as a solution to the double coincidence of wants. Another commodity, the most marketable, called money, was used to facilitate indirect exchange. All of this from Aristotle would seem to be diametrically opposed to Evans-Pritchard’s understanding of the great polymath.

Aristotle can be cited as one of the first economists to talk about the spontaneous origins of money, but he has erroneously been presented as an intellectual ancestor to Georg Friedrich Knapp, author of ‘The State Theory of Money’. The phrase “they put a stamp upon it” has been taken to imply that money has value because the state has endorsed it. Some people put their 21st century hats on, and assume the state introduced the quality stamp, but these were private mints stamping money; there is no evidence of state-owned mints at this time. More importantly, the stamp simply gave comfort to users of money that the coins had the requisite metallic content. This prevented deception, supporting the subjective value that money-holders attached to money, but it did not create the subjective value. This is a point lost by many Chartalist thinkers.

Ambrose Evans-Pritchard would have us believe that private money is an aberration:

The conjuring trick [of the Chicago Plan] is to replace our system of private bank-created money — roughly 97pc of the money supply — with state-created money. We return to the historical norm, before Charles II placed control of the money supply in private hands with the English Free Coinage Act of 1666.

Money was a means to overcome barter. Some two and a half thousand years ago, Aristotle noted how this was a spontaneous, market-driven process. It is true that the notes and coins produced by today’s states form a small percentage of the overall supply of money. Money has always been largely a creature of the private sector, though there is also a long history of government meddling and debasement.  Here’s what Adam Smith has to say on the matter:

From the time of Charlemagne among the French, and from that of William the Conqueror among the English, the proportion between the pound, the shilling, and the penny, seems to have been uniformly the same as at present, though the value of each has been very different; for in every country of the world, I believe, the avarice and injustice of princes and sovereign states, abusing the confidence of their subjects, have by degrees diminished the real quantity of metal, which had been originally contained in their coins. The Roman as, in the latter ages of the republic, was reduced to the twenty-fourth part of its original value, and, instead of weighing a pound, came to weigh only half an ounce. The English pound and penny contain at present about a third only; the Scots pound and penny about a thirty-sixth; and the French pound and penny about a sixty-sixth part of their original value. By means of those operations, the princes and sovereign states which per-formed them were enabled, in appearance, to pay their debts and fulfill their engagements with a smaller quantity of silver than would otherwise have been requisite. It was indeed in appearance only; for their creditors were really defrauded of a part of what was due to them. All other debtors in the state were allowed the same privilege, and might pay with the same nominal sum of the new and debased coin whatever they had borrowed in the old. Such operations, therefore, have always proved favourable to the debtor, and ruinous to the creditor, and have sometimes produced a greater and more universal revolution in the fortunes of private persons, than could have been occasioned by a very great public calamity.

All value is determined subjectively. The politicians in the Weimar Republic could not convince their citizens to accept the value of the money that they were issuing in bucket loads. Like King Canute, they can stand in front of the sea and command it to go back, but the millions of subjective valuations will never respond to a state decree of value.

Adam Smith

Let us now consider Ambrose Evans-Pritchard’s reference to Adam Smith and his views on the origin of money.

It is a myth – innocently propagated by the great Adam Smith – that money developed as a commodity-based or gold-linked means of exchange. Gold was always highly valued, but that is another story. Metal-lovers often conflate the two issues. 

When accusing a scholar of such standing as Adam Smith to be labouring under a myth, you really have to be sure of what you are alleging. Again, we will go to the original source and see if AEP’s claim stacks up to closer scrutiny.

3rd Edition 1784 Pages 33-42



The butcher has more meat in his shop than he himself can consume, and the brewer and the baker would each of them be willing to purchase a part of it. But they have nothing to offer in exchange, except the different productions of their respective trades, and the butcher is already provided with all the bread and beer which he has immediate occasion for. No exchange can, in this case, be made between them. He cannot be their merchant, nor they his customers; and they are all of them thus mutually less serviceable to one another. In order to avoid the inconveniency of such situations, every prudent man in every period of society, after the first establishment of the division of labour, must naturally have endeavoured to manage his affairs in such a manner, as to have at all times by him, besides the peculiar produce of his own industry, a certain quantity of some one commodity or other, such as he imagined few people would be likely to refuse in exchange for the produce of their industry. Many different commodities, it is probable, were successively both thought of and employed for this purpose. In the rude ages of society, cattle are said to have been the common instrument of commerce; and, though they must have been a most inconvenient one, yet, in old times, we find things were frequently valued according to the number of cattle which had been given in exchange for them. The armour of Diomede, says Homer, cost only nine oxen; but that of Glaucus cost a hundred oxen. Salt is said to be the common instrument of commerce and exchanges in Abyssinia; a species of shells in some parts of the coast of India; dried cod at Newfoundland; tobacco in Virginia; sugar in some of our West India colonies; hides or dressed leather in some other countries; and there is at this day a village in Scotland, where it is not uncommon, I am told, for a workman to carry nails instead of money to the baker’s shop or the ale-house.

In all countries, however, men seem at last to have been determined by irresistible reasons to give the preference, for this employment, to metals above every other commodity. Metals can not only be kept with as little loss as any other commodity, scarce any thing being less perishable than they are, but they can like- wise, without any loss, be divided into any number of parts, as by fusion those parts can easily be re-united again; a quality which no other equally durable commodities possess, and which, more than any other quality, renders them fit to be the instruments of commerce and circulation. The man who wanted to buy salt, for example, and had nothing but cattle to give in exchange for it, must have been obliged to buy salt to the value of a whole ox, or a whole sheep, at a time. He could seldom buy less than this, because what he was to give for it could seldom be divided without loss; and if he had a mind to buy more, he must, for the same reasons, have been obliged to buy double or triple the quantity, the value, to wit, of two or three oxen, or of two or three sheep. If, on the contrary, instead of sheep or oxen, he had metals to give in exchange for it, he could easily proportion the quantity of the metal to the precise quantity of the commodity which he had immediate occasion for.

Different metals have been made use of by different nations for this purpose. Iron was the common instrument of commerce among the ancient Spartans, copper among the ancient Romans, and gold and silver among all rich and commercial nations.

In summary , the division of labour causes and excess of goods needed for direct exchange, which allows a whole host of other commodities to be used to facilitate indirect exchange until various metals get settled on.

In discussing the use of metals and the control of the abuse of weights he comments as follows:

To prevent such abuses, to facilitate exchanges, and thereby to encourage all sorts of industry and commerce, it has been found necessary, in all countries that have made any considerable advances towards improvement, to affix a public stamp upon certain quantities of such particular metals, as were in those countries commonly made use of to purchase goods. Hence the origin of coined money, and of those public offices called mints; institutions exactly of the same nature with those of the aulnagers and stamp-masters of woollen and linen cloth. All of them are equally meant to ascertain, by means of a public stamp, the quantity and uniform goodness of those different commodities when brought to market.

The first public stamps of this kind that were affixed to the current metals, seem in many cases to have been intended to ascertain, what it was both most difficult and most important to ascertain, the goodness or fineness of the metal, and to have resembled the sterling mark which is at present affixed to plate and bars of silver, or the Spanish mark which is sometimes affixed to ingots of gold, and which, being struck only upon one side of the piece, and not covering the whole surface, ascertains the fineness, but not the weight of the metal.

So money arises from the people, via various commodities, with metals being selected invariably as first choice. The public minting process starts privately and then various despots, tyrants, governments get behind the stamping of coins.  Gold is a part of this process, but is one of many commodities. The key point is that money started its life as a commodity. Further on in this section, Smith gives many examples in history of how various commodities were used and references various texts to prove it.  Pliny is quoted from the Timaeus, Abraham and Ephron are used as examples, along with Henry III, Henry VIII and Robert the Bruce.

I doubt Smith is labouring under a myth. I find his reasoning and examples compelling.

Chartalists who hold, like Evans-Prichard, that money is the creature of the state often cite various examples of credit being granted in ancient empires long forgotton, but upon closer inspection you will see that some good was being exchanged and that the creation of a running tab of credit to facilitate these exchanges only prolonged the act of completing a transaction for commodity money.

A relatively modern example is tally sticks. A notched stick was split, with one half given to the person who advanced money, and the other to the person who had received it.  Matching the unique split between the two parts made sure you could not put more notches (claims to real money) on it as further transactions were embarked upon. Note that in all of this, money was the final settlement and the initial act to kick off the transaction and the credit. All these credit instruments mentioned by the Chartalist School and State Theory of Money School miss out this critical point. Credit was always eventually settled in money. Before fiat money proper, money was always a commodity of some kind or commodity-backed. This is an indisputable fact.

With a correct understanding of money’s origin, we can understand why it has value. Understanding this will enable us to conclude that if the state tries to detach money from the valuations of it by its citizens, it will cease to be an effective money. In a short period of time it will not be money. Ludwig von Mises shows us why in his 1912 book “The Theory of Money and Credit.”



4. The Determination of the Purchasing Power of Money

As soon as an economic good is demanded not only by those who want to use it for consumption or production, but also by people who want to keep it as a medium of exchange and to give it away at need in a later act of exchange, the demand for it increases. A new employment for this good has emerged and creates an additional demand for it. As with every other economic good, such an additional demand brings about a rise in its value in exchange, i.e., in the quantity of other goods which are offered for its acquisition. The amount of other goods which can be obtained in giving away a medium of exchange, its “price” as expressed in terms of various goods and services, is in part determined by the demand of those who want to acquire it as a medium of exchange. If people stop using the good in question as a medium of exchange, this additional specific demand disappears and the “price” drops concomitantly.

Thus the demand for a medium of exchange is the composite of two partial demands: the demand displayed by the intention to use it in consumption and production and that displayed by the intention to use it as a medium of exchange. With regard to modern metallic money one speaks of the industrial demand and of the monetary demand. The value in exchange (purchasing power) of a medium of exchange is the resultant of the cumulative effect of both partial demands.

Now the extent of that part of the demand for a medium of exchange which is displayed on account of its service as a medium of exchange depends on its value in exchange. This fact raises difficulties which many economists considered insoluble so that they abstained from following farther along this line of reasoning. It is illogical, they said, to explain the purchasing power of money by reference to the demand for money, and the demand for money by reference to its purchasing power.

The difficulty is, however, merely apparent. The purchasing power which we explain by referring to the extent of specific demand is not the same purchasing power the height of which determines this specific demand. The problem is to conceive the determination of the purchasing power of the immediate future, of the impending moment. For the solution of this problem we refer to the purchasing power of the immediate past, of the moment just passed. These are two distinct magnitudes. It is erroneous to object to our theorem, which may be called the regression theorem, that it moves in a vicious circle.

But, say the critics, this is tantamount to merely pushing back the problem. For now one must still explain the determination of yesterday’s purchasing power. If one explains this in the same way by referring to the purchasing power of the day before yesterday and so on, one slips into a regressus in infinitum. This reasoning, they assert, is certainly not a complete and logically satisfactory solution of the problem involved. What these critics fail to see is that the regression does not go back endlessly. It reaches a point at which the explanation is completed and no further question remains unanswered. If we trace the purchasing power of money back step by step, we finally arrive at the point at which the service of the good concerned as a medium of exchange begins. At this point yesterday’s exchange value is exclusively determined by the nonmonetary –industrial–demand which is displayed only by those who want to use this good for other employments than that of a medium of exchange.

But, the critics continue, this means explaining that part of money’s purchasing power which is due to its service as a medium of exchange by its employment for industrial purposes. The very problem, the explanation of the specific monetary component of its exchange value, remains unsolved. Here too the critics are mistaken. That component of money’s value which is an outcome of the services it renders as a medium of exchange is entirely explained by reference to these specific monetary services and the demand they create. Two facts are not to be denied and are not denied by anybody. First, that the demand for a medium of exchange is determined by considerations of its exchange value which is an outcome both of the monetary and the industrial services it renders. Second, that the exchange value of a good which has not yet been demanded for service as a medium of exchange is determined solely by a demand on the part of people eager to use it for industrial purposes, i.e., either for consumption or for production. Now, the regression theorem aims at interpreting the first emergence of a monetary demand for a good which previously had been demanded exclusively for industrial purposes as influenced by the exchange value that was ascribed to it at this moment on account of its nonmonetary services only. This certainly does not involve explaining the specific monetary exchange value of a medium of exchange on the ground of its industrial exchange value.

Finally it was objected to the regression theorem that its approach is historical, not theoretical. This objection is no less mistaken. To explain an event historically means to show how it was produced by forces and factors operating at a definite date and a definite place. These individual forces and factors are the ultimate elements of the interpretation. They are ultimate data and as such not open to any further analysis and reduction. To explain a phenomenon theoretically means to trace back its appearance to the operation of general rules which are already comprised in the theoretical system. The regression theorem complies with this requirement. It traces the specific exchange value of a medium of exchange back to its function as such a medium and to the theorems concerning the process of valuing and pricing as developed by the general catallactic theory. It deduces a more special case from the rules of a more universal theory. It shows how the special phenomenon necessarily emerges out of the operation of the rules generally valid for all phenomena. It does not say: This happened at that time and at that place. It says: This always happens when the conditions appear; whenever a good which has not been demanded previously for the employment as a medium of exchange begins to be demanded for this employment, the same effects must appear again; no good can be employed for the function of a medium of exchange which at the very beginning of its use for this purpose did not have exchange value on account of other employments. And all these statements implied in the regression theorem are enounced apodictically as implied in the apriorism of praxeology. It must happen this way. Nobody can ever succeed in construction a hypothetical case in which things were to occur in a different way.

Mises gives us the theory to explain the subjective value origins of money. It applies to all points in the history of money. Grasp this theory and you are liberated from the state view of money once and for all.

Will Commodity Money be the End of the City of London?

Evans-Pritchard seems to think the Chicago Plan would change the role of the City of London. Here, at last, he’s right. Banks would need to lend real savings, rather than simply extending credit. This is a good thing. Why? When you save, you refrain from consumption and put away money for future purchases.  One day you will buy goods and services made by entrepreneurs who have been lent your savings.  Thus, the right amount of money will be set aside to produce the right amount of goods and services in the future. The caveat is that entrepreneurs need to stay focused on producing what future consumers want. Thankfully, in the absence of quick and easy credit only competent entrepreneurs can survive.

With a sound banking system as suggested by Prof Huerta de Soto, and real savings and investment, we can see a return to the entrepreneurial glory days of our nation. But as long as the government retains the power to create money, our prosperity will be at risk.


Deck the halls with macro follies

In case you missed it, here’s another gem from

In an article reprinted at, John Papola explains:

Each year, our attention turns to the holidays… and to holiday consumer spending! We’re told repeatedly that, because consumer spending is 70 percent of measured GDP, such spending is vital to economic growth and job creation. This must mean that savings, the opposite of consumption, is bad for growth.

This view of macroeconomics was first popularly asserted by Thomas Malthus in 1820, nearly 200 years ago. Malthus believed recessions were caused by “underconsumption” because there was a “general glut” of goods unsold. To recover from a recession and grow, we needed to stop all the saving and spend more to buy up all the goods on store shelves. Savers are like the miserly Ebenezer Scrooge. If you want a happy holiday, you’ve got to clear those shelves and give people a reason to produce more and create jobs. Or so Malthus thought.

John Maynard Keynes resurrected this approach and built on it with his influential “General Theory”, which now underpins much of our government policy and public discussion of spending and economic growth. Keynesians believe aggregate spending drives the economy and savings is a “leak” out of the flow of spending. Indeed, this economic philosophy underpins many people’s widespread obsession with retail sales each holiday season. Keynesian Macro Santa’s sack is filled with spending.

But there is another view on recessions, recoveries and growth.

Classical and Austrian economists such as Adam Smith, Jean-Baptiste Say and Friedrich Hayek viewed savings as the vital lifeblood of economic growth and production as the means by which we live better and consume more in the long term. Our savings aren’t simply taken out of the economic system, but become the source of capital that entrepreneurs use to create new goods and increase productivity. These economists believe this increased productivity is the key to a wealthier world. Before we consume, we must effectively produce what others value — at prices that cover the costs. This fundamental idea, that our demand for goods is enabled and constituted by our supply of other goods came to be known as the “Law of Markets” and later “Say’s Law”. For classical and Austrian economics, recessions happen when producers make mistakes. They create goods that can’t be sold at a profit. These malinvestments tend to cluster in a recession as a result of systematic problems, such as disruptions in the financial system and often government interventions in the economy.

Recovery and growth in the classical and Austrian view is driven by restructuring production so that entrepreneurs discover again the best — i.e. the most valuable and sustainable — ways to serve customers. That process is led by new entrepreneurs and driven by savers who make capital available to fund new investments and new ventures. Sustainable saving and investment means creating more value for others while using fewer resources. This process lies at the core of healthy economic growth, including better job opportunities and a rising standard of living.


Class war, Adam Smith, and the Marginal Productivity Theory of Distribution

There is a pleasure almost cruel in seeing someone deploy irrefutable logic to destroy an opponent’s arguments. I felt it this week reading George Reisman’s Open letter to Warren Buffett where the well booted doctrines of Karl Marx got another kicking. By now Marx and his followers ought to be used to this sort of punishment at the hands of Austrians. Eugen von Böhm Bawerk produced his devastating destruction of Marx’s economics, Karl Marx and the Close of His System, back in 1896.

But Paul Samuelson was right when he said that “Karl Marx can be regarded as a minor post-Ricardian”. Marx simply took the aggregative, labour value theory based economics of David Ricardo and took them to their dismal and erroneous conclusions. And when Reisman writes “The doctrine of class warfare is a derivative of the exploitation theory, whose best-known proponent is Karl Marx” we ought to point out that it is found also in Ricardo’s predecessor Adam Smith.

Class War in The Wealth of Nations

Book One, Chapter VIII, of The Wealth of Nations is titled ‘Of the wages of labour’.  Smith charts the development from a situation of subsistence production where “the whole produce of labour belongs to the labourer” via the emergence of private property (which gives rise to rent) and stock (which gives rise to profit) to one where a payment for a good must be divided between the labourer (wages), the landlord (rent), and the stockholder (profit).

Smith goes on to say that “It seldom happens that the person who tills the ground has wherewithal to maintain himself till he reaps the harvest. His maintenance is generally advanced to him from the stock of a master, the farmer who employs him and who would have no interest to employ him, unless he was to share in the produce of his labour, or unless his stock was to be replaced to him with a profit” Smith says that “The produce of almost all other labour is liable to the like deduction of profit”.

Here we have the genesis of the Marxist theory of the workers alienation from the means of production, exploitation, and ‘class war’. Workers do not receive the full product of their labour as they did in the “early and rude state of society which precedes…the accumulation of stock and the appropriation of land”. Instead, this product goes to the stockholder as profit and the labourer receives wages.

With wages, Smith states, “The workmen desire to get as much, the masters to give as little as possible”. We have Marx’s “contending classes”. Smith goes on

It is not, however, difficult to foresee which of the two parties must, upon all ordinary occasions, have the advantage in the dispute, and force the other into a compliance with their terms. The masters, being fewer in number, can combine much more easily…In all such disputes the masters can hold out much longer. A landlord, a farmer, a master manufacturer, or merchant, though they did not employ a single workman, could generally live a year or two upon the stocks which they have already acquired. Many workmen could not subsist a week, few could subsist a month, and scarce any a year without employment. In the long-run the workman may be as necessary to his master as his master is to him, but the necessity is not so immediate.

Smith argued that wages would rise when an economy was growing but otherwise he posited a clear general tendency for wages to feel only downward pressures. From this flowed the idea of the ‘subsistence wage’ with which Malthus earned economics the tag of “the dismal science” and Lasalle’s Iron Law of Wages. Wages will stagnate, Smith argues, and profits will rise. Warren Buffett would not disagree.

But looking at the passage from Smith we can see much wrong with it, or at least, much that has no application today.

First, Smith says that stockholders are “fewer in number” than labourers and thus have a kind of oligopoly power. The error here, perhaps less when Smith was writing, is to regard labour as homogeneous. It isn’t. Skills, like capital, can be specific to a certain role and, thus non-transferable. Just as a “tractor is not a hammer”, Joleon Lescott is not Mariah Carey. You wouldn’t consider putting Mariah Carey on Darren Bent at corners and you probably wouldn’t want to hear Joleon Lescott sing Without You.

It follows that workers with different skills are not substitutes for one another; they are not, in other words, in competition. No brain surgeon ever accepted a lower wage from the fear that the hospital might hire a juggler instead.

Of course, where labour is unskilled it is homogeneous and we would expect to see the increased competition for jobs and resultant low wages which we do. At this skill level, also, capital can be substituted for labour providing a further downward pressure. The answer here is not to raise the banner of class warfare but to accumulate skills.

Second, Smith says that stockholders “can combine much more easily”. However, in practical experience, such cartels are always plagued with problems as we see with OPEC. If a cartel sets a minimum price there is always the temptation for one member to sell below that price and capture the market. Although here we are considering the case where a cartel is setting a maximum price for its labour inputs, the analysis is unchanged as we shall see.

Wages and the Marginal Productivity Theory of Distribution

Thirdly, Smith contends that “In all such disputes the masters can hold out much longer”. This might well be true but the question has to be asked; why would they? If, by hiring a worker at £30,000 per year a stockholder would increase his profit by £40,000 per year, why would that stockholder hold out, throwing away £10,000, in an attempt to drive the worker down to £20,000?

It could be said that the stockholder will lose out on £10,000 this year but will gain £20,000 in every subsequent year. But Smith said that stockholders were “fewer in number”, not that there was only one, so there are those cartel problems. Thus, if, in the initial period, stockholder A is willing to forgo £10,000 and hold out for a wage of £20,000 stockholder B will step in and offer the worker £30,000. He will make £10,000 profit while stockholder A makes nothing. There is a saying about stepping over a dollar to pick up a penny, in this case stockholder B picks up both.

Indeed, if the worker adds £40,000 to profits it makes sense for the stockholder to employ them at any wage up to that (tax wedges notwithstanding). We have arrived, as economists did after 1870, at the Marginal Productivity Theory of Distribution. This simply states that a factor (labour or capital) will be paid to the value of its marginal product.

So, if hiring a first barman generates £100 a week extra profit for a pub landlord that barman will be paid up to £100. If, however, hiring a second barman adds only £80 a week the marginal product of bar staff has fallen to £80 a week and so will the wage even of the first. If hiring a third barman adds just £50 a week and no one will take the job at that wage no one else will be hired and £80 a week will be the wage.

Of course, if there are two barmen earning £80 a week one could go on a cocktail course. His mojito’s might prove a draw, his marginal product will rise and so will his wage. By doing the course, ‘upskilling’, the first barman is differentiating his labour from that of barman two. Their labour is heterogeneous.

Smith himself saw a situation where in a growing economy, one in which the profits of stockholders were increasing, demand for labour would also increase. In this case “The scarcity of hands occasions a competition among masters, who bid against one another, in order to get workmen, and thus voluntarily break through the natural combination of masters not to raise wages”.

However, as we’ve seen, because of heterogeneity on both the labour (due to non-transferable skills) and stockholder (due to cartel issues) sides of the wage bargain it is this which is the general case and not the previously enunciated tendency for wages to fall and profits to rise. Because some ‘hands’ are skilled at some things and other ‘hands’ at other things there is at any given time a “scarcity of hands” in any profession requiring a modicum of skill. And because we have a number of potential “masters” we have at any given time “competition among” them.

Both profits and wages can rise together and the zero sum thinking of Marx and Buffett can be discounted. But Adam Smith’s role in this thinking should not be forgotten either.


Hard work needs honest money

In yesterday’s Telegraph, William Hague tells the Government’s business critics to stop complaining and work hard to deliver jobs. However, Mr Hague forgets that a day’s hard work is rewarded with a day’s pay: if that pay is in a money which someone else is producing at near zero cost, the value of hard work is undermined.

People who are slogging their guts out to make ends meet in an environment of rising living costs are bound to take the Telegraph’s reporting of Mr Hague’s remarks badly, and rightly too. The comments on the article are well worth reading.

The original interview is here and there is some good in it:

Things went “wrong over decades”, the Foreign Secretary suggests, with the idea growing that people could “live on expanded debt forever, rather than having to earn what we spend.”

I have argued again and again that 40 years of credit expansion — lending money into existence well in excess of real savings, trebling the money supply under New Labour by expanding debt — is the fundamental cause of this crisis.  It is the reason why the distribution of prosperity in our country is manifestly unjust, why wealth is concentrated around London and why the financial, building and state sectors are so dominant in our economic system.

In The Ethics of Money Production (PDF), Jörg Guido Hülsmann writes,

The prevailing ways of money production, relying as they do on a panoply of legal privileges, are alien elements in the capitalist economy. They provide illicit incomes, encourage irresponsibility and dependence, stimulate the artificial centralization of political and economic decision-making, and constantly create fundamental economic disequilibria that threaten the life and welfare of millions of people. In short, paper money and fractional-reserve banking go a long way toward accounting for the excesses for which the capitalist economy is widely chided.

Elsewhere in the book, Hülsmann explains the depth and extent of the damage done by money which is produced by expanding debt. At last a senior member of the Government is beginning to discuss similar ideas.

Senior politicians must realise that hard work cannot produce prosperity without the right institutions. In addition to Adam Smith’s “peace, easy taxes and a tolerable administration of justice”, hard work must be rewarded with honest money which holds its value, not money which the commercial banks and the Bank of England can produce at the touch of a button.

Money loaned into existence in ever greater quantities caused the present crisis. It has given us a society based on crushing burdens of work in exchange for rewards which quickly disintegrate. That is the problem which must be solved if hard work is to have proper meaning and if we are to have a moral and just society which delivers prosperity for all.

See also Ten plans for reform and this superb video:

This article was previously published at


Financial regulators and the free market

Adam Smith’s great insight was that in a commercial transaction both parties benefit. Before his time, it was generally believed that in an exchange of goods, one party usually gained what the other lost. The mistake was to misunderstand value: it is different to different people. A seller places greater value in the money than the product he sells for it, and the buyer places a greater value on the product than its cost, otherwise the deal would not happen.

Lovers of regulation do not seem to understand Adam Smith’s perception of enlightened self-interest. They believe unprincipled capitalists steal the widow’s mite. The prevalence of regulation, particularly in Europe, where everything must be regulated, is in this sense a complete denial of all economic progress since the days of mercantilism.

Regulation often defeats its objectives, a point which was made clear to me many years ago. I met the managing director of a spread-betting business at the time when there was a debate about whether or not spread-betting should be regulated as an investment activity. He welcomed regulation, because it would give his business added credibility, despite by definition being gambling. He was right: that is why everyone in the financial services business dealing with the public wants regulation. It enhances their credibility.

Unregulated, a business’s reputation is its most valuable asset. A regulated business does not have the same problem, so long as it obeys the regulations. Regulations replace the overriding need for a business to protect its reputation, and it is no longer solely concerned for its customers: the rule book has precedence. And the more regulation replaces reputation, the less important customers become. Nowhere is this more obvious than in financial services.

Back in the Eighties when single capacity was scrapped in London, and securities businesses were allowed to act as both brokers and market-makers, the conflict of interest was meant to be resolved by the interposition of a Chinese wall. We hardly ever hear the term nowadays, but this sham separation of broking from market-making demotes customers’ interests. Predictably, they have become cannon-fodder for the trading book, where the real profitability lies. And then there is the egregious example of MF Global, which it appears, has been permitted by the regulator to gamble and lose its customers segregated money.

The regulators assume the public are innocents in need of protection. They have set themselves up to be gamed by all manner of businesses intent on using and adapting the rules for their own benefits at the expense of their customers. These businesses lobby to change the rules over time to their own advantage and hide behind regulatory respectability, as clients of both MF Global and Bernie Madoff have found to their cost.

Where is the protection? Adam Smith must be turning in his grave.

This article was previously published at


Will the real Adam Smith please stand up

“Adam Smith had one overwhelmingly important triumph: he put into the center of economics the systematic analysis of the behavior of individuals pursuing their self-interest under conditions of competition.”– George Stigler [1]

A major debate has flared up recently about Adam Smith. Was he the father of free-market economics and libertarian thought, or some kind of radical egalitarian and social democrat?

Adam Smith as a Free-Market Hero

The traditional view, held by Milton Friedman, is that the Scottish philosopher was “a radical and a revolutionary in his time–just as those of us who preach laissez faire are in our time.” [2] He lauded Smith’s metaphor of the “invisible hand,” the famous Smithian idea that “by pursuing his own self interest, [every individual] frequently promotes that of the society.” [3] According to Friedman, “Adam Smith’s flash of genius was his recognition that the prices that emerged from voluntary transactions between buyers and seller — for short, in a free market — could coordinate the activity of millions of people, each seeking his own interest, in such a way as to make everyone better off.” [4] Other defenders of free-enterprise capitalism describe the invisible hand as “gentle,” “wise,” “far reaching,” and one that “improves the lives of others.” [5]

George Stigler, Friedman’s colleague at the University of Chicago, identified the invisible hand doctrine as “the crown jewel” and first principle of welfare economics, “the most important substantive proposition in all of economics.” [6] He waxed eloquently about the “grandparent” of modern economics, his “bold explorations, his resourceful detective work…, his duels and triumphs and defeats…. [his] superior mind…a clear-eyed and tough-minded observer…The Wealth of Nations has joined the great literature of all time; it was the most powerful assault ever launched against the mercantile philosophy that dominated Western Europe from 1500 to 1800.” [7] Adam Smith was Stigler’s favorite economist, and a portrait of the Chicago economist holding a copy of The Wealth of Nations hangs in the hall way of the business school at Chicago.

This is one area where the Austrians Ludwig von Mises and Friedrich Hayek concurred with the Chicago school. Like Stigler, Mises wrote an introduction to The Wealth of Nations, calling it a “great book.” According to Mises, Smith’s works are “the consummation, summarization, and perfection…of a marvelous system of ideas…presented with admirable logical clarity and an impeccable literary form…. [representing] the essence of the ideology of freedom, individualism, and prosperity.” Furthermore, “Its publication date — 1776 — marks the dawn of freedom both political and economic….It paved the way for the unprecedented achievements of laissez-faire capitalism.” He concluded,

There can hardly be found another book that could initiate a man better into the study of the history of modern ideas and the prosperity created by industrialization. [8]

In like manner, Hayek wrote a laudatory article on the 200th anniversary of the publication date of The Wealth of Nations. After praising earlier economists and warning of defects in Smith’s value and distribution theories, he went on to extol Smith as “the greatest of them all” because the Scottish economist, more than any of his contemporaries or ancestors, recognized that “a man’s efforts will benefit more people, and on the whole satisfy greater needs, when he lets himself be guided by the abstract signals of prices rather than perceived needs,” and thus Smith helped to create a “great society.” [9]

Social Democrats Contest the Free-Marketeers

Critics of laissez faire — from Cambridge economist Emma Rothschild to British Labor Party leader Gordon Brown — have recently become quite unhappy by what they consider a conspiracy by free-marketeers to claim Adam Smith as their hero and symbol of laissez faire. They seem to be especially annoyed that the Adam Smith Institute, a London-based free-market think tank, raised a popular statue of the grand old man on Mile High Street in Edinburgh on July 4, 2008.

In a series of books and articles, they have attempted to wrestle Adam Smith out of the hands of the free-market arena and into the camp of the social democrats. According to Oxford Professor Iain McLean and Illinois Professor Samuel Fleschaker, the Scottish philosopher was a “radical egalitarian” who, while endorsing economic liberalism, had a lively appreciation of market failure and ultimately rejected “ruthless laissez-faire capitalism” in favor of “human equality” and “distributive justice.” [10] These revisionists are quick to claim that Smith was no friend of rent-seeking landlords, monopolistic merchants and conspiring businessmen, and that he advocated an active state authority in support of free education, large-scale public works, usury laws, progressive taxation, and even some limits on free trade. They contend that Smith had more in common with Karl Marx than Thomas Jefferson. [11]

The critics of laissez faire offer a mixed review of Smith’s invisible hand. In their Keynesian textbook, William Baumol and Alan Blinder admit that “the invisible hand has an astonishing capacity to handle a coordination problem of truly enormous proportions.” [12] Despite expecting anarchic chaos, Frank Hahn discovers spontaneous order in Adam Smith’s market place. He honors the invisible hand theory as “astonishing,” noting

whatever criticisms I shall level at the theory later, I should like to record that it is a major intellectual achievement….The invisible hand works in harmony [that] leads to the growth in the output of goods which people desire. [13]

And yet despite these words of praise, Smith’s wonderful world is full of inefficiencies, waste, and imperfections. Accordingly, the public must beware of the “backhand,” “the trembling hand,” the “bloody hand,” the “iron fist of competition,” a hand “getting stuck,” and perhaps even a hand that may need to be “amputated.” [14]

To emphasize the imperfections of the market place, mainstream publishers have mostly assigned big-government advocates to write the introductions to the popular editions of The Wealth of Nations, including Marx Lerner and Robert Reich for the Modern Library editions, and Alan B. Krueger for the Bantam paperback edition, where he labels Adam Smith as a follower not of Milton Friedman but of John Rawls; his invisible hand is seen as “all thumbs.” [15]

Murray Rothbard’s Dissent

The political waters have been muddied a bit since libertarian Murray Rothbard and his followers have joined the critics in their attack on Adam Smith (one of a few examples where Rothbard departs company from Mises and Hayek). Rothbard took exception to the celebrated Adam Smith in his two volume history of economic thought, published at the time of Rothbard’s death in 1995. He lambasted the classical economists, arguing that Smith apostatized from the sound doctrines and theories previously developed by pre-Adamites such as Richard Cantillion, Anne Robert Turgot, and the Spanish scholastics. He asserted that Adam Smith’s contributions were “dubious” at best, that “he originated nothing that was true, and that whatever he originated was wrong,” and that The Wealth of Nations was “rife with vagueness, ambiguity and deep inner contradictions.” Specifically, his doctrine of value was an “unmitigated disaster”; his theory of distribution was “disastrous”; his emphasis on the long run was a “tragic detour”; and Smith’s putative “sins” include support for progressive taxation, fractional reserve banking, and a crude labor theory of value that Marxists later borrowed from Adam Smith and David Ricardo. [16]

Adam Smith Reveals the Invisible Hand

What about the metaphor of the “invisible hand,” the famous Smithian idea that “by pursuing his own self interest, [every individual] frequently promotes that of the society” [17]? Free-market economists from Ludwig von Mises to Milton Friedman have regarded it as a powerful symbol of unfettered market forces, what Adam Smith called his “system of natural liberty.” In rebuttal, the new critics belittle Adam Smith’s metaphor as a “passing, satirical” reference and suggest that he favored more of a “helping hand.” [18] They emphasize the fact that Smith used the phrase “invisible hand” only once in each of his two major works, The Theory of Moral Sentiments (1759) and The Wealth of Nations (1776). The references are so sparse that commentators seldom mentioned the expression by name in the 19th century. No notice was made of it during the celebrations of the centenary of The Wealth of Nations in 1876. In the 18th and 19th century, no subject index, including the well-known volume edited by Edwin Cannan, published in 1904, lists “invisible hand” as a separate entry. It was finally added to the subject index in 1937 by Max Lerner for the Modern Library edition. Clearly, it wasn’t until the 20th century that the invisible hand became a popular symbol of laissez faire.

Invisible Hand: Marginal or Central Concept?

Could the detractors be correct in their assessment of Adam Smith’s sentiments? Is the invisible hand metaphor central or marginal to Adam Smith’s “system of natural liberty”?

Milton Friedman refers to Adam Smith’s symbol as a “key insight” into the cooperative, self-regulating “power of the market to produce our food, our clothing, our housing…without central direction.” [19] George Stigler calls it the “crown jewel” of The Wealth of Nations and “the most important substantive proposition in all of economics.” [20] The idea that laissez faire leads to the common good is called “the first fundamental theorem of welfare economics” by Kenneth Arrow, Paul Samuelson, and Ronald Coase. [21]

On the other hand, Gavin Kennedy contended in earlier writings that the invisible hand is nothing more than an after-thought, a “casual metaphor” with limited value. [22] Emma Rothschild even goes so far as to declare, “What I will suggest is that Smith did not especially esteem the invisible hand…It is un-Smithian and unimportant to his theory” and was nothing more than a “mildly ironic joke.” [23]

Who’s right?

Adam Smith Reveals His Invisible Hand

A fascinating discovery uncovered by Daniel Klein, professor of economics at George Mason University, may shed light on this debate. Based on a brief remark by Peter Minowitz that the “invisible hand” phrase lies roughly in the middle of both The Wealth of Nations and The Theory of Moral Sentiments [24], Klein made preliminary investigations that led him to suggest deliberate centrality. [25] Klein then recruited Brandon Lucas, then a doctoral student at George Mason, to investigate further. Klein and Lucas found considerable evidence that Smith “deliberately placed ‘led by an invisible hand’ at the centre of his tomes” and that the concept “holds special and positive significance in Smith’s thought.” [26]

Klein and Lucas base their conjecture on two major points. First, the physical location of the metaphor: The single expression “led by an invisible hand” occurs almost dead center in the first and second editions of The Wealth of Nations. (It moves slightly away from the middle after an index and additions were added to later editions.)

Moreover, it appears again “well-nigh dead centre” in the final edition of The Theory of Moral Sentiments. Klein and Lucas admit that it was not in the middle of the first edition in 1759, speculating that “physical centrality was not initially a part of his intentions…[but that] by 1776, Smith had become intent on centrality.” Indeed, Smith moved the phrase “invisible hand” closer to the center of the book, first by appending an important essay on the origin of language and finally by making substantial revisions in the final edition. [27]

Second, Klein and Lucas note that as an historian and moral philosopher, Adam Smith commented frequently on the importance of middleness in architecture, literature, science, and philosophy. For example:

  • Smith wrote sympathetically about the Aristotelian golden mean, the idea that virtue exists “between two opposite vices.” For instance, between the two extremes of cowardice and recklessness lies the central virtue of courage.
  • In Smith’s essays on astronomy and ancient physics, Smith was captivated by Newtonian central forces and periodical revolutions.
  • Klein discovered that Smith, in his lectures on rhetoric, admired the poetry of the Greek poet Thycydides, who “often expresses all that he labours so much in a word or two, sometimes placed in the middle of the narration.” [28]

Midpoint analysis and centralized themes existed long before Adam Smith’s time. For example, the Talmud offers considerable commentary about midpoints in the Torah, especially in a poetic form called Chiasmus. Chiasmus is characterized by introverted parallelism, and found in Greek, Latin, Hebrew and Christian literature. A Chiasmus is a pattern of words or ideas stated once and then stated again but in reverse order. Classic examples are found in the Bible: “Who sheds the blood of a man, by a man shall his blood be shed…” (Genesis 9:6), or “The first shall be last and the last shall be first…” (Matthew 19:30).

Most Chiasmi have a “climactic centrality,” that is, the structure of the poem points to a central theme in the middle. For instance, the Psalmist writes, “Our soul is escaped as a bird out of the snare of the fowlers; the snare is broken, and we are escaped.” (Psalms 124:7) Here the Psalmist is urging us (the soul) to escape the clutches of Satan, even as a bird escapes the snare of the fowler or the hunter (the central word).

The standard pattern of a centralized Chiamus is:

  • A
  • B
  • C (central theme or focal point)
  • B
  • A

In sum, according to Klein and Lucas, the invisible hand represents the climatic centrality of Smith’s “system of natural liberty,” and is appropriately found in the middle of his works. By this discovery, if true, one goes from one extreme to the other — from seeing the invisible hand as a marginal concept to accepting it as the touchstone of his philosophy.

Klein and Lucas’s list of evidence is what a lawyer might call circumstantial, or “impressionistic,” to use Klein and Lucas’s own adjective. Taken as a whole, the documentation is either an ingenious breakthrough or a “remarkable coincidence,” to quote Gavin Kennedy. [29]

A few Smithian experts have warmed up to Klein and Lucas’s claim. Gavin Kennedy, who previously considered the invisible hand a “casual” metaphor, now sees a “high probability” in their thesis of deliberate centrality. [30] Others are more skeptical. “We have no direct evidence for the conjecture,” states Craig Smith, an expert on Adam Smith at the University of St. Andrews. The idea that Adam Smith deliberately hid his favorite symbol of his philosophy “strikes me…as very un-Smithian,” he states, and runs contrary to his policy of expressing thoughts in a “neat, plain and clever manner.” [31] Placing the shorthand phrase “invisible hand” in the middle of his works may not be plain, but is it not neat and clever?

We may never know the truth, since we have no record of Smith commenting on the matter. Fortunately, one does not need to depend on the physical centrality of the “invisible hand” to recognize the doctrinal centrality of his philosophy. As Craig Smith states, “I’m not convinced that Smith deliberately placed the invisible hand at the centre of his books, but I am certain that it lies at the heart of his thinking.” [32]

The Significance of the Invisible Hand Doctrine

There are many passages from the Wealth of Nations and the Theory of Moral Sentiments that elucidate the theme of “invisible hand,” the idea that individuals acting in their own self-interest unwittingly benefit the public weal, or that eliminating restrictions on individuals’ behaviors “better their own condition” and make society better off. Smith repeatedly advocates removal of trade barriers, state-granted privileges, and employment regulations so that entrepreneurs and enterprises can flourish. [33]

The invisible hand metaphor is an example of Smith’s law of unintended consequences.

Very early in The Theory of Moral Sentiments, Smith makes his first statement of this doctrine:

The ancient stoics were of the opinion, that as the world was governed by the all-ruling providence of a wise, powerful, and good God, every single event ought to be regarded, as making a necessary part of the plan of the universe, and as tending to promote the general order and happiness of the whole: that the vices and follies of mankind, therefore, made as necessary part of this plan as their wisdom and their virtue; and by that eternal art which educes good from ill, were made to tend equally to the prosperity and perfection of the great system of nature. [34]

Or this statement:

The man of system, on the contrary, is apt to be very wise in his own conceit; and is often so enamoured with the supposed beauty of his own ideal plan of government, that he cannot suffer the smallest deviation from any part of it. He goes on to establish it completely and in all its parts, without any regard either to the great interests, or to the strong prejudices which may oppose it. He seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. He does not consider that the pieces upon the chess-board have no other principle of motion besides that which the hand impresses upon them; but that, in the great chess-board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature might chuse to impress upon it. If those two principles coincide and act in the same direction, the game of human society will go on easily and harmoniously, and is very likely to be happy and successful. If they are opposite or different, the game will go on miserably, and the society must be at all times in the highest degree of disorder. [35]

Thus, we see how Smith’s argument is comparative. To quote Klein:

Hewing to the liberty principle generally works out better than not doing so—in this respect, Arrow, Stiglitz, and Hahn do disfigure Smith when they identify the invisible hand with some rarified perfection. We need not rehearse Smith on the ignorance, folly, and presumption of political power, on the corruption and pathology of political ecology….Smith sees the liberty principle as a moral, cultural, and political focal point, a worthy and workable principle in the otherwise dreadful fog of interventionism. [36]

To think that Adam Smith, the renowned absent minded professor, hid a little “invisible” secret in his tomes is indeed the ultimate irony. As Klein concludes, “That the phrase appears close to the center, and but once, in TMS and in WN might be taken as evidence that Smith did intend for us to take up the phrase.” [37]

I find Professor Klein’s story compelling, and have enjoyed showing copies of Smith’s works with a bookmark in the key passages, to students, faculty and interested friends. It has, in the words of Robert Nozick, “a certain lovely quality.” [38]

Will the Real Adam Smith Please Stand Up: My Own Odyssey

In this paper, I’ve discussed the controversies surrounding Adam Smith and the meaning and significance of his invisible hand. As an economist sympathetic with the Austrian school, I myself have gone through an odyssey in my attitude toward Adam Smith. When I first started writing my history, The Making of Modern Economics in the late 1990s, I was still quite infatuated with everything Rothbardian, including his critique of Adam Smith. In fact, I was the one who commissioned Murray Rothbard to write his history of thought in 1980, and like everyone else, was surprised by his attack on Adam Smith. It was a shocking indictment of the Scottish philosopher celebrated by almost all free-market economists, including Rothbard’s teacher Ludwig von Mises.

At that time, I had to decide, who was right, Rothbard or Mises? There was only one way to find out. I decided to read the entire 1,000-page Wealth of Nations, page by page and cover to cover, and come to my own conclusion. Two months later, I put the book down and said to myself: “Murray Rothbard is wrong and Mises is right.” Adam Smith has written a grand defense of the invisible hand and economic liberalism. I followed up by reading Smith’s other great work, The Theory of Moral Sentiments (1759), which reinforced my positive view of Smith.

My change of heart completely transformed my history. Suddenly, The Making of Modern Economics had a plot, an heroic figure, and a bold storyline. Adam Smith and his “system of natural liberty” became the focal point from which all economists could be judged, either adding to or distracting from his system of natural liberty. After coming under attack by socialists, Marxists and Keynesians, the invisible-hand model of Adam Smith was often left for dead but inevitably was revived, revised and improved upon by the French, Austrian, British, and Chicago schools, and ultimately triumphed with the collapse of the socialist central planning model in the early 1990s (although it is again being tested by the ongoing financial crisis).

Granted, Smith made numerous mistakes in his classic work, such as his crude labor theory of value, his attack on landlords, and his failure to recognize marginal subjective values, but French, British, Austrian and Chicago economists have done a great job improving upon the House that Adam Smith Built without destroying his fundamental system of natural liberty, and his policy prescriptions, which were largely libertarian (the classical model of limited government, free trade, balanced budgets, and sound money).

I noticed that Murray Rothbard largely ignored the strong libertarian language found in The Wealth of Nations and overemphasized marginal statements by Smith that were pro-government or anti-market. His attack on Smith reminds me of free-market critics who take the same parenthetical statements in Smith’s writings and make him into some kind of social democrat. Both are wrong.

Here are just a few samples of Smith’s strong libertarian voice in The Wealth of Nations (Modern Edition, 1965 [1776]):

Every man, as long as he does not violate the laws of justice, is left perfectly free to pursue his own interest in his own way, and to bring both his industry and capital into competition with those of any other man, or order of men. (p. 651, emphasis added).

To prohibit a great people…from making all that they can of every part of their own produce, or from employing their stock and industry in the way that they judge most advantageous to themselves, is a manifest violation of the most sacred rights of mankind. (p. 549)

And elsewhere:

Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice; all the rest being brought about by the natural course of things. All governments which thwart the natural course are unnatural, and to support themselves, are obliged to be oppressive and tyrannical. [39]

In sum, Mises, Hayek, Friedman and Stigler all had the right attitude when it came to Adam Smith. He established the “keystone” of the market economy.


[1] George Stigler, “The Successes and Failures of Professor Smith,” Journal of Political Economy 84:6 (December, 1976), p. 1201. Emphasis added.

[2] Milton Friedman, quoted in Fred R. Glahe, ed., Adam Smith and the Wealth of Nations: 1776-1976 Bicentennial Essays (Colorado Associated University Press, 1978), p. 7.

[3] Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (Liberty Fund, 1981 [1776]), p. 456.

[4] Milton and Rose Friedman, Free to Choose (Harcourt Brace Jovanovich, 1980), pp. 13-14.

[5] See chapter 9, “Faith and Reason in Capitalism,” by Mark Skousen, Vienna and Chicago, Friends or Foes? (Regnery, 2005) for a variety of comments, both positive and negative, about the invisible hand.

[6] George J. Stigler, “The Successes and Failures of Professor Smith,” Journal of Political Economy 84:6 (December, 1976), p. 1201. See Stigler’s quotation at the beginning of this paper.

[7] George J. Stigler, “Introduction,” Selections from the Wealth of Nations(Appleton-Century-Crofts, 1957), pp. vii-viii.

[8] Ludwig von Mises, “Why Read Adam Smith Today,” in Adam Smith, The Wealth of Nations (Regnery, 1998), pp. xi-xiii.

[9] Friedrich Hayek, The Trend of Economic Thinking: Essays on Political Economists and Economic History, The Collected Works of F. A. Hayek (University of Chicago Press, 1991), pp. 119, 121.

[10] Iain McLean, Adam Smith: Radical and Egalitarian (Edinburgh University Press, 2006), pp. 91, 120, passim, and Samuel Fleischaker, On Adam Smith’s Wealth of Nations: A Philosophical Companion (Princeton University Press, 2005).

[11] See especially Spencer J. Pack, Capitalism as a Moral System: Adam Smith’s Critique of Free Market Economy (Edward Elgar, 1991).

[12] William J. Baumol and Alan S. Blinder, Economics: Principles and Policies, 8th ed. (Harcourt College Publishers, 2001), p. 214.

[13] Frank Hahn, “Reflections on the Invisible Hand,” Lloyds Bank Review (April, 1982), pp. 1, 4, 8.

[14] See Emma Rothschild, Economic Sentiments: Adam Smith, Condorcet, and the Enlightenment (Harvard University Press, 2001), p. 119; John Roemer, Free to Lose (Harvard University Press, 1988), p. 2-3; and Frank Hahn, “Reflections on the Invisible Hand,” Lloyds Bank Review (April, 1982).

[15] Alan B. Krueger, “Introduction,” The Wealth of Nations (Bantham, 2003), p. xxiii. Krueger’s recommended reading list includes works of Robert Heilbroner and Emma Rothschild, and a brief reference to an article by George Stigler.

[16] Murray N. Rothbard, Economic Thought Before Adam Smith (Edward Elgar, 1995), pp. 435-436, 448, 451, 452, and 458. Even radical economist Spencer Pack considers his attack on Smith “unduly severe” and “one of the harshest attacks every made upon Smith’s work by a non-Marxist (or indeed any) economist.” See “Murray Rothbard’s Adam Smith,” Quarterly Journal of Austrian Economics 1:1 (1998), pp. 73-79.

[17] Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations(Liberty Fund, 1981 [1776]), p. 456.

[18] Iaian McLean, Adam Smith: Radical and Egalitarian, pp. 53, 82.

[19] Milton Friedman, “Adam Smith’s Relevance for 1976,” in Fred R. Glahe, ed., Adam Smith and the Wealth of Nations: 1776-1976 Bicentennial Essays (Colorado Associated University Press, 1978), p. 17.

[20] George Stigler, “Successes and Failures of Professor Smith,” p. 1201.

[21] Mark Skousen, The Making of Modern Economics, 2nd ed. (ME Sharpe, 2009), p. 219.

[22] Gavin Smith, “Adam Smith and the Invisible Hand: From Metaphor to Myth,” Econ Journal Watch 6:2 (2009), p. 240.

[23] Emma Rothschild, Economic Sentiments: Adam Smith, Condorcet, and the Enlightenment (Harvard University Press, 2001), pp. 116, 137.

[24] Peter Minowitz, “Adam Smith’s Invisible Hands,” Econ Journal Watch 1:3 (2004), p. 404.

[25] Daniel B. Klein, “In Adam Smith’s Invisible Hands: Comment on Gavin Kennedy,” Econ Journal Watch 6 (2), (May 2009), pp. 264-279.

[26] Daniel B. Klein and Brandon Lucas, “In a Word or Two, Placed in the Middle: The Invisible Hand in Smith’s Tomes,” Economic Affairs (Institute of Economic Affairs, March 2011), pp. 43, 50.

[27] The modern Glasgow edition published by Oxford University Press and reprinted by Liberty Fund does not include the language essay, so “led by an invisible hand” is not dead-center. However, The Theory of Moral Sentiments published by Richard Griffin & Co. in 1854, and reprinted by Prometheus Books in 2000, does contain the language essay, and “invisible hand” appears on page 264, within five pages of the center (269).

[28] Adam Smith, Lectures on Rhetoric and Belles Lettres (Liberty Fund, 1985), p. 95.

[29] Gavin Kennedy, “Adam Smith and the Role of the Metaphor of an Invisible Hand,” Economic Affairs (March 2011), p. 53. See also Gavin Smith, “Adam Smith and the Invisible Hand: From Metaphor to Myth,” Econ Journal Watch 6:2 (May 2009), pp. 239-263.

[30] Gavin Kennedy, “Adam Smith and the Role of the Metaphor of an Invisible Hand,” op. cit., p. 54.

[31] Craig Smith, “A Comment on the Centrality of the Invisible Hand,” Economic Affairs (March 2011), p. 58.

[32] Craig Smith, op. cit., p. 59. Ryan Hanley (Marquette University) expresses “considerable uneasiness” about Klein’s thesis and is “not yet convinced.” See “Another Comment on the Centrality of the Invisible Hand,” Economic Affairs (March 2011), pp. 60-61.

[33] Adam Smith, The Wealth of Nations, p. 341.

[34] Adam Smith, The Theory of Moral Sentiments (Liberty Fund, 1982 [1759]), p. 36. For a discussion of the invisible hand as a religious symbol of the “invisible God,” and the four levels of faith in capitalism, see chapter 9 in Mark Skousen, Vienna and Chicago, Friends or Foes? (Capital Press, 2005).

[35] Adam Smith, The Theory of Moral Sentiments, p. 234.

[36] Daniel B. Klein, “In Adam Smith’s Invisible Hands: Comment on Gavin Kennedy,” Econ Journal Watch 6:2 (May 2009), p. 275.

[37] Ibid., p. 277.

[38] Robert Nozick, Anarchy, State, and Utopia (Basil Blackwell, 1974), p. 18.

[39] Duguld Stewart, Biographical Memoirs of Adam Smith (1793).


A fascinating Austrian encounter with China’s top think-tank

A couple of weeks ago in the offices of the Adam Smith Institute, I addressed more than twenty of China’s most senior economic thinkers while they visited London. All were members of China’s Development Research Centre (DRC) – the leading think tank of Communist Party’s Central Committee and the State Council.

At their request, I touched on the history of the UK’s free market think tanks, the importance of maintaining independence and how, in the Anglo-sphere, such organisations are often funded by a diverse array of non-governmental sources including individuals, foundations and enterprises.

I also talked about money, banking, accountancy rules, the sovereign debt crisis and I even briefly managed to touch on the issue of gold. Everyone smiled when we mused over the fact that the Chinese state represents 32 percent of GDP while the UK government is heading towards 52 percent.

However, the real fun started when we moved to the questions and answers section. Very quickly, a hand went up in the front row and through the translator a gentleman on my right asked “have you ever heard of the Austrian School of Economics?” I smiled, paused, said “yes”, explained why, and we all moved forward.

Later, the leader of the delegation said that while Adam Smith had been translated in to high Chinese at the beginning of the twentieth century, the Communist Party had had it more accessibly translated thirty years ago – in the early 1980s.

Now, reflecting on all of this after the event, I was reminded of something a friend at Liberty Fund had said to me concerning the launch of The Online Library of Liberty in the middle of the last decade. Within two days of the library going live its South East Asian server out of Australia crashed. Under investigation it turned that it had been due to the number of students in China trying to download J.S. Mill’s On Liberty.

I have no idea how many people in China are reading the classical liberal ideas of Adam Smith and J.S. Mill or are in any way familiar with the greats of the Austrian School of Economics. But this is a question to which I wish I had an answer.


The Debt–Inflation Cycle and the Global Financial Crisis

Previously published in Global Policy, Volume 2, Issue 2, May 2011
London School of Economics and Political Science.

Peter J. Boettke and Christopher J. Coyne


Writing over 230 years ago, Adam Smith noted the ‘juggling trick’ whereby governments hide the extent of their public debt through ‘pretend payments’. As the fiscal crises around the world illustrate, this juggling trick has run its course. This article explores the relevance of Smith’s juggling trick in the context of dominant fiscal and monetary policies. It is argued that government spending intended to maintain stability, avoid deflation and stimulate the economy leads to significant increases in the public debt. This public debt is sustainable for a period of time and can be serviced through ‘pretend payments’ such as subsequent borrowing or the printing of money. However, at some point borrowing is no longer a feasible option as the state’s creditworthiness erodes. The only recourse is the monetarization of the debt which is also unsustainable due to the threat of hyperinflation.

Policy Implications

  • The fear of deflation on the part of policy makers has led to an inflationary bias which neglects or underestimates the costs of inflation.
  • The debt–inflation theory of economic crises must be considered as a viable alternative to the standard debt–deflation theory of economic crises.
  • In order to curtail the tendency of using the tools of monetary and fiscal policy to concentrate benefits and disperse costs, policy institutions must effectively tie the rulers’ hands.
  • After centuries of only fleeting success at curtailing the deficit, debt and debasement cycle of public policy, we may have to consider seriously the possibility that the only way successfully to constrain the state is to eliminate from its purview the task of monetary policy.

Writing in 1776, Adam Smith noted the following regarding public debt:

When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid. … publick bankruptcy has been disguised under the appearance of a pretend payment. … When it becomes necessary for a state to declare itself bankrupt, in the same manner as when it becomes necessary for an individual to do so, a fair, open, and avowed bankruptcy is always the measure which is both least dishonorable to the debtor, and least hurtful to the creditor. The honour of a state is surely very poorly provided for, when in order to cover the disgrace of real bankruptcy, it has recourse to a juggling trick of this kind … Almost all states, however, ancient as well as modern, when reduced to this necessity, have upon some occasions, played this very juggling trick
(Smith, 1776, pp. 929–930).

The implications of Smith’s logic regarding public debt have come to fruition as evidenced by the violent situation in the streets of Athens, the situation facing the PIIGS (Portugal, Italy, Ireland, Greece and Spain) and the pending fiscal crisis facing US states such as California, Illinois and New Jersey. In each of these instances, the current predicament did not arise over the past year or two, but rather was the result of decades of public policy decisions resulting in fiscal imbalance. While pretend payments and the juggling of finances were able to hide the underlying realities for decades, the bill has now come due.

Over 230 years after Smith wrote The Wealth of Nations, the Great Recession has again brought debates about the public debt, and the role of government more broadly, to the forefront. The purpose of this article is to explore the relevance of Smith’s ‘juggling trick’ in the context of the dominant fiscal and monetary policies. Our central argument can be stated as follows: government spending intended to maintain stability, avoid deflation and stimulate the economy leads to significant increases in the public debt. This public debt is sustainable for a period of time and can be serviced through ‘pretend payments’ such as subsequent borrowing or the printing of money. However, at some point borrowing is no longer a feasible option as the state’s credit- worthiness erodes. This implies that the ultimate result of Smith’s juggling trick is the monetarization of the debt in order for the state to avoid bankruptcy. This too, however, is an unsustainable policy due to the threat of hyperinflation which has ravaging effects as evidenced by Russia and Germany in the early 20th century.

We proceed as follows. The next section shows how the current debates over public debt mirror the debate that took place during the 1930s between John Maynard Keynes and F. A. Hayek. We also highlight how concerns over the debt–deflation spiral emerged as part of this debate and continue to drive policy today. Section 2 discusses the mechanisms underpinning the debt–inflation cycle. We contend that the focus on deflation leads to an inflation-biased policy which neglects the cost of inflation and the logic of democratic politics that Smith highlighted in the opening quote. Section 3 lays out the dilemma we face. On the one hand we have theories indicating that active fiscal and monetary policies are necessary for recovery and growth. At the same time, we have public choice theories which indicate that increased public debt is ultimately unsustainable. Section 4 concludes with the lessons learned.

1. Back to the future

In the 1930s, the main macroeconomic debate in economic theory and policy centered around the question of who was right, Keynes or Hayek? In the wake of the Great Depression, Keynes argued that unless action was taken to stimulate aggregate demand the economy would sink further into an abyss of unemployment and lackluster economic growth. In contrast, Hayek argued that fiscal irresponsibility threatened the recovery and long-term economic health of the economy. The key to recovery and growth, according to Hayek, was private investment.

Keynes won the day in the 1930s, but in the 1970s that same debate resurfaced with a more ambiguous resolution, and since 2008 the debate has returned with a vengeance at a variety of levels. The current debate mimics the earlier one in that there is intense academic dispute about the causes of the Great Recession, as well as the best way forward. Further, as during the 1930s, the debate is also being played out in newspapers and magazines, as well as in vigorous political dialogue between conservative and liberal politicians on both sides of the Atlantic. Perhaps nothing illustrates more how the current debate mirrors that of the 1930s than the comparison of the writings in the pages of the major newspapers (see Boettke et al., 2010).

On 17 October 1932, D. H. Macgregor, A. C. Pigou, J. M. Keynes, Walter Layton, Arthur Salter and J. C. Stamp (Macgregor et al., 1932) published a letter in the Times of London noting that private spending was one of the primary causes for the continuation and severity of the Great Depression. They argued that immediate government action was necessary to counteract the fall in aggregate demand. Two days later, T. E. Gregory, F. A. von Hayek, Arnold Plant and Lionel Robbins (Gregory et al., 1932) responded in the same paper arguing that private investment was necessary to recovery and growth.

Eighty years later, a similar debate took place. On 14 February 2010, a group of economists led by Timothy Besley published a letter in the Sunday Times arguing for a credible fiscal plan to create confidence in the robustness of the UK system (Besley et al., 2010). Only by reducing the structural budget deficit, the authors argued, could the confidence of private investors be maintained. Four days later, a group of economists led by Lord Skidelsky, Keynes’ biographer, published a letter in the Financial Times arguing that the immediate concern should not be reducing the deficit, but instead ensuring robust growth through public spending (Skidelsky et al., 2010).

As the comparison of these two exchanges illustrates, the high stakes in the 1930s regarding government policy still exist decades later. However, the debate cannot be adequately understood in broad brush strokes of free market versus government intervention, or even in terms of the effectiveness of fiscal policy or monetary policy. It is much more subtle than that, even as it does turn ultimately on the question of the self-correcting capacity of the market economy. To understand the debate, one has to recognize the classic position carved out in the 1930s by Irving Fisher (1933). Fisher argued that a debt–deflationary spiral can sink an economy into a great depression unless the appropriate policies are performed to prevent the downward spiral of economic activity. Deflation, in other words, must be avoided by the monetary authorities, even at significant cost.

This preoccupation with avoiding deflation necessarily leads to an inflation-biased monetary policy. The ‘chief source of the existing inflationary bias’, Hayek wrote, ‘is the general belief that deflation … is so much more to be feared that, in order to keep on the safe side, a persistent error in the direction of inflation is preferable’ (Hayek, 1960, p. 330). The practical problem in monetary policy under this set of assumptions results in a situation where because ‘we do not know how to keep price completely stable and can achieve stability only by correcting any small movement in either direction, the determination to avoid deflation at any cost must result in cumulative inflation’ (Hayek, 1960, p. 330).

There are at least two major policy issues with the preoccupation with deflation. First, a positive case for declining price levels can be made since deflation, if it reflects generalized productivity gains that result from technological innovation in an economy, is good, not bad (see Selgin, 1997). It is complicated, if not impossible, to sort out as a matter of public policy good deflation from bad deflation. As a result, we are back again to the situation of cumulative inflation stressed by Hayek. Second, the self-reversing of the economic errors caused by inflation can be interpreted as a collapse in spending and a corresponding decline in economic activity as resources are reallocated, and thus those who fear deflation will call for a re-inflation to forestall the debt–deflation downward spiral. Hayek argues that the problem politically is that moderate inflation will be viewed pleasantly and will be revealed to be costly only in the future, whereas deflation is immediately observable and painful. Expediency in politics will reinforce the push for inflation, whereas politics by principle would demand permitting market adjustment and the reallocation of resources however painful in the short run (see Hayek, 1973, pp. 55–71).

The concern of deflation, and the neglect of inflation, have continued to the present day as evidenced by a recent speech by Federal Reserve Chairman Ben Bernanke (2010) in which he noted:

the FOMC [Federal Open Market Committee] will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation.

Recognizing Fisher’s concern for the debt–deflationary spiral is crucial because while the debate between Keynes and Hayek focused largely on fiscal policy, the fear of deflation shifted focus to monetary policy. The combined result was, and continues to be, a policy characterized by a proactive Keynesian case for fiscal policy to stimulate growth, and a proactive monetarist (and proto-monetarist) policy to avoid deflation. This, however, puts us in the very situation raised by Smith in The Wealth of Nations. How do we avoid the natural tendency of politicians and policy makers to engage in the juggling trick that hides the true costs of these proactive fiscal and monetary policies through increased borrowing and the monetarization of debt which can ultimately destroy an economy?

2. The public debt–inflation cycle

Smith’s recognition of the juggling trick regarding public debt is especially prescient because it correctly recognized the incentives facing elected officials well before the public choice revolution of the 1960s. This focus on basic incentives was lost with the Keynesian revolution. As Zingales (2009a) notes, ‘Keynes studied the relation between macroeconomic aggregates, without any consideration for the underlying incentives that lead to the formation of these aggregates. By contrast, modern economics base all their analysis on incentives’. This is a crucial point because fiscal and monetary policy is not designed in a vacuum. Instead, we must consider the incentives at two levels. First, we must understand the incentives facing policy makers when they design policy. Second, we must consider the incentives created by those policies. Let us consider each of these incentives in turn.

The logic of Smith’s ‘juggling trick’ insight was based on the basic incentives facing elected officials. Government can raise revenue in three ways: taxation, debt and inflation. To maintain popularity, governmental leaders prefer not to raise explicit taxes, so the preferred method of revenue generation is to borrow and then pay debts back with debased currency (an implicit tax). The democratic bias is to concentrate the benefits of public policy on well-organized and well-informed voters in the short run, and disperse the costs of public policy on the ill-organized and uninformed masses in the long run. The least informed and organized interest group at any point of time is future generations. Hence, the natural proclivity for the ruling regime is to run deficits that result in accumulated public debt, which is paid off with debasement. Throughout history this governmental habit of deficit, debt and debasement is what has brought down regimes and with that sometimes civilizations (see Groseclose, 1961, pp. 57–76; Rothbard, 1990 [1963], pp. 63–64).

It is this logic that has historically underpinned calls for an independent central bank, and various constraints on the policy discretion of both the treasury and the central bank. Ideally, rules must be designed to prevent policy cooperation ⁄ collusion between the fiscal and monetary policy makers precisely because we know the history of the political temptations to be seduced by the opportunity to engage in the juggling trick that Smith so long ago identified.

However, the problem goes beyond the incentives facing policy makers. The process of engaging in Smith’s juggling trick also creates perverse incentives in the private arena as proactive fiscal and monetary policies have led to increased efforts on the part of private actors to influence these policies for their personal gain. This raises the return to lobbying and rent-seeking activities relative to productive entrepreneurial activities, which are necessary not only for immediate recovery, but for long-term growth.

This interplay between the incentives facing policy makers and private businesspeople has resulted in a ‘vicious circle’ of favouritism and a lack of trust in financial and political institutions by citizens (see Zingales, 2009b). Politicians are intertwined with private markets as the logic of special interests discussed above (see Smith et al., forthcoming). At the same time, politicians seek to signal to citizens that they are independent of private interests. They do so by adopting strong policies against those private interests in the wake of crisis – increased regulation, threatened and actual taxes and fines, etc. This attempt to send a strong signal, however, has the unintended effect of creating an uncertain environment for subsequent investment which further exacerbates the fundamental problem of encouraging private investment for recovery and growth.

3. Misdiagnosing the sickness and cure

We are faced with a dilemma. On the one hand, the dominant theories of economic crises indicate that government must play a proactive role in getting the economy out of the depressed state of affairs. Active fiscal policy must be used to stimulate aggregate demand while active monetary policy must be used to avoid a deflationary spiral. However, we also have public choice theories dating back to Adam Smith which indicate that these very government actions are unsustainable and economically destructive.

The trends seem to support the Smith ⁄ public choice line of reasoning. In Capitalism and Freedom, Milton Friedman (1962, p. 75) pointed out that the primary justification of the expansion of public expenditure since the Second World War has been the ‘supposed necessity for government spending to eliminate unemployment’; an idea, Friedman goes on to argue, that has been thoroughly discredited by theory and practice. But, as he points out, ‘The idea may be accepted by none, but the government programs undertaken in its name, like some of those intended to prime the pump, are still with us and indeed account for ever-growing government expenditures’ (Friedman, 1962, p. 76). Close to 20 years later, Friedman noted that little had changed from when he first made those observations. ‘The repeated failure of well-intentioned programs is not an accident. It is not simply the result of mistakes of execution. The failure is deeply rooted in the use of bad means to achieve good objectives.’ But in spite of the overwhelming record of failure, these programs continue to expand. ‘Failures are attributed to the miserliness of Congress in appropriating funds, and so are met with a cry for still bigger programs’ (Friedman and Friedman, 1980, pp. 87–88).

Further, in the 25-plus years since those words were written little has changed in the day-to-day operation of politics, though Friedman was successful in transforming the rhetoric in the direction of market-economics language. At best, the growth of government was slowed, but it is important to stress that neither the Reagan nor Thatcher administrations reversed the trend line, and in the subsequent years even that slowing of the growth of government was reversed, especially after the 11 September 2001 terrorist attacks and the ensuing military conflicts and enhanced domestic security measures.

It is important to stress this because one of the great mythologies is that the Great Recession is evidence of the failure of unregulated capitalism. A similar mythology arose concerning the Great Depression. As Friedman and Friedman summed it up:

The depression convinced the public that capitalism was defective; the war, that centralized government was efficient. Both conclusions were false. The depression was produced by a failure of government, not of private enterprise. As to the war, it is one thing for government to exercise great control temporarily for a single overriding purpose shared by almost all citizens and for which almost all citizens are willing to make heavy sacrifices; it is a very different thing for government to control the economy permanently to promote a vaguely defined ‘public interest’ shaped by the enormously varied and diverse objectives of its citizens (Friedman and Friedman, 1980, pp. 85–86).

Failing to distinguish between unregulated capitalism and state-led capitalism, or mercantilism, has two negative consequences. The first is that it runs the risk of misdiagnosing the problem. If failures are attributed to capitalism when they are in fact the result of distortions caused by fiscal and monetary policies, this will lead to an incorrect diagnosis of the actual problem. The second, and related, consequence is that it runs the risk of misdiagnosing the solution. If, in fact, the cause of downturns is distortions caused by past fiscal and monetary solutions, then it is incorrect to assume that these same policies are the solution to the very problem they caused.

There is reason to believe that both types of misdiagnosis are at work in the current crisis. Zingales (2009a) notes that Keynesian policies have not only failed to avoid the current crisis but instead were a contributing factor to its onset. He writes that ‘The Keynesian desire to manage aggregate demand, ignoring the long-run costs, pushed Alan Greenspan and Ben Bernanke to keep interest rates extremely low in 2002, fuelling excessive consumption by the household sector and excessive risk-taking by the financial sector’ (Zingales, 2009a). Similarly, Taylor (2009) has documented how easy monetary policy combined with government programs that unintentionally shifted the incentives for risk taking caused and prolonged the current crisis. Finally, Rajan (2010) highlights how the role of loose monetary policy and the political push for easy housing credit contributed to the current crisis.

Prior to the onset of the crisis, economists too quickly identified the lack of macroeconomic volatility with the perfection of central banking, rather than seeing policies in terms of Smith’s juggling trick whereby fiscal and monetary policies paper over (literally) the efforts by market forces to correct for the misleading signals of the previous period of manipulation of money and credit in the economy. The Fed ‘getting off track’, to borrow Taylor’s (2009) apt phrase, was due to efforts to keep the previous misguided set of economic activities afloat rather than permitting the necessary adjustment to economic reality by market participants.

To the extent that Zingales, Taylor and Rajan are correct that past fiscal and monetary policies were a factor in causing the current situation, what confidence do we have that those same policies can now solve the existing predicament they helped to create? Further, to the extent that these policies are successful, they will only be so in the short run as they are just a continuation of the juggling trick. As the debt crises around the world illustrate, while payment can be delayed, eventually the bill becomes due.

4. Lessons learned

What have we learned from the Great Recession? We would like to highlight three lessons which we hope will be the subject of subsequent debate and discussion.

First, the debt–inflation theory of economic crises must be considered as a viable alternative to replace the debt–deflation theory of economic crises. Under the debt–deflation theory policy makers interpret every downturn in economic activity as a potential deflation, and therefore counteract it with easy monetary policy. When this happens market corrections will be cut short, and the previous boom is recreated through the manipulation of money and credit.

Ludwig von Mises (1966 [1949]) and F. A. Hayek (1979) were early expositors of an expectation-based macro-economics arguing that efforts to offset economic downturns through monetary policy enter a dangerous game of expectations and anticipated inflation. As Hayek argued, ‘We now have a tiger by the tail: How long can this inflation continue? If the tiger [of inflation] is freed, he will eat us up; yet if he runs faster and faster while we desperately hold on, we are still finished!’(Hayek, 1979, p. 110, emphasis added) It is this theory of the ‘crack-up boom’ (see Mises, 1966 [1949], pp. 426–428) that very well may be what we have seen manifesting itself in reality with the onset of the Great Recession in 2008. If this is accurate then the policy steps taken to date have merely reinforced, rather than ameliorated, the problem as a market correction to previous malinvestments has been turned into a global crisis by the very steps taken to prevent the market correction from occurring.

Second, to curtail the tendency of using the tools of monetary and fiscal policy to concentrate benefits and disperse costs, policy institutions must effectively tie rulers’ hands to eliminate the possibility of engaging in the juggling trick that Smith warned against. The importance of establishing credible and binding constraints on monetary authorities and government spending is by no means a new idea. However, modern history has demonstrated the elusiveness of the quest to establish binding and credible constraints on monetary and fiscal authorities.

This has important implications because the relevant question is not if constraints should be established, but instead whether binding constraints can be established within the existing institutional framework. If that institutional framework is vulnerable to the inevitable errors committed by policy makers – either innocent or malevolent – then the problem is not in the framework, it is the framework. Milton Friedman (1962, pp. 50–51) recognized this possibility when he wrote:

Any system which gives so much power and so much discretion to a few men that mistakes – excusable or not – can have such far reaching effects is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic – that is the key political argument against an ‘independent’ central bank. But it is a bad system even to those who set security higher than freedom. Mistakes, excusable or not, cannot be avoided in a system which disperses responsibility yet gives a few men great power, and which thereby makes important policy actions highly dependent on accidents of personality. This is the key technical argument against an ‘independent’ bank. To paraphrase Clemenceau, money is much too serious a matter to be left to the Central Bankers.

Similarly, Buchanan and Wagner are pessimistic of the ability to restrain the state from engaging in juggling tricks leading them to conclude that, ‘politically, Keynesianism may represent a substantial disease, one that can, over the long run, prove fatal for a functioning democracy’ (Buchanan and Wagner, 1977, p. 56, emphasis added).

This leads to our third and final lesson. After centuries of only fleeting success at curtailing the deficit, debt and debasement cycle of public policy, we may have to consider seriously the possibility that the only way successfully to constrain the state is to eliminate from its purview the task of monetary policy. Rather than a centralized and government monopoly control of the money supply, perhaps more decentralized and competitive institutional arrangements might have to be relied upon. Of course, what is required is the attention of economists to examine such institutional arrangements in depth and with all their critical attention. What cannot continue is the standard practice of looking at central banking theory and practice as if they were to be done by fully informed agents who act only in the public interest. Instead, a robust theory of the institutions of the monetary framework must be developed.


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Author Information

  • Peter J. Boettke, Department of Economics, George Mason University, Fairfax, Virginia.
  • Christopher J. Coyne, Department of Economics, George Mason University, Fairfax, Virginia.

Adam Smith Reveals His (Invisible) Hand!

Today is the anniversary of the publication of Adam Smith’s most famous work,  ”The Wealth of Nations” (March 9, 1776).

To celebrate this important day, I’ve written an article for FEE on Dan Klein’s discovery about the “deliberate centrality” of the invisible hand in Smith’s work, and what it all means.  It will appear in print in the June issue of “The Freeman.”

For some time now, there’s been a controversy brewing about Adam Smith’s famous metaphor of the free market, “the invisible hand.”  Critics point out that it is used only once in each of Smith’s two major works, “The Theory of Moral Sentiments” (1759) and “The Wealth of Nations” (1776).  Therefore, they conclude, this much touted symbol of free-market capitalism was in reality a marginal concept to Smith.

But now Daniel B. Klein (GMU) has made a fascinating discovery: the invisible hand is physically located in the dead center of the middle of both books.  Prof. Klein argues for deliberate centrality by Adam Smith — that the invisible hand doctrine of “the system of natural liberty” was central to his work.  Adam Smith has finally revealed his (invisible) hand!

On a personal note, March 9 is also the pub date of ”The Making of Modern Economics” (March 9, 2001).  It is not a coincidence.  Adam Smith is the heroic figure of the book.   It is now in its 2nd edition.  Last year it won the Choice Book Award for Outstanding Academic Title.  The book is available in hardback, paperback, Kindle, and audio book — and translated into five languages.

I’m happy to announce that Prof. Klein has accepted my invitation to participate in a debate at this year’s FreedomFest (July 14-16, Las Vegas), on the subject:  “Libertarian, Conservative, or Radical Egalitarian:  Will the Real Adam Smith Please Stand Up?” I hope you will join us for this annual event.