Book Review: The Death of Money: The Coming Collapse of the International Monetary System by James Rickards
The title will no doubt give Cobden Centre readers a feeling of déjà vu, but James Rickards’ new book (The Death of Money: The Coming Collapse of the International Monetary System) deals with more than just the fate of paper money – and in particular, the US dollar. Terrorism, financial warfare and world government are discussed, as is the future of the European Union.
Though he quotes F.A. Hayek a few times, the Austrian School gets only one mildly disparaging mention in the entire book. This seems odd for an author who devotes a whole chapter to the benefits of the gold standard. His first bestselling book, Currency Wars, argues that currency wars are not just an economic or monetary concern, but a national security concern for the USA.
Rickards relies on emerging Chaos theories of economics and markets (1) to buttress his arguments in favour of sound money and prudent – limited – government. He uses the same insights, twinned with years of Wall Street experience, to explain why the “coming collapse of the dollar and the international monetary system is entirely foreseeable.”
One of Rickards’ key arguments is that exponential increases in the total size of credit markets mean exponential increases in risk. The gross size of derivative markets is the problem, irrespective of false assurances about netting, he claims. Politicians and central bankers have by and large learnt nothing from recent crises, and are still “in thrall to bank political contributions.”
He makes the case for the US federal government to reinstate Depression-era restrictions on banking activities and for most derivatives to be banned. As a former Federal Reserve Chairman, Paul Volcker, said in 2009, “the only useful thing banks have invented in 20 years is the ATM” – a sentiment Rickards would probably be sympathetic to.
The chapter dealing with the Fed’s hubris and what investment writer James Grant calls our “PhD Standard” of macroeconomic management will be familiar territory for readers of this site. The Fed is trapped between the rock of natural deflationary forces of excessive debt, an ageing population and cheap imports frustrating its efforts to generate a self-sustaining economic recovery and the hard place of annualised inflation of 2%. Rickards quotes extensively from eminent economist and Ben Bernanke mentor Frederic Mishkin, who noted in a 2013 paper titled Crunch Time: Fiscal Crises and the Role of Monetary Policy that “ultimately, the central bank is without power to avoid the consequences of an unsustainable fiscal policy.”
More interesting is the author’s attempt to map out what-happens-next scenarios. The chapter about the on-going transformation of the International Monetary Fund into the world’s central bank, and Special Drawing Rights (SDRs) into a global currency, is particularly insightful. Though Rickards doesn’t say it, Barack Obama’s former chief of staff (and current Mayor of Chicago) Rahm Emanuel’s dictum about never letting a crisis go to waste seems to apply here: hostile acts of financial warfare would lead to calls for more international regulation, and to more government intervention and monitoring of markets. Observers of the EU’s crab-like advance over the last half century will be familiar with the process.
Indeed, my only quibble with this book is Rickards’ starry-eyed take on the EU – soon to be “the world’s economic superpower” in his view. Though he makes a good argument – similar to Jesús Huerta de Soto’s – that relatively-tight European Central Bank monetary policy is forcing effective structural adjustments in the eurozone periphery, as well as in eastern states that wish to join the euro, his endorsement of other aspects of the EU seem too sweeping.
The author talks of the benefits of “efficiencies for the greater good” in supranational government, and how subsidiarity makes allowances for “local custom and practice”. But, as the regulatory débacle surrounding the Somerset floods has shown recently, EU rule frequently licenses bureaucratic idiocies that destroy effective, established national laws. Regulatory central planning for an entire continent is, I’d say, just as suspect as monetary central planning for one country.
The continent’s demographic problems are probably containable in the short-term, as Rickards says. But mass immigration is driving increasing numbers of white Europeans to far-right parties. And while there is consistently strong public support for the euro in the PIIGS (Portugal, Ireland, Italy, Greece and Spain), he’s silent on the broader question of the EU’s democratic legitimacy. No mention of those pesky ‘No’ votes in European Constitution, Maastricht and Lisbon Treaty referendums – or of the Commission’s own Eurobarometer polls, which show more and more Europeans losing faith in “the project”.
No matter I suppose: the eurocrats will rumble on regardless. But what was that quote about democracy being the worst form of government apart from all the others?
All in all though, this is a great book – even for someone like me who’s not exactly new to the economic doom ‘n’ gloom genre. As Rickards says at the end of his intro: “The system has spun out of control.”
(1) For example Juárez, Fernando (2011). “Applying the theory of chaos and a complex model of health to establish relations among financial indicators”. Procedia Computer Science 3: 982–986.
Editor’s note: this article, under the title “No end to central bank meddling as ECB embraces ‘quantitative easing’, faulty logic” appears on Detlev Schlichter’s site. It is reprinted with kind permission.
The 2nd edition of his excellent Paper Money Collapse is available for pre-order.
“Who can print money, will print money” is how my friend Patrick Barron put it succinctly the other day. This adage is worth remembering particularly for those periods when central bankers occasionally take the foot off the gas, either because they genuinely believe they solved the problem, or because they want to make a show of appearing careful and measured.
The US Federal Reserve is a case in point. Last year the Fed announced that it was beginning to ‘taper’, that is, carefully reduce its debt monetization program (‘quantitative easing’, QE), and this policy, now enacted, is widely considered the beginning of policy normalization and part of an ‘exit strategy’. But as Jim Rickards pointed out, the Fed already fully tapered twice – after QE1 and after QE2 – only to feel obliged to ‘qe’ again some time later. Whether Ms Yellen is going to see the present ‘taper’ through to its conclusion and whether the whole project will in future be remembered as an ‘exit strategy’ remains to be seen.
So far none of the big central banks has achieved the ‘exit’ despite occasional noises to the contrary. Since the start of the financial crisis in the summer of 2007, the global trend has been in one direction and one direction only: From easy money we moved to easier money. QE has been followed by more QE. As I mentioned before, the Fed’s most generous year in its 100-year history was 2013, any talk of ‘tapering’ notwithstanding.
ECB mistrusted by Keynesian consensus
Whenever the European Central Bank reduces its money printing and scales back its market rigging, it invariably unleashes the fury of the Keynesian and inflationist commentariat. In the eyes of its numerous critics, the ECB lacks the proper money-printing credentials of the more pro-active and allegedly more ‘modern’ central banks. It still has a whiff of the old Bundesbank about it, although a few years back, when the ECB flooded the European banking system with cheap liquidity, its balance sheet was larger as a share of GDP than those of its comrades, the Fed and the Bank of England.
The ECB went through two periods of restraint since the crisis: In early 2011 it began to hike interest rates, and in 2013, after the eurozone debt crisis died down, the ECB allowed its balance sheet to shrink by more than €700 billion as banks repaid cheap loans from the central bank. This stood in stark contrast to the Fed’s balance sheet expansion of about $1,000 billion over the same period. The first episode of restraint came to an end in 2012 when the ECB reversed its rate hikes and then cut rates further, ultimately to a new low of just 0.25 percent. Presently, we are still in the second period of restraint, although it too appears to be about to end soon as the ECB’s boss Mario Draghi hinted in his press conference last week at a newfound willingness to embrace unconventional policies to combat ‘deflation’ or even ‘long periods of low inflation’. (The ECB’s harmonized index of consumer prices stood probably at just 0.5% last month.) This means the ECB is likely to cut rates to zero or below soon, or to start asset purchases (‘QE’), or probably both.
This move is hardly surprising in the big scheme of things as outlined above, and the ECB will explain it officially with its mandate to keep inflation below but close to 2 percent, from which it does not want to deviate in either direction. This target itself is silly as it assumes that inflation of 1.8 percent is inherently better than inflation of zero (true price stability, if it ever was attainable), or inflation of minus 1.8 percent (deflation). This is, of course, precisely the argument that has been relentlessly and noisily trumpeted by the easy-money advocates in the media, the likes of Martin Wolf and Wolfgang Münchau in the Financial Times, and the reliably shrill Ambrose Evans-Pritchard in The Daily Telegraph, among others. A certain measure of inflation is deemed good, very low inflation is bad, and anything below zero, even mild deflation, potentially a disaster. But why should this be the case?
Moderate deflation, that is, slowly declining money prices, may or may not be a symptom of problems elsewhere in the economy, but that slowly declining money prices as such constitute an economic problem lacks any foundation in economics and can easily and quickly be refuted by even a cursory look at economic history. In the 19th century we find extended periods of ongoing, moderate deflation in many economies that simultaneously experienced solid growth in output and substantial rises in living standards, a “coincidence”, wrote Milton Friedman and Anna Schwartz in their influential A Monetary History of the United States, 1867 – 1960, that “casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible.”
Many commentators advance the argument that falling prices depress consumption as purchases get constantly deferred. Even the usually more sober FT-writer John Authers seems to have succumbed to this argument as he explained to his readers last Saturday that prices “fall, thanks to sluggish economic activity. Consumers do not buy now, as goods will be cheaper in future. This lack of consumption slows growth further, and pushes prices down even further.” (John Authers, “Draghi has to back his QE words with action” Financial Times, Saturday April 5/ Sunday April 6 2014, page 24)
This argument, constantly regurgitated by the cheerleaders of money-printing, is weak. First of all, it is certainly no argument in the present environment of close to zero but still positive inflation. If the ECB plans to fight even very low inflation, as Draghi stated at the ECB press conference, than this argument does nothing to support that policy. Certainly, no one defers any purchases when prices are just stable. However, and more importantly, even in a mildly deflationary environment of let’s say 1 to 2 percent per annum, the argument does appear to be a stretch.
Argument ignores time preference
Consumers only contemplate buying something that they consider an economic good, that is, that they consider useful, that they want because it expends some (subjective) use-value to them. In deferring a purchase they can, in a deflationary environment, save money but at the cost of not enjoying the possession of what they want for some time. By not buying a toaster now you may be able to buy it 1 or 2 percent cheaper in a year’s time, or 2 to 4 percent cheaper in two years’ time (always assuming, of course, that the mild deflation persists that long, which nobody can guarantee), but even these small monetary gains come at the expense of not enjoying ownership of the toaster for two years. The small monetary gain obtained by delaying purchases is not for free, as the argument seems to assume, but comes at the cost of waiting. I suggest that only a very small number of items, and only those for which there is very marginal demand indeed, would be affected.
Time preference is not a concept of psychology, it is a constituting element of human action. It is a priori to human action, which means it exists independent of experience or of personal circumstances as it is already entailed in the very concept of what constitutes an ‘economic good’.
If you experienced no time preference in relation to a specific good you would be indifferent as to whether you enjoyed the possession of that good today or tomorrow. And tomorrow you would be indifferent as to whether you enjoyed it that day or the next, and so forth. Logically, you would be indifferent as to whether you enjoyed possession of it at all, and this means that the good in question is not an economic good for you. You do not care for it.
As George Reisman put is succinctly: To want something means, all else being equal, to want it sooner rather than later.
Be honest, how many purchases over the past 12 months would you not have made had you had a reasonable chance of obtaining the item in question at a 1 or 2 percent discount if you waited a year?
That the prospect of falling prices does not usually deter consumption can be readily seen today in the market for consumer electronics (mobile phones, computers), which has been in deflation – and considerable deflation – for quite some time.
Argument ignores opportunity costs of holding money
The argument also seems to ignore that holding one’s wealth in the form of money involves opportunity costs. Rather than sitting on cash you could enjoy the things you could buy with it. In a deflationary environment, your cash hoard’s purchasing power slowly rises and you can afford ever more nice things with your money, which means the opportunity cost of not spending it constantly goes up. (In a way, while you are waiting four years to buy your toaster at an 8 percent discount to today’s price, buying the toaster is also becoming marginally more attractive to others who are presently holding cash and who may initially not even had an interest in a toaster.)
I think that all that would follow from secular (that is ongoing, systematic but moderate) deflation is that cash would be a more meaningful competitor for other depositories of deferred consumption. Saving by simply holding money makes sense in a deflationary environment, so other vehicles to save with (bonds and shares) would have to offer a return reasonably above the expected deflation rate to attract savings. I think this is not an unreasonably high hurdle.
Furthermore, if what Authers and others describe were true for even marginal deflation, that is, if marginal deflation indeed led to more deflation and a progressively weakening economy, the reverse must logically be true for marginal inflation. Consumers would accelerate their purchases to avoid the 1 or 2 percent loss in purchasing power per annum, and this would quickly drive inflation higher. If two percent deflation led to cash hoarding and a collapse in consumption, would the 2 percent inflation advocated today as ‘price stability’ not lead to a spike in money velocity and an inflationary boom? Either scenario seems highly unrealistic.
Monetary causes versus non-monetary causes
If we use the economic terminology correctly, then inflation and deflation are always monetary phenomena, that is, they always have monetary causes. (As an aside, I here use the now standard definition of inflation as an ongoing, trending rise in the general price level, and deflation as the opposite, rather than the traditional meaning of inflation as an expansion of the money supply and deflation as a contraction.) However, the starting point of the present discussion is simply some low readings on the official inflation statistics in the eurozone. And that those could have non-monetary causes, that they could be the consequence of a crisis-driven drop in real demand in certain industries and certain countries is a realistic assumption and is in fact implied by the arguments of the QE-advocates. Outright deflation is presently being recorded in Greece, Cyprus, and Spain. And John Authers’ short statement on deflation in the FT also starts from the assumption that “prices fall thanks to sluggish economic activity.”
But to the extent that recorded deflation is not due to a general rise in money’s purchasing power (due to a general rise in money demand or an unchanged or falling money supply, to which I come soon) but the result of some producers slashing certain prices in certain industries and regions, and of those price drops not being fully compensated by rising prices somewhere else in eurozone, then this has various implications:
Consumers cannot simply assume that this is a lasting trend. The liquidation of capital misallocations and the discounting of merchandise to get it moving are crisis phenomena and cannot simply be extrapolated into the future the way consumers may have extrapolated the secular deflation of gold standard economies in the 19th century. But the straight extrapolation of very recent price changes into the future is at the core of the argument that even small deflation would be disastrous.
Furthermore, it would seem bizarre to advice merchants to not slash prices when demand drops as that would, according to the logic advanced by Authers et al, only lead to further postponement of consumption and a further drop in demand as consumers would simply expect price declines to continue. Would hiking prices be a better strategy to counter falling demand? Should we reconsider the concept of the “sale” and of “discounting” inventory to encourage buying?
To a considerable degree, the reduction in certain prices for ‘real’ economic reasons could be part of the economic healing process. It is a way for many producers, sectors of the economy, and economic regions, to regain competitiveness. It is true that falling wages in certain industries or regions make it more difficult for workers to repay mortgages and consumer loans but often the lower wage may be the only way to avoid unemployment, which would make repaying debt harder still. Behind the often-quoted headline inflation rate of presently 0.5% per annum lie numerous relative price changes by which the economy re-balances. All discussions about the ‘price index’ ignore these all-important changes in relative prices. It so happens that what goes on with the multitude of individual prices in the economy adds up, according to the techniques of the ECB statisticians, to a 0.5% harmonized inflation rate at the moment, and it may all add up to -0.5% next month or next year, or maybe even – 1 percent. To simply conclude from this one aggregate price number that the economy is getting progressively sicker would be wrong.
There is no escaping the fact that recent economic difficulties are the result of imbalances that accumulated during the credit boom that preceded the 2007/2008 financial crisis, of which the eurozone debt crisis was an after quake. Artificially cheap money created the credit boom and these imbalances. A period of liquidation, contraction, changing relative prices and occasionally falling prices is now necessary, and short-circuiting this process via renewed central bank intervention seems counterproductive and ultimately dangerous.
There is, of course, the possibility that proper monetary causes are behind the eurozone’s low inflation and soon deflation, and that those might persist. Banks still feel constrained in their ability to extend new loans and thus create new money. The growth in bank lending and thus in wider monetary aggregates may fall short of the growth in money demand. But it is an essential feature of money that any demand for it can be fully satisfied with a rise in its price. Demand for money is always demand for readily exercisable purchasing power, and by allowing the market to lift the purchasing power of money, that is, through deflation, that demand can be met. The secular, moderate and largely harmless deflation of 19th century gold standard economies had essentially the same origin. Money production did not keep pace with money demand, so money demand was satisfied via slowly falling prices.
And here the same conclusion applies: a more restrained approach to lending, credit risk, and financial leverage, now adopted by banks and the public at large as a consequence of the crisis, may be a good thing, and for the central bank to mess with this process and to use ‘unconventional’ means to force more bank lending and money creation onto the system, out of some misguided commitment to the arbitrarily chosen statistical goal of ‘2-percent inflation’ seems foolish. If successful in raising the headline inflation rate it may succeed in creating the same imbalances (excessive leverage, misallocations of capital and distorted asset prices) that have created the recent crisis.
One commentator recently said the eurozone could ill afford deflation considering the size of its bloated banking sector. But the question is if it can afford the level of lending to attain 2 percent inflation considering the size of its bloated banking sector.
The fallacy of macroeconomics and macroeconomic policy
Let me be clear: I do not recommend a zero-inflation target or a target of moderate deflation. Moderate deflation in and of itself is a little a solution as moderate inflation in and of itself is a problem. I recommend no target as I reject the entire concept of ‘monetary policy’, of the notion that a state agency could conceivably enhance, through clever manipulation of interest rates and bank reserve policy, the coordinating powers of the market that help people realize their personal economic objectives through free trade.
We should remember that no one participates in the economy and in trade and commerce because his or her goal is that the general price level goes up by 2 percent, or that nominal GDP increases by 5 percent. People have their own personal objectives. The market is simply a powerful tool for voluntary and decentralized plan-coordination among independent individuals and groups of individuals that pursue their own goals. It is best left undisturbed. This entire project of ‘monetary policy’ is absurd in the extreme, regardless of what the target is.
It is the fallacy of macroeconomics that certain statistical aggregates, such as CPI, GDP or nominal GDP, are deemed reliable representatives of what goes on in a complex market economy, and it is dangerous hubris to believe that the state should define ‘targets’ for these statistical aggregates and then use policy intervention to achieve them. This might be an approach intellectually suitable for the ruler of a communist or fascist society. It is fundamentally at odds with free trade and a free market, and it must and will fail. That should have been a clear lesson from the financial crisis.
Instead, the mainstream consensus, deeply influenced by Keynesianism and macroeconomics, continues to embrace policy activism and intervention. I fully expect central banks to continue on their path towards more aggressive meddling and generous fiat money production. It won’t take long for the ECB to take the next step.
“The goods and services traded on the semi-secretive website Silk Road since February 2011 with the virtual currency Bitcoins were so varied that the Federal Bureau of Investigation described it as “the most sophisticated and extensive criminal marketplace on the internet today”.
￼Its philosophical underpinnings, however, were not solely a desire to get rich quick but, according to the FBI complaint published on Wednesday after the site was shut down, “Austrian economic theory” and the works of Ludwig von Mises and Murray Rothbard, economists closely associated with the Mises Institute, in the US state of Alabama.”
- More obnoxious anti-Austrian School slurs from the Financial Times, on this occasion by John Aglionby and Tracy Alloway.
The Daily Mail no longer has a monopoly on libelling the dead: the Financial Times is also doing a pretty good job. John Aglionby’s story this week (‘Libertarian economics underpinned Silk Road Bitcoin drug website’) was, even by the standards of a paper coloured pink that should really be coloured yellow, an extraordinary piece of character assassination. You do not have to be a believer in Austrian business cycle theory to find the linkage between an apparently criminal website and two widely respected economic theorists to be utterly objectionable. Those FT readers who were moved to respond on the paper’s website tended to think similarly:
“the lowest of lows..”
“FT trying to discredit Ludwig von Mises, the Austrian business cycle theory and Bitcoins all in one go.. for god’s sake, you do not have any decency left..”
“childish, glib and misleading.. a new low for the FT.. Disgusting, to say the least”
“Another shining example of the death of journalism”
“The goods and services traded on the semi-secretive website Silk Road since February 2011 with the virtual currency Bitcoins were so varied that the Federal Bureau of Investigation described it as “the most sophisticated and extensive criminal marketplace on the internet today”.
￼￼“Sorry to say, but you all seem to fail to understand that the FT is making a heroic attempt to switch from factual financial reporting to a top position in entertainment of the masses. Don’t you think they are doing well? I most certainly do.”
That the Austrian business cycle theory should be held in such low esteem by such a prominent financial journal might be taken as an admission of guilt for not having noticed the credit bubble while it was inflating, and for then having continually defended the (neo-Keynesian) establishment line rather than debate the practical value of any alternative policy course.
In Austrian business cycle theory, the central bank is the culprit responsible for every boom and bust, firstly in fuelling excessive bank credit growth and maintaining interest rates at overly stimulative lows; then in prolonging the inevitable recession by propping up asset prices, bailing out insolvent banks, and attempting to stimulate the economy via the mechanism of deficit spending. It is difficult to see why the theory is so problematic given that the US Federal Reserve, for example, is not an agency of the US government per se but rather a private banking cartel. When push comes to shove, whose interests will the Fed ultimately protect – those of the banks, or those of the rest of the productive population?
But in any discussion of the ‘long emergency’ enduring throughout the insolvent West, the role of politicians should not be ignored. If politicians had moderated their tendencies to make unaffordable promises to their electorates, western fiscal disasters and the attendant debt mountains would now be less dramatic. And if politicians were not slaves to the electoral calendar, it is fair to assume that difficult choices might even have been taken in the long term interests of their respective economies.
The current gridlock in the US political system (first over the shutdown and latterly over the debt ceiling) is a perfect example of grandstanding politicians abdicating all responsibility for the electorate they claim to serve. And as a glaring example of cognitive dissonance, Treasury bond investors’ responses to fears over a looming default really do take some beating. That beating should, of course, be reserved for investors stupid enough to believe that debt issued by the world’s largest debtor country should be somehow treated as risk-free, especially when the possibility of formal default is only a matter of days away.
Treasury bond defenders will no doubt point out that in a fiat currency world where the central bank has the freedom to print ex nihilo money to its heart’s content, the very idea of default is absurd. But that is to confuse nominal returns with real ones. Yes, the Fed can expand its balance sheet indefinitely beyond the $3 trillion they have already conjured out of nowhere. The world need not fear a shortage of dollars. But in real terms, that’s precisely the point. The Fed can control the supply of dollars, but it cannot control their value on the foreign exchanges. The only reason that US QE hasn’t led to a dramatic erosion in the value of the dollar is that every other major economic bloc is up to the same tricks. This makes the rational analysis of international investments virtually impossible. It is also why we own gold – because it is a currency that cannot be printed by the Fed or anybody else.
On the topic of gold, the indefatigable Ronni Stoeferle of Incrementum in Liechtenstein has published his latest magisterial gold chartbook. (FT: if you’re reading, Ronni is an Austrian, so you’ll probably want to start the character assassinating now.) Set against the correction in the gold price 1974-1976, the current sell-off (September 2011 – ?) is nothing new. The question is really whether our financial (and in particular debt) circumstances today are better than they were in the 1970s. We would merely suggest that they are objectively worse.
Trying to establish a fair price for gold is obviously difficult, but treating it as a commodity like any other suggests that the current sell-off is not markedly different from any previous correction during its bull run:
To cut to the chase, it makes sense to own gold because currencies are being printed to destruction; the long term downtrend in paper money (as expressed in terms of gold) remains absolutely intact:
And we cannot discuss the merits of gold as money insurance over the medium term without acknowledging the scale of the problem in (US) government debt:
Whatever happens in the absurd and increasingly dangerous debate over raising the US debt ceiling, the fundamental problem remains throughout the western economic system. Governments have lived beyond their means for decades and must tighten their belts. Taxes are certain to rise, and welfare systems certain to contract. Even if western governments manage to rein in their morbidly obese consumption patterns without a disorderly market crisis, their legacy will be felt by generations yet to come. The debt mountain cannot and will not resolve itself. (Why, again, we own gold; because we think there is a non-trivial chance of a gigantic financial system reset.) The piper must, at some point, be paid. Western economic policy can be distilled down into just four words: the unborn cannot vote.
This article was previously published at The price of everything.
Within the Austrian School of Economics there has long been disagreement and therefore occasionally fierce debate about the nature and consequences of fractional-reserve banking, from here on called simply FRB. FRB denotes the practice by banks of issuing, as part of their lending activities, claims against themselves, either in the form of banknotes or demand deposits (fiduciary media), that are instantly redeemable in money proper (such as gold or state fiat money, depending on the prevailing monetary system) but that are not fully backed by money proper. To the extent that the public accepts these claims and uses them side by side with money proper, gold or state fiat money, as has been the case throughout most of banking history, the banks add to the supply of what the public uses as money in the wider sense.
Very broadly speaking, and at the risk of oversimplifying things, we can identify two camps. There is the 100-percent reserve group, which considers FRB either outright fraud or at least some kind of scam, and tends to advocate its ban. As an outright ban is difficult for an otherwise libertarian group of intellectuals to advocate – who would ban it if there were no state? – certain ideas have taken hold among members of this group. There is the notion that without state support – which, at present, is everywhere substantial – the public would not participate in it, and therefore it would not exist, or that it constitutes a fundamental violation of property rights, and that it would thus be in conflict with libertarian law in a free society. This position is most strongly associated with Murray Rothbard, and has, to various degrees and with different shadings, been advocated by Hans-Hermann Hoppe, Jesus Huerta de Soto, and Jörg Guido Hülsmann.
The opposing view within the Austrian tradition is mainly associated with George Selgin and Larry White, although there are other notable members of this group, such as Steve Horwitz. This camp has assumed the label “free bankers” and it defends FRB against accusations of fraud and misrepresentation, maintains that FRB is a normal feature of a free society, and that no property rights violations occur in the normal conduct of it. But this group takes the defence of banking practices further, as it also maintains that FRB is not a disruptive influence on the economy, a position that may put the free bankers in conflict with the Austrian Business Cycle Theory, although the free bankers deny this. This point is different from saying that FRB is not fraudulent or suspect. We should always consider the possibility that otherwise perfectly legitimate activities could still be the cause of economic imbalances, even in a free market. If we did find that to be the case, we might still not follow from this that state intervention or bans are justified.
But the free bankers go even further than this. Not only is FRB not problematic, either on grounds of property rights nor on economic stability, FRB is even beneficial as it tends to maintain what the free bankers call short term monetary equilibrium, that is, through FRB the banks tend to adjust the supply of money (by issuing or withdrawing deposit money on the margin) in response to discretionary changes in money demand in such a way that disruptions would not occur that otherwise seem unavoidable under inelastic forms of money when changes in money demand would have to be absorbed by changes in nominal prices. FRB is thus not just legitimate, it is highly beneficial.
Purpose of this essay
As I said before, this is an old debate. Why should we reheat it? – Before I answer this question, I should briefly state my position: I am not fully in agreement with either camp. I do believe that the free bankers’ defence of FRB is largely successful but that their claims as to it being entirely innocuous and certainly their claims as to its efficiency in flexibly meeting changes in money demand are overstated. In my view, their attempts to support these claims fail.
FRB is, in principle and usually, neither fraud nor a scam, and the question to what extent the depositing public fully grasps how FRB works is not even material in settling this issue. In their 1996-paper ‘In defense of fiduciary media’, Selgin and White argue that the type of money that FRB brings into circulation has to be distinguished from fiat money; they explain that FRB is not fraudulent and that it does not necessarily involve a violation of property rights; third party effects, that is any potentially adverse effects that FRB may have on those who do not participate in it, are not materially different from adverse effects that may emanate from other legitimate market activity, and thus provide no reason for banning FRB; furthermore, Selgin and White claim that FRB is popular and that it would occur in a free market. I agree with all these points. There is no basis for banning FRB, so it should not be banned. This position is, in my view, correct, and it also happens to be obviously libertarian. I may add that I believe it is also almost impossible to ban FRB, or something like FRB, completely. We could ban FRB as practiced by banks today but in a developed financial system it is still likely that other market participants may from time to time succeed in bringing highly liquid near-money instruments into circulation, and that may cause all the problems that the 100-percent-reserve crowd associates with traditional FRB. The question is now the following: do these problems with FRB exist? The free bankers say no. FRB, in a free market, is not only not a source of instability, it is a source of stability as it manages to satisfy changes in money demand smoothly. These positive claims as to the power of FRB are the topic of this essay. I do not believe that these claims hold up to scrutiny.
Why is this relevant?
At first it does not appear to be relevant. Selgin and White declare in their 1996 paper, and I assume their position on this has not changed, that they are opposed to state fiat money and central banking. This sounds similar to the conclusions that I develop in my book, Paper Money Collapse. I advocate the strict separation of money and state. No central bank and no state fiat money. I think it is extremely likely that an entirely uninhibited free market in money and banking would again chose some kind of inflexible commodity – a natural commodity with a long tradition as a medium of exchange, such as gold, or maybe a new, man-made but scarce commodity, such as the cryptographic commodity Bitcoin, or something similar – as the basis for the financial system, and even if the market were to continue with the established denominations of dollars, yen, and so forth, as the public is, for now at least, still comfortable using them, would somehow link the issuance of these monetary units again to something inelastic that was not under anybody’s discretionary control.
In any case, if we assume that some type of ‘market-gold-standard’ would again resurface, it is very clear that under such purely market-driven, voluntary arrangements and with essentially hard money at its core, any FRB activity would be strictly limited. FRB-practicing banks would not have lender-of-last resort central banks watching their backs. There would be no limitless well of new bank reserves to bail out overstretched banks and to restart new credit cycles whenever the old ones have run their course. There would be no state-administered and tax-payer-guaranteed deposit insurance, or any other arrangement by which the cost of failure in banking could be socialized. Lowering reserve ratios and issuing additional fiduciary media (substitute money, i.e. deposit money) would be legal (the state would abstain from any involvement in monetary affairs, including the banning of any such activities) but it would come with considerable business risk, as it should be.
Would there still be FRB? Certainly. And in my view, the remaining FRB activity, adding as it does to the elasticity of the money supply at the margin and thus potentially distorting interest rate signals, is going to lead to capital misallocations to some degree, and thus initiate the occasional business cycle. That, in my view, is the price we have to pay for having a developed monetary economy and entire freedom in money and banking with all the undeniable advantages such a system brings. Importantly, I believe that these costs are unavoidable. But they are minor due to the absence of FRB-boosting state policy. – No, an entirely free market would not fulfil any dreams of uninterrupted bliss or realise the macroeconomist’s fantasy of everlasting ‘equilibrium’, both notions that Ludwig von Mises frequently rejected and ridiculed, but it would for sure be considerably better, and much more stable, than anything our present elastic monetary system can produce.
In Paper Money Collapse, I argue that inelasticity of supply is a virtue in money. That is why gold is such an excellent monetary asset. Complete inelasticity is unattainable in the real world but something like a proper gold standard is close enough. But for the ‘free bankers’ the remaining elasticity under restricted FRB (restricted by a stable commodity base) would be a boon. It would further stabilize the economy and establish…equilibrium. In my view, these claims are unsupported. But, you may say, why should we argue about the specific features of the post-fiat-money world if we are in agreement that such a post-fiat money world is in any case preferable to the present one?
The reason is simply this: how do we evaluate current policies? On this question I thought that most Austrians, as advocates of gold or something similar, and as critics of fiat money, would still be in broad agreement. But to my initial shock and my lasting amazement I found that some Austrian free bankers frequently cannot bring themselves to reject ‘quantitative easing’ and other heavy-handed central bank intervention on principle, and that they are able to embrace monetarist policy proposals, such as nominal GDP targeting by central banks, as a kind of second-best-solution that will do for as long as our first choice of separation of money and state is not realised. I believe these positions to stand in fundamental conflict with key tenets of the Austrian School of Economics and, apart from that and more importantly, to be simply unjustifiable. I think they are misguided. But it seems to me that the occasional support for them among free bankers originates in certain expectations as to what the equilibrating forces of ‘free banking’ would bring about in a free market in terms of a stable nominal GDP, and the free bankers can thus advocate certain forms of central bank activism if these are bound to generate these same outcomes. Therefore, in order to refute the idea of nominal GDP targeting we have to show that the free bankers’ expectations as to ‘monetary equilibrium’ under free banking lack a convincing analytical foundation. In this essay I want to pose some challenges for the free bankers. In a later article I hope to address NGDP-targeting as such.
Money does not need a producer
Among all goods money has a special place. It is the most liquid good and the only one that is demanded only for its exchange value, that is, its price in other goods and services. Anybody who has demand for money has demand for real money balances, that is, for effective purchasing power in the form of money. Nobody has demand for a specific quantity of the monetary asset per se, like a certain number of paper notes or a particular quantity of gold, but always for the specific purchasing power that these monetary assets convey.
In contrast to all other goods and services, changes in money demand can in theory be met by either producing additional quantities or by withdrawing and eliminating existing quantities of the monetary asset (changing the physical quantity of money), or by allowing the price of money, money’s exchange value, to change in response to the buying and selling of money versus non-money goods by the public (changing money’s purchasing power). Furthermore, it can be argued, as I do in Paper Money Collapse, that the superior market process for bringing demand for and supply of money in balance is the latter, i.e. the market-driven adjustment of nominal prices in response to the public’s buying and selling of money for non-money goods according to money demand. Why? – Well, mainly because the process of adjusting the physical quantity of money does not work. 1) We lack a procedure by which we can detect changes in money demand before they have begun to affect prices, and if prices are already beginning to change then these price changes already constitute the very process that satisfies the new money demand. This makes changing the quantity of money superfluous. 2) We lack a procedure by which we can expand and contract the supply of money without affecting the supply of credit and without changing interest rates. This makes changing the quantity of money dangerous. Money demand and loan demand are different things. Our modern fiat money systems are, in any case, not really designed for occasionally reducing the supply of money but for a continuous expansion of the money supply. As the Austrian Business Cycle Theory explains, expanding the supply of money by expanding bank credit must distort interest rates (artificially depress them) and lead to mismatches between voluntary saving and investment and thus to capital misallocations.
To this analysis the free bankers appear to voice a few objections. Before we look at the differences, however, let’s first stress an important agreement: the free bankers agree that nominal prices can do the adjusting and bring demand for and supply of money in balance. But they introduce an important condition: in the long run. In the short run, they argue, the process is not quite as smooth as many hard-money Austrians portray it to be.
Selgin and White (‘Defence’, 1996):
In the long run, nominal prices will adjust to equate supply and demand for money balances, whatever the nominal quantity of money. It does not follow, however, that each and every change in the supply of or demand for money will lead at once to a new long-run equilibrium, because the required price adjustments take time. They take time because not all agents are instantly and perfectly aware of changes in the money stock or money demand, and because some prices are costly to adjust and therefore “sticky.” It follows that, in the short run (empirically, think “for a number of months”), less than fully anticipated changes to the supply of or demand for money can give rise to monetary disequilibrium.
Thus, the first objection of the free bankers is that the account of the hard-money Austrians about the smooth adjustment of prices in response to changes in money demand is a bit superficial and slick. In the real world, not all prices will respond so quickly. Not all goods and services are being priced and re-priced in a continuous auction process, and when the public reduces money-outlays at the margin in an attempt to increase money-holdings, not every producer of goods and services will quickly adjust the price tags of his wares.
I do think some of this criticism is valid, and I am not excluding myself from it. My own account of the process of adjustment of money’s purchasing power sometimes runs the risk of glossing over the real-life frictions involved. However, to my defence, I acknowledged some of these problems in Paper Money Collapse, although I do not treat them extensively. See page 144-145:
In the absence of a flexible money supply, sudden changes in money demand will have to be fully absorbed by changes’ in money’s purchasing power. One could argue that this, too, has the potential to disrupt the otherwise smooth operation of the economy. Indeed, as we have seen, this phenomenon will also affect the prices of different goods differently. [This refers to the fact that when, for example, people try to raise their money holdings, they will reduce money-outlays on non-money goods or sell non-money goods for money, but they won’t cut every single expenditure item by an equal amount, or liquidate a tiny portion of each of their assets but will always cut the expenditure or sell the asset that is lowest on their present value scale. Downward pressure on prices from rising money demand will thus not be the same for all prices.]…A change in the demand for money will change overall prices but also relative prices and therefore the relative position of economic actors and the allocation of resources in the economy. All of this is true but it must lead to a different question: Is any of this avoidable….?
Is ‘monetary disequilibrium’ a unique phenomenon?
The free bankers are correct to point to these problems but it is also true that every change in the preferences of economic agents leads to similar problems. If consumer tastes change and money-flows are being redirected from certain products to certain other products, this, too, means that nominal spending on some items is being reduced. Profitability will decline in some parts of the economy and increase in others. This, too, will ultimate redirect resources and change the economy but all of these processes “take time because not all agents are instantly and perfectly aware …” of what is going on, and also for other reasons, including the stickiness of some prices. I think agents are never “instantly and perfectly aware” of anything, and that the slickness of economic models is never matched by reality. Accordingly, the real world is constantly in disequilibrium, and as economists we can only explain the underlying processes that tend towards equilibrium without ever reaching it. I wonder, however, if the concerns of the free bankers, valid though they are, are not just examples of the frictions that always exist in the real world, in which tastes and preferences change constantly, and change in an instant, but prices, knowledge, and resource use always move more slowly.
Furthermore, the issue of stickiness of prices should not be overstated. These days many prices do appear rather flexible and tend to adjust rather quickly: not only those of financial assets but also industrial commodities, and even many consumer goods, from used cars to hotel stays to flight tickets to everything on eBay. Discounting in response to a drop in nominal spending is the first of line of defense for almost every entrepreneur, I would guess, and if what the entrepreneur faces is indeed a higher money demand among his clientele, rather than a genuine change in consumption preferences, then sales should stabilize quickly at the lower price.
But I think the main point is this: how can the banks do better? What do the free bankers say to my two points above that changing the quantity of money is not really a viable alternative to allowing changes in nominal prices? Let’s address the first point first:
Point 1) We lack a procedure by which we can detect changes in money demand before they have begun to affect prices, and if prices are already beginning to change then these price changes already constitute the very process that satisfies the new money demand. This makes changing the quantity of money superfluous.
How do banks detect a change in money demand – before it has affected prices?
Banks have no facility to create money and money alone (deposit money, fiduciary media). New money is always a byproduct of banks’ lending operations. Banks can only create money by expanding their balance sheets. Thus, they always create an asset (a new loan) at the same time they create a new liability (the demand deposit in which the bank pays out the loan to the borrower, and which is part of the money supply). Therefore, if you suddenly experience a rise in money demand, if you suddenly feel the urge to hold more of your wealth in the form of the most fungible object (money), the bank can’t help you. Of course, you could go to the bank and borrow the money and then keep it in cash. This is a possibility but I think we all agree – and the free bankers seem to agree as well – that this is very unusual, and that it must be rare. Banks meet loan demand, not money demand, and the two are not only different, they are the opposite of one another. Borrowers do not have a high marginal demand for money; quite to the contrary, they have a high marginal demand for goods and services, i.e. non-money items (that is why they are willing to incur interest expense). The loan is in the form of money but the borrowers usually spend the money right away on whatever they really desire.
Banks are not in the money-creation business (or only in it by default – no pun intended); they are really in the lending business. The idea that rising money demand would articulate itself as higher loan demand at banks is wrong, and the free bankers do not usually make that mistake. They know (and some of them even stress) that money demand articulates itself in the markets for non-money goods and services (including, but not restricted to, financial assets). People reduce or increase spending in order to establish the desired money holdings.
To the extent that, when people experience a higher money demand, they sell financial assets to banks, the banks do indeed directly experience the heightened money demand, and if the banks increase their FRB activities in response and expand their balance sheets accordingly (the financial assets they buy enter the asset side of the balance sheet – they are the new loans – and the new demand deposits the banks issue to pay for them sit on the liability side of the balance sheet), the quantity of money is indeed being expanded in response to money demand. But to the extent that the public does not sell to FRB-practicing banks or that the public reduces other outlays or sells non-financial assets, the banks are not directly involved as counterparties. How can they still detect a rising money demand?
[As an aside, the free bankers sometimes speak of ‘the public having a higher demand for demand deposits or ‘inside money’ ’, and that the banks should be allowed to ‘accommodate’ this. I think these statements are confusing. Depositing physical cash in a bank, or conversely liquidating demand deposits to increase holdings of physical cash, are transactions between various forms of money. In a functioning FRB system, both forms of money, physical cash and bank-produced deposit money, are almost perfect surrogates. Both are used side by side, and both satisfy the demand for money. That is the precondition for FRB to work. The factors that occasionally determine preferences for a specific form of money are fundamentally different from those that affect the demand for money overall. If the public, for example, reduces demand deposits and accumulates physical cash, i.e. switches from ‘inside money’ to ‘outside money’, this may be because it is concerned about the health of the banks, and this is unrelated to the public’s demand for money, which in this case may be unchanged. As an example, in the recent crisis, the demand for physical cash increased in many countries, relative to the demand for bank deposits. At the same time, overall money demand also probably increased. But importantly, both phenomena are fundamentally different.]
The answer is this: if the public, in an attempt to raise money holdings, reduces money spending, this will slow the velocity of money, and to the banks this will be clearly visible. Money doesn’t change hands as quickly as before, and that includes transaction-ready deposit money at banks. Importantly, the slower velocity of money means a reduced risk of money outflows for each bank, in particular the likelihood of transfers to other banks that are a drain on existing bank reserves. Thus, the banks now have more scope to conduct FRB, that is, to reduce their reserve ratios, lower loan rates and issue more loans, and obviously to produce more deposit money in the process.
In the essay mentioned above, ‘In defence of fiduciary media’, this explanation appears in footnote 29, the emphasis here is different and so is the wording but the essence is the same, in my view. Banks increase FRB in response to a drop in money velocity. A rising money demand articulates itself in a lower velocity and thus a tendency for more FRB:
But how can the banks manage to expand their demand deposits, if total bank reserves have not changed? The increased demand to hold demand deposits, relative to income [increased money demand, DS], means that fewer checks are written per year per dollar of account balances. The marginal deposit dollar poses less of a threat to a bank’s reserves. Thus a bank can safely increase its ratio of deposits to reserves, increasing the volume of its deposits to the point where the rising liquidity cost plus interest and other costs of the last dollar of deposits again equals the marginal revenue from a dollar of assets.
I think this explanation is exceedingly clever and accurate. I do not, because I cannot, object to the logic. But does it help us? I have two observations:
1) Is it really probable that this process is faster and more efficient than the adjustment of nominal prices? The objection of the free bankers was that the adjustment of nominal prices takes time. But so does this process. The bankers will not be “instantly and perfectly aware” of what is happening anymore than the producers of goods and services. When the public reduces spending in order to preserve money balances the effect will be felt as soon by the producers of whatever the public now spends less money on, as by the bankers who see fewer cheques being written. Why would we assume that the bankers respond faster? Sure, prices can be sticky, but does that mean that accelerated FRB will always beat nominal price changes in terms of speed? Will the bankers always expand their loan book faster than the affected producers discount their product? It is not clear to me why this would be the case.
2) More importantly, the banks will, by definition, give the new deposit money first not to those who have a higher demand for money but to their loan clients who, we just established, have no demand for money but for goods and services, and who will quickly spend the money. From there, the money will circulate and may, finally, reach those who do indeed have a higher demand for money. But there is no escaping the fact that this is a roundabout process. For the very reason that banks can only produce money as a byproduct of their lending business, those who do demand higher money balances can only ever be reached via a detour through other markets, never directly. Bank-produced money has to go through the loan market first, and has to change hands a few times, before it can reach those who originally experienced a high money demand. There is no process as part of which we could ever hear a banker say to any of his customers: you have a higher money demand? Here, have some. – The question is now, what type of frictions or unintended consequences of this procedure of satisfying money demand do we encounter? Are these frictions likely to be smaller or even greater than the frictions inherent in allowing nominal prices to do the adjusting to meet changes in money demand?
Before we address these frictions a few words on a related topic: the free bankers sometimes seem to imply that unwanted fiduciary media (demand deposits, inside money) would return to the banks. This is not correct, or rather, it would only be correct if people wanted to exchange the demand deposit for physical cash but this is a transaction that is, as we have seen, unrelated to money demand. Claims against any specific bank may be unwanted, or demand deposits may be wanted less than physical cash, but this is unrelated to overall money demand. If deposit money is seen as a viable money good, and this is the precondition for FRB to work, any excess holding of money, whether inside money or outside money, whether cash or demand deposit, will not be returned to a bank and exchanged but will be spent! If banks increase their FRB activities and bring new fiduciary media into circulation, this money will circulate until it reaches somebody with genuine money demand. Often – when money demand has not risen simultaneously – this process involves inflation as a lower purchasing power for each monetary unit is required to get the public to voluntarily hold the new monetary units.
Is money demand a form of desired saving?
According to the free bankers, banks respond to a drop in money velocity as a result of rising money demand by engaging in extra FRB. At lower velocity, the risks inherent in FRB are smaller and this encourages banks to reduce their reserve ratios marginally, create extra loans and produce extra money, i.e. new deposit money that is now satisfying at least some of the new money demand. But what about the extra bank credit that also comes into existence? Hasn’t Mises shown that bank credit expansion is a source of economic instability; that bank credit expansion sets off business cycles? If extra loans at lower interest rates are not the result of additional voluntary saving but simply of money printing, and these loans still encourage extra investment and capital spending, then these additional projects will ultimately lack the real resources, resources that only voluntary saving can free up and redirect towards investment, that are needed to see the projects through to conclusion and to sustain them. Extra bank credit is thus bound to upset the market’s process of coordination between saving and investment – coordination that is directed via market interest rates. Would the extra FRB not start a Misesian business cycle? Would the allegedly faster and smoother process of satisfying changed money demand via FRB, via the adjustment in the nominal quantity of money rather than nominal price changes, not create new instabilities as a result of the artificially lower interest rates and the extra bank credit that are the necessary mirror image of new deposit money?
In Austrian theory, desired savings are a function of time preference. A lower time preference means the public attaches a lower importance to consumption in the near future relative to consumption in the more distant future. The discount rate at which future goods are discounted is lowered and the propensity to save rises, i.e. the willingness to reallocate income from meeting present consumption needs to meeting future consumption needs rises. The extra savings are offered on the loan markets at marginally lower rates. This encourages a marginal increase in investment. The marginally lower rates on the loan market thus accurately reflect the marginally lower time preference of the public. But lower rates as a result of credit expansion and FRB can unhinge this process. That is the core message of the Austrian Business Cycle Theory. How can the free bankers get out of this dilemma?
The free bankers counter this point by claiming that an increased demand for money reflects a lower time preference. Holding more money is a form of saving.
Although in the already quoted “Defence of Fiduciary Media”, Selgin and White at some point state that
We agree that time preference and money demand are distinct, and that a change in one does not imply a change in the other.
They also write, and this is more crucial to the case they are making, I believe,
The argument for the equilibrating properties of free banking rests in part on recognizing that an increased demand to hold claims on intermediaries, including claims in the form of banknotes and demand deposits, at the expense of holding additional consumer goods, is equivalent to an increase in desired saving.
In any case, in the examples they provide later, time preference, desired saving, and money demand always move together.
While I agree that accumulating money balances can be a form of saving (I say that much in Paper Money Collapse), it does not have to be the case, and I think it is more helpful to disentangle saving, consumption and money demand. Holding money is non-consuming, as Selgin and White point out, but it is equally non-investing.
If I sell my laptop on e-Bay so I have more readily spendable money (demand deposits) in my bank account so that I can take advantage of any unforeseen spending opportunities during my holiday in Greece, would we say that my time preference has declined, and that this is an act of saving? This is a switch from a consumption good to money, and Selgin and White would label this an act of saving, at least as I understand them. But the laptop would have delivered its use-value to me over a long period of time. Now I hold instantly spendable demand deposits instead. Has my time preference really dropped?
Here is a different example, one where we encounter a switch from investment goods to money, an example that Selgin and White put forward in their paper and where they argue that in such an operation total desired saving remains unchanged. Time preference remains the same. In the example given, the public sells bonds and accumulates cash or demand deposits instead. Both, money and bonds are non-consumption goods and thus saving-instruments in the Selgin and White definition. According to their theory, the banks would now acquire the bonds and issue deposit money against them. By doing this (increased FRB activity), the banks satisfy the demand for more money and keep interest rates from rising – which is appropriate as overall desired savings have not changed and time preference is still the same. – However, has the public’s time preference really not changed? Rather than holding a less liquid, long-term debt instrument the public now holds the most fungible asset (money). Is it fair to say that when people liquidate their bond portfolios that their time preference remains unchanged? – Maybe the public does this precisely for the reason that time preference has increased. The public may spend the money soon on consumption goods, or the public considers market interest rates too low and as no longer representative of the public’s time preference, and a drop in bond prices (rise in yields) is thus warranted to reflect this, and should not be cancelled out by the banks’ accelerated FRB.
The short run versus the long run
Furthermore, I suspect that there is an inconsistency in claiming that, in the long run, nominal price changes do bring the demand for and supply of money in line and then to argue that in the short run, money demand is best – and automatically – met by quantitative changes in the supply of money via FRB. The long run is evidently only a string of short runs, and if changes in money demand have been satisfied in the short run via FRB, how can these changes then still exercise up- or downward pressure on nominal prices in the long run?
The free bankers are correct to point to real-life frictions in the process of satisfying a changed money demand via an adjustment of nominal prices. The process is neither smooth nor instant, but then almost no market process is in reality. Their explanation that a rise in money demand will lead to a drop in money velocity and that this will, on the margin and under normal conditions, encourage additional FRB and thus an expansion of bank-produced money also strikes me as correct. Yet, the free bankers fail, in my view, to show convincingly why this process would be faster and smoother than the adjustment of nominal prices, and in particular, why the extra bank credit that also comes into existence through FRB would not generate the problems that the Austrian School under Mises has explained extensively.
If only a subset of the population, rather than the entire public, experiences a higher money demand – and this must be the more likely scenario by far – and this subset than reduces nominal spending on those goods and services that are relevant to this group, and if this then leads to a marginal drop in the prices of these goods and services, the extra demand of this group for real money balances has been met with potentially fairly limited frictions and side-effects, I would argue. By comparison, FRB can never meet money demand of any group directly. Banks always have to inject the new money into the economy via the loan market, that is, at a point where money demand is low and demand for non-money goods is high. Money demand will always be met in a roundabout way. Furthermore, the lowering of interest rates through the additional FRB activity is only unproblematic if the additional demand for real money balances is identical with desired saving and reflects a reduce time preference. These are rather heroic assumptions indeed.
Ludwig von Mises – The real free banker
The 100-percent-reserve Austrians have stuck – correctly in my view – with one of the most important insights of Austrian monetary theory as developed by the school’s most distinguished 20th century representative, Ludwig von Mises, namely the destabilizing force of credit expansion. Unfortunately, the 100-percent-reserve Austrians have taken the critique of banking too far. Claims of misrepresentation, deception, and fraud as being constituting elements of FRB go too far and remain ultimately unsupported.
The self-styled ‘free bankers’ are correct to reject these claims but they are taking their defense of FRB too far as well. By claiming that FRB could smoothly and quickly satisfy any changes in money demand they assign equilibrating properties to FRB that are ultimately unsupportable. In the process, they risk ignoring some of the most relevant Misesian insights. In particular the free bankers, it seems to me, tend to ignore that in an established FRB system, bank-produced fiduciary media (such as demand deposits) will be seen as near-perfect surrogates for money proper (such as state fiat money or gold). In such an environment the banks can (within limits) expand FRB and thus create more fiduciary media regardless of present money demand. Unwanted money (deposit money) then leads to a rise in money velocity and an upward pressure on nominal prices – it does not lead to the public exchanging deposit money for physical cash, as that would be just a switch from one form of money to another. Therefore, the unwanted bank-produced money – that entered the economy via the bank loan market – does not return to the banks. In my view, the free bankers ignore some of the dangers in FRB and overstate its equilibrating powers.
Both camps refer to Mises as an authority, albeit the ‘free bankers’ generally less so. Selgin and White, in their 1996 paper, quote Mises as a champion of free banking. I do, however, believe that the quote, taken from Human Action, has to be read in the context of Mises’ life-long and unwavering commitment to a proper gold standard. Here is the quote:
Free banking is the only method for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all the information required about their financial status. But under free banking it would have been impossible for credit expansion with all its inevitable consequences to have developed into a regular – one is tempted to say normal – feature of the economic system. Only free banking would have rendered the market economy secure against crises and depressions.
Crises and depressions, in Misesian theory, do not come about because of short-term mismatches between money demand and money supply, or frictions in the adjustment of nominal prices, but because of credit expansion. In order to appreciate Mises’s concerns over credit expansion, one does not have to consider bankers fraudsters (or ‘banksters’), and I can see no evidence in Mises’ writing that he saw bankers that way. But in order to agree with him that banks should be as free as all other enterprises – which, importantly, includes the freedom to fail – you do not have to assign them mystical equilibrating powers, either.
Mises’ conclusions were consistent and his recommendations practical: introduce inelastic, inflexible, apolitical money as the basis of the financial system, a hard monetary core, such as in a proper gold standard, and then allow banks the same freedom, under the same laws of corporation, that all other businesses enjoy – no special bans and no special privileges, such as ‘lenders of last resort’ or tax-payer-backed deposit insurance – and you can allow the market to operate. I believe that this should be the policy proposal under which all Austrians can and should unite.
Any deviation from the core Misesian message also occasionally gets ‘Austrians’ into some strange political company. With their damnation of FRB and allegations of fraud, the 100-percent-reserve Austrians seem at times to play into the hands of populist anti-bank fractions that have recently grown in influence since the financial crisis started, and to inadvertently be associated with the statist proposals of organizations such as the UK’s Positive Money or IMF economists Benes and Kumhof, all of whom consider money-creation by private banks – FRB- as the root of all evil and propose full control over the monetary sphere by the state – a proposal that could not be further from Mises’ ideals.
On the other side, the free bankers are in such awe of the assumed equilibrating powers of FRB in a free market that they confidently predict a stable (or at least reasonably stable) nominal GDP – and if we do not have free banking and a free market yet, why not have today’s central banks target nominal GDP to get a similar result under today’s statist monetary infrastructure? Bizarrely, and completely indefensibly, in my view, these Austrians end up joining forces with aggregate-demand-managing Keynesians or money-supply-managing monetarists. This is not only in fundamental conflict with many tenets of the Misesian framework – it is simply misguided, even under considerations of monetary realpolitik, i.e. of what is politically practicable presently but better than the present system.
Banks should be free but can only ever be so within a proper capitalist monetary system, and that is a system with a market-chosen monetary commodity at its core, and most certainly a hard and inelastic one. No new ‘target’ for central bank policy can ever achieve results that mirror the outcome of a properly functioning monetary system and a free banking market. We do not have a gold standard and free banking at present, and under these conditions I would suggest that a central bank that imitates a gold standard as closely as possible – i.e. one that ultimately keeps the monetary base fairly stable – would be, under the circumstances, the second best’, or least worst, solution. But a full treatment of the NGDP-targeting proposal will have to wait for another blog.
In the meantime, the debasement of paper money continues.
This article was previously published at DetlevSchlichter.com.
Continued from Et in Arcadia ego
Here we come full circle, for what this essentially presumes is that there exist no means by which to achieve the ready monetization of credit since that insidious process – which is one favoured equally by the fractional free bankers as much as by the central banking school and the chartalists – breaks the critical linkage of sacrifice today for satisfaction tomorrow which is what ensures that we do not overstretch our resources or overextend the timelines pertaining to their employment.
Though we have already touched upon the basis for this affirmation, it is so pivotal to the argument, that I will test your indulgence in trying to bring home the point, once and for all.
When credit is not erroneously transmuted into money, it means that I, the lender, cede temporary control over my property to you, the borrower, postponing my enjoyment of the satisfactions it confers because you have made it plain to me that your desire for it is currently greater than mine. This difference in preference is – like all such disparities – an exploitable opportunity for us both and, recognising this, my existing claim over a specified quantum of current goods is voluntarily transferred to you, meaning I must abstain from its consumption (whether productive or exhaustive) while you partake of it in my place in what is a wholly co-operative and, moreover, a logically and physically coherent exchange.
You, in return, promise to render me a somewhat larger service some specified time hence, as the reward for my forbearance and the price of your exigency. That surplus – what we regard as the interest payable – will therefore be seen to be the price of time not of money, much less of ‘liquidity’ as the Keynesians would have us believe. Hence, it emerges as a phenomenon much more fundamental to our psychology as mortals and to the Out of Eden impatience with which this afflicts us than to any happenstance of the ‘market for loanable funds’. Once you accept this interpretation, you are at once made aware of just what an abomination is an officially-sanctioned zero – or in some cases, a negative – interest rate and you are presumably one step from wondering whether this monstrosity can be anything other than unrelievedly counter-productive.
Next, however, imagine that I take your IOU to the bank and that peculiar institution registers my claim upon its (largely intangible) resources in the form of a demand liability of the kind which – by custom, if not by legal privilege – routinely passes in the marketplace as money. Your promissory note – a title to a batch of future goods not yet in being – has now undergone what we might facetiously call an ‘extreme maturity transformation’ which it has conferred upon me the ability to bid for any other batch of present goods of like value without further delay. It should, however, be obvious that no such goods exist since you have not had time to generate any replacements for the ones whose use I, their lender, supposedly forswore until such time as your substitutes are ready to used to fulfil your obligations, something we agreed would be the case only at some nominated point in the future.
More claims to present goods than goods themselves now exist (strictly speaking, the proportion of the first relative to the second has been artificially increased) and thus the actions we may now simultaneously undertake have become dangerously incongruous. Our initially co-ordinated and therefore unexceptionable plans have become instead a cause of what is an inflationary conflict no less than would be the case if I had sold you my place at the head of the queue for the cinema only to try to barge straight past you in a scramble for the seat in question.
What is worse, is that this disharmony will not be limited to us two consenting adults – indeed, we may both actually derive an undiminished benefit from it – but by dint of the very fact that the disturbance we have caused will ripple through the monetary aether to inflict its pain upon some wholly innocent third party who is blithely unaware of the shift in the monetary relation which we have occasioned with the aid of the bank. In our cinema analogy, the bank has given me a duplicate ticket which will allow me to bump some uncomprehending late-arrival out of the place for which he has paid and denying him his right to see the show.
Monetization in this manner has done nothing less than scramble the economic signals regarding the availability of goods in time and space. Thus it confounds rational economic calculation in the round and so begins to render honest entrepreneurial ambition moot. Such a legalised misdemeanour is bad enough in isolation, but we know that this will be anything but an isolated infraction. When banks can monetize debts, they will: when they can grant credit in the absence of prior acts of saving, they will – indeed, we demand that they do no less out of the misplaced fear that otherwise economic expansion will be derailed.
The truth is, of course, that the greater the number of economic decisions which come to be conducted on such a falsified basis, the higher and more unstable is the house of cards we are constructing on the credulity of the masses, the conjuring tricks of their bankers, and the connivance of the authorities who are charged with their supervision. Worse yet, the feedbacks at work are such that each new card we add to the pile appears to justify the installation of every other card beneath it and the more imposing the edifice grows, the more eagerly we rush to make our own contribution to this financial Tower of Babel and the more frenetically the banking system works to assist us until it finally collapses under the weight of its own contradictions.
To modern ears, more attuned to the rarefied talk of the exotica of credit default swaps, payment-in-kind junk bonds, and barrier options, this may all seem rather laboured and old-fashioned with its parallels to the classical treatment of the ‘wage fund’ and its echoes of the hard money Currency School which fought the great controversy of the 19th Century with its loose credit, Banking School challengers.
For this I make no apology, for much of what we Austrians stand for can trace its roots back to the reasoning first laid out by Overstone, McCulloch, and Torrens in that grand debate, just as our opponents tonight can trace their lineage back to the likes of Tooke, Fullarton, and Gilbart (I might here blushingly recommend to you a modest little tome entitled ‘Santayana’s Curse’ in which I deal with the relevance of the background to that debate to modern-day finance).
It is also important to bear in mind that the game of finance cannot be conducted in a vacuum, to always be clear that its workings exert a profound effect on everyday decision making and that finance is a force for good when the rules of that game are in harmony with those laws of scarcity and opportunity which govern what is loosely termed the ‘real’ economy of men and materials.
Moreover, the elision of these two types of claims – money and credit – by what must be a fractional reserve bank has dramatically raised the stakes. The near limitless, fast-breeder proliferation of credit which this enables and the facile transformation of this credit into money breaks all sorts of self-regulating, negative feedback mechanisms between supply, demand, price, and discount rate. Greater, credit-fuelled demand leads to higher prices.
Higher prices should discourage further demand, but instead encourage more people to borrow in order to play for a further rise in prices, just as it flatters the banking decision to grant such loans since the earlier ones now appear to be over-collateralized and their risk consequently diminished. Divorced from a grounding in the world of Things and no longer intermediators of scarce savings but simply keystroke creators of newly negotiable claims, our modern machinery is all too prone to unleash a spiral of destabilizing – and ultimately disastrous – speculation in place of what should be a mean-reverting arbitrage which effortlessly and naturally reduces rather than exacerbates untoward economic variation.
Sadly, my monetarist and Keynesian rivals see nothing but positives in this arrangement and given their unanimity on the issue, I would hazard a guess that the complex adaptive system types are happy enough to bow to this consensus and to accept that this is simply the way things are when they construct their models and run their simulations. The laymen – even the expert laymen, if I may be allowed such an oxymoron – have been even more united in bemoaning anything which might inhibit banks’ ability to shower credit upon everyone and anyone who asks them for it. If we had no shadow banks, who would give the aspiring taxi-driver the price of his medallion or the wannabe nest-maker her mortgage, one participant asked, as if we all took it for granted that to enjoy goods for which one has not earned the means to pay was their god-given right.
Nor do the free-fractional types, as eloquently represented here by Professor George Selgin, have any objection to the mechanism itself, being, on the contrary, keen to suggest it will do far more good than harm by dampening down fluctuations which they fear may emanate from a suddenly increased to desire to hold money for its own sake. All they ask is that the ‘free’ banks they advocate are forced to come out from under the aegis of a central bank of issue and away from the current fiction of government deposit insurance and so have no-one to shield them from the consequences of any excess or imprudence into which they might stray.
It will probably not now surprise you to learn that while we agree that banks should indeed stand on their own two feet like those involved in any other branch of business, very few of us Austrians share his sanguinity on this issue, either on theoretical grounds or as a result of our own somewhat different interpretation of the (mainly Scottish) historical record.
For our part, we would rather that the kernel of money-proper around which all other obligations are arrayed is both unable to be near-costlessly expanded at political or commercial will or shrunk as a consequence of any wider calamity. Given this fixity, we trust that any change in economic circumstances will see prices adjust to reflect that without occasioning any major harm (our model economy has undergone a radical Auflockerung by now to ensure this). Nor do we believe that credit will be denied all flexibility, certainly not within the dictates of what the saver can be persuaded to accord to the investor, or the vendor to the buyer.
It is true that this would be a world characterized by the slow decline of most prices as human ingenuity and honest entrepreneurship were continuously brought to bear on the eternal problem of scarcity, but neither would this hold for us any terrors. After the initial transition, people would soon become acclimatized to such a benign environment and would adjust their expectations and their capital structures to best fit it.
As for Professor Selgin’s bogeyman of a sudden tumultuous rush to hold money for its own sake – which apocalypse he fears above all should we prohibit his Free Banks from printing up such liabilities, willy-nilly – we see little reason to believe such impulses could reach very far up the pecuniary Richter scale in a society which had wisely denied itself the volatile mix of massive fictitious capital, extreme leverage, inflationary gambling, morally-hazardous speculation, soft-budget public choice profligacy, and reckless maturity mismatches with which we are so afflicted in our present era of easy-money, chronic price-appreciation, and the granting of overarching central-bank ‘put-options’.
Sound money is more likely to prove conducive to sound business practice and hence to a sound night’s sleep for all.
To sum up then, the only valid economics is micro, not macro; individual, not aggregate. Value is subjective not objective. The consumer is sovereign in the choice of where he spends his dollar – and all values can be imputed from where he does so – but he should first earn that dollar through his prior contribution to production.
Entrepreneurial discovery is the evolutionary mainspring which drives our secular material advance and the entrepreneurial profit motive – in an honest-money, rent-free world – is the ‘selfish gene’ of that ascent. That same motivation mobilizes the set-aside of thrift in the form of capital and capital – to risk pushing the biological metaphor beyond the point of useful illustration – is the enzyme pathway leading to the synthesis of what it is we most urgently want at the lowest possible cost.
In all of this, the workings of a sound money should be so seamless and subliminal that we pay it no more attention than we do the fibre-optic networks or 4G radio waves used for the transmission of our digital data. Finance should be based on funding – i.e., the sequencing and surrender of the right to employ real resources through time.
That economics is an Austrian economics, not a monetarist one, a Keynesian one, nor a complex-adaptive system one and I heartily recommend it to your consideration.
Continued from Been there, done that, bought the T-shirt
Having broadly tried to demonstrate where we differ from our rivals and where we find their tenets most objectionable, you might be hoping that I will now be tempted to go into the details of what an Austrian might recommend by way of a remedy for our current ills even though this would exhibit a clear infraction of Hayek’s admonition that ‘the curious task of economics is to demonstrate to men how little they really know about what they imagine they can design’!
So, rather than having me succumb to such a ‘fatal conceit’, let me instead sketch the outlines of what would, in an Austrian estimation, be a world in which we would be unlikely to repeat our present stupidities, certainly not on the Olympian scale on which we currently practise them.
Firstly, we should recognise that much of our success as a species comes from our adherence to that peculiar form of competitive co-operation which we Austrians term ‘catallactics’ – i.e., the business of exchange, of trading the fruits of our varying endowments, aptitudes, and accomplishments to the mutual benefit of both counterparties to what may well be a single-priced transaction but which is nonetheless never a zero-sum one (at least when it is undertaken voluntarily and in good faith).
As a direct consequence of this, we can assert in the strongest possible terms that we therefore tamper with the means by which we conduct such dealings – we meddle with our medium of exchange, our money – only at our peril. To us, dishonest money is the root of all evil, not ‘shadow banks’, ‘moral hazard’, ‘regulatory capture’ or any of the manifold offshoots of human cupidity in general, for the ability of such perennial failings to wreak widespread havoc in either financial markets or economies, per se, would be much more severely limited if money were not so easily corrupted alongside the men who use it.
A good deal of discussion has taken place at this gathering and many ideas have been thrown up – many of them earnest, most of them shrewd, some of them even practicable – as to how to improve our present modus operandi. But unless banking and finance better reflect economic reality – and by this I mean of course Austrian reality! – all of them will be in vain: not so much shuffling the deckchairs on the Titanic as pruning the vines growing on the slopes of Mt Vesuvius, perhaps.
It should be further recognised that a vital subset of our economic interactions consists of that swap of jam today for jam, not just tomorrow, but for a long succession of tomorrows that we might more grandly term ‘intertemporal’ exchange. Indeed, it can be argued that this process is even more intrinsic to our humanity: that the move away from such hand-to-mouth activities as scavenging, foraging, and predation and towards the rational provision for the future by means of forward planning is very much what put the sapiens into the Homo, way back when Also sprach Zarathustra was first ringing out as the soundtrack to Mankind’s great Odyssey from the campfire to the Computer Age.
It is in this devotion of forethought and its associated deferral of immediate gratification where the concept of ‘capital’ first comes into our story and while this opens up before us a vista of riches bounded only by the interplay of our imagination and our willingness to make a short-term sacrifice in order to gain a longer term advantage, it is intrinsically fraught not only with estimable risk, but with unknowable uncertainty, as well as being subject to the further proviso that our own actions’ influence may well serve to increase the range of possible outcomes far beyond what we had first thought likely.
Keynes himself waxed lyrical about the ‘dark forces of time and ignorance’ – even if his own teachings have done more than most over the intervening years to enhance the occultation and obscurity against which his fellow men would have to contend – so it should not come as a surprise when we next insist that none of our man-made institutions can be said to be well-crafted if they aggravate these difficulties.
Economic institutions should thus allow information to percolate in as uncorrupted a manner as possible and should allow for feedback signals to be generated in as direct and unequivocal a fashion as they can. These should clearly flag where both success and failure has occurred so that useful adaptations can proliferate while the ineffective ones are abandoned as rapidly as can be. In essence this means that we must not pervert prices and, since every price is necessarily a money price, the unavoidable inference is that we should not mess with money.
A corollary to this is that there should be the least possible impediment to any and all such adaptations being attempted; indeed, much Austrian ink was spilled during that dark decade of the 1930s in arguing that the surest remedy for the many ills then afflicting the West was to sweep away the obstacles to change and to lubricate the working of the machinery – to practice a policy of Auflockerung, in the phrase of the day.
Following on from this, it should be evident that property should be inviolate and the wider rules of contract should be both transparent and consistent in their application. The law should be concerned principally with equity, the courts with providing a cost-effective and disinterested forum for the arbitration disputes arising from any violations of the first and of any failure to fulfil commitments freely made under the second. Aside from the many ethical considerations attaching to such a demand, we would argue for it additionally in terms of the need to reduce all the uncertainties under which men must act to their achievable minimum if we are to encourage the widest degree of peaceful association, the richest web of commercial relations, and the greatest degree of capital formation that we can.
What we do not want is to be inflicted with a shifting snowball of often retro-active regulation. We must avoid a diffusion or supersession of individual responsibility and desist from fuzzy, catch-all law-making – in fact, we should tolerate as little legal positivism as possible, especially of the kind enacted, often cynically, during periods of crisis. We must insist that the state offers neither explicit nor implicit guarantees, that no bail-outs, or back-door favours be extended to the privileged few at the expense of the disenfranchised many. Finally, it should be impressed upon our elective rulers that the politics of disallowing loss, however well-intentioned, is nothing more than a policy of disavowing gain.
Though there are wider ramifications, the worlds of money and finance should, of course, be subject to all the above strictures. Here, we would again emphasize that to interfere wilfully with the substance of our money is to put oneself in breach of most of these guidelines; indeed, that this is perhaps the most heinous of all infractions, since it entails the most pervasive attack upon both property and the sanctity of contract that there can be since it involves a post hoc and highly arbitrary change in the dimensions of the very yardstick by which the terms of all such agreements are drawn up.
We would further contend that the paving stones on our road to the future, on the intertemporal highway whose praises we have already sung, are nothing more than our investments. These should be funded with scarce savings, not financed by the paltry fiction of banking book entries and hence the business of investment should be conducted only in accordance with the balance we can jointly negotiate between our current ends and our ends to come; that is, on a schedule which naturally emerges to reflect our societal degree of time preference and which does not emanate solely from the esoteric lucubrations of some central banking Oz.
Progress may be less spectacular this way, unpunctuated as it will be by the violent outbreaks of first mass delusion and later disillusion which comprise the alternations of Boom and Bust. But it will be, by that same measure, steadier and more self-sustaining. Absent such a condition, the fear I have already raised is that all the well-meaning calls for better financial regulation and more condign penalties for banking malfeasance are so many straws in the wind as far as a better functioning financial apparatus is concerned.
In passing, the very fact that we are all gathered here to bring so much effort and expertise to bear on the problems thrown up by our contemporary methods of finance shows just how far we have strayed from a true appreciation of its abiding scope as what is effectively little more than a glorified, if somewhat disembodied, form of logistics. Finance should be a record of the assignment of goods and property rights across time and space – a four-dimensional bill of lading, as it were. It would be better were it seen for what it is – a means and not an end; the flickering reflection of a deeper Reality on the wall of Plato’s cave, not a towering 3D IMAX rendition of a screenwriter’s imagining. It should once again be valued only as the carthorse and not as the cargo he pulls behind him.
This article is the fourth in a series. The final instalment will follow shortly.
Continued from Scylla & Charybdis
The guilty secret shared by many disciples of these two schools is that they are well aware that theirs is very much a busted flush, as is made plain by the procession of very public breast-beatings and existential re-examinations which they have conducted in the years of post-Lehman purgatory by way of atonement for their failures. Indeed, one measure of the dissatisfaction felt at the failings of these Terrible Twins – the money illusionists and the flushing-toilet hydraulicists – lies in the attention now being focused on the work being done by my third opponent and his peers under the guise of the ‘complex adaptive system’ approach.
To an Austrian, in truth, there is much about this last that seems thoroughly unobjectionable, so much so that it is hard to resist an invocation of Gunnar Myrdal’s trenchant dismissal of Keynes’ for his linguistically-challenged commission of the sin of many a monoglottal, English-speaking economist – that of ‘unnecessary originality’.
I say this because in many ways the Complexity guys are simply putting a computer-age spin on concepts we have been trying to articulate for the past three generations.
We, too, start from the bottom-up by focusing on the individual – or the ‘agent’ as he is now known. We, too, believe that order is emergent, knowledge is dispersed, network effects are key, and that the attainment of equilibrium is a mirage.
Where I suspect we differ is that we are more radically subjectivist in a way that it cannot be possible to capture in a mathematized ‘model’. One might also be dubious about the degree of ‘scientism’ involved – i.e., the extent to which there has been an invalid application of the precepts of physics to what is after all a social phenomenon. One might also be wary of the inherent dangers of being too prescriptive in laying out what the ‘agents’ may or may not do.
Among the caveats is the fact that we Austrians hold that scales of preference and utility are ordinal, not cardinal, and so are not arithmetically tractable. Moreover, we cannot see it as a complete solution to go to the trouble of atomizing what was formerly a faceless, monolithic ‘aggregate’ only to have to deny the atoms their own individuality, however capricious their expression of this property may be. We must be wary therefore of driving out the ghost and leaving only the machinery behind.
Nor do we then want to thrust our poor little cellular automata into a Game of Life whose inevitably arbitrary choice of rules is predicated on the very same contradictory framework from which we are trying to free ourselves – namely, the one prescribed by the traditional schools of macromancy. Not only would we wish to avoid our agents’ freedoms being prejudiced by the suppositions of the mainstream, we would also wish them to do more than play out a mere financial simulation, however rich it might be in revealing the structural flaws in our existing institutional architecture and in warning us of its proclivity to the negative feedbacks, price cascades, and other malign outcomes which have come to plague it.
For us, a better imagined microcosm would include scope for the real-world action of entrepreneurs, those principal vectors of eco-genetic adaptation and selection, those drivers of change and arbitrageurs of profitable possibilities, the men and women who are constantly seeking out new combinations of action and innovative mixes of things in order to deliver more value at lower cost to a wider range of customers. Any toy universe which leaves out a reasonable representation of entrepreneurial endeavour – and the fact that this quintessential force for betterment thrives best in conditions which lie outside the bounds of equilibrium, yet away from the ragged edge of chaos – is likely to produce a poor facsimile of the real economy.
Our stipulation for an improved virtual landscape would also insist it addresses a major failing of mainstream macro, viz., its poor handling, if not outright neglect, of the role of capital – a critical construct which is neither a financial variable (despite the unfortunate overlap of terminology with the world of book-keeping) nor, strictly, a mere physical entity like a factory or a machine tool, but which is rather a hybrid which includes both the use of the Thing and the process by which it is employed such that ‘capital’ becomes as much a verb as a noun, if you will.
It may be that we do a disservice both to the judgement and the ingenuity of our Complex System friends, but it does seem questionable that the kind of ‘experts’ they are likely to have consulted would have advised them to incorporate such features when writing their programs just as it is beyond our ken as to exactly how they would go about doing so, even if asked.
If it really is the case that either they have not or they cannot, theirs must very much still be considered a work-in-progress and not yet a fully-formed tool of analysis.
This article is the third in a series. Continue to Part 4: Et in Arcadia ego.
“…the stoppage of issue in specie at the Bank [in 1797] made no real addition to the financial powers of the country. On the contrary, it diminished considerably the real efficiency of those powers, while it introduced a facility in money-transactions, which has cost the country more in real comfort, and will probably cost it more in lasting expense, than any circumstance that has ever occurred.”
“If there had been less facility, there probably would have been more utility in those transactions; money would have been more valuable and more valued. The [fixed income] stocks probably would have been lower in price, but certainly no less deserving of confidence. There would have perhaps been a larger discount on floating [short-dated] securities; but there would have been fewer complaints of the expense of living; and, above all, the country would have had the unimpaired glory of having resisted all dangers from without, as well as within, without the sacrifice or suspension of any one principle of public faith.”
Reply of Walter Boyd to a letter from a friend sent 9th January, 1801
‘The Future of Finance’ was a conference convened in May by the Knowledge Transfer Network with the support of, among others, the Institute for New Economic Thinking and Oxford’s Said Business School. As part of the programme, a debate was staged between the representatives of four ‘schools’ of economic thought – the Monetarists, as represented by the former ‘Wise Man’ Professor Tim Congdon; the Keynesians, as championed by Christopher Allsopp, formerly of the BoE’s MPC; the Complex Adaptive Systems approach of Professor Doyne Farmer of ‘Newtonian Casino’ fame, and the Austrians whose corner was fought by yours truly.
The following essay attempts to expand upon the arguments I made that night in what was obviously a much more concise form, together with some more general thoughts thrown up by the conference at large. Since the event in question was deliberately – if courteously – adversarial and given that it was consciously staged as a species of entertainment, rather than one of deep academic debate, it will be apparent that none of us protagonists were fully able to develop our views beyond what could be incorporated into a few minutes’ pitch to our audience.
Moreover, none of us were allowed any subsequent opportunity for further attack or rebuttal, but could only respond, in the round, to a sampling of questions posed by the audience. In the circumstances, if the arguments of my opponents seem in anyway superficial as I summarize them here, I trust they will be gracious enough to accept, by way of an apology, the acknowledgement that my own propositions on the night will have seemed no less denuded of context or justification than perhaps did theirs.
Their bloody sign of battle is hung out
Ladies and Gentlemen, if you have heard of us ‘Austerians’ at all, you probably have in mind a caricature of us as loony liquidationists, eager for a Bonfire of the Vanities in which to purge the sins of all those who seem to have enjoyed the late Boom rather more than we did as we paced up and down outside the party, weighed down with our sandwich boards on which were emblazoned the injunction, “Repent Ye now for the End is nigh!”
Naturally, I don’t quite see it like that, nor do I feel shy about proclaiming our virtues over those supposedly possessed by the Tweedledee and Tweedledum of macromancy – the monetarists and the Keynesians – whose alternating and often overlapping policy prescriptions have, in the immortal words of Oliver Hardy, gotten us into one nice mess after another.
The monetarists – or perhaps we should call them the ‘creditists’, since they are not often overly clear about the crucial distinctions which exist between money, the medium of exchange, and credit, a record of deferred contractual obligation – tend to be children of empiricism. I hasten to add that, for an Austrian, there are few greater insults that can be bandied about: Mises himself once waspishly observed that the modern dean of monetarism, Milton Friedman, was not an economist at all, but merely a statistician.
To digress a moment, ‘money’ is different from ‘credit’ and the refusal to consider how, or in what manner is what leads to many errors, not just of thought but also of deed, for if there is one thing that modern finance is pre-eminently equipped to do, it is to transform the second into the first and thereby pervert the subtle webs of economic signalling which are so fundamental to our highly dissociated yet profoundly inter-dependent way of life.
We could of course come over all philosophical about money being a ‘present good’ – indeed, the archetypical present good – and about credit being a postponed claim to such a good. We could then go on to point out that, far from being a scholastic quibble, such a distinction is of great import to the smooth functioning of that vast assembly line which we call the ‘structure of production’ and that to subvert their separation is to call up from the vasty deep the never-quite exorcised demons of the ‘real bills’ fallacy and to begin to set in train the juggernaut of malinvestment which will soon induce a widespread incompatibility among the individually-conceived, yet functionally holistic schemes of which we are severally part and so lead us through the specious triumph of the Boom and into that grim realm of wailing and the gnashing of teeth we know as the Bust.
Later, we shall have more detail to add to this, our Austrian diagnosis of the role of monetized credit in the cycle, but for now let us instead point out that money is a universal means of settlement of debts and thus acts as a much-needed extinguisher of credit. In making this assertion, I have no wish to deny that the latter cannot be novated, put through some kind of clearing mechanism, and hence cross-cancelled, in the absence of money – as was the often nearly attained ideal aim at the great mediaeval fairs, for example – simply that the presence of a readily accepted medium of exchange greatly facilitates this reckoning. Furthermore, though a new crop of expositors has sprung up to make claims that credit is historically antecedent to money (though the plausible use of polished, stone axe-heads as a proto-money which was current all along the extensive Neolithic trade routes of 5,000 years ago might give us renewed cause to doubt this now-fashionable denial), this is hardly to the point in the present discussion.
Money may or may not have sprung up, as is traditionally suggested, to avoid the well-known problems of barter, but, however it arose, what it did do was obviate the even more glaring impediments of credit – namely that, as the etymology of the word reminds us, ‘credit’ requires the establishment of a bond of trust between lender and borrower, a trust whose validation is, moreover, subject to the vicissitudes of an ever-changing world by being a temporally protracted arrangement.
Thus, while money’s joint qualities of instantaneity and finality may confer decided advantages upon its users, its main virtue indisputably lies in the impersonal nature of its acceptance in trade for it is this which frees us from the limited confines of our networks of trust and kinship and so greatly magnifies the division of labour and deepens the market beyond all individual comprehension in a mutually beneficial, ‘I, Pencil’ fashion.
For its part, credit certainly may help us get by with less money, never moreso than when we have become drunk on its profusion and giddy at the possibilities this abundance seems to offer amid the boom. Then, we may truck and barter more and more by swapping one claim for another almost to the exclusion of the involvement of money proper but, as the great Richard Cantillon pointed out almost three centuries before Lehman’s sudden demise forcefully impressed the lesson upon us modern sophisticates once more,
…the paper and credit of public and private Banks may cause surprising results in everything which does not concern ordinary expenditure… but that in the regular course of the circulation the help of Banks and credit of this kind is much smaller and less solid than is generally supposed…
Silver alone is the true sinews of circulation.
This article is the first in a series. Continue to Part 2: Scylla & Charybdis.
You cannot escape an all-pervasive sense of crisis these days. Impending doom does not only announce itself in actual events but also via the proliferation of ever more hair-raising schemes that claim to solve our problems. Maybe it should not surprise us if, at a time when the world’s most powerful central banks keep interest rates at zero for years on end and keep printing quantities of money that are simply outside the facilities of human imagination (trillions? quadrillions?), bravely hoping it will end differently this time, people get the impression that economics holds no certainties, that it is merely an exercise in limitless creativity. In his excellent speech to the New York Fed, Jim Grant reminded us that when the Financial Times first explained to their readers what QE was, back in 2009, one of those readers wrote in a letter to the editor: “I can now understand the term ‘quantitative easing, but . . . realize I can no longer understand the meaning of the word ‘money’.” – This gentleman is not alone. The basics of monetary economics have been tossed out the window and a merry ‘anything goes’ of policy proposals has descended on us. Otherwise sane-looking men and women now propose that, although years of zero interest rates have not solved our problems, everything will change once interest rates are negative. We should all get checks from the central bank with free money to spend, and government bonds at the central bank should be cancelled. Grown men dream of money from helicopters and money buried in bottles in the ground. “Whom the gods would destroy, they first make mad.”
Just when you thought it could not get any madder there comes a policy proposal that sets a new low in monetary policy discussion. Of course, in the current climate it is being hailed as ‘epic’ and ‘revolutionary’. The easily excitable Ambrose Evans-Pritchard, a tireless campaigner for man’s exploration of the unknown in the field of money, could not believe his eyes: “So there is a magic wand after all,” he writes in the Daily Telegraph, “one could eliminate the net public debt of the US at a stroke and, by implication, do the same for Britain, Germany, Italy or Japan.” It gets better all the time. No longer are we confined to debating arduous strategies for crawling slowly back to sustainable growth, no, we can now simply wipe out all our debt.
Harry Potter meets Irving Fisher
The proposal under discussion is the IMF’s Working Paper 12/202 by Jaromir Benes and Michael Kumhof (a link to a PDF version is provided in this article). It is titled “The Chicago Plan Revisited” and presents itself as a restatement of the ideas of Irving Fisher and Henry Simons of the University of Chicago from the 1930s and 40s, and an application of these ideas to the present crisis. It suggests the following:
‘Private money’ creation is the root of all economic evil. Most money today is created by ‘private’ banks through fractional-reserve banking. This means money-creation is linked to loan creation and debt accumulation. A hundred-percent reserve system is to be established by the state and the state will forthwith crack down on any attempt by the private sector to issue liquid financial instruments – near monies – that could be accepted by the public as cash equivalents. Money creation is put under the full control of the state. The new system is to be implemented right away in one big swoop: the banks are forced to borrow the needed reserves from the government (Treasury) to achieve the new 100 percent reserve ratios instantly. The government creates these reserves – as is usual in a fiat money system – out of thin air. In the US, this plan would amount to new reserves to the tune of 184 percent of GDP, according to Benes/Kumhof, which means $27.6 trillion or 15 times the combined size of QE1 and QE2. With the new 100% reserve requirement, this money will not circulate and not allow for further bank credit creation, which – it is expected by the authors – makes this intervention not inflationary. (A portion of the new reserves will also be cancelled in the next step.) The new reserves allow the government/central bank to ultimately transfer ownership of the bank assets to itself.
Importantly, these new reserves are issued in a process very different from how reserves are issued and placed with the banks today, for example through ‘quantitative easing’, and how it was suggested by Irving Fisher in 1935 (“100% Money”), or Milton Friedman in 1960 (“A Program for Monetary Stability”). These more ‘conventional’ procedures do not allow for any large-scale elimination of debt. Central banks acquire bank assets by exchanging them for newly created reserve money, which they issue as a claim against themselves (a liability), and under normal accounting principles, any write-down of the new assets (debt ‘forgiveness’) would necessarily cause the extinction of the bank reserves as well. Writing down debt shortens the balance sheet of the central bank and thus reduces the central bank’s liabilities, which are the banking system’s reserves.
Benes and Kumhof circumvent this by simply claiming that the new fiat reserves are not just a new liability of the central bank but that they are assets as well, Treasury Credit or ‘commonwealth equity’. Through this accounting gimmick, the state can issue new assets, simply as an administrative act. Thus, the new reserve money lengthens the balance sheets of BOTH central bank and ‘private’ banks in a first step, that is, the new reserve money is simultaneously an asset AND a liability for both. This novel approach then allows balance sheet reduction later on and debt forgiveness without elimination of the new reserves that now back bank deposits by 100%. (See model balance sheets on pages 64 to 66 of the Benes/Kumhof paper and compare them to the model balance sheet presented by Irving Fisher on page 57 of “100% Money”, 1935, which is much more conventional.)
At the end of this process, not only has a lot of debt disappeared, the separation of the ‘credit’ and the ‘money’ sphere of the economy is now total, and so is the state’s control over the monetary economy. This, Benes and Kumhof, make perfectly clear, is the ultimately goal of the exercise, and they claim it is to our benefit. Why? Here (very differently from Fisher and Friedman or, for that matter, any monetary theorist) they do not argue as economists, but quote anthropologists and certain monetary historians who claim that 1) money originated not spontaneously from direct exchange but is a creation of the state, or rather the state’s early precursors, such as priests and religious masters of ceremony; this is deemed important because the origin of money determines the “nature of money” (page 12) and therefore determines who should best control its issuance. 2) They argue that thousands of years of monetary history confirm that the state can be trusted fully with the monetary privilege. (If you remember history somewhat differently, then according to Benes and Kumhof you have to rethink. The paper follows a select group of maverick anthropologists and monetary activists that have simply rewritten monetary history. Needless to say, none of this was ever claimed by Irving Fisher or Milton Friedman, and to my knowledge, not even Henry Simons.)
Finally, the paper presents an elaborate econometric model that shows that all of this will work in reality.
In this essay I will do four things: I will put the proposed paper in the context of ‘Austrian ’ and Monetarist monetary theory, and show that it is not only outside these intellectual traditions but that its main argument is not even economic in nature. I will show that the core problem Benes and Kumhof claim to have identified is bogus, and that they do not understand money creation in our economy. I will then look at the paper’s peculiar historical, and non-economic, justification of complete state control of money, and show that this argumentation is highly dubious but also irrelevant. I will then show that the proposal presented relies on unprecedented forms of state intervention and crucially advances the notion that the state can create vast new assets – commonwealth equity – by decree, which allows it to claim to have no net debt and thus engage in loan acquisition and ‘debt forgiveness’.
What this paper is not: it is neither ‘Austrian’ nor Monetarist
Benes and Kumhof, early in their paper, claim that fractional-reserve banking increases the risk of bank runs, causes boom-bust cycles, and that a 100 percent reserve system would ensure greater stability. These observations are, in principle, correct. But this is, sadly, where it stops. Benes and Kumhof do not build on these insights. In fact, for their further argument these insights are completely irrelevant. Their paper does not bother to investigate the full range of effects of bank credit expansion, and ask, for example, if the expansion of base money by the central bank under a 100%-reserve system could not have similar or even the same adverse effects that deposit-money expansion has in a fractional-reserve system.
The Austrian School has provided the most comprehensive analysis of the effects of bank credit expansion and has shown most conclusively why more inelastic (‘harder’) monetary systems offer greater stability. Expanding the money supply always has disruptive effects as the inflow of new money must distort interest rates, and interest rates are crucial for the coordination of investment activity with voluntary saving. The question the ‘Austrians’ ask is not, who should control money creation, but should anybody control money creation? Should anybody even create money on an ongoing basis? Once a commodity of reasonably inelastic supply, such as gold, is widely accepted as money, any quantity of this monetary asset – within reasonable limits – is sufficient, and indeed optimal, to satisfy any demand for money. Demand for money is demand for purchasing power in the form of money, and can always be met by allowing the market to adjust the price of the monetary asset relative to non-money goods. No money creation is needed, and any ongoing money creation is in fact disruptive.
‘Austrians’ tend to be critical of fractional-reserve banking but they are equally critical – in fact, even more critical – of fiat money and central banking. The problems they studied would also occur – and are even more likely to occur – if the fractional-reserve-banking system was replaced with one gigantic state central bank.
But Benes and Kumhof did not call their paper ‘The Austrian Plan Revisited’ but ‘The Chicago Plan Revisited’. The approach and the goals of the Chicago School were different. But it is still worth mentioning that in his 1935 book “100% Money” Irving Fisher suggested that his plan could be combined with the gold standard, something that is impossible with the Benes/Kumhof plan and that Benes and Kumhof show no interest in. Here is Fisher, page 16:
Furthermore, a return to the kind of gold standard we had prior to 1933 [before the domestic gold standard was abolished by Roosevelt and private gold confiscated, DS] could, if desired, be just as easily accomplished under the 100% system as now; in fact, under the 100% system, there would be a much better chance that the old-style gold standard, if restored, would operate as intended to operate.
This would indeed be the 100% gold standard that many ‘Austrians’ propose, and a system immeasurably more stable than what we have today. However, it was certainly not Fisher’s primary objective to restore the gold standard. Fisher wanted to maintain the fiat money system and consolidate the control of the central bank over the banking system by eliminating any remaining discretion by ‘private’ banks. Fisher was a big proponent of price index numbers. He believed the purchasing power of money could be measured accurately through statistics – a fallacy that is still widely believed today and still causes confusion and harm – and he was an early advocate of inflation-targeting. (For an Austrian School response to Fisher’s original plan see Ludwig von Mises, Human Action, 1949, Chapter XVII, 12. The Limitation on the Issuance of Fiduciary Media)
25 years later, Fisher’s fellow Chicagoan Milton Friedman also proposed a version of the 100% plan, this time with even less reference to boom-bust cycles or the potential for a gold standard. Friedman was an advocate of central banking because he believed that monetary and economic stability could be achieved by guaranteeing a stable, persistent and moderate expansion of the money supply, which is at the core of Friedman’s Monetarism. In a 100% system the state central bank – so he argued – can make sure that this would happen.
Importantly, both Fisher and Friedman had an asymmetrical view of monetary expansion. The ongoing expansion of the money supply – and therefore persistent injections of new money into the economy – were not considered harmful (quite to the contrary), as long as the money inflow remained moderate, but any contraction of the money supply (shrinking of bank balance sheets and destruction of money) was seen as a major problem and to be avoided at almost all cost. Their plans for full reserve banking was largely motivated by a desire to avoid the destruction of previously created deposit money. Of course, ‘Austrians’ see this very differently. The expansion of money – even if moderate and controlled – must already cause problems (capital misallocations), and when these problems come to the surface they cannot be suppressed with yet more money creation, at least not forever (although this is attempted under Friedman’s proposal for very easy monetary policy in crises).
It should now be clear why the Austrian School is enjoying a revival in the present crisis, not the Chicago School. Fisher and Friedman did not get their 100%- system with complete control over money creation for the central bank but whatever power central banks had in recent decades – and that power was formidable – was used in ways that were strongly influenced by the Chicago School. Fisher and Friedman have shaped modern central bank orthodoxy to this day. As long as inflation is moderate central bankers believe that no monetary problem exists, in line with Fisher. Even in the run-up to the present, spectacular financial crisis, inflation remained moderate in most major countries, at least in the common (and dangerously narrow) CPI definition. And for the past two decades, any crisis that, if left unchecked, could have caused bank balance sheet deleveraging and credit contractions was aggressively fought with low interest rates and base-money injections from the central bank, according to Friedman. In fact, the Bernanke Fed has repeatedly referred to Friedman’s policy descriptions as a blueprint for its own actions. However, none of this has prevented major financial imbalances to build, and these policies have even helped create these imbalances, as Austrian theory would suggest.
But I digress. None of this makes any impression on Benes and Kumhof. In fact, Benes and Kumhof seem decidedly uninterested in monetary theory, business cycle theory, or the Austrian School. There is no mention of Mises or Hayek, and only Carl Menger is mentioned – in a footnote and disapprovingly.
Instead, the paper sets up an entirely new and I believe bogus problem based on the premise that in our monetary system money is supposedly provided ‘privately’, that is, by ‘private’ banks, and ‘state-issued’ money only plays a minor role. From this rather confused observation, the paper derives its key allegation that ‘state-issued money’ ensures stability, while ‘privately-issued money’ leads to instability. This claim is not supported by economic theory and certainly not by anything in the Austrian School or, for that matter in Friedman’s Monetarism or Irving Fisher’s original plan. Monetary theory does not distinguish between ‘state-controlled money’ and ‘privately produced’ money, it is a nonsensical distinction for any monetary theorist. An attempt to give credence to this distinction and its alleged importance is made in a later chapter in the Benes/Kumhof paper but, tellingly, this attempt is not based on monetary theory but on an ambitious, if not to say bizarre, re-writing of the historical record.
Benes and Kumhof create an artificial problem
For any analysis of the present financial system a distinction between state-created money and privately created money is entirely artificial and of no help whatsoever, because in our system money is created in a process in which ‘private’ banks are intimately connected with the state central bank. Any distinction between ‘private’ and ‘state’ is thus arbitrary and for an analysis of the economic consequences of such a system meaningless. Yes, most money in circulation today is deposit money and sits on the balance sheets of nominally ‘private’ banks, but the reserves are state fiat money, only to be created by the state central bank, which the nominally private banks have to have an account with in order to receive a banking license. Fractional-reserve-banks rely crucially on state-sponsored and state-controlled central banks that have a lender-of-last-resort function and that can – in a fiat money system – create bank reserves at will, no cost, and without limit, and are, under normal circumstances willing to do so to backstop the banks. Without this crucial backstop fractional-reserve banking on the scale on which it has been practiced in recent years and decades would be inconceivable. In their description of the present system, Benes and Kumhof take no account of any of this. Frankly, they do not appear to understand it.
Here are two statements from the IMF paper that may at first appear sensible but that on closer inspection reveal the grave misunderstanding of our present system by Benes and Kumhof:
“In a financial system with little or no reserve backing for deposits, and with government-issued cash having a very small role relative to bank deposits, the creation of a nation’s broad monetary aggregates depends almost entirely on banks’ willingness to supply deposits.” (page 5)
But what determines the willingness of the banks to supply deposits? Fractional-reserve banking (supplying deposits) is lucrative but also risky for the banks as the public can demand redemption of deposits in cash or in transfers to other banks, and banks cannot create cash or the reserve money required to facilitate transfers. These forms of money remain the prerogative of the state central bank. It is the certainty, or high probability, under present institutional arrangements that the central bank will support the banks and continue to supply whatever amount of cash and reserves is needed, that allows the banks to supply – very profitably, of course – vast amounts of deposit money on the basis of small reserve money. Should the public demand payment in cash, the central bank can reasonably be expected to stand by the banks and supply the needed cash.
In recent decades, the global banking system found itself on numerous occasions in a position in which it felt that it had taken on too much financial risk and that a deleveraging and a shrinking of its balance sheet was advisable. I would suggest that this was the case in 1987, 1992/3, 1998, 2001/2, and certainly 2007/8. Yet, on each of these occasions, the broader economic fallout from such a de-risking strategy was deemed unwanted or even unacceptable for political reasons, and the central banks offered ample new bank reserves at very low cost in order to discourage money contraction and encourage further money expansion, i.e. additional fractional-reserve banking. It is any wonder that banks continued to produce vast amounts of deposit money – profitably, of course? Can the result really be blamed on ‘private’ initiative?
Fractional-reserve banking on today’s scale requires two things: 1) a state-sponsored central bank that has the monopoly of bank reserve-provision and that has a lender-of-last resort function for the banking industry; 2) the central bank must have complete control over bank reserves and be able to create them at no cost and without limit. In short, the precondition for large-scale fractional-reserve banking is a complete, unrestricted fiat money system. By contrast, the ability of the central bank to create reserves is fundamentally restricted under a gold standard.
The gold standard was abolished and replaced with a system of entirely unconstrained state fiat money through an act of politics. The state established monopolistic central banks that have a lender-of-last-resort function for the banking sector. The state thus created the infrastructure that allows banks to supply vast amounts of deposits, and over the decades has repeatedly subsidized this activity and socialized its risks.
Here is the second statement by Benes and Kumhof:
“The control of credit growth would become much more straightforward because banks would no longer be able, as they are today, to generate their own funding, deposits, in the act of lending, an extraordinary privilege that is not enjoyed by any other type of business.” (page 5)
But what exactly constitutes the privilege? – In a free society, you are, of course, free to issue your own fiduciary media – just issue checks against yourself and have them circulate as money surrogates. You will probably have to convince the public that you will convert these checks into money proper on demand in order to persuade the public to use the checks as money equivalents, and even then you may not succeed. But if the public believes you and your endeavor is successful, you have indeed become a money-producer and can fund your own lending with your checks. In fact, this is pretty much how fractional-reserve-banking originated. So far no privilege. It only becomes a privileged business, and possible on the scale we see it today, once the state supports it. The ‘Austrian’ solution is straightforward: remove the privilege! Without fiat money, central banks and state-sponsored deposit insurance, let us see how much ‘private’ money creation there really is!
No theory but revisionist history
Benes and Kumhof try to argue in a separate part of the paper that the distinction between ‘privately produced’ money and ‘state-produced’ money is meaningful and important. Here, they completely depart from any traditional analysis of money or even any that could still be called ‘economic’. An economic analysis of money understands money as a useful social institution and thus starts with an inquiry of what money is used for in general, including today by today’s money users (that includes you and me), and tries to explain, based on reasoning, what would therefore make for good money in a general context, including the present one. Benes and Kumhof, however, do not argue conceptually as economic theoreticians but as (re-)interpreters of history. History can tell us what is good money and how it comes about. The anthropologists and monetary historians Benes and Kumhof quote claim that because money originated – supposedly – with the state its issuance is best controlled by the state. Again, no economic – conceptual, logical, theoretical – explanation is given for why that should be the case and why this could be upheld as a general rule. Allegedly, history tells us that the state is a responsible issuer of money and the private sector an irresponsible one. And that’s that.
The interpretation of the historical record that is provided in support of this allegation ranges from the adventurous to the outright bizarre. Instances in which the redeemability of deposit money in gold and silver was abandoned by official decree and vast amounts of fiat money were created to fund wars, revolutions or other state expenditures, such as during the Revolutionary War in America, the Civil War in America, or 1920s Weimar Germany, are reinterpreted to show that the ensuing inflations and outright currency disasters cannot be blamed on the state but are entirely the result of the involvement of ‘private’ money issuers.
“Colonial paper monies issued by individual states were of the greatest economic advantage to the country…The Continental Currency issued during the revolutionary war was crucial for allowing the Continental Congress to finance the war effort. There was no over-issuance by the colonies,… The Greenbacks issued by Lincoln during the Civil War were again a crucial tool for financing the war effort, [Hooray! Another war courtesy of paper money! DS] … The one blemish on the record of government money issuance was deflationary rather than inflationary in nature.”
Really? – The ‘colonials’ that were issued to fund the war with Britain ended up worthless, and to this day there is the idiom “worthless as a continental” in the American language. The period of the Civil War, too, was one of unusually high inflation, and in 1879 the USA decided to go back on a gold standard, at which point a period of considerable growth and rising prosperity set in.
While the enthusiasm for paper-money-funded wars on the part of Benes and Kumhof is already a bit disturbing, what is particularly striking is that Benes and Kumhof, and the ‘historians’ they quote (in particular the activists David Graeber, an anthropologist and leading figure of the Occupy Wall Street movement, and Stephen Zarlenga, founder and director of the American Monetary Institute), try nothing short of a complete re-writing of economic history and suggest conclusions – not only in one instance but throughout ALL of monetary history – that not only fly in the face of the generally accepted historical record but also common sense. The state as a monopoly-issuer of money with no restriction whatsoever becomes a trusted guardian of the common weal – simply by being a state!
Their whole argument gets kooky in the extreme when they address more recent instances of fiat money currency disasters, for which we not only have ample documentation that supports the opposite interpretation but which some of the most distinguished monetary theorists actually lived through themselves and experienced first hand – and which they explained succinctly.
Ludwig von Mises wrote a seminal book on monetary theory in 1912 (Theories des Geldes und der Umlaufmittel), in which he laid the foundations for the Austrian Business Cycle Theory and in which he predicted (!) the European hyperinflations of the 1920s. He lived through the hyperinflation in Austria in 1923, and, as the chief economist of the Vienna Chamber of Commerce, was in direct contact with the key players in government and central bank. He later wrote his memoirs.
Benes and Kumhof now claim that all these accounts are simply wrong. The main culprit was not the state but the private sector. We only have to ask state officials (!) and they can tell us what really happened. Here is the IMF working paper, page 17:
“The Reichsbank president at the time, Hjalmar Schacht, put the record straight on the real causes of that episode in Schacht (1967).”
According to Benes/Kumhof, Schacht blames the inflation on aggressive money creation by the private sector but his account also suggests that this was only possible because the Reichsbank generously redeemed deposit money in Reichsmark, that is, the central bank provided essential support for money expansion. With a generous backstop from the state the private sector will, of course, create money. But does that mean the state had nothing to do with the whole debacle? Kumhof, Benes and their prime source, Zarlenga, seem to not understand the role of central banks and the essential ingredient of state-backing for large-scale fractional-reserve banking. Furthermore, Schacht is a source of a somewhat dubious reliability in this debate. Schacht became a Hitler supporter later on, introduced socialist New-Deal-type policies in Germany, and helped the Nazis with re-armament and plans for German autarky. I am not saying this to discredit Schacht as an economic observer, only to highlight that he had – and this is probably an understatement – a considerable pro-state bias in all his economic views and is hardly an objective observer on the question of whether the state can be trusted with money. (As an aside, all totalitarian ideologies are anti-gold and pro-paper money and central banks. The Socialists, the Communists, the National-Socialists, the Fascists – they all hated to see the state restrained in its manoeuvrability by a gold standard.)
Benes and Kumhof’s case simply ignores the numerous historical accounts that paint a very different picture, such as the work by English historian Adam Ferguson whose seminal book “When Money Dies” has recently found a wide new readership. It ignores the eye-witness reports of one of the most distinguished economists of the 20th century, Ludwig von Mises, or the work of Swiss monetary historian Peter Bernholz.
I am not a historian and I want to be careful in dismissing challenges to the established historical record out of hand, but the account presented here strikes me as simply ridiculous, unscientific, mystical pro-state propaganda. As a scientific argument it is without merit.
But almost the worst aspect of it is this: where are the economics, where is conceptual analysis and reasoning? Even if we accepted – simply for argument’s sake and contrary to the overwhelming evidence to the contrary – that the state has more often than not been a good guardian of the money privilege, what are the explanations for this, what are the theoretical and conceptual arguments that underpin this historical pattern? Could we rely on this always being the case? If it is in the “nature of money” (Benes/Kumhof) to be provided by the state, is it therefore in the “nature of the state” to always provide good money, or would we need specific institutional arrangements, legal frameworks, or some ‘good-money’-culture or tradition for this to be the case? Of course, Benes and Kumhof provide no answers.
This part of the paper is simply unscientific because the argument is essentially mystical. The whole idea that a socially useful institution such as money can only be understood if we understand its “nature”, which does not derive from how people use it (including you and me today) but from how it came into being thousands of years ago, is nothing if not rooted in mysticism.
Money is a tool, and so are hammers. If I asked you to tell me what a hammer is for, what makes for a good hammer and a bad hammer, and what type of hammer I need for a specific purpose, would you tell me that I first have to understand the “nature” of the hammer, and to do so I would have to ask anthropologists how the first hammers came into being and what the first hammers or hammer-like tools were used for?
Remember what I said above about circulating your own checks as fiduciary media? That is a pretty good description of paper money issuance. The newly circulated paper money is accounted for as a liability on the balance sheet of the paper money creator, and the things he acquires through issuing/spending this new paper money become the corresponding assets. By issuing paper money the money creator lengthens his balance sheet, while those who transact with the money-creator neither lengthen nor shorten their balance sheets but exchange positions on the asset side of their balance sheets, they replace other, previously held assets with new money.
This can also be observed in the creation of base money (extra bank reserves) by central banks today. When the Federal Reserve creates an extra $1 trillion as part of ‘quantitative easing’ and decides to buy mortgage-backed securities from its member-banks, then the Fed’s balance sheet expands by $1 trillion dollars. The new bank reserves are on the liability-side of its balance sheet, while the mortgage-backed securities are on the asset-side. The balance sheets of the banks do not expand as a result of the Fed operation. The banks simply replace mortgages with new reserves. Both are on the asset side of their balance sheets. Their asset-mix has changed. They now have more reserves.
This process could be extended until almost all bank assets have moved to the central bank and the banks are fully reserved and thus cease to be fractional-reserve banks. This was precisely the process that Irving Fisher had in mind when he wrote “100% Money” in 1935 (see page 57), and Milton Friedman when he wrote “A Program For Monetary Stability” in 1960.
At no point did any of these economists suggest, nor does any central bank today suggest, that the creation of new paper money enhances the overall wealth of society, that there is now more property in this society. It is also clear from this process that ‘debt forgiveness’ by the central bank is difficult. The central bank can issue enough reserve money to acquire all bank assets but whenever it writes down the book value of any of these assets it also has to shrink the liability side of its balance sheet, it has to destroy reserve money.
Benes and Kumhof now come up with an entirely novel approach. The state simply declares that its new reserve money is also an asset in its own right. Per decree the state creates wealth: Treasury Credit or commonwealth equity. The central bank books the new reserves on its liability side, just as in a conventional money creation process but now does not book existing assets against it that it acquires from whoever books the new reserves as assets (the banks). The corresponding asset is now ‘Treasury Credit’, which did not exist before but now comes into being per government decree. At this stage, the central bank’s balance sheet lengthens without any acquisition of new assets – the offsetting asset is created simultaneously with the reserve money liability!
The balance sheets of the banks now also lengthen: the banks book the new reserves on their asset side without (at this stage) transferring other assets to the money-issuer. The asset-side of their balance sheets lengthens. The corresponding lengthening of the liability side is achieved by booking ‘Treasury Credit’ as a liability.
It is this slight-of-hand that allows, in the following steps, various bank assets to get written off without a corresponding shrinking of reserve money. Only via the accounting gimmick of creating central bank assets out of thin air (and not just new central bank liabilities) and thus claiming that overall wealth – new assets – have been created administratively by the government can the large-scale debt write-off that is the paper’s allegedly strongest selling point, proceed.
All of this is state intervention in private contracts and property rights on a gigantic scale. The state may have the power to rewrite accounting rules and simply claim the existence of mysterious ‘government wealth’. Stranger things were claimed by governments in the 20th century. But what are the consequences? How will the public react? What confidence will it have in the new 100% state controlled monetary system?
Simply writing off all household debt is a mixed blessing. How would you feel if you worked hard and saved and did pay down your debt to give your family financial security, only to find out that your irresponsible and reckless neighbors, living high on the hog on credit cards, just saw all their debt wiped out by the Benes/Kumhof plan?
All power to the state!
This whole plan is nonsense on the greatest scale. Benes and Kumhof have thoroughly embarrassed themselves. Maybe we should simply look the other way and ignore this ill-conceived rubbish, maybe excuse it as the confused musings of two state-worshipping econometricians who fell under the spell of the New Age historicism of Graeber and Zarlenga, which they saw as a great opportunity for some fancy econometric modeling. But this comes with endorsement from the IMF, a major state-organization. Could it be that those who benefit from the accumulation of more state power feel that all the widespread banker-bashing and the erroneous but skillfully planted notion of the failure of capitalism can be turned even more to their advantage? Even the otherwise intervention-happy Ambrose Evans-Pritchard has his doubts:
Arguably, it would smother freedom and enthrone a Leviathan state. It might be even more irksome in the long run than rule by bankers.
Ambrose, for once I agree.
In the meantime, the debasement of paper money continues.
This article was previously published at DetlevSchlichter.com.
Interventions in markets by governments and central banks are routine and we take them for granted. No one questions them, but they can create dangerous distortions. Their reason for intervening is to take price determination away from markets and consumers.
The authorities and big business do not like leaving prices to free markets because prices are subjective: in other words, prices are decided by the desires of the consumer and not the cost of production. This is the central plank in the Austrian School’s explanation of economic theory in free markets, and it therefore follows that what consumers actually want and at what price must in turn determine prices through the whole supply chain. Keynesians do not take this view, dismissing the influence of consumers on actual prices as a short-term effect that does not fundamentally challenge the importance of costs. They do not like uncertainty over prices, because it invalidates their economic models.
If you accept the Austrian School’s argument, free markets are to be cherished, and interventions only result in less efficient use of economic resources. If you go with the Keynesians, you will believe there is room for the market to fail, arising from aberrations in consumer behaviour. They call it “animal spirits”. They tell us that changes in the allocation of economic resources by the free market are not always justified, opening the door to market intervention.
There are no prizes for guessing where big business stands in this Keynesian vs Austrian debate. Given the choice between dancing to the consumer’s tune and looking for government subsidy it always opts for the latter. It has a vested interest in supporting Keynesian economics.
This is why big business believes in government. Government is a source of subsidy and protective regulation. Equally, government naively believes that it must consult big business to form successful industrial and economic policies. The result of this symbiotic relationship is that government intervenes in almost everything that has a price both directly and indirectly through the manipulation of interest rates.
The effect is to downgrade the importance of consumers’ wants and needs, which are most effectively expressed in free markets. The consumer, who is also a taxpayer, ends up paying the government to rig prices against him. No one, surely, can argue that this is a satisfactory way of proceeding.
But what about those animal spirits? The answer is simple: prices and products get out of line with what consumers actually want, almost always as a result of government interventions. It can be because government has subsidised or protected the wrong production, or it can be because it has provided easy money in the past and consumers have become financially over-extended. Today, both reasons are there in spades.
Understand this, and it becomes obvious that the popular solution advocated by Keynesians and big business alike, of increasing the pace of intervention, will not erase those pesky animal spirits. Instead, the cost, borne by the hapless consumer in his role as taxpayer, actually accelerates, as well as distorting markets even more.
Market intervention is what has got us here, and more of it is definitely not the cure.
This article was previously published at GoldMoney.com.