Economics

The bankruptcy of governments

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

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

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

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

Economics

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

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

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

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

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

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

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

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

Money

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

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

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

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

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

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

The economy

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

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

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

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

Banks

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

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

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

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

Government finances.

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

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

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

Population demographics

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

Conclusion

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

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

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

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

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

Thank you.

This transcript was previously published at GoldMoney.com.

Economics

Welfare and the case for honest money

I do not doubt that the Government is sincere in its wish to make Britain “open for business” and to deliver greater life chances through reform of the welfare state. I gave some time to the Centre for Social Justice and now I see many of their ideas filtering through to public policy.  I support those reforms from both a practical perspective and in view of their moral necessity.

The Prime Minister is correct to talk of the culture we have lost, particularly in respect of private shame. I am put in mind of C S Lewis’ book The Abolition of Man: there is, after all, such a thing as right and wrong. Lewis predicted humanity’s ultimate destiny on the path which embraces subjective morality: a dystopian society in which “we find the whole human race subjected to some individual men, and those individuals subjected to that in themselves which is purely ‘natural’ — to their irrational impulses.” 

Some readers will recognise the problem and the dangers but reject the state’s role in finding a solution. However, we do not live in that world where the state is comprehensively rejected. There is a welfare state and it needs reform. The Government is getting on with it, and in the right direction too.

However, what the Government is not addressing is the de-civilising effects of inflation, that is, increasing the money supply.

What is commonly called “inflation” – a rise in the general price level – is an automatic consequence of debasing the currency. And currency debasement has been fierce in our lifetimes: the consequences have been and remain profound.

There is a presentation which, in one form or another, I have given many times. It shows, in a few charts:

  • How the state has grown inexorably since 1900,
  • How taxation reached an apparent limit at rather less than the scale of state spending, remaining there since 1971 or thereabouts.
  • Where our debt projections are heading,
  • How our money has been debased, particularly since 1971.

By the end of the presentation, I have explained our banking, fiscal and economic crisis. Given that what it shows is a monetary and fiscal catastrophe, people receive it surprisingly well. As far as I can tell, people can handle the truth and they want it.

One of the key slides is a price index from 1750-2003:

The grotesque debasement since 1971 – when Bretton Woods finally collapsed – hides the detail of the nineteenth century on a linear scale, so I include the same chart on a log scale. The log chart shows that, despite a number of crises and fluctuations, a pound in 1900 bought about the same basket of goods as a pound in 1800.

In contrast, money has lost almost all its value since the Second World War.

The Ethics of Money Production by Jörg Guido Hülsmann is particularly relevant at this point. Hülsmann writes:

To appreciate the disruptive nature of inflation in its full extent we must keep in mind that it springs from a violation of the fundamental rules of society. Inflation is what happens when people increase the money supply by fraud, imposition, and breach of contract. Invariably it produces three characteristic consequences: (1) it benefits the perpetrators at the expense of all other money users; (2) it allows the accumulation of debt beyond the level debts could reach on the free market; and (3) it reduces the [purchasing power of money] below the level it would have reached on the free market.

While these three consequences are bad enough, things get much worse once inflation is encouraged and promoted by the state. The government’s fiat makes inflation perennial, and as a result we observe the formation of inflation-specific institutions and habits. Thus fiat inflation leaves a characteristic cultural and spiritual stain on human society

He goes on to write of inflation’s tendency to centralise government, to extend the length of wars, to enable the arbitrary confiscation of property, to institutionalise moral hazard and irresponsibility, to produce a race to the bottom in monetary organisation, to encourage excess credit in corporations and to yoke the population to debt.  He explains how “The consequence [of inflation] is despair and the eradication of moral and social standards.”

That all sounds familiar.

Hülsmann’s work is not scripture of course, but neither are his ideas isolated. Consider Ayn Rand:

Whenever destroyers appear among men, they start by destroying money, for money is men’s protection and the base of a moral existence. 

It is my firm view that inflation – the debasement of money – was the primary cause of the banking crisis. That inflation was a deliberate policy choice of welfare states. You may recall Eddie George’s remarks in 2007 and now Mervyn King has said, “Of all the many ways of organising banking, the worst is the one we have today.”

Moreover, if Hülsmann, Rand and other scholars including Mises and Hayek are to be believed, then inflation is also a major contributor to the moral and spiritual decline of our country. No amount of welfare reform alone will solve that.

All is not lost however. To return to that log-scale price index, money’s value was substantially more volatile in the first half of the nineteenth century than in the second. In 1844, the Bank Charter Act, Peel’s Act, took from the banks the privilege of extending bank notes in excess of specie (coins of inherent worth).  It was recognized that this extension of candy-floss credit un-backed by prior production of real value was a systemic cause of economic and banking crises.

Unfortunately, that Act left the banks unmolested in their ability to create deposits. As our system of money and bank credit has evolved, that loophole, combined with central banking and the socialisation of risk, has delivered us into our present predicament.

It falls to our generation to solve this problem and that is why we established The Cobden Centre.

As Martin Wolf wrote in the Financial Times on 9th November 2010, “The essence of the contemporary monetary system is creation of money, out of nothing, by private banks’ often foolish lending.” And then we wonder why house prices have raced out of reach. We wonder why the basement garages in Canary Wharf are full of supercars while what was once our industrial heartland languishes in state dependency.

I admire the Prime Minister and the coming welfare reforms. I will back them gladly. But, until we end inflation as a way to fund the promises of the welfare state, we shall not have done the decent thing. We shall not have established objective morality in banking and in that lifeblood of society: money.  Honest money is a prerequisite for social progress and it must be delivered if reform is to succeed.

Economics

Why I Founded the Cobden Centre

Toby BaxendaleI founded the Cobden Centre inspired by the writing of F A Hayek, particularly his reference in “Denationalization of Money: the Argument Refined” (IEA, 1976) from which the following quote is taken.

Free Money Movement

What we now need is a Free Money Movement comparable to the Free Trade Movement of the 19th century, demonstrating not merely the harm caused by acute inflation, which could justifiably be argued to be avoidable even with present institutions, but the deeper effects of producing periods of stagnation that are indeed inherent in the present monetary arrangements.

Now of course that Free Trade Movement was the movement set up by the businessman and radical social reforming liberal, Richard Cobden. Hayek knew that the original founders of that movement attacked the import tariffs or “Corn Laws” that harmed ordinary people. The Corn Laws forced the price of basic food stuffs so high that the working man was almost paying what we would pay today on our mortgages.

The legal privilege that this gave landowners to price gouge the masses at the expense of the privileged few was an outrage and the courageous corn law reformers did away with this invidious protection by repealing the Importation Act of 1815 with the Importation Act of 1846.

In Bright, J. and Thorold Rogers, J.E. (eds.) [1870](1908) Speeches on Questions of Public Policy by Richard Cobden, M.P., Vol. 1, London: T. Fisher Unwin, republished as Cobden, R. (1995), London: Routledge/Thoemmes, they cite a quote from a working man who sums up the iniquities of the Corn Laws that Richard Cobden used:

When provisions are high, the people have so much to pay for them that they have little or nothing left to buy clothes with; and when they have little to buy clothes with, there are few clothes sold; and when there are few clothes sold, there are too many to sell, they are very cheap; and when they are very cheap, there cannot be much paid for making them: and that, consequently, the manufacturing working man’s wages are reduced, the mills are shut up, business is ruined, and general distress is spread through the country. But when, as now, the working man has the said 25s. left in his pocket, he buys more clothing with it (ay, and other articles of comfort too), and that increases the demand for them, and the greater the demand…makes them rise in price, and the rising price enables the working man to get higher wages and the masters better profits. This, therefore, is the way I prove that high provisions make lower wages, and cheap provisions make higher wages.

Sir Robert Peel, who was Prime Minster at the time, was very educated in the works of Hume, Ricardo and Smith: he understood the law of comparative advantage. With a massive starving Irish population (the “potato famine”) and pressure from the likes of Cobden at home, Peel powered through the repeal of the laws. In Morley, J. (1905) The Life of Richard Cobden, 12th ed., London: T. Fisher Unwin, 985 p., republished by London: Routledge/Thoemmes (1995), Peel said in his resignation speech after the repeal had been done for the UK:

In reference to our proposing these measures, I have no wish to rob any person of the credit which is justly due to him for them. But I may say that neither the gentlemen sitting on the benches opposite, nor myself, nor the gentlemen sitting round me—I say that neither of us are the parties who are strictly entitled to the merit. There has been a combination of parties, and that combination of parties together with the influence of the Government, has led to the ultimate success of the measures. But, Sir, there is a name which ought to be associated with the success of these measures: it is not the name of the noble Lord, the member for London, neither is it my name. Sir, the name which ought to be, and which will be associated with the success of these measures is the name of a man who, acting, I believe, from pure and disinterested motives, has advocated their cause with untiring energy, and by appeals to reason, expressed by an eloquence, the more to be admired because it was unaffected and unadorned—the name which ought to be and will be associated with the success of these measures is the name of Richard Cobden. Without scruple, Sir, I attribute the success of these measures to him.

The pound Sterling has lost some 99% of its value since the suspension of commodity-backed money post World War I, as successive governments have chosen not to confront their electorates in an honest fashion and say how much all the activities they say they are doing for you to get your vote will cost you. Instead, tax receipts pick up the majority of the costs of government, but there is always a bit of debt they choose to monetize. This means printing it out of nothing or creating it electronically our of nothing, a term which today is now called QE or quantitive easing.

So, instead of a Free Money Movement, I have started what I call the “Honest Money Movement”.

Why do I use the word honest?

Well I simply use it to show that, like the iniquitous Corn Laws that our forefathers sought to destroy as they gave privilege and wealth to one minority party at the expense of the masses, governments can take everyone’s wealth to benefit them and the few who organize this wealth transfer for them, i.e. the Central Bank and its client banks in the private sector who organize bond sales and purchases. They get the new money wealth effect first, just like the aristocratic land owners of old got the excess price of corn at the expense of the masses of working people.

If honest money is demanded, a government can no longer monetize debt it has to live or fall by its tax receipts only. This means when a politician comes to you at election time with a menu saying “we are going to give you X and Y” they will now have to say, “we propose to take £A and £B from you and give £A and £B to Mr X and Mrs Y” and you can then decide the merits of this knowing what you are getting yourself involved with.

Sir Robert Peel plays another role in our story. He was the first Prime Minster to do something about the bad effects of private sector bankers issuing notes purporting to convert into gold on demand. The trouble being, just as the landed aristocrats kept corn high at the expense of the wealth of the people, so the goldsmiths issued promises to pay on demand on bits of paper that functioned as money, over the actual amount of gold in their safe keeping. This criminality was stopped by the Bank Charter Act of 1844: the original text can be seen here and the amended text, that is still in force today, can be seen here.

Unfortunately for us, there was no restriction on the creation of demand deposits. A demand deposit is where a bank creates an IOU or a bank deposit out of thin air which functions as money.

You as the deposit holder can make payments to anyone who will accept your transfer of this IOU to them. Whenever you write a cheque it is drawn on a bank deposit, whenever you make an electronic payment, you make it from a bank deposit. In Peel’s day, there were over 20 bits of paper, called promissory notes, issued by the goldsmiths of the day, to every unit of gold. When people tried to redeem in gold, there was a “panic” and bust followed the boom.

The rapid creation of bank demand deposits since then has had the same effect. I seek to encourage an amendment to the Bank Charter Act to include deposits and finish off the job that Peel so courageously started. This would stop credit-fuelled boom and bust. All booms and busts, even the South Sea Bubble and the Tulip Mania, can be traced back to credit-fuelled binges that have been created by governments. Remove this power from the governments and their proxies, the bankers, and we can have honest money, peaceful enjoyment of the fruits of our labours and the enrichment of only those who earn it.

A starting point to advance this honest money movement is our banking reform proposal is available here. I hope you will help push for reform and end dishonest money and dishonest government.

More information

  • Toby’s interview with Brian Micklethwait explores Toby’s philosophy in more detail: it can be found here.
  • The staggering errors behind the policy of QE.
  • In The Causes of the Economic Crisis, Mises forecasts and explains the breakdown of the German mark and the market crash of 1929: buy here or read online here (PDF).