Click for Telegraph Story
Today, the Telegraph reports, UK house price growth ‘approaching madness’:
The speed UK property prices are rising at is “approaching madness”, analysts have warned, after data showed house prices jumped 2.4pc in February, the biggest monthly increase in five years.
The rise, revealed in the latest Halifax House Price Index, outstripped analysts’ expectations of a 0.7pc rise, renewing fears of a house price bubble.
House prices advanced 7.9pc on an year-on-year basis, the figures showed, taking the average price across the UK to £179,872 and marking the strongest annual uplift since October 2007.
The Chancellor’s policies of “monetary activism” and “credit easing” including Funding for Lending and Help to Buy have, on their own terms, succeeded. According to Kaleidic Economics, the Austrian measure of the money supply is now expanding by over 12% year on year:
Click for Kaleidic’s data
Nothing has been learned since Hayek wrote Monetary Theory and the Trade Cycle. His preface could have been written today:
It is a curious fact that the general disinclination to explain the past boom by monetary factors has been quickly replaced by an even greater readiness to hold the present working of our monetary organization exclusively responsible for our present plight. And the same stabilizers who believed that nothing was wrong with the boom and that it might last indefinitely because prices did not rise, now believe that everything could be set right again if only we would use the weapons of monetary policy to prevent prices from falling.The same superficial view,which sees no other harmful effect of a credit expansion but the rise of the price level, now believes that our only difficulty is a fall in the price level, caused by credit contraction.
… There is no reason to assume that the crisis was started by a deliberate deflationary action on the part of the monetary authorities, or that the deflation itself is anything but a secondary phenomenon, a process induced by the maladjustments of industry left over from the boom. If, however, the deflation is not a cause but an effect of the unprofitableness of industry, then it is surely vain to hope that by reversing the deflationary process, we can regain lasting prosperity. Far from following a deflationary policy, central banks, particularly in the United States, have been making earlier and more far-reaching efforts than have ever been undertaken before to combat the depression by a policy of credit expansion—with the result that the depression has lasted longer and has become more severe than any preceding one. What we need is a readjustment of those elements in the structure of production and of prices that existed before the deflation began and which then made it unprofitable for industry to borrow. But, instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion.
On its own terms, systematic intervention in the market for credit has succeeded: it has restarted the Domesday machine which delivered us into this mess. Those of us who have studied Mises, Hayek and the other Austrian-School masters will know that our present economic system remains built on sand.
The Bank of England
This article originally appeared in The Telegraph on 5 March 2014. It is reproduced by permission of the author.
Five years ago today, the Bank of England cut interest rates about as low as they can go: 0.5 percent. And there they have remained.
If rates have been rock bottom for five years, our central bankers have been cutting them for even longer. You need to go back almost nine years to find a time when real interest rates last rose. Almost a million mortgage holders have never known a rate rise.
And this is all a Good Thing, according to the orthodoxy in SW1. Sure, low rates might hit savers, who don’t get such good returns, but for home owners and businesses, it’s been a blessing.
Don’t just compare the winners with the losers, say the pundits. Think of the whole economy. Rates were set at rock bottom shortly after banks started to go bust. Slashing the official cost of borrowing saved the day, they say.
I disagree. Low interest rates did not save the UK economy from the financial crisis. Low interest rates helped caused the crisis – and keeping rates low means many of the chronic imbalances remain.
To see why, cast your mind back to 1997 and Gordon Brown’s decision to allow the Bank of England to set interest rates independent of any ministerial oversight.
Why did Chancellor Brown make that move? Fear that populist politicians did not have enough discipline. Desperate to curry favour with the electorate, ministers might show themselves to be mere mortals, slashing rates as an electoral bribe.
The oppostite turned out to be the case. Since independence, those supermen at the central bank set rates far lower than any minister previously dared. And the results of leaving these decisions to supposedly benign technocrats at the central bank has been pretty disastrous.
Setting interest rates low is simply a form of price fixing. Set the price of anything – bread, coffee, rental accommodation – artificially low and first you get a glut, as whatever is available gets bought up.
Then comes the shortage. With less incentive to produce more of those things, the supply dries up. So, too, with credit.
With interest rates low, there is less incentive to save. Since one persons savings mean another’s borrowing, less saving means less real credit in the system. With no real credit, along comes the candyfloss variety, conjured up by the banks – and we know what happened next. See Northern Rock…
When politicians praise low interest rates, yet lament the lack of credit, they demonstrate an extraordinary, almost pre-modern, economic illiteracy.
Too many politicians and central bankers believe cheap credit is a cause of economic success, rather than a consequence of it. We will pay a terrible price for this conceit.
Low interest rates might stimulate the economy in the short term, but not in a way that is good for long-term growth. As I show in my paper on monetary policy, cheap credit encourages over-consumption, explaining why we remain more dependent than ever on consumer- (and credit-) induced growth.
Cheap credit cannot rebalance the economy. By encouraging over-consumption, it leads to further imbalances.
Think of too much cheap credit as cholesterol, clogging up our economic arteries, laying down layer upon layer of so-called “malinvestment”.
“Saved” by low rates, an estimated one in 10 British businesses is now a zombie firm, able to service its debts, but with no chance of ever being able to pay them off.
Undead, these zombie firms can sell to their existing customer base, keeping out new competition. But what they cannot do is move into new markets or restructure and reorganise. Might this help explain Britain’s relatively poor export and productivity performance?
What was supposed to be an emergency measure to get UK plc through the financial storm, has taken on an appearance of permanence. We are addicted to cheap credit. Even a modest 1 per cent rate rise would have serious consequences for many.
Sooner or later, interest rates will have to rise. The extent to which low interest rates have merely delayed the moment of reckoning, preventing us from making the necessary readjustments, will then become painfully evident.
We are going to need a different monetary policy, perhaps rather sooner than we realise.
Ambrose Evans-Pritchard recently pinned the blame for the financial crisis on “Asia’s `Savings Glut’”. This idea is not new. For readers who may have missed it the first time, we’re republishing this article from September 2009 which argues that monetary policy caused the boom, the bust and the savings glut.
Martin Wolf – Global Imbalances
Distinguished commentator and economist Martin Wolf of the FT holds that the savings glut was the source of the excess liquidity that caused the current crisis in which we all find ourselves.
Wolf’s views are expressed crisply in this PowerPoint presentation. In summary, he tells how the Mercantilist approach of the emerging nations after the Asian crisis of the 90s led to a policy of setting exchange rates to encourage exports and limit imports, supported by the stockpiling of foreign currency (a majority in USD) to fund the whole program. The imbalances can be seen as either a “savings glut” or a “money glut.”
I believe from reading Wolf’s articles in the FT that the suggestion is that the savings glut nations not only have policies of fixing exchange rates to encourage exports over imports but also that the people in those nations have a much greater propensity to save than their Western counterparts. It is argued that this demand for money, certainly in USD, causes the Federal Reserve to embark on an expansionist policy.
From page 15 of Wolf’s presentation:
- My own view is that the savings glut caused the money glut, by driving the Federal Reserve to pursue expansionary monetary policies, which then led to the reserve accumulations in the creditor countries
- But it is also possible to view the Federal Reserve as the causal agent: the money glut causes the savings glut
- Either way, the reserve accumulations and fixed exchange rates played a big role in the story
I interpret Wolf’s remarks to mean that when the massive accumulated USD reserves in the emerging nations were partially spent, a surge in liquidity arrived back at the shores of the USA, causing a housing bubble, subprime lending, less than secure CDO’s etc and the bust we now observe.
Wolf is in good company. It would seem that Federal Reserve Chairman Ben Bernanke has endorsed this view in at least the following two recent speeches.
Chairman Ben S. Bernanke, Council on Foreign Relations, Washington, D.C., March 10, 2009 :
Financial Reform to Address Systemic Risk
The world is suffering through the worst financial crisis since the 1930s, a crisis that has precipitated a sharp downturn in the global economy. Its fundamental causes remain in dispute. In my view, however, it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s. In the simplest terms, these imbalances reflected a chronic lack of saving relative to investment in the United States and some other industrial countries, combined with an extraordinary increase in saving relative to investment in many emerging market nations. The increase in excess saving in the emerging world resulted in turn from factors such as rapid economic growth in high-saving East Asian economies accompanied, outside of China, by reduced investment rates; large buildups in foreign exchange reserves in a number of emerging markets; and substantial increases in revenues received by exporters of oil and other commodities. Like water seeking its level, saving flowed from where it was abundant to where it was deficient, with the result that the United States and some other advanced countries experienced large capital inflows for more than a decade, even as real long-term interest rates remained low.
Chairman Ben S. Bernanke, The Morehouse College, Atlanta, Georgia, April 14, 2009:
Four Questions about the Financial Crisis
Importantly, in our global financial system, saving need not be generated in the country in which it is put to work but can come from foreign as well as domestic sources. In the past 10 to 15 years, the United States and some other industrial countries have been the recipients of a great deal of foreign saving. Much of this foreign saving came from fast-growing emerging market countries in Asia and other places where consumption has lagged behind rising incomes, as well as from oil-exporting nations that could not profitably invest all their revenue at home and thus looked abroad for investment opportunities. Indeed, the net inflow of foreign saving to the United States, which was about 1-1/2 percent of our national output in 1995, reached about 6 percent of national output in 2006, an amount equal to about $825 billion in today’s Dollars.
Saving inflows from abroad can be beneficial if the country that receives those inflows invests them well. Unfortunately, that was not always the case in the United States and some other countries. Financial institutions reacted to the surplus of available funds by competing aggressively for borrowers, and, in the years leading up to the crisis, credit to both households and businesses became relatively cheap and easy to obtain.
I submit that these two great economists have made a grave error. The government of the USA has legal tender laws that allow only it, ultimately, to create USD via its sanctioned agent, the US Federal Reserve. As it is in charge of the stock of Dollars and the fractional-reserve banking system, it is (counterfeiting aside) the sole source of all issuances.
As I have pointed out in other articles on this site, we use money to exchage our goods and services that we make/provide for sale for other goods and services. Money is the final good for which all other goods and services exchange. Dollars in the USA are the final good you use to exchange your goods for goods offered by other people. A price of a good exchanged for another good is the amount of money paid for that good.
If the pool of money is getting larger, there will be more Dollars to exchange for goods and services. If the quantity of goods and services offered for sale and the number of Dollars in circulation are growing at the same rate, it is possible to argue, if you are prepared to set aside the problems of relative prices, that the “general price level” will be unaffected. However, any economist would argue that if the supply of money increases faster than the supply of goods and services, prices will rise: like any other good, money is devalued by creating more of it.
Therefore, the cause of the crisis can be found only at the door of the monetary authority that created the money in the first place – i.e. the Federal Reserve and other deficit-nation central banks – and not with the saving glut nations. All they have done is seek to exchange some of their goods and services for some of the goods and services of the USA, expressing a time preference along the way. This transfer of ownership does not in itself “bid up prices” to create an “asset price boom”: it is the creation of new money which devalues it.
If new Dollars are locked away for a time and only return to their original economy in an abrupt fashion, they could well seem to be the cause of a sudden asset price bubble, but the prior cause can only be the creation and supply of the wherewithal to do this in the first place.
A Note on Mercantilism
Wolf mentions in his PowerPoint presentation quite rightly that the modern trade regime we have is “in short, a mercantilist hybrid”. Many of the Classical Economist and Political Philosophers such as Hume, Locke, Smith and in later times David Ricardo, point out in various writings that the bullion (gold and silver) that was invariably money was not wealth as such but that the goods they exchanged against were. So, create more money with no associated increase in productivity and the prices of things will rise. Consequently, the Mercantalist goal of having exports higher than imports and thus more bullion at home would just mean that prices would rise at home and cause a flow of that specie to move away from home. Therefore, if in the analogy you substitute US Dollars for bullion, our saving glut nations will get nowhere fast pursuing this policy.
Gold represented claims on already produced wealth. Thus it makes perfect sense that the more wealthy (industrially-devloped, capitalistic etc) countries had more gold historically. As we do not have a link to gold anymore, the USD acts in its capacity as the World Reserve Currency, like gold of old. Using this analogy, the gold producer / gold miner writ large is the Fed and other Central Banks. Dollars will flow away from the mine in exchange for goods and services and this causes a transfer of ownership of goods and services from people in the USA to people in the saving glut nations but can have nothing to do with asset price bubbles as the money was printed by the Fed and no one else. To argue that the savings glut itself has caused the asset price boom is seemingly to endorse the Mercantalist doctrine that was so clearly discredited many moons ago.
Some other reflections on this concept of a “Savings Glut” disturb me and lead me to question whether it is really a meaningful concept at all.
These saving glut nations still seem to have massive gluts but if spending the glut caused the bubble, you would expect the glut to have fallen as well; seemingly, it has not.
If nations save to create a glut, they must indeed refrain from consumption on domestic goods to boost the supply of export goods. This means cheap goods arrive on the shores of the deficit nations. Can this cause a boom across the economy? I think not.
The deficit nations are largely well-developed. As a 40-year-old entrepreneur with a mature business and a happy family, all well rooted in Hertforsdhire, I often say to my wife, “If I was 18 again, I would be straight out to China to exploit some of those massive developmental opportunities. The whole economy seems to be like Manchester was in the Victorian times.” So why do savings there, which should attract a greater rate of return there, not stay there?
In summary, the Fed has more than doubled its money supply since the mid 90’s as have other leading deficit nations. The savings glut and the boom and bust is only attributable to the lax money creation programs of irresponsbile central bankers around the world. They have a poor understanding of economic history and they make an intellectual mistake in misunderstanding what those Classical thinkers knew: money is not wealth.
Last week, DIW – the Deutsches Institut für Wirtschaftsforschung (German Institute for Economic Research) – an influential think tank, proposed an ingenious solution to the Euro Zone debt crisis. The German government should issue a Zwangsanleihe, a compulsory bond that every German with savings of €250,000 or more should be compelled to underwrite with 10 percent of his or her own money. Such measures could help the German state grab another €230 billion in resources from the private sector to support its bailout commitments, the DIW economists announced with apparent satisfaction.
Didn’t economists once used to explain the importance of clearly delineated and legally protected private property, of free and voluntary exchange, and of true market prices? By explaining how capitalism works, these economists also demonstrated the limits and dangers of state interference, which is the reason why those who prefer to put their faith in strong political leadership and governmental design rather than the spontaneous order of free markets derided economics – after Thomas Carlyle – as the ‘dismal science’.
Maybe this is a somewhat romanticized definition of the term ‘economist’. Many statists, socialists and cranks have also adopted the label over the past 300 years. Yet, the history of economics shows that its greatest and most enduring contributions have come from those social scientists who explained how the voluntary, contractual interaction of independent, self-interested individuals creates a system that works to the advantage of society overall, and I may be forgiven for having assumed – or hoped – that in the early 21st century certain insights would have been so completely accepted that they could function as some kind of common ground for civilized discussion. I am fully aware that as an Austrian School economist I am at the ‘extreme’ free market end of the spectrum of economic opinion but I had thought – again naively, I guess – that certain principles would be unquestioned even by those who are happy to assign a larger role to the state. After all, in most cases these economists still claim to be advocates of the market economy, at least in some broader definition of the term, and given this position I had assumed that they, too, must assign at least a certain importance to the concept of ‘private property’, and that any blatant violation of private property by the state must at least give them a moment’s pause.
Well, it could be said that if all these economists took private property really seriously, they would have already become ‘Austrians’, so maybe I should not be surprised by the willingness of ‘mainstream’ economists to sacrifice the private property of third parties. But surprised I am. Surprised at what seems to be a growing enthusiasm for government-friendly quick fixes that come with little regard for the principles of capitalism and the free society, and with no consideration for the long run consequences.
Dismal no more
Since the start of the ‘global financial crisis’, or ‘the great endgame of the global fiat money experiment’, as I like to call it, we have witnessed a merry anything-goes of economic interventionism, an increasingly desperate and shameless struggle by the bureaucracy to sustain the unsustainable. And simultaneously, what I consider to be an intellectual shift among the economics profession. Eager to no longer be ‘dismal scientists’ but to be politically relevant and pragmatic instead, the economists have quickly taken to devising ever more audacious policies to help the state escape the consequences of decades of habitual overspending, reckless borrowing, and artificial cheapening of credit. The end seems to justify the means, and the end is to maintain the status quo, regardless of how bizarrely unbalanced it has become.
That economists are still advocates of free markets and defenders of justly acquired private property is a myth, at least when we consider the economists who dominate the policy debate. Apart from those at think tanks, such as the DIW, this includes economists at the central banks, the IMF, the OECD, and in the nominally ‘private’ banking sector that has by now become a state protectorate. Here, nobody likes to hear about spontaneous interaction, voluntary exchange, and true market prices, but almost everybody seems to love debt monetization (‘quantitative easing’), the manipulation of specific asset prices (‘operation twist’ or ECB-imposed yield caps on sovereign bonds), substantial government ‘stimulus’ spending, ‘fiscal transfers’, and various other forms of market distortions and bureaucratic interference.
Take the alleged beauty of currency debasement. I find it remarkable how many economists claim that it would be preferable for Greece (and by implication for other countries) to be able to print her own local money and debase it to her heart’s content. Sure, devaluing the monetary unit may provide a shot in the arm to the local export industry and create a very short-lived illusion of competitiveness. These ‘benefits’ are fleeting and the group of beneficiaries is small. But debasement will make many people poorer. All those who save by holding domestic money balances will see their purchasing power diminished.
That this is in the interest of ‘The Greeks’ has been amply refuted by the very actions of Greek savers. They are shifting deposits to banks in the Euro Zone core not only out of concern over local banks, but also in an attempt to protect the purchasing power of their savings, i.e. their property, from confiscation through inflation.
Failure is an option
The central problem in the present crisis – in Europe and elsewhere – is that states have assumed obligations they are unable to meet. So have many banks. In principle, this should only be of concern to the two parties to the contract – debtor and creditor. Ultimately, any entity can go bankrupt, including sovereign states, and there is no need to drag an ever larger group of innocent bystanders into this calamity. Specifically, there is no reason why a defaulted state would have to force its citizens to adopt a new currency. There is as little need for all Greeks to stop using the euro after the bankruptcy of the Greek government as there is for all Californians to stop using the dollar after the bankruptcy of the Californian government.
It is, of course, to be expected that a defaulted government would find it difficult to borrow again and that it, therefore, would have to live within the confines of its income from taxation. This is precisely why the political and bureaucratic class doesn’t like it – and why their intellectual handmaidens, the economists, come up with schemes to instead make everybody else pay. They’ll happily impose an inflation tax on all money-users as long as it keeps the state borrowing and spending and living high on the hog on confiscated wealth, and as long as it keeps the banks from shrinking and asset prices from falling. The status quo must be protected at all cost.
All these interventions are inherently conservative in nature (they conserve the prices and structures of the preceding boom) and, without exception, they protect the reckless from the consequences of their mistakes, and they punish the prudent. Those who did not allow themselves to get seduced by ‘easy money’ during the ‘bubble’ years and who managed their finances conservatively and saved would – in a truly capitalist system – now be the beneficiaries of the ‘bust’ – and thus provide the raw material for a real recovery. They could pick up assets ‘on the cheap’ were it not for the various policies (zero interest rates, unlimited bank funding, QE) designed to keep the prices of such assets at artificially high levels for the benefit of their present owners, often the banks. As savers are thus barred from buying assets at appropriately lower prices, they have no choice but to stay on the sidelines, holding saving deposits in which their capital gets whittled away by negative real interest rates, another policy designed to protect banks and a debt-addicted public sector.
One of the advantages of basing an economy on private property is that the success and failure of actions can be (reasonably) clearly attributed and that responsibility is specific and limited, and not communal and open-ended. This requires that the failure of institutions and policies must be clearly visible and not hidden, and that the market must be allowed to liquidate failure. In the present debate, however, most economists seem to be of the view that what is to be avoided at all costs is the recognition of failure, the liquidation of imbalances, and the shrinkage of certain entities, regardless of the sheer silliness of their outsized liabilities.
Flooding the economy with new money is an attempt to mask the failure of various institutions and policies and to socialize the effects of such failure. Here is the dirty little secret of monetary policy: printing limitless fiat money may be costless to the central banks but it is not costless to society.
“Hooray, we are inflating the debt away!”
But it is likely to get worse. The present stalemate is not making anybody happy. The economy is not being cleansed of its dislocations and neither is any sustainable growth momentum developing. Frustration and impatience are likely to rise. My concern is that most establishment economists are now intellectually prepared to embrace even more aggressive intervention, including a no holds barred monetary über ‘stimulus’ to break the gridlock and try and ‘inflate the imbalances away’. This is the final insult to anybody who believes in private property as it involves the wholesale expropriation of the saving classes. Such policies will require additional draconian market interventions. Large parts of the ‘private’ sector will have to be turned into captive holders of bonds, in particular government bonds. Highly regulated entities, such as banks, insurance companies and pension funds, are the obvious candidates, and they are already being lined up for this. Capital controls will be reintroduced. All of this will have disastrous consequences for the economy. Attempts to ‘inflate the debt away’ are a recipe for economic Armageddon. They do not lead to a balanced, deleveraged and cured economy but to total currency collapse, which tends to decimate the middle class. That such policies are even being contemplated now, I find shocking.
Such an outcome is, of course, not inevitable. Our future is not predetermined. There is always a chance that those in power will simple ignore these economists.
But maybe I am just being naïve again.
This article was previously published at Paper Money Collapse.
“Most economists, it seems, believe strongly in their own superior intelligence and take themselves far too seriously. In his open letter of 22 July 2001 to Joseph Stiglitz, Kenneth Rogoff identified this problem. “One of my favourite stories from that era is a lunch with you and our former colleague, Carl Shapiro, at which the two of you started discussing whether Paul Volcker merited your vote for a tenured appointment at Princeton. At one point, you turned to me and said, “Ken, you used to work for Volcker at the Fed. Tell me, is he really smart ?” I responded something to the effect of, “Well, he was arguably the greatest Federal Reserve Chairman of the twentieth century.” To which you replied, “But is he smart like us ?”
- Satyajit Das.
What are days for, asked Philip Larkin. His answer: they are where we live. Where can we live but days?
Ah, solving that question
Brings the priest and the doctor
In their long coats
Running over the fields.
What is economics for, we might then ask, given the conspicuous failure of the profession either to warn of the looming financial crisis ahead of time, or to identify any meaningful practical solutions once the crisis took hold. J.K.Galbraith gave one of the better responses:
Economics is extremely useful as a form of employment for economists.
But P.J. O’Rourke’s definition is probably better: economics being an entire scientific discipline of not knowing what the hell you’re talking about. And there’s some debate over the use of that adjective scientific.
It’s that adjective scientific that gives rise to the essential problem with economics. It isn’t a science, or at least it isn’t a science that any decent scientist would recognise. Eric Beinhocker’s excellent ‘The Origin of Wealth’ tells us that modern economics was born out of the Frenchman Leon Walras’s singular failure to achieve anything with his life. Having failed dismally and respectively at mathematics, engineering, journalism and banking, he elected thereafter to steal and misapply scientific principles from the world of physics to the nascent sphere of economics. And the rest is history. As computer programmers might have it: garbage in, garbage out.
The philosopher Karl Popper identified falsification (or ‘testability’) as the criterion that distinguishes between scientific and unscientific theory. Galileo called his own experimental tests cimenti, or ‘trials by ordeal’. Any scientific theory can be tested by experience – by observation or experiment. Try telling that to an economist. So we get a ‘profession’ that promotes ‘theories’ like the Capital Asset Pricing Model and advocates policies like ‘quantitative easing’ and that awards Nobel Prizes to people like Paul Krugman.
Here is an alternative definition of an economist. An economist is a sponsored clown jester in the employ of either a bank or a government (these days, there is not much between the two), whose sole purpose is to toe the party line. If the party is a bank, the party line is that banks need to be supported by the rest of society at any cost, even if that cost is a multi-year depression. If the party is a government, the party line is just keep paying your taxes and shut up.
To my knowledge there is only one sensible economic school, namely that of the so-called Austrians. The reason it is sensible is because it recognises the limitations of economic theory, and because it acknowledges the primacy of the individual, especially the entrepreneur, the fundamental wealth-creating force in the modern economy. The workings of ‘the market’ cannot be modelled with any precision because the market is us. This would also explain why behavioural economics has a rational appeal in a world choked with dry and inappropriate theorizing.
Unfortunately for those of us with a purist’s approach to the business of investing, ‘the market’ is rapidly becoming something of an endangered species. Your mission, should you choose to accept it, is to try and identify any asset of significance that isn’t experiencing huge and artificial distortion to its price by forces that we might term ‘the monetary authorities’ and their huge and daunting printing presses. Inasmuch as participating in ‘the market’ is a game, it’s a game of water polo with a blue whale as referee.
But there’s the ‘nice-to-have’ market, and then there’s the ‘market-as-currently-exists’, with all its attendant monetary debauchery and artificial, bad bank-perpetuating stimulus. We may not want to be starting the investment journey from here, but we do not have the choice. Amid all the stimulus and the QE and the LTRO, the bubbles denoting investment insanity are more than usually visible. They are, more to the point, wearing high visibility jackets, sounding klaxons, and wearing garishly coloured T-shirts and party hats announcing ‘We are a giant bubble !’ They include, but are by no means limited, to:
- 10 year UK Gilts yielding 2%
- 10 year German Bunds yielding 1.75%
- 10 year US Treasuries yielding 2%.
At the same time,
- UK CPI stands at 3.4% (conventional Gilt buyers are losing money in real terms).
- Euro zone CPI stands at 2.3% (Bund buyers are losing money in real terms).
- US CPI stands at 2.7%. (Treasury bond buyers are losing money in real terms).
Alternatively, whoever is piling into this horrible rubbish and appreciates income might want to consider instead the following FTSE 100 stock, here anonymized:
- It’s in a broadly defensive sector
- It has an Altman Z score (our preferred balance sheet sanity check) of over 4
- It has a price / earnings ratio of 6
- It has an indicated gross dividend yield of 7%.
The fixed coupon government bonds above have no chance of protecting an investor from inflation. The common stock above has at least a fighting chance, but in the meantime offers a gross yield more than three times higher than any of them. We may be wrong, but by comparison to the poisonous trash currently trading in the government bond markets, the stock look more like an opportunity.
Pop quiz. Without Googling, which former economist described quantitative easing in January 2009 as “the Robert Mugabe school of economics” – and by March 2009 had held true to a prevailing spirit of intellectual consistency and acknowledged that “directly increasing the amount of money flowing into the economy is now the only clear option” ? Clue: in 2008 he announced that “the Government must not compromise the independence of the Bank of England by telling it to slash interest rates”. The following month, he called on the Chancellor to urge the Bank of England to make “a large cut in interest rates”.
What are economists for?
Ah, solving that question
Brings the men in white coats
Running over the fields.
This article was previously published at The price of everything.
A very intelligent friend of mine of markedly different political persuasions said the other day that he avoided “technical economic arguments” with me as I’ve just graduated with a degree in economics. I was rather sad to hear this.
The simple truth is that after doing a module called, say, ‘Introduction to Economic Principles and Policy’, you will not study very much more which will add greatly to your understanding of the subject. Beyond that, in an ‘Intermediate Microeconomics’ course for example, you are simply ladling mostly unnecessary algebra onto the subject.
Take this from a course in ‘Intermediate Macroeconomics’ for example:
This is actually some of the more accessible math involved in modern economics. Furthermore, the concepts it is dealing with, constant returns to scale and the per worker production function, are pretty straightforward. Yet many, including almost all university economics lecturers, will tell you that this is economics. It is, in fact, simply applied algebra – mathematics looking for a real world application. Economists eager to give their art the patina of science and mathematicians searching for real world relevance have combined to render economics impenetrable.
This trend also stems from the view of economics as the study of a mechanism. People may now laugh at the model of the economy A.W. Phillips built in the basement of the London School of Economics in 1949 with its gurgling pipes full of different coloured liquids representing money literally sloshing around an economy controlled by sluice gates. But it isn’t conceptually different from the computerised models that are in use today guiding research and government policy.
These models often fail. If your model is based on erroneous assumptions, such as the creation of phantom capital called Quantitative Easing actually stimulating an economy, you will get erroneous outputs; Garbage In Garbage Out as they say. But there is a more fundamental problem. There is no exogenous ‘thing’ called ‘The Economy’ which can be quantified and controlled, there is only each of us doing what we do every day. That is why Ludwig von Mises called his great treatise on economics ‘Human Action’. Or as Friedrich von Hayek rapped recently “The economy’s not a car. There’s no engine to stall. No experts can fix it. There’s no “it” at all. The economy is us”.
It is little wonder that even intelligent people feel themselves cowed and run in terror from the thicket of abstraction that shrouds modern economics. It needn’t be like this. The great works of the discipline, those of Adam Smith or Carl Menger for example, managed to lay the foundations of the subject without it.
And it is sad that people like my friend feel put off because the economy affects all of us and, to return to the point made by the rapping Hayek, it is the study of all of us. Given this we all have economic insights by virtue of being human beings, the very subject of economics itself. As von Mises wrote:
Economics must not be relegated to classrooms and statistical offices and must not be left to esoteric circles. It is the philosophy of human life and action and concerns everybody and everything. It is the pith of civilization and of man’s human existence.
Do not leave economics to the abstract eggheads. Pick up Economics in One Lesson by Henry Hazlitt, Free to Choose: A Personal Statement by Milton Friedman or even Eat the Rich: A Treatise on Economics by P.J. O’Rourke: writers who, in these books and others, passed the economist Armen Alchian’s test of whether they truly understood the subject – they could explain it to someone who doesn’t know a darn thing about it.
Economics is about you. It is your subject. Reclaim and enjoy it.
Editor’s note: the Cobden Centre bookstore is here.
Phase 1: Greenspan, the arch money crank
The Greenspan “put”, and the collective adoption by most central bankers of low interest rates after the dot-com bust and 9/11, caused one of the largest injections of bank credit in history. Since bank credit circulates as money, we can say public policy has created the largest amount of new money in history.
This should never be confused with creating new wealth. That is what entrepreneurs do when they use the existing factors of production — land, labour and capital — in better ways, to make new and better products. The money unit facilitates this exchange.
Now to a money crank. He will assume that new money will raise prices simultaneously and proportionately, so the net effect of the economy is that all the ships rise with the tide at the same rate. He’ll say that money is neutral and does not have any effect on the workings of the economy.
One of the great insights of the older classical economists, and in particular the Austrian School, is that new money has to enter the economy somewhere. Injected money causes a rise in the price levels associated with the industry, businesses, or people who are fortunate enough to be in receipt of the new money. Prices change and move relative to other prices. It is often quite easy to see where the new money enters into the economy by observing where the booms are.
Suppose a banker sells government bonds to another part of the government (as has been the case with UK QE policy). For selling, say, £30bn of government debt to the Bank of England, he gets a staggering, eye-popping bonus. With his newly minted money, he buys a new £10m house in Chelsea, a £5m yacht in Southampton, some diamonds for the wife to keep her happy, and lives a happy and rich life. The estate agent spends his commission on a luxury car, and some more humdrum items that mere mortals buy. At each point in time, the prices of the goods favoured by the recipients of new money are being bid up relative to what they are not spending on. Eventually these distortions ripple through the economy, and the people furthest from the injection of new money — those on fixed income, pensioners, welfare recipients — end up paying inflated prices on the basic goods and services they buy. A real transfer of wealth takes place, from the poorest members of society to the richest. You could not make this up. I am no fan of the “progressive” income tax, but I certainly can’t support a regressive wealth transfer from the poor to the rich!
Even when the government was not creating new money itself, it was setting the interest rate, or the costs of loanable funds, well underneath what would naturally be agreed between savers and borrowers. Bankers are exclusively endowed with the ability to loan money into existence, so they welcome the low rates and happily lend, charging massive fees to enrich themselves in the process.
After the dot-com bubble, it was property prices that went up and up. Not only do we have the richer first recipients of new money benefiting at the expense of the poor, we have a massive mis-allocation of capital to “boom” industries that can only be sustained so long as we keep the new money creation growing.
Our present monetary system is both unethical and wasteful of scarce resources. We do not let counterfeiters lower our purchasing power, and we should not let governments and bankers do it.
Phase 2: Bush & Brown – private debt nationalised by the Sovereign
This flood of new money brought more marginal lending possibilities onto the horizon of the bankers.
They devised a range of exotic products whose names are now familiar: CDO, MBS, CDO-squared, Synthetic CDO, and many more — all created to get lower quality risk off the issuing bank’s balance sheet, and onto anyone’s but theirs!
In 2007/2008, bankers started to wake up to the fact that everyone’s balance sheets were stuffed with candyfloss money, at which point they suddenly got the jitters and refused to lend to each other. As we know, bankers are the only people on the planet who do not have to provide for their current creditors; they can lend long and borrow short. Thus, the credit crunch happened when the demand for overnight money to pay short-term creditor obligations ran dry.
Our political masters then decided that we could not let our noble bankers go bust; we had instead to make them the largest welfare state recipients this world has ever known! Not the £60 per week and housing benefit kind for these characters, but billions of full-on state support to bail out their banks. They failed at their jobs and bankrupted many, but they kept their jobs with 6, 7, or 8 figure salaries!
Bush told us that massive state intervention was needed to save the free market. Brown said the same. We were told that there would be no cash in the ATMs and society would most certainly come to an end if heroic action was not taken to “save the world”, as Brown so memorably put it (though he seemed to think he had accomplished this feat singlehandedly). Thank God for Gordon!
Now in Iceland, a country I was trading with at the time, their banks did go bust; no one could bail them out. But within days the Krona had re-floated itself and payments continued; within weeks they had a functioning economy.
Within days the good assets of Lehman Bros had been re-allocated, sold to better capitalists than they.
But with these notable exceptions, socialism was the order of the day. Bank’s inflated balance sheets were assumed by sovereign states. Like lager louts on a late night binge, after a Vindaloo as hot as hell itself, heads of government seemed to care little for the inevitable pain that would follow, as states tried to digest what they had so hastily ingested. Indeed, the failed organs of the nationalised banks survive only on life support, enjoying continuous subsidy through the overnight discount window.
But the sovereign governments, under various political colours, had a history of binging. In our case the Labour Party spent more than it could possibly ever raise off the people in open taxes, and the Tories offer “cuts” which in reality mean that the budgets of some departments will not increase as quickly as they were planned to.
Phase 3: King Canute, sovereign default
Default is the word that can’t be mentioned. In reality, we should embrace default. This debt is never going to be repaid. Never, that is, in purchasing power terms.
S&P ratings agency have hinted at this with the recent US rating downgrade. They know the American government can always mint up what it needs so long as it has a reserve currency. They also know that this is a soft default. In real terms, people seem likely to get back less than they put in.
Hard default should be embraced by the smaller nations like Greece and Ireland, so they can rid themselves of obligations they cant afford to pay. This will be good for taxpayers in the richer countries of Europe, as they will no longer be bailing out those who foolishly lent to these countries. It will be good, too, for the debtor nations, as they can remove themselves from the Euro and devalue until they are competitive again. They will, however, need to learn to live within their means. Honest politicians need to come to the fore to effect this.
Yes, this will be painful and the people who lent these profligate and feckless politicians the money will get burnt.
However, the FT has recently seen prominent advocates for a steady 4%-6% inflation target. This is the debtors’ choice and the creditors’ nightmare, with collateral damage for those on fixed or low incomes, for the reasons mentioned above. Should we let the Philosopher Kings have their way?
“Let all men know how empty and worthless is the power of kings. For there is none worthy of the name but God, whom heaven, earth and sea obey”.
So spoke King Canute the Great, the legend says, as waves lapped round his feet. Canute had learned that his flattering courtiers claimed he was “so great, he could command the tides of the sea to go back”. Now Canute was not only a religious man, but also a clever politician. He knew his limitations – even if his courtiers did not – so he had his throne carried to the seashore and sat on it as the tide came in, commanding the waves to advance no further. When they didn’t, he had made his point: though kings may appear ‘great’ in the minds of men, they are powerless against the fundamental laws of Nature.
King Canute, where are you today? We need honest politicians and brave men to step forward and point out the folly of trying paper over the cracks. Unless banks write off under-performing (or never-to-perform) securities from both the private sector and the public sector, we will progressively impoverish more and more people.
Let better business people buy the good assets of the bust banks, and let them provide essential banking services.
Let the sovereigns that can’t pay their way go bust and not impoverish us any further with on-going bailouts. In all my years in business, your first loss is always your best loss.
Yes, this will be painful. Politicians, fess up to the people: you do not have a magic bullet and you can’t offer sunshine today, tomorrow and forever.
I fear that if we do not do this, we approach the end game: the total destruction of paper money. Since August the 15th 1971, paper money has not been rooted in gold. It is the most extreme derivative product, entirely detatched from its underlying asset. Should the failure of this derivative come to pass, we will have to wait for the market to create something else. Will we be reduced to barter, as the German people were in the 20s?
A process of wipe out for all will be a hell of a lot harder than sensible action now. It is still not too late.
Recently, Paul Krugman claimed that the threat of an invasion by space aliens could bring the US economy out of recession in eighteen months. I expect many readers of this site found that both funny and worrying. It reminded me of an excellent science fiction novel I read years ago, “The Forever War” by Joe Haldeman.
Most political movements try to present themselves as positive about humanity. But privately their supporters often admit to seeing “noble lies” and social engineering more positively than they would publicly say. I don’t think libertarians or classical liberals are completely immune to this. In “The Forever War” a leftist author criticises conservatives, but also allows himself to think through the consequences of the ideas of American leftists.
Novels about interstellar war are often quite macho and conservative. “The Forever War” was seen as a response to one of those books, “Starship Troopers” by Robert Heinlein. It begins with an attack by aliens on starships travelling from earth to colonize other planets. It then follows a soldier, Private Mandella, through the ensuing war against the aliens. It becomes clear much later that the start of the war had been a mistake by jumpy humans, not a hostile alien attack. That is rather like the “Gulf of Tonkin Incident” in the Vietnam war. Haldeman wrote “The Forever War” in the early 70s after his own service in Vietnam; the interstellar war he describes is eerily similar to the Vietnam war and clearly a commentary on it.
When the soldiers first return to earth an army captain comes to meet them, he says:
“I’m twenty-three, so I was still in diapers when you people left for Aleph … to begin with, how many of you are homosexual?” Nobody. “That doesn’t really surprise me. I am, of course. I guess about a third of everybody in Europe and America is.
“Most governments encourage homosexuality – the United Nations is neutral, leaves it up to the individual countries – they encourage homolife because it’s the one sure method of birth control.”
Over the course of the book that policy becomes stricter and heterosexuality comes to be seen as a mental illness. It’s interesting to consider if future governments will try strategies like this. As the story progresses it hints that governments have encouraged recreational drug use too for the same reason.
The captain continues:
“… the population of the world is nine billion. It’s more than doubled since you were drafted. And nearly two-thirds of those people get out of school only to go on relief”.
“Relief”, it turns out, is the dole. Here we have the “Gloomy Keynesian” idea that as technology progresses unemployment becomes much greater. It turns out that jobs are rationed and only certain people are eligible so there is a thriving black market in faking this eligibility. Haldeman supposes that the war provides the Keynesian solution to this problem: producing the technology to fight the war creates employment and stimulates output.
The main effect of the war on the home front was economic, unemotional – more taxes but more jobs as well. After twenty-two years, only twenty-seven returned veterans, not enough to make a decent parade. The most important fact about the war to most people was that if it ended suddenly, Earth’s economy would collapse.
And at the very end of the book when some ancient history is discussed:
… the old soldiers were still around, and many of them were in positions of power. They virtually ran the United Nations Exploratory an Colonization Group, that was taking advantage of the newly discovered Collapsar jump to explore interstellar space.
Many of the early ships met with accidents and disappeared. The ex-military men were suspicious. They armed the colonizing vessels, and the first time they met a Tauran ship they blasted it.
They dusted off their medals and the rest was going to be history.
You couldn’t blame it all on the military though. The evidence they presented for the Taurans having been responsible for the early causalities was laughably thin. The few people who pointed this out were ignored.
The fact was, Earth’s economy needed a war, and this one was ideal. It gave a nice hole to throw buckets of money into, but would unify humanity rather than dividing it.
Here we see the problems many leftists have with their own ideas. If Keynes is right about economics or if Malthus is right about population  then that has dark implications. Of course there’s nothing wrong with an idea that leads us to a dark place if that idea is right, but there’s no need to worry if it’s wrong.
Writing about the recent earthquake in Virginia, Steve Horwitz gave a very clear criticism of this kind of thinking:
… the problem with the ‘disasters are good for the economy’ nonsense, and GDP more generally, is that it confuses a flow with a stock. GDP measures a flow of activity, not a stock of wealth. Destroying things and then rebuilding them might increase economic activity in the area affected (by drawing resources from elsewhere), but leaves us with less wealth than we would have had without the disaster. That is the real meaning of the Broken Window Fallacy.
It’s a mistake to think that Keynesians want to waste resources in order to increase employment. Their argument is that it isn’t very important how efficient a spending project is during a recession. They would prefer it if the output of a project were useful because if it were, that would clearly be beneficial. But, they don’t require a project to be efficient; their view is that if no good spending projects are politically feasible, then bad ones will do. They believe that during a recession there are great spin-off benefits to spending on output. They believe that it will stimulate production and employment and make society wealthier in the long run.
Keynesian commentators often seem to believe that the level of GDP output proves that a certain amount of capital wealth exists to be used, so when GDP increases that means society is richer. GDP is certainly an indicator of wealth; output can only be produced because capital and labour exist to produce it. But, many different levels of output are possible with the same capital. The amount of existing stocks of goods that are processed into new outputs depends on the demand for those new outputs.
In the recent controversy over the Virginia earthquake some Keynesian commentators I’ve read have expressed the view that it’s all about “crowding out”. Crowding out is a macroeconomic idea often put forward by critics of the Keynesians. In its simplest form, the argument is that every pound the government tax from someone, or borrow from someone, is a pound that would have been spent on private sector output. So, according to this argument “stimulus” policies will have no beneficial effect. I agree with this idea to some extent. The problem with it is that the private sector doesn’t only sell GDP output; existing assets are also for sale, including financial assets such as bonds and share. That means a person may receive income and spend it on things that aren’t output. Also, once the seller of an asset receives the proceeds he may not spend them on output either; he may buy another asset. Eventually somebody in the chain will spend on output, though that may take a long time. This means a government could increase output by taxing people who are likely to spend their money on assets and using the proceeds to buy output goods.
I don’t think the crowding out explanation helps us very much. As Horwitz says, the important issue isn’t whether output falls, everybody know output falls during a recession. The important question is: what does a fall in output mean?
One possibility is that investors and businesses are being irrationally cautious. Instead of investing in new projects which could earn profits in the future for them and increase output to the benefit of everyone they rush into relatively secure investments such as money, bonds, blue chip stocks and gold. Keynesians are fond of the idea of the irrationality of the market because it supports this view (they aren’t particularly interested in disputing Austrian Business Cycle Theory as a cause of recessions). I think this possibility is a distraction; to the degree that markets can be irrational it’s close to impossible to say in which direction they’re being irrational .
There is an alternative view, though: investors may be making a sensible decision to avoid investing in new projects because the risk/reward ratio is too poor to make it worth their while. That decision may certainly reduce employment in the short-run, but that doesn’t show that it reduces society’s overall wealth. It may well be that this decision isn’t only sensible for investors. The processing of existing resources into new goods doesn’t necessarily add value from anyone’s point of view. Keynesian economists often assume that it’s always worthwhile to convert existing resources into output at the same rate that prevailed before a recession. There is no reason to think this is true.
– Those interested in the history of economic thought will notice the influence of Malthus. Thomas Malthus was good at coming to unsettling conclusions. He suggested that real wages will fall in the long-run to the minimum necessary for subsistence, consigning the human race to poverty in the long term. Malthus also proposed a macroeconomic theory similar to Keynes’s, long before him.
 – This is the weakest form of the Efficient Markets Hypothesis.
Banking theory remains one of the most heatedly debated areas of economics within Austrian circles, with two camps sitting opposite each other: full reservists and free bankers. The naming of the two groups may prove a bit misleading, since both sides support a free market in banking. The difference is that full reservists believe that either fractional reserve banking should be considered a form of fraud or that the perceived inherent instability of fiduciary expansion will force banks to maintain full reserves against their clients’ deposits. The term free banker usually refers to those who believe that a form of fractional reserve banking would be prevalent on the free market.
The case for free banking has been best laid out in George Selgin’s The Theory of Free Banking. It is a microeconomic theory of banking which suggests that fractional reserves will arise out of two different factors,
- Over time, “inside money” — banknotes (money substitute) — will replace “outside money” — the original commodity money — as the predominate form of currency in circulation. As the demand for outside money falls and the demand for inside money rises, banks will be given the opportunity to shed unnecessary reserves of commodity money. In other words, the less bank clients demand outside money, the less outside money a bank actually has to hold.
- A rise in the demand to hold inside money will lead to a reduction in the volume of banknotes in circulation, in turn leading to a reduction of the volume of banknotes returning to issuing banks. This gives the issuing banks an opportunity to issue more fiduciary media. Inversely, when the demand for money falls, banks must reduce the quantity of banknotes issued (by, for example, having a loan repaid and not reissuing that money substitute).
Free bankers have been quick to tout a number of supposed macroeconomic advantages of Selgin’s model of fractional reserve banking. One is greater economic growth, since free bankers suppose that a rise in the demand for money should be considered the same thing as an increase in real savings. Thus, within this framework, fractional reserve banking capitalizes on a greater amount of savings than would a full reserve banking system.
Another supposed advantage is that of monetary equilibrium. An increase in the demand for money, without an equal increase in the supply of money, will cause a general fall in prices. This deflation will lead to a reduction in productivity, as producers suffer from a mismatch between input and output prices. As Leland Yeager writes, “the rot can snowball”, as an increase in uncertainty leads to a greater increase in the demand for money. This can all be avoided if the supply of money rises in accordance with the demand for money (thus, why free-bankers and quasi-monetarists generally agree with a central bank policy which commits to some form of income targeting).
Monetary (dis)equilibrium theory is not new, nor does it originate with the free bankers. The concept finds its roots in the work of David Hume and was later developed in the United States during the first half of the 20th Century. The theory saw a more recent revival with the work of Leland Yeager, Axel Leijonhufvud, and Robert Clower. The integration of monetary disequilibrium theory with the microeconomic theory of free banking is an attempt at harmonizing the two bodies of theory. If a free banking system can meet the demand for money, then a central bank is unnecessary to maintain monetary stability.
The integration of the macro theory of monetary disequilibrium into the micro theory of free banking, however, should be considered more of a blemish than an accomplishment. It has unnecessarily drawn attention away from the merits of fractional reserve banking and instead muddled the free bankers’ case. Neither is it an accurate or useful macroeconomic theory of industrial misbalances or fluctuations.
The Nature of Price Fluctuations
The argument that deflation resulting from an increase in the demand for money can lead to a harmful reduction in industrial productivity is based on the concept of sticky prices. If all prices do not immediately adjust to changes in the demand for money then a mismatch between the prices of output and inputs goods may cause a dramatic reduction in profitability. This fall in profitability may, in turn, lead to the bankruptcy of relevant industries, potentially spiraling into a general industrial fluctuation. Since price stickiness is assumed to be an existing factor, monetary equilibrium is necessary to avoid necessitating a readjustment of individual prices.
Since price inflexibility plays such a central role in monetary disequilibrium, it is worth exploring the nature of this inflexibility — why are prices sticky? The more popular explanation blames stickiness on an entrepreneurial unwillingness to adjust prices. Those who are taking the hit rather suffer from a lower income later than now. Wage stickiness is also oftentimes blamed on the existence of long-term contracts, which prohibit downward wage adjustments.
Austrians can supply an alternative, or at least complimentary, explanation for price stickiness. If equilibrium is explained as the flawless convergence of every single action during a specific moment in time, Austrians recognize that an economy shrouded in uncertainty is never in equilibrium. Prices are set by businessmen looking to maximize profits by best estimating consumer demand. As such, individual prices are likely to move around, as consumer demand and entrepreneurial expectations change. This type of “inflexibility” is not only present during downward adjustments, but also during upward adjustments. It is “stickiness” inherent in a money-based market process beset by uncertainty.
It is true that government interventionism oftentimes makes prices more inflexible than they would be otherwise. Examples of this are wage floors (minimum wage), labor laws, and other legislation which makes redrawing labor contracts much more difficult. These types of labor laws handicap the employer’s ability to adjust his employees’ wages in the face of falling profit margins. Wages are not the only prices which suffer from government-induced inflexibility. It is not uncommon for government to fix the prices of goods and services on the market; the most well-known case is possibly the price fixing scheme which caused the 1973–74 oil crisis. There is a bevy of policies which can be enacted by government as a means of congesting the pricing process.
But, let us assume away government and instead focus on the type of price rigidity which exists on the market. That is, the flexibility of prices and the proximity of the actual price to the theoretical market clearing price is dependent on the entrepreneur. As long as we are dealing with a world of uncertainty and imperfect information, the pricing process too will be imperfect.
Price rigidity is not an issue only during monetary disequilibrium, however. In our dynamic market, where consumer preferences are constantly changing and re-arranging themselves, prices will have to fluctuate in accordance with these changes. Consumers may reduce demand for one product and raise demand for another, and these industries will have to change their prices accordingly: some prices will fall and others will rise. The ability for entrepreneurs to survive these price fluctuations depends on their ability to estimate consumer preferences for their products. It is all part of the coordination process which characterizes the market.
The point is that if price rigidity is “almost inherent in the very concept of money”, then why are price fluctuations potentially harmful in one case but not in the other? That is, why do entrepreneurs who face a reduction in demand originating from a change in preferences not suffer from the same consequences as those who face a reduction in demand resulting from an increase in the demand for money?
Price Discoordination and Entrepreneurship
In an effort to illustrate the problems of an excess demand for money, some have likened the problem to an oversupply of fiduciary media. The problem of an oversupply of money in the loanable funds market is that it leads to a reduction in the rate of interest without a corresponding increase in real savings. This leads to changes in the prices between goods of different orders, which send profit signals to entrepreneurs. The structure of production becomes more capital intensive, but without the necessary increase in the quantity of capital goods. This is the quintessential Austrian example of discoordination.
In a sense, an excess demand for money is the opposite problem. There is too little money circulating in the economy, leading to a general glut. Austrian monetary disequilibrium theorists have tried to frame it within the same context of discoordination. An increase in the demand for money leads to a withdrawal of that amount of money from circulation, forcing a downward adjustment of prices.
But there is an important difference between the two. In the first case, the oversupply of fiduciary media is largely exogenous to the individual money holders. In other words, the increase in the supply of money is a result of central policy (either by part of the central bank or of government). Theoretically, an oversupply of fiduciary media could also be caused by a bank in a completely free industry but it would still be artificial in the sense that it does not reflect any particular preference of the consumer. Instead, it represents a miscalculation by part of the central banker, bureaucrat, or bank manager. In fact, this is the reason behind the intertemporal discoordination — the changing profit signals do not reflect an underlying change in the “real” economy.
This is not the issue when regarding an excess demand for money. Here, consumers are purposefully holding on to money, preferring to increase their cash balances instead of making immediate purchases. The decision to hold money represents a preference. Thus, the decision to reduce effective demand also represents a preference. The fall in prices which may result from an increase in the demand for money all represent changes in preferences. Entrepreneurs will have to foresee or respond to these changes just like they do to any other. That some businessmen may miscalculate changes in preference is one thing, but there can be no accusation of price-induced discoordination.
The comparison between an insufficient supply of money and an oversupply of fiduciary media would only be valid if the reduction in the money supply was the product of central policy, or a credit contraction by part of the banking system which did not reflect a change in consumer preferences. But, in monetary disequilibrium theory this is not the case.
None of this, however, says anything about the consequences of deflation on industrial productivity. Will a rise in demand for money lead falling profit margins, in turn causing bankruptcies and a general period of economic decline?
Whether or not an industry survives a change in demands depends on the accuracy of entrepreneurial foresight. If an entrepreneur expects a fall in demand for the relevant product, then investment into the production of that product will fall. A fall in investment for this product will lead to a fall in demand for the capital goods necessary to produce it, and of all the capital goods which make up the production processes of this particular industry. This will cause a decline in the prices of the relevant capital goods, meaning that a fall in the price of the consumer good usually follows a fall in the price of the precedent capital goods. Thus, entrepreneurs who correctly predict changes in preference will be able to avoid the worst part of a fall in demand.
Even if a rise in the demand for money does not lead to the catastrophic consequences envisioned by some monetary disequilibrium theorists, can an injection of fiduciary media make possible the complete avoidance of these price adjustments? This is, after all, the idea behind monetary growth in response to an increase in demand for money. Theoretically, maintaining monetary equilibrium will lead to a stabilization of the price level.
This view, however, is the result of an overly aggregated analysis of prices. It ignores the microeconomic price movements which will occur with or without further monetary injections. Money is a medium of exchange, and as a result it targets specific goods. An increase in the demand for money will withdraw currency from this bidding process of the present, reducing the prices of the goods which it would have otherwise been bid against. Newly injected fiduciary media, maintaining monetary equilibrium, is being granted to completely different individuals (through the loanable funds market). This means that the businesses originally affected by an increase in the demand for money will still suffer from falling prices, while other businesses may see a rise in the price of their goods. It is only in a superfluous sense that there is “price stability”, because individual prices are still undergoing the changes they would have otherwise gone.
So, even if the price movements caused by changes in the demand for money were disruptive — and we have established that they are not — the fact remains that monetary injections in response to these changes in demand are insufficient for the maintenance of price stability.
Implications for Free Banking
To a very limited degree, free banking theory does rely on some aspects of monetary disequilibrium. The ability to extend fiduciary media depends on the volume of returning liabilities; a rise in the demand for money will give banks the opportunity to increase the supply of banknotes. However, the complete integration of monetary disequilibrium theory does not represent theoretical advancement — if anything, it has confused the free bankers’ position and unnecessarily contributed to the ongoing theoretical debate between full reservists (many of which reject the supposed macroeconomic benefits of free banking) and free bankers.
We know that an increase in the demand for money will not lead to industrial fluctuations, nor does it produce any type of price discoordination. Like any other movement in demand, it reflects the preferences of the consumers which drive the economy. We also know that monetary injections cannot achieve price stability in any relevant sense. Thus, the relevancy of the macroeconomic theory of monetary disequilibrium is brought into question. Free banking theory would be better off without it.
This suggests, though, that a rejection of monetary disequilibrium is not the same as a rejection of fractional reserve banking. It could be the case that a free banking industry capitalizes on an increase in savings much more efficiently than a full reserve banking system. Or, it could be that the macroeconomic benefits of fractional reserve banking are completely different from those already theorized, or even that there are no macroeconomic benefits at all — it may purely be a microeconomic theory of the banking firm and industry. These aspects of free banking are still up for debate.
George A. Selgin, The Theory of Free Banking: Money Supply under Competitive Note Issue
(Totowa, New Jersey: Rowman & Littlefield, 1988). Also see George A. Selgin, Bank Deregulation and Monetary Order
(Oxon, United Kingdom: Routledge, 1996); Larry J. Sechrest, Free Banking: Theory, History, and a Laissez-Faire Model
(Auburn, Alabama: Ludwig von Mises Institute, 2008); Lawrence H. White, Competition and Currency
(New York City: New York University Press, 1989).
 Leland B. Yeager, The Fluttering Veil: Essays on Monetary Disequilibrium (Indianapolis, Indiana: Liberty Fund, 1997), pp. 218–219.
 Ibid., p. 218.
 Clark Warburton, “Monetary Disequilibrium Theory in the First Half of the Twentieth Century,” History of Political Economy 13, 2 (1981); Clark Warburton, “The Monetary Disequilibrium Hypothesis,” American Journal of Economics and Sociology 10, 1 (1950).
 Peter Howitt (ed.), et. al., Money, Markets and Method: Essays in Honour of Robert W. Clower (United Kingdom: Edward Elgar Publishing, 1999).
 Steven Horwitz, Microfoundations and Macroeconomics: An Austrian Perspective (United Kingdom: Routledge, 2000).
 Some of the criticisms presented here have already been laid out in a forthcoming journal article: Phillip Bagus and David Howden, “Monetary Equilibrium and Price Stickiness: Causes, Consequences, and Remedies,” Review of Austrian Economics. I do not support all of Bagus’ and Howden’s criticisms, nor do I share their general disagreement with free banking theory.
 Yeager 1997, pp. 222–223.
 Laurence Ball and N. Gregory Mankiw, “A Sticky-Price Manifesto,” NBER Working Paper Series 4677, 1994, pp. 16–17.
 Horwitz 2000, pp. 12–13.
 Yeager 1997, p. 104.
 Yeager 1997, p. 223. Yeager quotes G. Poulett Scrope’s Principles of Political Economy, “A general glut — that is, a general fall in the prices of the mass of commodities below their producing cost — is tantamount to a rise in the general exchangeable value of money; and is proof, not of an excessive supply of goods, but of a deficient supply of money, against which the goods have to be exchange.”
 Joseph T. Salerno, Money: Sound & Unsound (Auburn, Alabama: Ludwig von Mises Institute, 2010), pp. 193–196.
 This is Menger’s theory of imputation; Carl Menger, Principles of Economics (Auburn, Alabama: Ludwig von Mises Institute, 2007), pp. 149–152.
The advent of a European Union with a single currency was hailed by Nobel laureate Robert A. Mundell as
a great step forward, because it will bring forth new and for once meaningful ideas about reform of the international financial architecture. The euro promises to be a catalyst for international monetary reform.
Unfortunately, by underwriting member countries’ financial risk with impunity, the EU made the euro the catalyst of unsound monetary policies that are now leading the Union into an economic maelstrom. Still less has euroization set the pace for an international reform of the monetary machinery.
Milton Friedman was more cautious about this super currency. The euro’s real Achilles heel, he said, would prove to be political: a system under different governments subject to very different political pressures could not endure a common currency. Without political integration, the tension and friction of the national institutional systems would condemn it to failure. Indeed the problem is always political, but not in the sense meant by Friedman. Regardless of the degree of political integration, governments’ spending and dissipation, which are unalterable tendencies of any political organism, make irredeemable paper monies act as transmission belts for financial and economic disruptions.
At the outset of the 2010 Greek crisis that triggered the European domino effect, Professor Mundell pointed out that there was nothing inherently bad in the euro as such; the problem lay in the country’s public debt spiralling out of control. However, being a strong advocate of financial and monetary “architectures” as means for pursuing monetary and non monetary ends, he should have acknowledged that irredeemable currencies cannot be examined independently of the political framework in which they are embedded, because politics inevitably extends the role of money beyond its original function as a medium of exchange, making it trespass into the field of “economic policies”. Official theory does not see money as a neutral device, but as an instrument of policy for purposing ends which conflict with its primary goal: to retain the value of the monetary unit. Failing this primary goal, monetary architectures no matter how they are framed make for economic devastation.
Is a monetary order a constitution?
Robert Mundell’s assertion — that a monetary order is to a monetary system what a constitution is to a political or electoral system — unintentionally sheds light on the authoritarian nature of today’s irredeemable money governance and its fraudulent practices. Where is the flaw in this catching parallel? The flaw is that if a monetary order stands for a constitution, i.e. a democratic framework of laws and regulations, it does not provide for a separation of powers. The money order as a legislative system coincides with the executive power, the money system, embracing the range of practices and policies pursued for monetary and non monetary ends. Moreover, the judicial system is concentrated in the same hands because monetary authorities are not accountable to anyone. With the exception of governments that, being their source of power, may be considered “ghost writers” of monetary constitutions, no one else can influence money legislation. In other words, in this framework there is no room for an “electorate” (producers and consumers). What basic law regulates the relationships between individuals and their monetary orders by guaranteeing fundamental rights?
The basic law of the gold standard was the free convertibility of currencies, allowing individuals to redeem paper into gold on demand. This acted as protection against money misuse by banks or governments. Convertibility was for producers and consumers the means to express their vote on the degree of money reliability. Money was an instrument of saving. Paper money, or fiduciary circulation, as opposed to the banknote which was a title of credit, could be issued too but it had to comply with the law of gold circulation whereby the total volume of currency, coins, banknotes and paper notes had to correspond exactly to the quantity of metallic money necessary to allow economic exchanges. This being the purpose of the monetary system, banks, to avoid insolvency risks and gold reserves outflow had to adjust, through the discount rate policy, the issue of fiduciary papers to the real needs of economy.
Therefore gold was a barrier against the use of money as an instrument of power. Its value was fixed on the world market where gold was always in demand. Gold then had the same value in each country, and that’s why it was a stable international means of payment. Finally exchange rates were stable, not because they were arbitrarily controlled by government but because they were always gravitating towards the gold parity, the rate at which currencies were exchanged, and this was determined by their respective gold content. Roughly stated, the gold standard was an order providing for a separation of powers: the fundamental law of metallic circulation was the constitution, the banking system was the executive power which was controlled by producers and consumers representing the judicial power to sanction abuses. In today’s monetary order, producers and consumers have become legally disarmed victims of monetary legislation, deprived of the weapon of defence against money manipulation.
A trail of broken monetary arrangements
Central banks are the pillars of the monetary order because they are the source of the world’s supply and they regulate it. They control circulation, expand and restrict credit, stabilize prices and, above all they act as instruments of State finances. They are both “anvil and hammer”, trying to adapt the system to all occasions, remedying abuse by a still greater abuse, and considering themselves immune from the consequences. For these reasons, the leading architects of the world financial order should explain how the very same institutions that are pursuing unsound policies domestically might realistically think to establish a sound monetary order at a higher level.
The most important architecture, after the Second World War, was the Bretton Woods Agreement (1944). A “managed” form of gold standard was designed to give a stable word monetary order by a fixed exchange rate system with the dollar as the key currency, redeemable in gold only to central banks, and with member countries’ currencies pegged to the dollar at fixed rates and indirectly redeemable in gold. But the huge balance of payments deficit and high inflation in the US should have made gold rise against the dollar. A crisis of confidence in the reserve currency pushed foreign countries’ central banks to demand conversion into the metal, panicking the US, which promptly closed the gold window.
After the end of Bretton Woods in 1971, fiat currencies began to rule the world
The Smithsonian Agreement (1971-1973) which followed Bretton Woods was hailed by President Nixon as the “greatest monetary agreement in the history of the world” (!). It was an order based on fixed exchange rates fluctuating within a narrow margin, but without the backing of gold. Again, countries were expected to buy an irredeemable dollar at an overvalued rate. The system ended after two years.
Within the West European block, fixed exchange rates remained, but floating within a band against dollar. “The snake”, as the arrangement was called, died in 1976. Major shocks, including the 1973 oil price spike and the 1974 commodity boom, caused a series of currency crises, repeatedly forcing countries out of the arrangement. But this did not persuade them to abandon the dream of intra-European currency stability. The snake was replaced in 1979 by the European Monetary System (EMS) with its basket of arbitrarily fixed-but-adjustable exchange rates floating within a small band and pegged to the European currency unit (ecu), the precursor of euro.
Yet the arrangement ultimately failed, again due to a series of severe shocks (a global recession, German economic and monetary unification, liberalization of capital controls). Rather than abandoning the system, European governments adopted much wider fluctuation bands, reaffirming their commitment to an order based on fixed rates and irredeemable currencies.
So we arrive at an arrangement without historical precedent: sovereign nations with a single legal tender issued by a common central bank — the Euro entered into function in 1999. The stated aims of the single currency were noble: to facilitate trade and freedom of movement, providing for a market large enough to give each country better insulation against external shocks. Unfortunately, it couldn’t provide the member states with a system of defence against the internal shocks inherent to any irredeemable currency.
History confirms that currencies cannot rest on stability pacts and similar restrictions. Mainstream economists have long argued that the euro crisis has arisen from the lack of common social and fiscal policies, but the architects of the European currency were also well aware of this. Their aim was always to forge a European people, and a socialist European superstate, on the back of the euro. They had not the patience for a European state to naturally emerge in the same manner as the US, from a population sharing the same culture and language. “Europe of the people and for the people” was a misleading disguise to give an economic prison the honest appearance of a democratic and liberal project.
So in the end, Euroland has been working as a hybrid framework of institutions to which members countries delegate some of their national sovereignty in exchange for access to a larger market, capital, and low interest rates. But they entered an region of anti-competitive practices, antitrust regulations, redistributive policies, lavish subsidies, and faux egalitarianism — a perfect economic environment in which to run astronomical debts. The euro system represents one of the most significant attempts to place a currency at the service of political and social objectives, and it is for this reason that it will remain a source of problems.
Descent into the maelstrom
Today’s monetary orders are shaped to pursue what Rothbard has called the economics of violent intervention in the market. They are, in essence, based on a socialist idea of money. Accordingly they make for a framework of laws, conventions, and regulations fitting the interests of the rulers. In this framework it is the public debt that has utmost importance. Indeed, it is the monetary order that has developed the concept of debt in the modern sense. Because the management of public finances have become the supreme direction of economic policy, treasuries are now in charge of the national economies. Through the incestuous relationships they maintain with central banks, they are able to create the ideal monetary conditions in which to borrow ad libitum. Purely monetary considerations such as providing a stable currency are disregarded. Political, fiscal and social ends prevail over everything else.
In the last eighty years, monetary orders have allowed an abnormal increase in finance, banking, debt, and speculation completely unrelated to a development of sound economic activity and wealth production, but due instead to government’s overloading of central banking responsibilities. Unfortunately, the outcome is the de facto insolvency of the world monetary order. The ensuing adverse effects may be still delayed with the aid of various measures, interventions and expedients, but not much time is left. The stormy sea of debt has already produced a whirlpool that will be sucking major economies into a maelstrom, and the larger they are, the more rapid will be their descent. It remain to be seen what shape they will take after the shipwreck. Gloomy as the situation may appear, it is not hopeless because such an event might be the sole opportunity to cause a decisive change. It might be that instead of resuming the art of monetary expedients to create irredeemable money, governments and banks let them fade into oblivion. This would allow people to take their monetary destiny back into their own hands.