Following his introduction to Mises, Dr Eamonn Butler has released his latest book, Austrian Economics – A Primer. I recommend it strongly if you want to grasp the fundamentals of the Austrian School of Economics as quickly as possible: at just 118 pages, this pamphlet can be tackled in one sitting.
With Keynesian-inspired policies which ‘spend your way out of recession’ clearly not working, the Austrian School provides a better explanation for recent events than more ‘mainstream’ thinking, whether Keynesian or Monetarist.
Over the course of the book, Eamonn explains the Austrian view of the importance of human agency, values and knowledge in shaping the markets, that is social cooperation. Vitally, it explains the origin of the present cycle of boom and bust: the government’s cheap credit policies, which encouraged people to borrow and discouraged saving, creating an artificial boom that inevitably ended.
For many years, the Austrian School of Economics has been sidelined, but it’s great to see that it is now rising in popularity as people become increasingly critical of the way governments and central banks have handled the economy.
Butler’s systematic and simple yet comprehensive primer is a great addition to a stable which also includes The Austrian School: Market Order and Entrepreneurial Creativity by Jesus Huerta de Soto. While Huerta de Soto’s first-class book is perhaps aimed at a more technical audience, Butler has made the Austrian School highly approachable. A strength shared by both works is to be measured and inclusive where “Austrians” can be confrontational.
Eamonn has made a superb job of outlining this important school of thought and his book should prove a great success. You can buy it here.
One of our good supporters has sent us in an article to publish by Christopher Snowdon, who with the support of the courageous campaigners for liberty at the Taxpayers Alliance is setting out to challenge and demolish the work of Wilkinson and Pickett’s The Spirit Level: Why more equal societies almost always do better. Open-minded readers of this site will no doubt come to their own conclusions. Comment at The Guardian is warming up on the matter.
Myths rarely turn into conventional wisdom overnight. Usually they evolve gradually, exaggerated and embellished in the retelling. But in the case of The Spirit Level, a work of political science published last year, the transition from legend to gospel has been made with dizzying speed.
As its subtitle suggests, The Spirit Level: Why more equal societies almost always do better argues that the success of entire nations depends not on their absolute wealth but on the size of the gap between the highest and lowest earners. The ‘less equal’ nations suffer most severely from health and social problems, while the ‘more equal’ countries—particularly the Nordic states—are happier, healthier, more trusting, slimmer, more charitable and more socially cohesive.
The book’s authors—social epidemiologists Richard Wilkinson and Kate Pickett—insist that this phenomenon is not due to poverty, but is the result of the ‘psychosocial’ stress of living in an “unfair” country. Inequality, they say, acts like a “pollutant spread throughout society” with rich and poor equally susceptible to its toxic effects. The lesson is clear—if you want to mend the broken society, reject free market capitalism and adopt the Scandinavian model.
What raises The Spirit Level above the average left-wing polemic is what The Guardian described as its “inarguable battery of evidence”. This takes the form of a series of scatter graphs which, while crude, are consistent in their message: nearly all undesirable outcomes are more common in less equal countries. So neatly does this “battery of evidence” appeal to those who thought Gordon Brown was too right-wing, that it has been readily embraced by many on the left, including both Milliband brothers. A hotly debated political issue has, it seems, now been answered by science; an ethical question that has exercised the greatest minds for centuries has been answered with hard data.
If only things were so simple. In reality, The Spirit Level presents the world as its authors would like to see it, with inconvenient facts ignored and whole nations erased from the narrative. While claiming to study all rich market economies, countries such as Czech Republic, South Korea, Slovenia and Hong Kong never feature. If they had, the reader would see that the latter performs very well under almost every criteria despite extreme inequality (as does Singapore), while the Czech Republic and Slovenia do much less well despite having a very narrow gap between rich and poor.
If the sample group seems oddly selective, so too are the criteria of what makes a country “do better”. Wilkinson and Pickett focus on Scandinavia’s relatively low rate of illegal drug use without mentioning its high rate of alcoholism. They devote a chapter to the higher rate of imprisonment in less equal countries without discussing the more pertinent—and hardly coincidental—fact that these countries also have less crime. They confidently assert that people in egalitarian societies are more philanthropic, have stronger family relationships and are more involved in the local community. Had they sought empirical evidence for any of this, they would have found that it is actually the people in less equal countries who give more to charity, have fewer divorces and are most likely to be a member of a local club or association.
And so it goes on. Remarkably few of The Spirit Level’s claims stand up to scrutiny. If the book demonstrates anything, it is how easily statistics can be transformed into the proverbial ‘damned lies’. Nonetheless, it is a book that should not be ignored. Not only has it built up a large and avid readership, but it represents a milestone for those who view the narrowing the wealth gap as more important than creating wealth. While the traditional aim of the left was to alleviate poverty by making the poor richer, inequality can be alleviated by narrowing inequality in ways that need not make anyone richer.
Indeed, Wilkinson and Pickett seem indifferent to how inequality is reduced and explicitly state that economic growth is not the answer. By their rationale, society would improve if the poor got 5% poorer so long as the rich got 20% poorer. Rounding up Britain’s millionaires and sailing them to the Antarctic would not only make life better for the poor but, still less improbably, would make life better for everyone. But without a compelling reason to believe such a reduction will materially benefit the working class, the authors leave themselves open to accusations of trading in the politics of envy.
Herein lies the problem with focusing on relative income instead of absolute income. There are things we can do to make the poor richer which might also reduce inequality, and vice versa, but the two objectives are not always compatible. The government’s recent decision to raise the tax threshold to £10,000, for example, should make the poor richer, but if the rich find ways to get even richer in the mean time, will the resulting inequality make things worse? It is not obvious how or why, but the logic of The Spirit Level says it must.
In the end, the case for reducing inequality remains a moral and political question. It is not one that be answered by science. The Spirit Level represents an ingenuous attempt to bridge the gap between faith and reason but, like all grand unifying theories, it can be filed under ‘too good to be true’.
The Great Austrian applied and theoretical economist Dr Frank Shostak has allowed us to publish this small article that should give you a good understanding on how to approach an economic problem, what emphasis you should place on theory and what on empirics. How indeed to distinguish a good theory from a bad theory and how everything must be rooted in the study of the purposeful actions of man. For some of our readers this may be a boring subject, but it is about the foundations of what is and is not good economics, so I do urge you to persevere and read on. Our thanks to Dr Shostak.
Toby Baxendale
Government releases of various economic indicators such as GDP, the CPI, and unemployment receive wide coverage in popular media such as TV networks and newspapers. In a measured and authoritative voice, various economists and other experts who are interviewed discuss their views regarding the health of the economy. Thus, a rise in an indicator like GDP is interpreted as good news while a decline is seen as pointing to trouble ahead.
The experts’ opinions are not only confined to the health of the economy in general. They also offer their advice regarding various forms of investments. Some economists who present their assessments seem to be able to offer viewers not only qualitative but also quantitative analyses.
For instance, they will advise viewers that the economy is likely to grow by 0.6 percent in the next quarter, and thereafter the growth will jump to 1.2 percent. Or, they will state that low inflation makes it so much easier for the central bank to lower interest rates to strengthen economic growth.
These types of comments leave a deep impression on viewers that economists are really on top of the issues. But what are the tools that economists and financial experts utilise in their assessments of the economy? What is the basis of their framework of thought?
Making the Data Talk
In order to make the data “talk,” economists utilise a range of statistical methods that vary from highly complex models to a simple display of historical data. It is generally held that by means of statistical correlations one can organise historical data into a useful body of information, which in turn can serve as the basis for assessments of the state of the economy. It is believed that through the application of statistical methods on historical data, one can extract the facts of reality regarding the state of the economy.
Unfortunately, things are not as straightforward as they seem to be. For instance, it has been observed that declines in the unemployment rate are associated with a general rise in the prices of goods and services. Should we then conclude that declines in unemployment are a major trigger of price inflation? To confuse the issue further, it has also been observed that price inflation is well correlated with changes in money supply. Also, it has been established that changes in wages display a very high correlation with price inflation.
So what are we to make out of all this? We are confronted here not with one, but with three competing “theories” of inflation. How are we to decide which is the right theory? According to the popular way of thinking, the criterion for the selection of a theory should be its predictive power. On this Milton Friedman wrote,
The ultimate goal of a positive science is the development of a theory or hypothesis that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed.[1]
Is Everything Uncertain?
According to mainstream thinking so long as the model (theory) “works,” it is regarded as a valid framework as far as the assessment of an economy is concerned. Once the model (theory) breaks down, we look for a new model (theory). For instance, an economist forms a view that consumer outlays on goods and services are determined by disposable income. Once this view is validated by means of statistical methods, it is employed as a tool in assessments of the future direction of consumer spending. If the model fails to produce accurate forecasts, it is either replaced, or modified by adding some other explanatory variables.
The tentative nature of theories implies that our knowledge of the real world is elusive.
Since it is not possible to establish “how things really work,” then it does not really matter what the underlying assumptions of a model are. In fact anything goes, as long as the model can yield good predictions. According to Friedman,
The relevant question to ask about the assumptions of a theory is not whether they are descriptively realistic, for they never are, but whether they are sufficiently good approximation for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.[2]
Two Kinds of Economists
The view that our knowledge is tentative and that we can never be certain about anything, has given rise to two groups of economists. In one camp there are the so-called theoreticians, or “ivory-tower economists,” who generate various imaginary models and use them to form an opinion on the world of economics.
In the other camp we have the so-called “practical” economists, who derive their views solely from the data. Whereas the ivory-tower economists are of the belief that the key to the secret of the economic universe is via abstract models, the “practical” economists hold that if one “tortures” the data long enough, it will ultimately confess and the truth will reveal itself.
Economic theory, however, must have only one purpose–to explain the essence of economic activity. But statistical methods are of no help in this regard. All that various statistical methods can do is just describe and compare the movements of various historical pieces of information. These methods cannot identify the driving forces of economic activity. Likewise, models that are based on economists’ imagination are not of much help either since these theories are not ascertained from the real world.
Contrary to popular thinking, economics is not about GDP, or CPI, or other economic indicators as such, but about human activities that seek to promote people’s lives and well being. One can observe that people are engaged in a variety of activities. They are performing manual work, they drive cars, and they walk on the street and dine in restaurants. The distinguishing characteristic of these activities is that they are all purposeful.
Thus manual work may be a means for some people to earn money, which in turn enables them to achieve various goals such as buying food or clothing. Dining in a restaurant could be a means to establishing business relationships. Driving a car could be a means for reaching a particular place. In other words, people operate within a framework of ends and means; they are using various means to secure ends.
Purposeful action implies that people assess or evaluate various means at their disposal against their ends. At any point in time, people have an abundance of ends that they would like to achieve. What limits the attainment of various ends is the scarcity of means. Hence, once more means become available, a greater number of ends, or goals, can be accommodated–i.e., people’s living standards will increase. Another limitation on reaching various goals is the availability of suitable means. Thus to quell my thirst in the desert, I require water. The diamonds in my possession will be of no help in this regard.
Human Action Is Central
To undertake the identification of data, one is required to reduce it to its ultimate driving force, which is purposeful human action. For instance, during an economic slump, a general fall in the demand for goods and services is observed. Are we then to conclude that the fall in demand is the cause of an economic recession?
We know that people persistently strive to improve their life and well being. Their demands or goals are thus unlimited. The only way then for general demand to fall is via people’s inability to support their demand. From this we can infer that we have problems on the production side, i.e., their means are the likely causes of an observed general fall in demand.
Alternatively, consider the situation in which the central bank announces that increasing money supply growth, while price inflation is low, can lift real economic growth. To make sense of this proposition we must examine the essence of money. Money is the medium of exchange. Being the medium of exchange, money can only facilitate existing real wealth. It cannot create more wealth. Money cannot be used in production. It cannot be used in consumption. Hence we can conclude that printing money is not the right means to promote economic growth. It follows from this that the goal–of lifting real economic growth–cannot be achieved by means of printing money.
The knowledge that people are pursuing purposeful actions also permits us to evaluate the popular way of thinking that holds that the “motor” of the economy is consumer spending–i.e., demand creates supply. We know, however, that without means, no goals can be met. But means do not emerge out of the blue; they must be produced first. Hence, contrary to the popular thinking, the driving force is supply and not demand.
The fact that man pursues purposeful actions implies that causes in the world of economics emanate from human beings and not from outside factors. For instance, contrary to popular thinking, individual outlays on goods are not caused by real income as such. In his own unique context, every individual decides how much of a given income will be used for consumption and how much for investments. Whilst it is true that people will respond to changes in their incomes, the response is not automatic. Every individual assesses the increase in income against the particular set of goals he wants to achieve. He might decide that it is more beneficial for him to increase his investment in financial assets rather than to increase consumption.
Numbers Do Not Explain
Without the knowledge that human actions are purposeful, it is not possible to make sense out of historical data. On this Rothbard wrote,
One example that Mises liked to use in his class to demonstrate the difference between two fundamental ways of approaching human behavior was in looking at Grand Central Station behavior during rush hour. The “objective” or “truly scientific” behaviorist, he pointed out, would observe the empirical events: e.g., people rushing back and forth, aimlessly at certain predictable times of day. And that is all he would know. But the true student of human action would start from the fact that all human behavior is purposive, and he would see the purpose is to get from home to the train to work in the morning, the opposite at night, etc. It is obvious which one would discover and know more about human behavior, and therefore which one would be the genuine “scientist”[3].
The popular view that sets predictive capability as the criterion for accepting a model is absurd. Even the natural sciences, which mainstream economics tries to emulate, don’t validate their models this way. For instance, a theory that is employed to build a rocket stipulates certain conditions that must prevail for its successful launch. One of the conditions is good weather. Would we then judge the quality of a rocket propulsion theory on the basis of whether it can accurately predict the date of the launch of the rocket? The prediction that a successful launch will take place on a particular date in the future will only be realised if all the stipulated conditions hold. Whether this will be so cannot be known in advance. For instance, on the planned day of the launch it may be raining. All that the theory of rocket propulsion can tell us is that if all the necessary conditions will hold, then the launch of the rocket will be successful. The quality of the theory, however, is not tainted by an inability to make an accurate prediction of the date of the launch.
The same logic also applies in economics. Thus we can say confidently that, all other things being equal, an increase in the demand for bread will raise its price. This conclusion is true, and not tentative. Will the price of bread go up tomorrow, or sometime in the future? This cannot be established by the theory of supply and demand. Should we then dismiss this theory as useless because it cannot predict the future price of bread? According to Mises,
Economics can predict the effects to be expected from resorting to definite measures of economic policies. It can answer the question whether a definite policy is able to attain the ends aimed at and, if the answer is in the negative, what its real effects will be. But, of course, this prediction can be only “qualitative.”[4]
The fact that people consciously pursue purposeful actions provides us with definite knowledge, which is always valid as far as human beings are concerned. This knowledge sets the base for a coherent framework that permits meaningful assessments of the state of an economy. In contrast, analyses that rely solely on statistical correlations cannot be of much help, for they are totally groundless. Hence comments made by various experts who rely on such frameworks are arbitrary. All that these experts can do is repeat already-known data and simply offer a baseless view – they can tell us nothing about the essence of economic activity.
Fanciful Assumptions
Similarly, we must reject all the comments that are based on “purely” theoretical models, which derive their foundation from economists’ imaginations. A model, which is not derived from reality, cannot possibly explain the real world.
For example, in order to explain the economic crisis in Japan, the famous mainstream economist Paul Krugman employed a model that assumes that people are identical and live forever and that output is given.[5] Whilst admitting that these assumptions are not realistic, Krugman nonetheless argued that somehow his model can be useful in offering solutions to the economic crisis in Japan.
Conclusion
The arbitrary nature of mainstream economics has given rise to the view that there is a gulf between theory and practice. A distinction is made between theoretical and practical assessments. Comments like “it is a great theory; however, I cannot make use of it” are often heard. Yet there is no such thing as a good but not applicable theory. To be applicable, a theory must emanate from the facts of reality, i.e., the fact that human beings are engaged in purposeful actions. Economists and various other financial experts who derive their knowledge of the economy solely from statistical correlations of various historical data run the risk of misleading themselves and their audiences. Even when they appear to be ‘right’ ie. their ‘forecasts’ prove ‘correct’, this is merely due to coincidence – they are ‘right’ but for the wrong reasons. Such an approach proves unsustainable as soon as the coincidental factors diverge again. Likewise economists who base their views on imaginary models are not in a position to say anything meaningful, and whatever they utter is just plain arbitrary.
[1] Milton Friedman, Essays in Positive Economics, Chicago: University of Chicago Press, 1953.
Over at CentreRight, I have set out briefly the mistake presently being made by policymakers in the US, which I expect to be mirrored in the UK later this morning. For example:
Injecting more new money, whether through QE or credit expansion in excess of real savings, will not “fight recession”. It will merely delay and worsen the eventual downturn, because injecting new money is bound to shift activity from sustainable economic action to action supported only by that new money.
Sooner or later, the mainstream economic paradigm must shift to accept the importance of time and hence a robust capital theory. Everyone’s prosperity depends upon it.
By kind permission of Paul Birch, we reproduce his essay setting out a proposal for honest money through bearer shares, previously published on this site in October 2009. Paul’s own site may be found here: www.paulbirch.net.
1. Introduction
Nobody understands money, least of all economists. Too sweeping a statement? Perhaps. But every analysis of the workings of monetary systems that I have ever read has been seriously in error at one or more crucial points. This is true not only of the supposedly impartial opuses of academic economics, but also of the writings of Marxists, socialists, Keynesian dirigists, free-marketeers, anarcho-capitalists, libertarians and utopians of every flavour.
On important issues of monetary policy, then, and whether a free market in money is either workable or desirable, the protestations of the experts must be considered unreliable. In particular, the claims of libertarian-leaning economists, such as Ludwig von Mises, that the operation of “free banking” would be both stable and superior to the system of government monopoly called “central banking” need to be treated with scepticism; they have not proved what they think they have proved.
Here I intend to give a description of certain aspects of the creation and use of money free of major error; it is conceivable that I may not entirely succeed. I shall argue that free banking, as it is usually understood, may be liable to gross instabilities and inefficiencies, especially in a free-market environment, and that a centralised fiat currency has definite advantages. However, I shall then describe an alternative form of free-market banking that appears not to suffer from these deficiencies and into which the current system of state control could be metamorphosed. I shall argue that it is the innate honesty or dishonesty of the banking method that most distinguishes good money from bad; and that it is of the greatest importance to ensure that the laws under which banking takes place are able effectively to restrain all dishonest forms of banking, including those in which the dishonesty is most subtle.
2. What is Money?
So what is money? A deceptively easy question, that. Answers from the past include “gold”, “silver and gold”, “a medium of exchange”, “a promise to pay”, “a store of value”, “a measure of demand”, “just another commodity”. Such answers hold a germ of truth, but only lead to controversy, because they miss the essential point. All along we’ve been asking the wrong question. Instead, let us ask a new one:
What is the function of money?
The function of money is to keep track of who owes what to whom. In a world in which there is division of labour and in which we obtain diverse satisfactions by the voluntary exchange of goods and services we have need of an accounting device to permit this exchange to take place at minimal cost and without undue coercion or confusion. This accounting device we call money. Simple barter is not enough, because the goods I want are seldom held by the person to whom I can render service.
Imagine a central register, detailing every transaction entered into by each and every person, and containing a list of all the favours owed by each and every person to each and every other person. That would do it. It would be hideously complicated, but it would work. Fortunately, though, we needn’t go to such lengths, because in a market economy most of that data is redundant. All we really need to know is the current balance to the account of each person — how much the rest of the world owes him or how much he owes the rest of the world — and even that need not be centrally recorded.
In a market economy, then, the function of money is to reduce the transaction costs of honest trade (including gifts and bequests other than those directly in kind) by reliably and efficiently registering the indebtedness resulting from previous transactions. The details of those previous transactions no longer matter; only the present net position counts (except for incomplete transactions, such as when you have bought an item but not yet paid for it).
So, if the function of money is to keep track of honest trade, can we now answer the original question in a more enlightened and constructive way? I think we can.
The Chinese government has many financial problems coming up, the worst of which is trying to get rid of all those US Treasury securities that they have accumulated over the years without causing a cataclysmic run on the US dollar, and thereby wiping out the value of most of what they have left before they can unload it safely onto the world’s debt markets.
Peter Schiff has long predicted that eventually the Chinese will stop producing for the Americans and sending cargo ships full of produce to the west coast of the USA, which usually return empty except for bundles of US Treasury notes stuffed into the captain’s cabin safe, and will re-tool their industries instead and start consuming their own production.
The transition will be painful, however, as the Chinese government switches from lending money to the American government so that American consumers can buy Chinese goods at Walmart, so virtually every economist of a non-Austrian persuasion disagrees with the Schiff analysis, often vehemently; “Chinese producers need US consumers,” claim these other economists — “it’s the caboose in front of the engine,” responds Mr Schiff.
If Schiff is right, then one of the first signs of this reversal and re-coupling of the Chinese productive economy will be the eventual full flotation of the Chinese Renminbi and its complete de-pegging from the US dollar. In the video below, scroll through to 6:40 where Mr Schiff describes what he thinks may mark the beginning of this fiendishly tricky and highly risky process.
Is he right about the eventual full flotation of the Renminbi? Well, I’m highly biased on that and you can probably guess my opinion. However, watch the piece and make up your own mind:
Advisory Board Member Steve Baker, MP for Wycombe, yesterday made his maiden speech in the House of Commons. The full text may be found here. The articles which most closely inspired the speech are here and here.
The following section of the speech — which we have annotated with links to relevant articles — made some key points about honest money:
As a trustee of a charity for economic education, I would like to give what is perhaps an alternative perspective on the cause of the banking crisis; I hope that Members will indulge me. I should like to put to them a proposition that is uncontroversial: around the world, the system of money is a product of the state. Our monetary system is characterised by private banking, with a fractional reserve controlled by a central bank, which determines monetary policy and has a monopoly on the issue of legal tender. A Monetary Policy Committee sets interest rates.
The banks have the legal privilege of treating depositors’ money as their own. In the words of Irving Fisher,
“our national circulating medium is now at the mercy of loan transactions of banks”.
In the other place, in the Banking Bill debate of 5 February 2009, the Earl of Caithness explained eloquently the base of 19th-century judicial decisions-and yes, our system of money has evolved since then-that enabled that situation to take place. He called it
The Bank Charter Act 1844 ended the practice of banks over-issuing notes, but it left them virtually unmolested in their ability to issue deposit currency to be drawn by cheque. That loophole haunts us today. Unlike the situation in respect of any other commodity, in the case of money, price controls do not drive the product off the market. Artificially lowered interest rates increase the demand for credit, and decrease the supply of savings, but the legal privilege granted to banks means that they can meet demand by extending credit that is unbacked by real savings. There is a good argument to say that that causes the boom-and-bust cycle, the misdirection of resources in the capital structure of production, and over-consumption by consumers. That is the biggest problem that we face today.
We could talk about the moral hazard of having a state-backed lender of last resort and state deposit guarantees, and of the socialisation of the cost of failure; I only wish that I had time to touch on the accounting rules on derivatives. Perhaps that is for another day. My political hero, Richard Cobden, spoke on the subject. He held
“all idea of regulating the currency to be an absurdity”,
but I see that time is short; I shall have to save the rest of the quote for another day.
Today, money is a product of the state. The Bank of England controls the price, quantity and quality of money. Perhaps if we were talking about any other commodity, there would be far less confusion over and questioning of the cause of the crisis. If money is a product of the state, we should ask ourselves, “Is this a good idea?”
In the coalition, we have a Government ideally suited to be conservative to preserve what is good, but radical to change all that is bad. If we are to have a once-in-a-generation, fundamental review of the role of government, let us also examine government’s role in the system of money and bank credit.
In recognition of soaring inflation, and the looming threat that our new government will resort to monetisation of the national debt, we are bringing forward this classic article, originally published in December 2009.
Mr Smith works hard, plans carefully, and saves what he can, putting his money into a building society. He pays his credit card bills off each month, and tries to overpay his mortgage when he can.
Mr Smith got a 3% pay rise last year – inflation was only 2% – so he felt good about that. But… he doesn’t feel any wealthier.
Year after year, the government had said that the economy was growing strongly, but still, things seemed harder for his family and him. Train ticket prices up again. Heating bills rocketed when the price of oil went up, but never seemed to come down. He swears a loaf of bread and a pint of milk were much cheaper in years gone by.
When he changes his cash for Euros, he realises that his holiday in France is now unbearably expensive. His tax rates didn’t go up, but still, after all his bills were paid, he seemed to have less and less spare cash than he remembers a few years ago.
There are Mr Smiths everywhere. Careful folk, who plan, save for a rainy day and have a sense of personal responsibility.
Smith is the target.
It is Mr Smith who is going to pay for the banking crisis.
His saved wealth will pay the national debt.
His prudence will bail out Gordon Brown’s profligacy.
His forgone holiday will pay the banker’s bonuses.
His careful spending will pay for the vast number of quangos.
His financial planning will bail out the failed NHS computer project, over-budget military programs and ID cards.
His sense of responsibility will end up funding the destruction meted out in Iraq and Afghanistan.
It won’t be the politicians or the bankers who pay for global warming – he will.
He knows he pays tax… but what is hard for him to comprehend is that there is another pernicious process draining his wealth and subverting his hard work towards paying for the misjudgement of others. Whether he likes it or not, he naively pays for the decisions made by the political class.
He has no choice. No option. He was never asked to vote for it. And for the most part, the act of theft is so subtle he doesn’t even know it is happening.
Why does he feel poorer?
Why is it that Mr Smith seemed to miss the ‘boom’, yet is hurting more in the bust? Why doesn’t life get easier for him? What is going on?
Inflation.
As technology produces things more cheaply, Mr Smith should have been able to reap the rewards – except that things don’t get cheaper for him. Society cheats him when the government opens the spigot of new money, washing this value away as the torrent of new money chases prices higher beyond his reach.
The winners are always those close to the gusher – the banks, financiers and politicians. These are the ones who get to spend the new money first, thus chase prices up before Mr Smith gets any sniff of what is happening.
To save or to invest?
Think about your personal circumstances. Every time your payslip comes in, you have a choice of how much to spend and how much to save. Every rational person knows that there is a balance to be struck between current enjoyment (consumption) and future enjoyment (savings – or deferred consumption).
This choice is exactly the same for society as a whole. As a country, we must decide how much to consume, and how much to defer consumption in order to allow our children and us to enjoy things in the future.
The choice for us all is simple. Defer consumption and invest for the future, or consume and enjoy now.
What is the process by which we save for the future? There are two ways.
Voluntary saving. If society needs to invest for the future, but people prefer to consume, then the savings rate – the profits paid on investments and/or the interest rate paid on deposits, rises until people choose to defer consumption and invest.
Forced saving. Government policy forces a decrease of the purchasing power of money via inflation of the money supply. The net effect is a transference of wealth from savers and fixed income groups towards net borrowers (itself included). It also creates an artificial pool of liquidity into which the government can sell its IOUs.
The evil of Forced Saving
The natural state of affairs in a free market, with a more consistent supply of money, is that general prices fall as technology advances. The prudent are rewarded, and borrowers have to carefully evaluate and moderate their flights of fancy, only investing borrowed funds carefully in sound projects.
When the value of money declines, savers find that their money buys less, whilst borrowers are happy to find that they can repay their debts with money of a decreased value. It’s like borrowing five books from the library and finding that you are only required to give four back!
By setting a target for rising prices and then pulling levers to increase the supply of money in the economy to achieve it, the government prevents the natural response of general prices to competition, increased efficiency and innovation: they stop prices from falling.
Entrepreneurs, innovators, inventors and new businesses exist because they believe that they can satisfy society’s wants better than they have been served before. They have ideas, innovations and take risks in order to provide goods that are cheaper than they otherwise would be. Businesses operating in a competitive environment always seek to reduce costs, be that one step more efficient and produce a cheaper or better widget. As group of people, entrepreneurs bring efficiency and innovation, and they make stuff cheaper.
The benefit to Mr Smith should be that his income goes further. As time progresses, technological innovation should mean he can buy more with the same cash. But that’s not what happens, as any pensioner knows. Saved money buys far less now than it did at the time it was saved.
Governments achieve rising prices by encouraging the supply of new money. This new money comes from the central bank via its control of the banking system. The first users of this new money are invariably politicians, finance capitalism and big business. These guys get to use the newly minted money first, and thus spend it first. This process bids up prices, leaving everyone else chasing behind, and poor old Mr Smith last in the queue.
What an evil system it is then, when government can control money in such a way as to give it a first user advantage that penalises all those in the general population whose wealth is being rapidly diluted. A process that systematically violates and loots pensions, savings, fixed incomes and the actions of prudent, and rewards the profligate, the speculative borrowers and above all, rewards the biggest borrower of all: Government.
Let’s be clear. The current system is a process that diverts the benefits of innovation and technological advancement that should accrue to the general population, and thrusts it towards the desired spending of the well connected and the political class.
We need to stop this continual violation of the little man. Mr Smith has to start realising what is happening to him.
That’s why I’m proud to support the efforts of the Cobden Centre.
The M3 money supply in the United States is contracting at an accelerating rate that now matches the average decline seen from 1929 to 1933, despite near zero interest rates and the biggest fiscal blitz in history.
But this begs the question, “Why is the money supply dependent on interest rates and government spending?”
It turns out the great economist Irving Fisher told us back in the 1930s: banks create and destroy credit money by granting and calling loans. As Fisher wrote:
Thus our national circulating medium is now at the mercy of loan transactions of banks; and our thousands of checking banks are, in effect, so many irresponsible private mints.
He went on (emphasis mine):
As the system of checking accounts, or check-book money, based chiefly on loans, spreads from the few countries now using it to the whole world, all of its dangers will grow greater. As a consequence, future booms and depressions threaten to be worse than those of the past, unless the system is changed.
Fisher set out the problem in the 1930s and a solution, one which offered the possibility of paying off the national debt and largely ending economic cycles: 100% reserves on demand deposits. We face the same problem today and we have the same tantalising possibilities.
The Banking Bill fails to address the fault which has led to every major banking and currency crisis during the past 200 years, including this one. It merely, lazily and weakly, papers over the cracks. Like Lilliputians, we are trying to tie down Gulliver with ever more strands of rope. It did not work then; it has not worked since 1811; and it will not work now.
This is why colleagues and I established The Cobden Centre: we need honest money now to end the crisis and set us on a firm foundation for a sustainable and healthy future economy.
To set Toby’s “Emperor’s New Clothes” proposal in context, we are bringing forward a number of classic articles.
This article was originally published on 20 January 2010. It is a speech by James Tyler to the Adam Smith Institute Next Generation Group on 6 October 2009. This speech is also available on hedgehedge.com.
I have spent the best part of the last two decades pitting my wits against the market. It’s an unforgiving game: I’ve seen ups and downs, and many of my rivals buried under an avalanche of hubris, passion, illogical thought and unchecked emotion.
I have witnessed the sheer folly of the ERM crisis, the Asian crisis, the failure of the Gods at Long Term Capital Management and the insanity of the tech boom.
I have enjoyed the ‘NICE’ decade (Non-Inflationary Constant Expansion), and scared myself silly during the credit crisis.
I am a trader.
I risk my own money and live or die by my decisions, and face the threat of personal bankruptcy every time I switch my screens on. I get no salary – indeed I turn up at the start of the month with a large office overhead – a ‘negative’ salary. I have no fancy company pension scheme, no lucrative monopoly or franchise.
I eat what I kill.
Mistakes cost me my livelihood, so, above all, my decisions have to be rooted in practical and logical decision making.
Some have called my kind parasitic, but I would have said that I bring order, efficiency, predictability, stability and deep liquidity to a crucial process: a process that makes the whole world keep ticking.
I make money work.
I make the market in interest rate derivatives: a market born out of the neo classical revolution in finance fostered in Chicago during the 1970s. I am a child of Friedman, Fisher Black, Myron Scholes and the modern international financial system.
My analysis was steeped in the neo-classical, efficient markets paradigm.
Friedman’s ideal was working. Enlightened central bankers guided the free market with gentle nudges and short term liquidity infusions, free floating currencies gently adjusted themselves to the constant flow of new information and efficient and rational markets took all in their stride.
Credit flowed, people got wealthier, economies developed and all was well.
Following his introduction to Mises, Dr Eamonn Butler has released his latest book, Austrian Economics – A Primer. I recommend it strongly if you want to grasp the fundamentals of the Austrian School of Economics as quickly as possible: at just 118 pages, this pamphlet can be tackled in one sitting.