Book Review: The Death of Money: The Coming Collapse of the International Monetary System by James Rickards
The title will no doubt give Cobden Centre readers a feeling of déjà vu, but James Rickards’ new book (The Death of Money: The Coming Collapse of the International Monetary System) deals with more than just the fate of paper money – and in particular, the US dollar. Terrorism, financial warfare and world government are discussed, as is the future of the European Union.
Though he quotes F.A. Hayek a few times, the Austrian School gets only one mildly disparaging mention in the entire book. This seems odd for an author who devotes a whole chapter to the benefits of the gold standard. His first bestselling book, Currency Wars, argues that currency wars are not just an economic or monetary concern, but a national security concern for the USA.
Rickards relies on emerging Chaos theories of economics and markets (1) to buttress his arguments in favour of sound money and prudent – limited – government. He uses the same insights, twinned with years of Wall Street experience, to explain why the “coming collapse of the dollar and the international monetary system is entirely foreseeable.”
One of Rickards’ key arguments is that exponential increases in the total size of credit markets mean exponential increases in risk. The gross size of derivative markets is the problem, irrespective of false assurances about netting, he claims. Politicians and central bankers have by and large learnt nothing from recent crises, and are still “in thrall to bank political contributions.”
He makes the case for the US federal government to reinstate Depression-era restrictions on banking activities and for most derivatives to be banned. As a former Federal Reserve Chairman, Paul Volcker, said in 2009, “the only useful thing banks have invented in 20 years is the ATM” – a sentiment Rickards would probably be sympathetic to.
The chapter dealing with the Fed’s hubris and what investment writer James Grant calls our “PhD Standard” of macroeconomic management will be familiar territory for readers of this site. The Fed is trapped between the rock of natural deflationary forces of excessive debt, an ageing population and cheap imports frustrating its efforts to generate a self-sustaining economic recovery and the hard place of annualised inflation of 2%. Rickards quotes extensively from eminent economist and Ben Bernanke mentor Frederic Mishkin, who noted in a 2013 paper titled Crunch Time: Fiscal Crises and the Role of Monetary Policy that “ultimately, the central bank is without power to avoid the consequences of an unsustainable fiscal policy.”
More interesting is the author’s attempt to map out what-happens-next scenarios. The chapter about the on-going transformation of the International Monetary Fund into the world’s central bank, and Special Drawing Rights (SDRs) into a global currency, is particularly insightful. Though Rickards doesn’t say it, Barack Obama’s former chief of staff (and current Mayor of Chicago) Rahm Emanuel’s dictum about never letting a crisis go to waste seems to apply here: hostile acts of financial warfare would lead to calls for more international regulation, and to more government intervention and monitoring of markets. Observers of the EU’s crab-like advance over the last half century will be familiar with the process.
Indeed, my only quibble with this book is Rickards’ starry-eyed take on the EU – soon to be “the world’s economic superpower” in his view. Though he makes a good argument – similar to Jesús Huerta de Soto’s – that relatively-tight European Central Bank monetary policy is forcing effective structural adjustments in the eurozone periphery, as well as in eastern states that wish to join the euro, his endorsement of other aspects of the EU seem too sweeping.
The author talks of the benefits of “efficiencies for the greater good” in supranational government, and how subsidiarity makes allowances for “local custom and practice”. But, as the regulatory débacle surrounding the Somerset floods has shown recently, EU rule frequently licenses bureaucratic idiocies that destroy effective, established national laws. Regulatory central planning for an entire continent is, I’d say, just as suspect as monetary central planning for one country.
The continent’s demographic problems are probably containable in the short-term, as Rickards says. But mass immigration is driving increasing numbers of white Europeans to far-right parties. And while there is consistently strong public support for the euro in the PIIGS (Portugal, Ireland, Italy, Greece and Spain), he’s silent on the broader question of the EU’s democratic legitimacy. No mention of those pesky ‘No’ votes in European Constitution, Maastricht and Lisbon Treaty referendums – or of the Commission’s own Eurobarometer polls, which show more and more Europeans losing faith in “the project”.
No matter I suppose: the eurocrats will rumble on regardless. But what was that quote about democracy being the worst form of government apart from all the others?
All in all though, this is a great book – even for someone like me who’s not exactly new to the economic doom ‘n’ gloom genre. As Rickards says at the end of his intro: “The system has spun out of control.”
(1) For example Juárez, Fernando (2011). “Applying the theory of chaos and a complex model of health to establish relations among financial indicators”. Procedia Computer Science 3: 982–986.
Continued from Been there, done that, bought the T-shirt
Having broadly tried to demonstrate where we differ from our rivals and where we find their tenets most objectionable, you might be hoping that I will now be tempted to go into the details of what an Austrian might recommend by way of a remedy for our current ills even though this would exhibit a clear infraction of Hayek’s admonition that ‘the curious task of economics is to demonstrate to men how little they really know about what they imagine they can design’!
So, rather than having me succumb to such a ‘fatal conceit’, let me instead sketch the outlines of what would, in an Austrian estimation, be a world in which we would be unlikely to repeat our present stupidities, certainly not on the Olympian scale on which we currently practise them.
Firstly, we should recognise that much of our success as a species comes from our adherence to that peculiar form of competitive co-operation which we Austrians term ‘catallactics’ – i.e., the business of exchange, of trading the fruits of our varying endowments, aptitudes, and accomplishments to the mutual benefit of both counterparties to what may well be a single-priced transaction but which is nonetheless never a zero-sum one (at least when it is undertaken voluntarily and in good faith).
As a direct consequence of this, we can assert in the strongest possible terms that we therefore tamper with the means by which we conduct such dealings – we meddle with our medium of exchange, our money – only at our peril. To us, dishonest money is the root of all evil, not ‘shadow banks’, ‘moral hazard’, ‘regulatory capture’ or any of the manifold offshoots of human cupidity in general, for the ability of such perennial failings to wreak widespread havoc in either financial markets or economies, per se, would be much more severely limited if money were not so easily corrupted alongside the men who use it.
A good deal of discussion has taken place at this gathering and many ideas have been thrown up – many of them earnest, most of them shrewd, some of them even practicable – as to how to improve our present modus operandi. But unless banking and finance better reflect economic reality – and by this I mean of course Austrian reality! – all of them will be in vain: not so much shuffling the deckchairs on the Titanic as pruning the vines growing on the slopes of Mt Vesuvius, perhaps.
It should be further recognised that a vital subset of our economic interactions consists of that swap of jam today for jam, not just tomorrow, but for a long succession of tomorrows that we might more grandly term ‘intertemporal’ exchange. Indeed, it can be argued that this process is even more intrinsic to our humanity: that the move away from such hand-to-mouth activities as scavenging, foraging, and predation and towards the rational provision for the future by means of forward planning is very much what put the sapiens into the Homo, way back when Also sprach Zarathustra was first ringing out as the soundtrack to Mankind’s great Odyssey from the campfire to the Computer Age.
It is in this devotion of forethought and its associated deferral of immediate gratification where the concept of ‘capital’ first comes into our story and while this opens up before us a vista of riches bounded only by the interplay of our imagination and our willingness to make a short-term sacrifice in order to gain a longer term advantage, it is intrinsically fraught not only with estimable risk, but with unknowable uncertainty, as well as being subject to the further proviso that our own actions’ influence may well serve to increase the range of possible outcomes far beyond what we had first thought likely.
Keynes himself waxed lyrical about the ‘dark forces of time and ignorance’ – even if his own teachings have done more than most over the intervening years to enhance the occultation and obscurity against which his fellow men would have to contend – so it should not come as a surprise when we next insist that none of our man-made institutions can be said to be well-crafted if they aggravate these difficulties.
Economic institutions should thus allow information to percolate in as uncorrupted a manner as possible and should allow for feedback signals to be generated in as direct and unequivocal a fashion as they can. These should clearly flag where both success and failure has occurred so that useful adaptations can proliferate while the ineffective ones are abandoned as rapidly as can be. In essence this means that we must not pervert prices and, since every price is necessarily a money price, the unavoidable inference is that we should not mess with money.
A corollary to this is that there should be the least possible impediment to any and all such adaptations being attempted; indeed, much Austrian ink was spilled during that dark decade of the 1930s in arguing that the surest remedy for the many ills then afflicting the West was to sweep away the obstacles to change and to lubricate the working of the machinery – to practice a policy of Auflockerung, in the phrase of the day.
Following on from this, it should be evident that property should be inviolate and the wider rules of contract should be both transparent and consistent in their application. The law should be concerned principally with equity, the courts with providing a cost-effective and disinterested forum for the arbitration disputes arising from any violations of the first and of any failure to fulfil commitments freely made under the second. Aside from the many ethical considerations attaching to such a demand, we would argue for it additionally in terms of the need to reduce all the uncertainties under which men must act to their achievable minimum if we are to encourage the widest degree of peaceful association, the richest web of commercial relations, and the greatest degree of capital formation that we can.
What we do not want is to be inflicted with a shifting snowball of often retro-active regulation. We must avoid a diffusion or supersession of individual responsibility and desist from fuzzy, catch-all law-making – in fact, we should tolerate as little legal positivism as possible, especially of the kind enacted, often cynically, during periods of crisis. We must insist that the state offers neither explicit nor implicit guarantees, that no bail-outs, or back-door favours be extended to the privileged few at the expense of the disenfranchised many. Finally, it should be impressed upon our elective rulers that the politics of disallowing loss, however well-intentioned, is nothing more than a policy of disavowing gain.
Though there are wider ramifications, the worlds of money and finance should, of course, be subject to all the above strictures. Here, we would again emphasize that to interfere wilfully with the substance of our money is to put oneself in breach of most of these guidelines; indeed, that this is perhaps the most heinous of all infractions, since it entails the most pervasive attack upon both property and the sanctity of contract that there can be since it involves a post hoc and highly arbitrary change in the dimensions of the very yardstick by which the terms of all such agreements are drawn up.
We would further contend that the paving stones on our road to the future, on the intertemporal highway whose praises we have already sung, are nothing more than our investments. These should be funded with scarce savings, not financed by the paltry fiction of banking book entries and hence the business of investment should be conducted only in accordance with the balance we can jointly negotiate between our current ends and our ends to come; that is, on a schedule which naturally emerges to reflect our societal degree of time preference and which does not emanate solely from the esoteric lucubrations of some central banking Oz.
Progress may be less spectacular this way, unpunctuated as it will be by the violent outbreaks of first mass delusion and later disillusion which comprise the alternations of Boom and Bust. But it will be, by that same measure, steadier and more self-sustaining. Absent such a condition, the fear I have already raised is that all the well-meaning calls for better financial regulation and more condign penalties for banking malfeasance are so many straws in the wind as far as a better functioning financial apparatus is concerned.
In passing, the very fact that we are all gathered here to bring so much effort and expertise to bear on the problems thrown up by our contemporary methods of finance shows just how far we have strayed from a true appreciation of its abiding scope as what is effectively little more than a glorified, if somewhat disembodied, form of logistics. Finance should be a record of the assignment of goods and property rights across time and space – a four-dimensional bill of lading, as it were. It would be better were it seen for what it is – a means and not an end; the flickering reflection of a deeper Reality on the wall of Plato’s cave, not a towering 3D IMAX rendition of a screenwriter’s imagining. It should once again be valued only as the carthorse and not as the cargo he pulls behind him.
This article is the fourth in a series. The final instalment will follow shortly.
In a recent Mises Daily, ”A Golden Opportunity“, Patrick Barron and Godfrey Bloom make the case for Germany to withdraw from the monetary union combined with a strong argument that “a golden Deutsche Mark is possible and desirable”. This recommendation may be a step in the right direction, but it leaves Germany with a central bank and a discretionary monetary policy: “The Bundesbank would be responsible for monetary policy just as it was before Germany joined the EMU”. They conclude,
A prerequisite to market acceptance of any gold money would be confidence in the integrity of the sponsoring institution. Not only is the Bundesbank known for its integrity and reverence for stable money; Germany itself has a worldwide reputation for the rule of law, advanced financial architecture, and a stable political system. For these reasons, Germany would prove to the world that a gold-backed money is not only possible but desirable. (emphasis added)
Joe Salerno, in ”Gold Standards: True and False“, provides some sound guidance on discussion of a return to gold. What is ultimately desired is a return to a market-chosen money, which has historically been a commodity — gold or silver money, not a gold- or silver-”backed” money. Salerno’s caution continues to be relevant. He argues,
A significant development in the current controversy over the role of gold in the U.S. monetary system, which has potentially important implications for both monetary theory and policy, has gone largely unnoticed by commentators on both sides of the debate. I am referring to the emergence of a new defense of gold that differs fundamentally from the traditional case for the gold standard. This development has been obscured by the diversity of plans for monetary reform coming out of the pro-gold camp. A close examination of these proposals, however, reveals that they are of two distinct types; they differ not only in the reasons they offer for considering a gold standard desirable, but also in their conception of what monetary arrangements constitute a “gold standard.”
First, there are the proposals that embody the traditional “hard money” arguments for the gold standard. These arguments focus on the desirability of a free-market commodity money vis-à-vis a government-monopolized paper fiat money. The basic thrust of the hard money proposals is to render government monetary policy superfluous by restoring a genuine gold standard under which the quantity and value of money is determined solely by market forces. The second group of pro-gold writers, whose proposals have received the most publicity, have eschewed the traditional hard-money case for gold and in its stead constructed a quite novel case purporting to demonstrate that gold can provide government monetary authorities with an effective instrument for managing the money-supply process within the established fiat-money framework. For this group, the raison d’être of a gold-based monetary regime is that it facilitates the achievement of government monetary policy objectives. Needless to say, the gold standard envisioned by these policy-oriented advocates differs quite radically from the ideal of the hard-money group. The gold “price rule,” which is the monetary reform favored by most policy-oriented gold advocates, bears only a superficial resemblance to the traditional conception of the gold standard. (emphasis added)
Given Professor Salerno’s careful differentiation of proposed gold standards as either true or false standards, one must be careful when evaluating any proposal for a return to gold. Questions of concern:
- Will the proposal, in the short run, be a better monetary system with better monetary policy than the current system of nationalized (or “continentalized,” in the case of the euro) fiat moneys?
- Is the proposal one that will move the system over time to a true gold standard — a gold-coin standard?
- Will the proposal become like the interwar gold-exchange standard, a false standard that will likely lead to economic results that will discredit gold (and/or silver) as money?
Salerno’s comments are equally applicable to other current discussions concerning gold that have recently appeared in the Wall Street Journal. Seth Lipsky, in ”The Gold Standard Goes Mainstream“, points out that, as a result of Ron Paul’s influence, “In the ferment within today’s Republican Party, there’s a growing realization that America’s system of fiat money is part of the economic problem.” He concludes,
It is no small thing that Mr. Romney’s platform calls for a gold commission and an audit of the Fed. The last Republican to run on a platform calling for a dollar “on a fully convertible gold basis” was Dwight Eisenhower, who cast the promise aside once in office. That’s a strategic misstep for Mr. Romney, should he win in November. (emphasis added)
In a critique of a return to gold, John H. Cochrane of the University of Chicago concludes, “No monetary system can absolve a nation of its fiscal sins.”
Ron Paul, in “Why Monetary Freedom Matters,” reinforces Salerno’s caution on true reform, a market determined money, versus reforms, that while perhaps better than a “false trust in fiat money” will leave too many opportunities for monetary mischief. Paul states, “As far back as the Gold Commission (1982), I’ve made the case for gold.” But he wouldn’t close down the central bank: he would legalize competition in currencies, repeal legal-tender laws, and eliminate all taxes on silver or gold purchases, and allow private mints. In essence, his proposal is
similar to what F. A. Hayek (1976, 1978) had talked about. Why don’t we denationalize money, legalize competition, allow free markets to work, and allow free-market banking to work?
Armed with Salerno’s strong case for a true gold standard, you be the judge. In my judgment, Ron Paul is on the right track; Cochrane is misdirected by false gold standards; and Barron and Bloom’s proposal, while attractive in the short run, is (if not accompanied by Paul’s suggested reforms in the United States and elsewhere) most likely a step in the wrong direction.
Advocates of sound money should be heartened by the interest currently being generated for monetary reform. Discussion should be guided with a few things in mind:
- Gerald P. O’Driscoll Jr.’s concerns about abolishing central banks,
- Salerno’s gold standard: true or false, and
- Paul’s caveat that
Others are thinking about it [monetary reform], but some of them would like to internationalize something different than the dollar reserve standard. They would like to have another fiat currency and a pretend alliance with gold — and they want to move control over a new global currency into the IMF and the World Bank. I think that would be a disaster. (emphasis added)
Let’s hope Lipsky’s optimism concerning a gold commission becomes a reality where a “well-conceived and well-staffed gold commission” (preferably one dominated by Austrian-influenced economists) actually sorts out the issues in favor of competition in currency and an evolution toward a gold-coin standard à la the outline provided by Paul.
 See “Central Banks: Abolish or Reform.” HT to Kurt Schuler at Free Banking.
 For legislation embodying Paul’s suggestions see “Free Competition in Currency Act of 2011″ (H.R. 1098).
This article was previously published at Mises.org.
“Sir, I see Sir Mervyn King has signalled that he no longer believes that price stability should be the Bank of England’s primary objective. Perhaps if he had his gold-plated, index-linked pension replaced by a private sector annuity pension he would be more focused on reducing inflation.”
- Letter to the Financial Times from Mr Tony Clarke of Plymtree, Devon, 11th October 2012.
A thousand years ago, back in 1999, a handful of technologist writers created something called The Cluetrain Manifesto. Cluetrain (as in “The clue train stopped there four times a day for ten years and they never took delivery” – said by a veteran of a fast-failing Fortune 500 company) was a reworking of Luther’s 95 Theses of 1517 – credited with sparking the Reformation. Cluetrain remains a strikingly prescient account of how the Internet will change Business As Usual. Among Cluetrain’s theses:
- All markets are conversations; the Internet provides a means of connecting people and allowing them to engage and transact on a scale previously impossible;
- Hyperlinks subvert hierarchy; the ability of the Internet to link effortlessly to information outside the formal hierarchical structure of traditional business changes Business As Usual at a profound level;
- A metaphysical construct called ‘The Company’ is the only thing standing between internetworked markets and intranetworked employees; markets are getting more informed more quickly than companies are.
I read The Cluetrain Manifesto whilst working as a portfolio manager at Merrill Lynch Private Banking in London. It had a profound effect on me. (Ironically, I first read about Cluetrain in a research piece by Henry Blodget, Merrill’s internet analyst who was subsequently barred from the securities industry for life after being charged with securities fraud. Not that that has stopped him from making a living opining on all things Internet – that’s the power of the internet for you.) Separately, three things had combined to give me a somewhat jaundiced view of my then employer. Firstly, Charles Schwab and its discount brokerage model was eating Merrill’s breakfast. Secondly, in allowing its analysts carte blanche to promote their material on channels like CNBC (which the company didn’t provide for staff), Merrill Lynch, crucially in a business so heavily dependent upon information and proprietary information, had successfully managed to disintermediate its own employees – a fact that wasn’t lost on our clients. Thirdly, they had managed to fire just about everybody in the intake I joined when I chose to transfer from Merrill’s institutional fixed income business. This wasn’t like working in an investment house – this was like the first day of the Battle of the Somme.
Fuelled with Dutch courage by The Cluetrain Manifesto, I elected to walk, and take my chances in the digital economy..
The culturally transformational power and potential of the Internet features strongly in Douglas Carswell’s new book, ‘The End of Politics – and the birth of iDemocracy’. Carswell is a Conservative MP, Eurosceptic and libertarian who also maintains a handy blog. He is also deeply sceptical about central planning and the delusional role of intellectuals and supposed experts – people Friedrich Hayek described as ‘second-hand dealers in ideas’. His thought experiment, which follows below, is notable:
Imagine you were an alien flying past planet Earth in AD 1000. Looking for signs of intelligent life, you would probably consider the Chinese empire on the far eastern part of the Asian land mass. There you would see large towns, canals, the invention of the compass and gunpowder. You might well expect China to be the dominant player in human affairs over the coming thousand years.
You might also spot some of the cities and temples produced by 5,000 years of civilisation in India.
If you flew over the north western part of the Eurasian land mass, on the other hand, you would see “only the occasional hovel amid thick forests, with a few baronial castles here and there”.
So how did Europe end up dominating much of the subsequent 1,000 years? Why were the Chinese, in other words, not the first to circumnavigate the world?
The West rose, suggests the Australian historian E.L. Jones in his book ‘The European Miracle’, because Europe, unlike the empires of the Ming, the Mughals or the Ottomans, was never a unified state. Power remained dispersed and diffused.
Western society was remarkably innovative and dynamic because – until remarkably recently – power was so dispersed and constrained, little could be organised by deliberate design.
[Europe] lacked the social and political institutions that might have enabled one person or elite to manage to run Europe uniformly according to any particular design – despite the best efforts of the medieval papacy, the Habsburgs, Napoleon and the Kaiser.
The West’s lead in terms of scientific discovery, learning, navigation and technology are all consequences of the West’s ascendancy, not causes of it.
China, conversely, did not only fall behind Europe over the centuries to come. “China by the end of the millennium had fallen behind China at the beginning of the millennium”. Astonishingly, someone living in China in 1950 would have been poorer than someone living in China a thousand years beforehand.
‘The End of Politics’ has much in common with Guy Fraser-Sampson’s similar cri de coeur for sanity in the management of our society and economy, ‘The Mess We’re In’ (see our Commentary of the same title of 6th August). In other words, it’s the politicians’ fault – and ideally, the Internet will help in the process of slopping out the Augean stables.
Those stables are certainly filthy. It is disturbingly easy to get a profound sense of gloom from the analysis. Another example. What is the biggest purchase you will ever make in your lifetime? You will probably answer: a mortgage. Perhaps school or university fees. A car. A divorce.
The answer is: government.
For every $100 that the average American worker earns, $36 is spent on paying for the government – $29 directly in payroll taxes and $7 in various consumption taxes when the average American tries to spend the rest of his or her pay packet.
In Japan, the average worker pays for ¥33 of government for every ¥100 earned (I’m surprised it’s not higher).
In Britain, the average worker buys £46 of government for every £100 earned.
In France and Germany, after spending €59 paying for government, the average worker has only €41 left to spend on themselves.
As we suggested in a recent commentary (‘Think small’), national salvation across Europe requires not bigger government but much, much smaller. But that would be to fight against the tide. According to Carswell, there are so many quangos in the UK (quasi-autonomous non-government organisations – even the vocabulary is inflationary) that nobody knows the true figure for sure – estimates vary between 766 and 1,148. We have even run out of letters of the alphabet to name them all. The letters FSA, for example, refer to both the Food Standards Agency and the Financial Services Authority, the City regulator so adept at overseeing our banks. In the words of Matt Ridley,
Government has employed more and more ambitious elites able to capture a greater and greater share of societies’ income by interfering more and more in people’s lives as they give themselves more and more rules to enforce, until they kill the goose that lays the golden eggs.
Decline set in, writes Carswell, as the mandarins attempted to do more and more by design.
First, officials required farmers to produce in accordance with official decrees, rather than in response to what the market required. Then they insisted on trade with the outside world through quotas.
Possessed of an almost celestial arrogance, the mandarins believed they could micro-engineer all human and social affairs. Cocooned in their remote administrative capital, they issued decrees that encouraged the emergence of corporate monopolies, while regulating ever more aspects of business and commerce. They debauched the currency, making worthless a system of money in pursuit of an imperial design.
But Carswell is not talking about Ming China in the fifteenth century; he is referring to Europe today.
Lest the gloom seems overwhelming, ‘The End of Politics’ is surprisingly upbeat – provided the transition to smaller government (which is surely inevitable) ends up being more orderly than chaotic. As regards the pursuit of sound money and the role of the Internet in helping to facilitate that journey, I was intrigued to see that fellow MoneyWeek scribe Dominic Frisby is plotting a book, too. ‘Life After the State’ will be available as soon as it receives enough pledges from early adopters. It’s being crowd-sourced. I’ve already pledged, and I would encourage you to do likewise, which you can from here. Vive la révolution !
This article was previously published at The price of everything.
I am not holding my breath over the Republicans’ plans for another gold commission to investigate the possibility of returning the USA to a gold standard in the case of the Romney-Ryan ticket winning.
Of course, I like the Classical Gold Standard, which existed from about 1880 to 1914, and I am convinced it was a humongous mistake to do away with it, a mistake that was further compounded by the abandonment of its weak successor, Bretton Woods, in 1971. And you know what I think of our present unconstrained fiat money system: It is suboptimal, unstable and unsustainable. It is fundamentally incompatible with capitalism, and it has now amassed so many colossal imbalances, from overstretched banks to a gigantic and never to be repaid public debt load, that it is firmly beyond repair. It is in its endgame.
But I don’t believe the best solution would be to go back to a government-run gold standard. We should not trust politicians and bureaucrats with money, certainly never again with entirely unconstrained fiat money, but probably not even with a monetary system that comes with the strait jacket of an official gold standard. I would argue instead for the complete separation of money and state, and for an entirely private monetary system. Let the market decide what should be money and how much there should be of it. I do strongly believe that gold would again play an important role in such a system. After all, gold and silver have been chosen forms of money for thousands of years, in all cultures and societies. That is what the trading public always went for when it was free to choose.
Nevertheless, I would agree that even an ‘official gold standard’, such as the US had before 1933, and in particular before the Federal Reserve was established in 1913, would still be much better than anything we have today. But the chances of such a system being reintroduced are slim.
Political obstacles are immense
Remember, there already was a gold commission under Ronald Reagan in the early 1980s, and it rejected the idea. And I think the chances for a return to gold through the established political process were considerably better 30 years ago than they are today.
For all his faults, Reagan was a much more libertarian politician than Romney, with incomparably better free market credentials, a stronger philosophical core, and a superior talent for communication. I don’t trust today’s Republican Party implementing a truly libertarian program.
Also, in the early 1980s, it would have been much easier to transition to a gold standard. Constant fiat money expansion had not yet created the massive imbalances and the illusions of prosperity that characterize our economies today. Back then the total debt of the US government was less than $1,000 billion. Today, the annual budget deficit is bigger than that. Today, the withdrawal symptoms would be considerably larger for the state, the financial industry and the distorted and hugely inflated asset markets, all of which are now thoroughly addicted to the crack cocaine of a never-ceasing flow of super-easy money. In the early 1980s, then-Fed chairman Paul Volcker had in fact stopped the printing press for a while and allowed higher interest rates to cleanse the system of some of the accumulated distortions. There was in fact a discernible political will to implement hard money. Compare that to the situation today!
So if Romney wins the election (a very big if), then it is still likely that the commission will reject the idea, in my opinion. Nobody wants to take the short-term pain of turning off the monetary tap, even if the long run benefits are considerable. Wall Street, the media, academia, and, of course the Fed, are strongly on the side of fiat money. I don’t see any commission overruling these powerful factions.
In many ways, the worst outcome would be some watered down, pseudo-gold standard under the management of the Fed. If the crisis then persisted, which it would, the easy-money advocates would blame everything on the ‘gold standard’ tying the hands of ‘our saviour, the central bank’. This is also a problem for a Romney-win in general, which is unlikely to bring the pro-market changes America needs although his policies will be branded ‘free market’ by the statist media. If Obama remains in office, at least nobody will call his program ‘capitalism’.
Media and academia are mainly pro-state, pro-politics, anti-gold
So I guess, we hard-money nutcases will have to wait for the crisis to get worse, while the advocates of fiat money and central banking can relax and happily cheer on the Printmaster-in-chief as he creates good and lasting jobs with QE5 and QE6. What has, however, been interesting in recent days has been the response in the mainstream media. Commentators have been in a state of apoplectic fit over the gold commission, writing dismissive pieces against gold that are as full of hysterical rage as they are void of economic reasoning.
I am fully aware, of course, that the present easy-money system controlled by educated bureaucrats has its adherents, in particular among people who perceive every problem in society to be best solved by politicians and the state. But the extent of economic nonsense and disinformation that was disseminated in these tirades, and the strenuous, laboured defence of the present system, I still found remarkable.
Bloomberg diagnosed that the critics of Fed activism, zero-interest rates and unlimited QE, suffer from an “anti-inflation obsession” that borders on “derangement”, while Robin Banerji in a piece for the BBC website remarks that advocating the gold standard had been the domain of “economic eccentrics” and followers of “folksy” libertarian Ron Paul, in short, ill-adjusted people who have not gone with the times, who are nostalgic, longing “for a simpler age”. You see, if you are an advocate of the gold standard you may suffer from psychological problems. Fittingly, Banerji’s article for the BBC is titled: ‘Gold standard: Could it return in the US?’, which make it sound like a disease. ‘Cholera: Could it return in the US?’.
Unfortunately, Mr. Banerji’s article does not give the economic layman a clear comparison of the key features of the two systems, fiat money and gold standard. Instead, the reader is left with the vague sense that a gold standard would either collapse instantly or lead to grave instability. The present system is, by comparison, described as successful and inherently stable.
To this effect, the article quotes three mainstream economists – Kenneth Rogoff, Anil Kashyap (return to gold “incredibly crazy”) and Charles Wyplosz – all opponents of a return to gold. Wyplosz provides this remarkable insight:
There has been no significant inflation in the advanced economies for the last 25 years, so the need for gold to defeat inflation seems unnecessary.
Hmmm. From 1997 to 2007, that is, the ten years that preceded the start of the present crisis, house prices in the US appreciated 3 times faster than in the preceding 100 years. We had drastic asset price inflations and various asset price bubbles around the world over the past 25 years, plus explosions in general indebtedness and massive bank balance sheet expansions, and these inflations set us up for the present crisis. Real estate booms that ended in banking crises occurred in Japan, Scandinavia, South East Asia, the US, the UK, Ireland and Spain, to name just the examples that come to mind immediately. But I guess, as long as a pint of milk in the supermarket only goes up by 3 percent a year, there is ‘no significant inflation’ for Mr. Wyplosz. Remarkable.
“Stable paper money versus unstable gold money.” – Really?
While the present system is supposedly doing swell, the gold standard is a source on instability. Harvard-man Rogoff has this to say:
The price of gold fluctuates a lot and therefore the price of your currency would fluctuate a lot.
This is a popular fear about the gold standard, and it is without any substance whatsoever, and any foundation in economic theory or history. Today’s gold price is volatile because gold has been (partially) demonetized and is now fluctuating against state-issued paper money, and the resulting price movements tell us more about the instability of fiat money than of gold.
Take a look at history: whenever gold was money, fluctuations in the purchasing power of money, or fluctuations in the ‘value of money’, if you like, were extremely small to almost non-existent. Inflations and deflations as problematic macro-economic phenomena were largely unknown when gold was money. Inflation and (corrective) deflation only became problems when the state introduced paper money. If you look at long-dated charts of the purchasing power of the world’s oldest currencies – the British pound and the US dollar – you can spot easily when these currencies were taken off gold or silver, and when they were later put back on gold or silver.
Gold has been stable money, while paper money has always been – without exception – unstable money. Paper money has always led to inflations, usually followed, at some point, by corrective deflations. Abandoning commodity money always increased uncertainty over money’s purchasing power for the money-user.
The pound and the dollar have, in their very long history, never lost as much purchasing power as quickly as they have since 1971, when Nixon closed the gold window.
To imply that gold could be unstable money is putting the historical record on its head. If we judge the two monetary alternatives, fiat money and gold standard, purely on purchasing power stability, there can be no question that the gold standard wins easily. The historical record is not even mixed on this. Also remember that at no point in history was gold or silver replaced with fiat money, because the public demanded an end to ‘volatile commodity money’ and craved ‘stable fiat money’. This never happened, to my knowledge. But on the other hand, monetary systems have repeatedly gone back from paper money to commodity money, such as gold, in an effort to restore economic stability. Britain did it in 1821 and the US in 1879. I find it hard to believe that Rogoff does not know this. Why he is happy to portray it otherwise, I can only guess. And the journalist Banerji is evidently uninterested in checking the facts.
In a similar direction go statements like these, again from Rogoff:
[The effect on the US economy of a return to a gold standard] could either be inflationary or deflationary depending on the initial rate.
Again this is highly misleading as it falsely associates the gold standard with uncertainty and instability. Based on history and economic theory, we can predict with reasonable certainty that a return to a gold standard would be deflationary in the near-term – almost regardless of the initial rate – as the preceding inflationary boom is unwound, but provide monetary stability in the long run. Under a gold standard the supply of (core) money would be essentially fixed or could only be expanded very slowly. There would no longer be any monetary policy, and banks would no longer enjoy the privilege of a “lender of last resort”. These are the key differences to the present system. Because of our fiat money system, the relative prices of many assets are distorted by constant monetary expansion, which does not – contrary to widespread misconception – lift all prices uniformly but some prices more than others. Additionally, banks are running low capital and reserve ratios because of the safety net provided by the printing press. The change of monetary regime would cause many prices to adjust, many probably to decline, and many banks to shrink their balance sheets to protect reserves. Once we are through this deflationary adjustment – which is, in my view, unavoidable at some stage anyway – we can expect the gold standard to give us money of superior purchasing power stability, as I explained above.
Over time, a proper gold standard can be expected, on conceptual grounds, to even deliver moderate deflation. Prices would have a slight tendency to decline over time. Statistically and historically, this phenomenon has been very minor, indeed, and such secular deflation, if it occurs at all, is never an obstacle to strong growth.
The problems of transition
Rogoff is, however, correct to highlight the general importance of the initial dollar-gold rate established by the new gold standard. The US has a sizable gold hoard but at the present gold price it is worth ‘only’ about $440 billion when years and decades of paper money creation have caused the monetary base to balloon to $2,600 billion, and M2 to more than $10,000 billion. For the official gold stock to back the entire monetary base the dollar would have to be devalued versus gold to a new price of $10,000 per once of gold, compared to $1,690 per ounce now; and if M2 was to be backed completely with gold, the new gold price would have to be $38,000 per ounce! Such a drastic revaluation of the dollar could have various knock-on effects, certainly in the international gold and commodity markets but probably elsewhere. Rogoff is right to point this out.
However, these are problems with the transition from one system to another. I am the first to admit that after 40 years of unrestricted fiat money creation a smooth and friction-free transition back to sound money is anything but straightforward. This is also my biggest criticism of present-day easy-money policies: they create illusions of stability by creating more imbalances and making a return to a stable system more difficult. But such a return will one day be necessary and unavoidable.
None of these objections mean that a transition to sound money is ultimately not possible and the long run benefits of it not highly desirable. Remember that transitions from paper systems back to gold were achieved repeatedly throughout history. More importantly, these points say little about the workings of a gold standard versus the operation of a fiat money system. The reader must wonder why anybody in his right mind would even contemplate going back to gold when all a gold standard could ever give us was volatility, uncertainty and chaos.
Well, in fairness to Banerji, he had this to say about the gold standard:
From 1945-1971, the period of the “gold exchange standard”, the US fixed the dollar to gold at $35 an ounce. Growth rates were higher and rises in wealth were more equitably shared across society than in the years that followed. Unemployment has been higher, growth lower, and wealth more unevenly distributed since the US dollar came off gold in 1971.
But then he hastens to add: “This could have been coincidence, however.”
What are the effects of money creation?
The Bloomberg opinion piece is equally hostile to the gold standard idea but it is less confusing and misleading, and instead provides the reader with a clear and rousing endorsement – incredibly naive and misguided, in my opinion – of fiat money and central bank activism, an apparently wonderful system that we would have to do without if the mad Republicans brought the gold standard back.
Contrary to what gold bugs and other Fed-bashers say, the Fed’s dual mandate and its policy of quantitative easing — buying bonds to nudge down interest rates– have been vital strengths, not weaknesses. They have helped to support demand and bring unemployment down, albeit slowly. Fiscal paralysis in Washington made the Fed’s unorthodox measures all the more necessary. Far from being reckless, the Fed has been too timid and needs to embark on the third round of QE that Chairman Ben S. Bernanke keeps hinting is on the way.
The key argument is a familiar one, and it goes something like this: economic crises occur, they just happen, gold standard or no gold standard, but under our present system we at least have a central bank that can lower interest rates and print lots of money to stimulate demand and get us out of the crisis.
Behind it lies a dangerous simplification, namely that fiat money creation has two effects and two effects only: all else being equal, injections of money lift the price level (i.e. they cause inflation) and lift GDP. Rising prices are sometimes good and sometimes bad. You can, of course, have too much inflation. But the growth-boosting effect of more money is always welcome. So, whenever inflation is not a problem (or when there is even a risk of deflation) the printing of money is an unequivocal positive. Who can be against it?
But injections of new money into the economy have many other effects than just lifting two entities of national account statistics. Have those who hold this simplistic macro-economic view ever thought about how the micro-economic act of injecting a certain amount of new money into the economy at a specific point, namely the banking sector, is supposed to translate directly, smoothly, and instantly into the macro-economic phenomena of higher prices all around and more economic activity all around? Alas, the whole thing is slightly more complicated.
Thankfully, but still unbeknown to the folks at Bloomberg, for centuries many high-caliber economists have worked hard to understand and explain the full range of effects of money injections. Indeed, one of the very first economists ever, Richard Cantillon, already made it an important aspect of his work, and his insights – almost 300 years ago – were already superior to what you can read in most financial market commentary today. For Cantillon already stressed that an inflow of new money will not lift all prices simultaneously and by the same extent but some prices more than others and some sooner than others. And that is as true today as it was in the early 18th century.
An inflow of new money into the economy must always change relative prices. Therefore, it must affect the use of scarce resources, the structure of production, and the distribution of income. Every inflow of new money must therefore create winners and losers. As a rule, the early recipients of the money (today, those are mainly to be found in the financial industry) benefit at the expense of the later recipients.
Inflows of new money tend to lower interest rates and also change the structure of interest rates, which in turn will affect the extent of investment and the structure of investment in the economy. In short, the delicate co-ordination between voluntary saving and capital investment that, in a free market, is conducted by market interest rates, is systematically distorted. The artificial cheapening of credit through money injections leads to capital misallocations and mal-investment.
For 200 years, many economists have blamed the business cycle on monetary expansion, usually as a result of artificial bank credit creation, often encouraged by the abandonment of a commodity anchor. The effects of money inflows listed above tend to create near-term booms that must be followed by corrective recessions later on. This phenomenon has to date been analyzed most comprehensively and convincingly by the Austrian School economists Ludwig von Mises and F.A. Hayek.
Mises called it the fundamental non-neutrality of money. Money can never be neutral. This means that any monetary economy, including a gold standard economy, will be subject to occasional disruptions emanating from the use of money, but the more elastic the supply of money is, and the more the supply of money is constantly expanded, the more severe these disruptions must be. Elastic money is also unstable and destabilizing money.
The crisis that the Fed is fighting today with easy money is the result of a housing bubble that the Fed itself inflated when it provided easy money to fight the previous recession, and that recession was the result of the collapse of the internet-bubble in 2001 which had previously been inflated by the Fed itself when it provided easy money to fight the consequences of the Asian debt crisis and the collapse of the hedge fund, LTCM, in 1999, which…. you get the idea.
Fact is, our unrestricted fiat money system is moving us progressively away from monetary stability and economic sanity. The Fed and other central banks have become serial bubble-blowers, and they have now created such vast imbalances that they are all on zero interest rates and repeated rounds of asset purchases to keep the system from collapsing. It requires such a naïve and simplistic macro-economic viewpoint as the one espoused by the Bloomberg editors to not see that this system is simply unsustainable.
I do not think that the US Republican Party will bring us back to a gold standard anytime soon. Sadly, I think the crisis will have to get much worse before this will be achieved. But there can be no question that we will have to transition to a hard money system eventually. The future of capitalism and a free society depends on it.
As Ludwig von Mises wrote in 1965:
If our civilization will not in the next years or decades completely collapse, the gold standard will be restored.
This article was previously published at Paper Money Collapse
It was a great pleasure and a privilege to be asked by Jeff Tucker of Laissez Faire Books to write this foreword to Liberalism, the timeless classic written by Ludwig von Mises in 1927.
This edition of Liberalism is available through the Laissez Faire Club.
Foreword by Toby Baxendale
This is a timeless book.
It is a book of political thought. In fact, it is Mises’s only book fully dedicated to this subject. As he mentions in his own opening remarks, he has kept it brief so as to appeal to the widest audience he can without dumbing down his message.
For those readers new to Mises — you may have heard, for example, that this genius created the foundations of economics from using the epistemology of Kant with shades of Aristotle to set the logical deductive foundations of economics, and you find this a bit too heavy going for your opening introduction to the thoughts of arguably the greatest economist ever — then I submit, you have your great starter book.
By opening your account of this man here, you will embark on a fascinating discovery of more than just the economic program of liberalism. But as you then progress to other works by Mises, you will encompass the whole philosophical corpus of liberalism.
I read this book as a counterblast against the direction in which John Stuart Mill took liberalism in his post–On Liberty writings, down the route of socialism and in defense of a truly positive conception of liberalism.
This quote is tucked away in the appendix.
John Stuart Mill is an epigone of classical liberalism and, especially in his later years, under the influence of his wife, full of feeble compromises. He slips slowly into socialism and is the originator of the thoughtless confounding of liberal and socialist ideas that led to the decline of English liberalism and to the undermining of the living standards of the English people. Nevertheless — or perhaps precisely because of this — one must become acquainted with Mill’s principal writings:
Principles of Political Economy (1848)
On Liberty (1859)
Without a thorough study of Mill it is impossible to understand the events of the last two generations. For Mill is the great advocate of socialism. All the arguments that could be advanced in favor of socialism are elaborated by him with loving care. In comparison with Mill all other socialist writers — even Marx, Engels, and Lassalle — are scarcely of any importance.
One cannot understand liberalism without a knowledge of economics. For liberalism is applied economics; it is social and political policy based on a scientific foundation.
Mises’s greatest student, F.A. von Hayek, some 17 years later wrote his more famous The Road to Serfdom in a similar vein to Mises’s 1927 Liberalismus (the original title and date of issue).  As with all Mises’s works, there are no compromises; where Hayek throws compromise to interlocutors, Mises does not.
J.S. Mill in On Liberty was indeed the first to bring to the modern reader the distinction between the negative and positive conceptions of liberty. Negative liberty is total and unconditional freedom from acts of intervention on the part of the state and its enforcers. Positive liberty, in contrast, is the freedom to participate in the various activities of life, which may involve some compromise of negative liberty in order to empower individuals to fulfill their lives, such as the provision (via coercion of you and others) of a nicer house for a poor person so he can participate in the peaceful enjoyment of life. According to Mill’s distinction, the book you are about to read is formally in the negative tradition.
However, I would encourage the view that this book is actually a very empowering and positive outline of the political theory of liberalism — and should be viewed that way. There is nothing negative about justifying the existence of the sovereign to have the sole duty to protect your private property so you can have the quiet and peaceful enjoyment of it. (The lay reader will please observe that private property is not just items like your house and other chattels; it is the entire possession of your own mind, your own body, both spiritual and temporal.) This is truly a magnificent and positive conception of liberty.
Mises confirms this point and illustrates with an example in chapter 3, part 8, “Freedom of Movement”:
Liberalism has sometimes been reproached on the ground that its program is predominantly negative. This follows necessarily, it is asserted, from the very nature of freedom, which can be conceived only as freedom from something, for the demand for freedom consists essentially in the rejection of some sort of claim. On the other hand, it is thought, the program of the authoritarian parties is positive. Since a very definite value judgment is generally connoted by the terms “negative” and “positive,” this way of speaking already involves a surreptitious attempt to discredit the political program of liberalism.
There is no need to repeat here once again that the liberal program — a society based on private ownership of the means of production — is no less positive than any other conceivable political program. What is negative in the liberal program is the denial, the rejection, and the combating of everything that stands in opposition to this positive program. In this defensive posture, the program of liberalism — and, for that matter, that of every movement — is dependent on the position that its opponents assume towards it. Where the opposition is strongest, the assault of liberalism must also be strongest; where it is relatively weak or even completely lacking, a few brief words, under the circumstances, are sufficient. And since the opposition that liberalism has had to confront has changed during the course of history, the defensive aspect of the liberal program has also undergone many changes.
This becomes most clearly evident in the stand that it takes in regard to the question of freedom of movement. The liberal demands that every person have the right to live wherever he wants. This is not a “negative” demand. It belongs to the very essence of a society based on private ownership of the means of production that every man may work and dispose of his earnings where he thinks best. This principle takes on a negative character only if it encounters forces aiming at a restriction of freedom of movement.
Why, according to Mises, is the liberal program only about the protection of private property? Let us read Mises’s own words from chapter 1, part 1, “Property,” as he can encapsulate the answer far better than I can:
Human society is an association of persons for cooperative action. As against the isolated action of individuals, cooperative action on the basis of the principle of the division of labor has the advantage of greater productivity. If a number of men work in cooperation in accordance with the principle of the division of labor, they will produce (other things being equal) not only as much as the sum of what they would have produced by working as self-sufficient individuals, but considerably more. All human civilization is founded on this fact. It is by virtue of the division of labor that man is distinguished from the animals. It is the division of labor that has made feeble man, far inferior to most animals in physical strength, the lord of the earth and the creator of the marvels of technology. In the absence of the division of labor, we would not be in any respect further advanced today than our ancestors of a thousand or ten thousand years ago.
Human labor by itself is not capable of increasing our well-being. In order to be fruitful, it must be applied to the materials and resources of the earth that Nature has placed at our disposal. Land, with all the substances and powers resident within it, and human labor constitute the two factors of production from whose purposeful cooperation proceed all the commodities that serve for the satisfaction of our outer needs. In order to produce, one must deploy labor and the material factors of production, including not only the raw materials and resources placed at our disposal by Nature and mostly found in the earth, but also the intermediate products already fabricated of these primary natural factors of production by previously performed human labor. In the language of economics we distinguish, accordingly, three factors of production: labor, land, and capital. By land is to be understood everything that Nature places at our disposal in the way of substances and powers on, under, and above the surface of the earth, in the water, and in the air; by capital goods, all the intermediate goods produced from land with the help of human labor that are made to serve further production, such as machines, tools, half-manufactured articles of all kinds, etc.
Now we wish to consider two different systems of human cooperation under the division of labor-one based on private ownership of the means of production, and the other based on communal ownership of the means of production. The latter is called socialism or communism; the former, liberalism or also (ever since it created in the nineteenth century a division of labor encompassing the whole world) capitalism. The liberals maintain that the only workable system of human cooperation in a society based on the division of labor is private ownership of the means of production. They contend that socialism as a completely comprehensive system encompassing all the means of production is unworkable and that the application of the socialist principle to a part of the means of production, though not, of course, impossible, leads to a reduction in the productivity of labor, so that, far from creating greater wealth, it must, on the contrary, have the effect of diminishing wealth.
The program of liberalism, therefore, if condensed into a single word, would have to read: property, that is, private ownership of the means of production (for in regard to commodities ready for consumption, private ownership is a matter of course and is not disputed even by the socialists and communists). All the other demands of liberalism result from this fundamental demand.
From chapter 1, part 8, “Democracy”:
For the liberal, the state is an absolute necessity, since the most important tasks are incumbent upon it: the protection not only of private property, but also of peace, for in the absence of the latter the full benefits of private property cannot be reaped.
These considerations alone suffice to determine the conditions that a state must fulfill in order to correspond to the liberal ideal. It must not only be able to protect private property; it must also be so constituted that the smooth and peaceful course of its development is never interrupted by civil wars, revolutions, or insurrections.…
Here is where the social function performed by democracy finds its point of application. Democracy is that form of political constitution which makes possible the adaptation of the government to the wishes of the governed without violent struggles. If in a democratic state the government is no longer being conducted as the majority of the population would have it, no civil war is necessary to put into office those who are willing to work to suit the majority. By means of elections and parliamentary arrangements, the change of government is executed smoothly and without friction, violence, or bloodshed.
Although Hobbes is never mentioned in Liberalism, I see much of Hobbes in Mises. I read Leviathan as the great British philosopher Michael Oakeshott did in his famous introduction to the 1946 edition of that book, as being the founder of the British Enlightenment tradition. Mises sits full square in that tradition. Tearing up the ancient natural-law tradition and setting up the sovereign state as the master protector of the private property of all individuals, thus guaranteeing the fullest possible freedom to live ones life in peace. In addition he was undoubtedly a committed democrat with regard to his favored method of choosing who runs the sovereign.
If you have come to this book to find out a little bit about Mises the economist — and no, not just any economist, but as I mentioned before, arguably the greatest economist ever — you will be pleased to find some great insights that you should savor until you read his full epistemological and economic treatise, Human Action.
One of my favorite university debates as a student at the London School of Economics (LSE) was with socialist students, foaming at the mouth with great indignation regarding all they perceived as injustice in the world, riven with jealousy and envy, concerning why we should not be bothered about the wealth displayed by “the rich.”
When confronted by a rabid debater suggesting that all Rolls Royce cars should be scrapped and all production stopped because with millions starving in the world the money should be spent on feeding these people, I would typically respond with this: “What have you got against the hard-working people of Crewe [a town in Cheshire, UK, where the famous car is a major employer] and the honest money they earn making these things and then spend freely on other goods and services? Why should they not be allowed to earn a living providing things people want instead of being put out of work to satisfy your political objectives?”
As I reread Liberalism to write this foreword, I discovery from Mises, with his laser-like logical precision, I am totally wrong! The buying of the Rolls Royce car by the rich should not be defended on those grounds but by a far sounder chain of economic reasoning. I quote from the section called “The Inequality of Wealth and Income“:
Our defense of luxury consumption is not, of course, the argument that one occasionally hears, that is, that it spreads money among the people. If the rich did not indulge themselves in luxuries, it is said, the poor would have no income. This is simply nonsense. For if there were no luxury consumption, the capital and labor that would otherwise have been applied to the production of luxury goods would produce other goods: articles of mass consumption, necessary articles, instead of “superfluous” ones.
The luxury of today is the necessity of tomorrow. Every advance first comes into being as the luxury of a few rich people, only to become, after a time, the indispensable necessity taken for granted by everyone. Luxury consumption provides industry with the stimulus to discover and introduce new things. It is one of the dynamic factors in our economy. To it we owe the progressive innovations by which the standard of living of all strata of the population has been gradually raised.
It is a pleasure to have one’s reasoning corrected by the great master. There is plenty of good economic reasoning packed into this short book.
I will leave you with one final analogy that I hope will stay in your mind between the diligent doctor who advises the right, slow, and brick-by-brick economic way to prosperity and the impatient politician who wants to bring jam today and jam tomorrow with endless sunshine forever, as readers of this book who fall into the former camp along with Mises may find this a useful way of describing the liberal predicament to others:
If a doctor shows a patient, who craves food detrimental to his health the perversity of his desire, no one will be so foolish as to say: “The doctor does not care for the good of the patient; whoever wishes the patient well must not grudge him the enjoyment of relishing such delicious food.” Everyone will understand that the doctor advises the patient to forgo the pleasure that the enjoyment of the harmful food affords solely in order to avoid injuring his health. But as soon as the matter concerns social policy, one is prone to consider it quite differently. When the liberal advises against certain popular measures because he expects harmful consequences from them, he is censured as an enemy of the people, and praise is heaped on the demagogues who, without consideration of the harm that will follow, recommend what seems to be expedient for the moment.
For lovers of the liberal program, our task is thus hard, but one thing is for sure: reason is on our side, and Mises is one of its finest servants.
I hope you enjoy the book. Thank you, LFB, for bringing this book back to life for a new audience.
Ayot St. Peter, Hertfordshire, UK
June 10, 2012
 When, in the section titled “The Impracticability of Socialism,” Mises discusses the “calculation problem” — that is, the impossibility of economic calculation under socialism — we can see that what became the more famous Hayekian “knowledge problem” is touched upon here.
The leadership of a socialist society would thus be confronted by a problem that it could not possibly solve. It would not be able to decide which of the innumerable possible modes of procedure is the most rational. The resulting chaos in the economy would culminate quickly and irresistibly in universal impoverishment and a retrogression to the primitive conditions under which our ancestors once lived.
I mention this not to in any way denigrate the masterful work of Hayek — just to underscore the true primacy of his teacher, Mises.
 Mises mentioned the traditional factors of production in this quote but does not mention that it is the entrepreneur who combines these factors to make useful things for his fellow man in a constantly dynamic and moving economy. Rest assured, all of Mises’s other works are replete with this valuable insight that makes economics relevant to the real world. I can only assume that this is missed out here as it is covered off so well elsewhere.
UK Chancellor George Osborne and Bank of England Governor Mervin King last week announced another round of fiscal and monetary stimulus measures, including steps to ease the funding for banks and allow them to extend more loans.
If these measures were hoped to instil confidence they must be classified as a failure. We have lived through quite a few years of unprecedented and fairly persistent monetary accommodation and occasional rounds of QE by now, and I doubt that yet another dose of the same medicine will cause great excitement. Furthermore, observers must get confused as to what our most pressing problems really are. Have we not had a real banking crisis in the UK in 2008 because banks were over-extended and in desperate need of balance sheet repair? Is a period of deleveraging and a rebuilding of capital ratios not urgently required and unavoidable? Let’s not forget that the government is still a majority-owner of RBS and holds a large chunk of Lloyds-TSB. If banks are still on life-support from the taxpayer and the central bank, is it wise to already prod them to expand their balance sheets again and create more credit to ‘stimulate’ growth?
The same confusion exists on fiscal policy. Is the Greece crisis not a stark warning to all other sovereign borrowers out there, which are equally and without exception on a slippery slope toward fiscal Armageddon, that it is high time for drastic reduction in spending and fundamental fiscal reform? If the Bank of England or the government assume any of the risk of the latest additional credit measures, then the taxpayer is on the hook.
None of this will instil confidence, not in the economy and not in the banks, and certainly not in politics. UK newspaper ‘The Independent’ headlined: “King pushes the panic button”, which I consider a pretty apt description.
Banks are parastatal dinosaurs
One thing is now clear to even the most casual observer: banks are not capitalist businesses. In their present incarnation they have little to do with the free market and no place in it. They are constantly oscillating between two positions: One moment, they are a state protectorate, in desperate need of support from the state printing press or unlimited taxpayer funds, as, in the absence of such support, we are supposedly faced with the dreaded social fallout of complete financial collapse; the next moment they are a convenient tool for state policy, simply to be fed with ample bank reserves and enticed with low interest rates to create yet more cheap credit and help manufacture some artificial growth spurt. Either the banks are the permanent welfare queens of the fiat money systems, or convenient policy levers for the macro-economic central planners. In any case, capitalist businesses look different.
Central banks and modern fiat money banks are quite simply a blot on the capitalist system. In order for capitalism to operate smoothly they will ultimately have to be removed. I believe that the underlying logic of capitalism will work in that direction. Personally, I believe that trying to ‘reform’ the present system is a waste of time and energy. It is particularly unbecoming for libertarians as they run the risk of getting infected with the strains of statism that run through the system. Let’s replace this system with something better. With a market-based monetary system.
When and how exactly the present system will end, nobody can say. I believe we are in the final inning. Around the world, all major central banks have now established zero or near-zero interest rates and are using their own balance sheets in a desperate attempt to avoid their highly geared banking systems from contracting or potentially collapsing. If you think that this is all just temporary and that it will be smoothly unwound when the economy finally ‘recovers’, then you are probably on some strong medication, or have been listening for too long to the mainstream economists who are, in the majority, happy to function as apologists for the present system.
I still believe that chances are we will, at some point, get the full throttle, foot-on-the pedal monetary overkill, the ultimate uber-QE that will push the system over the edge. This will be the moment when central bankers discover – and discover the hard way – that their ability to print their fiat money may well be unlimited but that the public’s confidence in this fiat money certainly is not. The whole system will blow up in some hyperinflationary fireball, which has been the end of most previous experiments with complete fiat money systems, all others having ended with a voluntary return to commodity money before the public had lost complete faith in the system. And the prospect for a voluntary and official return to a gold standard seems slim at present. However, this is not the topic of this essay.
The future of money
I am often asked what will come next after the present system collapsed? Will we have to go back to barter? – No. Obviously, a modern capitalist economy needs a functioning monetary system. My hope is that from the ashes of the current system a new monetary system arises that is entirely private and not run by states – and that does not have the unholy state-bank alliance at its core, an alliance that exists in opposition to everything that the free market stands for. Nobody can say what this new system will look like precisely. Its shape and features will ultimately be decided by the market. In this field, as in others, there are few limits to human inventiveness and ingenuity. But we can already make a few conceptual points about such a system, and we should contemplate working on such a system now while the old system is in its death throes.
A private gold ‘standard’…
Free market monetary systems, in which the supply of money is outside political control, are likely to be systems in which money proper is a commodity of limited and fairly inelastic supply. It seems improbable that a completely free market would grant any private entity the right to produce (paper or electronic) money at will and without limit. The present system is unusual in this respect and it is evidently not a free market solution. Neither is it sustainable.
The obvious candidates are gold and silver, which have functioned as money for thousands of years. We could envision a modern system at whose centre are private companies that offer gold and silver storage, probably in a variety of jurisdictions (Zurich, London, Hong Kong, Vancouver). Around this core of stored monetary metal a financial system is built that uses the latest information and payment technology to facilitate the easy, secure and cheap transfer of ownership in this base money between whoever chooses to participate in this system (Yes, there would be credit cards and wire transfers, and internet or mobile phone payments. There would, however, be no FOMC meetings, no Bank of England governor writing letters to the Chancellor, and no monetary policy!).
Are these gold and silver storage companies banks? — Well, they could become banks. In fact, this is how our present banking system started out. But there are important differences about which I will say a few things later. In any case this would be hard, international, private and apolitical money. This would be capitalist money.
Another solution would be private virtual money, such as Bitcoin.
Bitcoin is immaterial money, internet money. It is software.
Bitcoin can be thought of as a cryptographic commodity. Individual Bitcoins can be created through a process that is called ‘mining’. It involves considerable computing power, and the complex algorithm at the core of Bitcoin makes the creation of additional Bitcons more difficult (and thus more expensive) the more Bitcoins are already in existence. The overall supply of Bitcoins is limited to 21 million units. Again, this is fixed by the algorithm at the core of it, which cannot be altered.
Thus, creating Bitcoin money is entirely private but not costless and not unlimited. Most people will, of course, never ‘mine’ Bitcoins, just as under the gold standard most people didn’t mine gold. People will acquire Bitcoins through trade, by exchanging goods and services for Bitcoins, then using the Bitcoins for other transactions.
Bitcoin is hard money. Its supply is inelastic and not under the control of any issuing authority. It is international and truly capitalist ‘money’ – of course this assumes that the public is willing to use it as money.
There are naturally a number of questions surrounding Bitcoin that cannot be covered in this essay: is it safe? Can the algorithm be changed or corrupted and Bitcoins thus be counterfeited? Are the virtual “wallets” in which the Bitcoins are stored safe? – These are questions for the computer security expert or cryptographer, and I am neither. My argument is conceptual. My goal is not to analyze Bitcoin as such but to speculate on the consequences of a virtual commodity currency, which I consider feasible in principle, and I simply assume – for the sake of the argument – that Bitcoin is already the solution. Whether that is indeed the case, I cannot say. And it is – again – for the market to decide.
There is one question for the economist, however: could Bitcoin become widely accepted as money? Would this not contradict Mises’ regression theorem, which states that no form of money can come into existence as a ready medium of exchange; that whatever the monetary substance (or non-substance), it must have had some other commodity-use prior to its first use as money. My counterargument here is the following: the analogy is to the banknote, which started life not as a commodity but as a payment device, i.e. a claim on money proper which was gold or silver at the time. Banknotes were initially used as a more convenient way to transfer ownership in gold or silver. Once banknotes circulated widely and were generally accepted as media of exchange in trade, the gold-backing could be dropped and banknotes still circulated as money. They had become money in their own right.
Similarly, Bitcoin can be thought of, initially, as payment technology, as a cheap and convenient device to transfer ownership in state paper money. (Bitcoins can presently be exchanged for paper money at various exchanges.) But as the supply of Bitcoins is restricted while the supply of state paper money constantly expands, the exchange-value of Bitcoins is bound to go up. And at some stage, Bitcoin could begin to trade as money proper.
A monetary system built on hard, international and apolitical money, whether in the form of a private gold system or Bitcoin, would be a truly capitalist system, a system that facilitates the free and voluntary exchange between private individuals and corporations within and across borders, a system that is stable and outside of political control. It would have many advantages for the money user but there would be little role for present-day banks, which goes to show to what extent banks have become a creature of the present state-fiat money system and all its inconsistencies.
Banks profit from money creation
Banks conduct fractional-reserve banking (FRB), which means they take deposits that are supposed to be safe and liquid and therefore pay the depositor little interest, and use them to fund loans that are illiquid and risky and thus pay the bank high interest. Through the process of fractional-reserve banking, banks expand the supply of money in the economy; they become money producers, which is, of course, profitable. Many mainstream economists welcome FRB as a way to expand money and credit and ‘stimulate’ extra growth but as the Currency School in Britain in the 19th century and in particular the Austrian School under Mises and Hayek in the early 20th century have argued convincingly (and as I explain in detail in Paper Money Collapse) this process is not only risky for the individual banks, it is destabilizing for the overall economy. It must cause boom-bust cycles.
It cannot be excluded that banks could conduct FRB even on the basis of a private system of gold-money or Bitcoin. However, in the absence of a backstop by way of a central bank that functions as a lender-of-last resort, the scope for FRB would be very limited indeed. It would be too dangerous for banks to lower their reserve ratios (at least to fairly low levels) as that would increase the risk of a bank-run.
I am sometimes told that I am too critical of the central banks and the state, and that I should direct my ire toward the ‘greedy’ ‘private’ banks, for it is the ‘private’ banks that create all the money out there through FRB. Of course they do. But FRB is only possible on the scale it has been conducted over recent decades because the banks are supported – and even actively encouraged – in their FRB activities by a lender-of-last resort central bank, in particular as the central bank today has full and unlimited control over fiat money bank reserves. Under a system of hard money (gold or Bitcoin), even if the banks themselves started their own lender-of-last resort central bank, that entity could not create more gold reserves or Bitcoin reserves and thus provide unlimited support to the banks.
FRB is particularly unlikely to develop in a Bitcoin economy, as there is no need for a depository, for safe-keeping and storage services, and for any services that involve the transfer of the monetary system’s raw material (be it gold or state paper tickets) into other, more convenient forms of media of exchange, such as electronic money that can facilitate transactions over great distances. The owner of Bitcoin has an account that is similar to his email account. He manages it himself and he stores his Bitcoin himself. And Bitcoin is money that is already readily usable for any transaction, anywhere in the world, simply via the internet. The bank as intermediary is being bypassed. The Bitcoin user takes direct control of his money. He can access his Bitcoins everywhere, simply via the SIM card in his smartphone.
The tremendous growth in FRB was made possible by the difficulty of transacting securely over long distances with physical gold or physical paper tickets. This created a powerful incentive to place the physical money with banks, and once the physical money was in the banks it became ‘reserves’ to be used for the creation of additional monetary assets.
Channelling true savings into investment is very important, but remember that FRB is something entirely different. It involves the creation of money and credit without any real, voluntary saving to back it. FRB is not only not needed, it is destabilizing for the overall economy. Under gold standard conditions, it created business cycles. Under the system of unlimited fiat money and lender-of-last-resort central banks, it created the super-cycle, which is now in its painful endgame.
Banks make money from payment systems
When I recently made arrangements for a trip to Africa I dealt directly with local tour operators there, which, today, can be done easily and cheaply with the help of email, websites, and Skype. Yet, when it came to paying the African tour operators I had to go through a process that has not changed much from the 1950s. Not only were British and African banks involved, but also correspondence banks in New York. This took time and, of course, cost money in form of additional fees.
Imagine if we could have used gold or Bitcoin! The payment would have been as easy and fast as all the email-communication that preceded it. There would have been no exchange rates and little fees (maybe in the case of gold) or no fees (in the case of Bitcoin).
Another example: Last year I gave a webinar at the Ludwig von Mises Institute (LvMI). The LvMI is located in Auburn, Alabama, I did the seminar from my home in London, the LvMI’s technology officer sat in Taiwan, and the seminar attendants were spread all over the world. All of this is now possible – cheaply, quickly and conveniently – thanks to technology. Yet, when the LvMI paid me a fee it had to go through a few banks – again, correspondence banks in New York – it took quite some time and it incurred additional costs. And the fee from LvMI was paid in a currency that I cannot use directly in my home country.
Banks make money from monetary nationalism
Future economic historians will pity us for having worked under a strange and inefficient global patchwork of local paper currencies – and for having naively believed that this represented the pinnacle of modern capitalism. Today, every government wants to have its own local paper money and its own local central bank, and run its own monetary policy (of course, on the basis of perfectly elastic local fiat money). This is naturally a great impediment to international trade and the free flow of capital.
If I want to spend the money I got from the LvMI where I live (in Britain), I have to exchange the LvMI’s dollars for pounds. I can only do that if I find someone who is willing to take the opposite side of that transaction, someone who is willing to sell pounds for dollars. The existence of numerous monies necessarily re-introduces an element of partial barter into money-based commerce. Sure, the 24-hour, multi-trillion-dollar a day fx market can accommodate me, and do so quickly and cheaply, but this market is only a second-best solution, a highly developed make-shift to cope as best as possible with the inefficiencies of monetary nationalism. The better, most efficient and capitalist solution would be to use the same medium of exchange around the world. The gold standard was a much superior monetary system in this respect. Moving from the international gold standard to a system of a multitude of state-managed paper currencies meant economic regression, not progress.
One hundred years ago, you could take the train from London to Moscow and use the same gold coins all along the way for payment. There was no need to change your money even once. (Incidentally, neither did you need a passport!)
The notion of the ‘national economy’ that needs a ‘national currency’ was always a fiction. So was the idea that economies work better if money, interest rates and exchange rates are carefully manipulated by local bureaucrats. (This fiction is still spread by many economists who make a living off this system.) The biggest problem with monetary policy is that there is such a thing as monetary policy. But in today’s increasingly globalized world, these fictions are entirely untenable. Capitalism transcends borders, and what it needs to flourish is simply hard, apolitical and thus international money. Money that is a proper tool for voluntary human interaction and cooperation and not a tool for politics.
Banks benefit from the present monetary segregation. They profit from constantly exchanging one paper money for another and from foreign exchange trading. Non-financial companies that operate internationally are inevitably forced to speculate in currency markets or to pay for expensive hedging strategies (again paying the banks for providing them).
Banks make money from speculation
There is, of course, nothing wrong with speculation in a free market. However, in a truly free market there would be few opportunities for speculation. Today the heavy involvement of the state in financial markets, the existence of numerous paper currencies, all managed for domestic political purposes, and the constant volatility that is generated by monetary and fiscal policy create outsized opportunities for speculation. Additionally, the easy money that central banks provide so generously to prop up their over-extended FRB-industry is used by many banks to speculate in financial assets themselves, often by anticipating and front-running the next move of the monetary authorities with which these banks have such close relationships. And to a considerable degree, banks pass the cheap money from the central banks on to their hedge fund clients.
Remember that immediately after the Lehman collapse, investment banks Goldman Sachs and Morgan Stanley, which previously had shunned deposit and retail banking but have always been heavily involved in securities trading, quickly obtained banking licenses in order to benefit from the safety-net the state provides its own fiat-money-deposit banks.
Banks channel savings into investment
Yes, to some degree they still do this, and this is indeed an important function of financial intermediaries. However, asset managers can do the same thing, and they do it without mixing this services with FRB and money-creation. In general, the asset management industry is much more transparent about how it allocates its clients’ assets, it has a clear fiduciary responsibility for these assets, and it cannot use them as ‘reserves’. In the gold or Bitcoin economy of the future, you will, of course, be free to allocate some of your money to asset managers who mange investments for you.
Have I been too harsh on the banks? – Maybe. The bankers, in their defence, will say that they are not the source of all these inefficiencies, that they simply help their clients deal with the inefficiencies of a state-designed and politicized monetary system – and that they reap legitimate rewards for the help they provide. – Fair enough. To some degree that may be true. But it is very clear that the size, the business models, the sources of profitability, and the problems of modern banks are uniquely and intimately linked to the present, fully elastic paper money system. As I tried to show, even if the paper money system was meant to last – and it certainly is not – the forces of capitalism, the constant search for better, more efficient and durable solutions, coupled with technological progress, would put enormous market pressures on the present banking industry in the years to come. But given that our present system is not the outcome of market forces to begin with, that a system of fully elastic, local state monies is not necessary, that it is suboptimal, inefficient, unstable, and unsustainable, and that it is already in its endgame, I have little doubt that modern banks will go the way of the dodo. They are to the next few decades what the steel and coal industries were to the decades from 1960 to 1990. They are parastatal dinosaurs, joined at the hip with the bureaucracy and politics, bloated and dependent on cheap money and state subsidy for survival. They are ripe for the taking.
The demise of the paper money system will offer great opportunities for a new breed of money entrepreneurs. In that role, I could see gold storage companies, payment technology companies, Bitcoin service providers and asset management companies. If some of these join forces, the opportunities should be great. The world is ready for an alternative monetary system, and when the present system collapses under the weight of its own inconsistencies, there would be something there to take its place.
The present fiat money economy is ripe for some Schumpeterian ‘creative destruction’.
In the meantime, the debasement of paper money continues.
This article was previously published at Paper Money Collapse.
With a Critique of the Errors of the ECB and the Interventionism of Brussels
1. Introduction: The Ideal Monetary System
Theorists of the Austrian school have focused considerable effort on elucidating the ideal monetary system for a market economy. On a theoretical level, they have developed an entire theory of the business cycle which explains how credit expansion unbacked by real saving and orchestrated by central banks via a fractional-reserve banking system repetitively generates economic cycles. On a historical level, they have described the spontaneous evolution of money and how coercive state intervention encouraged by powerful interest groups has distanced from the market and corrupted the natural evolution of banking institutions. On an ethical level, they have revealed the general legal requirements and principles of property rights with respect to banking contracts, principles which arise from the market economy itself and which, in turn, are essential to its proper functioning.
All of the above theoretical analysis yields the conclusion that the current monetary and banking system is incompatible with a true free-enterprise economy, that it contains all of the defects identified by the theorem of the impossibility of socialism, and that it is a continual source of financial instability and economic disturbances. Hence, it becomes indispensable to profoundly redesign the world financial and monetary system, to get to the root of the problems that beset us and to solve them. This undertaking should rest on the following three reforms: (a) the re-establishment of a 100-percent reserve requirement as an essential principle of private property rights with respect to every demand deposit of money and its equivalents; (b) the abolition of all central banks (which become unnecessary as lenders of last resort if reform (a) above is implemented, and which as true financial central-planning agencies are a constant source of instability) and the revocation of legal-tender laws and the always-changing tangle of government regulations that derive from them; and (c) a return to a classic gold standard, as the only world monetary standard that would provide a money supply which public authorities could not manipulate and which could restrict and discipline the inflationary yearnings of the different economic agents.
As we have stated, the above prescriptions would enable us to solve all our problems at the root, while fostering sustainable economic and social development the likes of which have never been seen in history. Furthermore, these measures can both indicate which incremental reforms would be a step in the right direction, and permit a more sound judgement about the different economic-policy alternatives in the real world. It is from this strictly circumstantial and possibilistic perspective alone that the reader should view the Austrian analysis in relative “support” of the euro which we aim to develop in the present paper.
2. The Austrian Tradition of Support for Fixed Exchange Rates versus Monetary Nationalism and Flexible Exchange Rates
Traditionally, members of the Austrian school of economics have felt that as long as the ideal monetary system is not achieved, many economists, especially those of the Chicago school, commit a grave error of economic theory and political praxis when they defend flexible exchange rates in a context of monetary nationalism, as if both were somehow more suited to a market economy. In contrast, Austrians believe that until central banks are abolished and the classic gold standard is re-established along with a 100-percent reserve requirement in banking, we must make every attempt to bring the existing monetary system closer to the ideal, both in terms of its operation and its results. This means limiting monetary nationalism as far as possible, eliminating the possibility that each country could develop its own monetary policy, and restricting inflationary policies of credit expansion as much as we can, by creating a monetary framework that disciplines as far as possible economic, political, and social agents, and especially, labour unions and other pressure groups, politicians, and central banks.
It is only in this context that we should interpret the position of such eminent Austrian economists (and distinguished members of the Mont Pèlerin Society) as Mises and Hayek. For example, there is the remarkable and devastating analysis against monetary nationalism and flexible exchange rates which Hayek began to develop in 1937 in his particularly outstanding book, Monetary Nationalism and International Stability. In this book, Hayek demonstrates that flexible exchange rates preclude an efficient allocation of resources on an international level, as they immediately hinder and distort real flows of consumption and investment. Moreover, they make it inevitable that the necessary real downward adjustments in costs take place via a rise in all other nominal prices, in a chaotic environment of competitive devaluations, credit expansion, and inflation, which also encourages and supports all sorts of irresponsible behaviours from unions, by inciting continual wage and labour demands which can only be satisfied without increasing unemployment if inflation is pushed up even further. Thirty-eight years later, in 1975, Hayek summarized his argument as follows:
“It is, I believe, undeniable that the demand for flexible rates of exchange originated wholly from countries such as Great Britain, some of whose economists wanted a wider margin for inflationary expansion (called ‘full employment policy’). They later received support, unfortunately, from other economists who were not inspired by the desire for inflation, but who seem to have overlooked the strongest argument in favour of fixed rates of exchange, that they constitute the practically irreplaceable curb we need to compel the politicians, and the monetary authorities responsible to them, to maintain a stable currency” [italics added].
To clarify his argument yet further, Hayek adds:
“The maintenance of the value of money and the avoidance of inflation constantly demand from the politician highly unpopular measures. Only by showing that government is compelled to take these measures can the politician justify them to people adversely affected. So long as the preservation of the external value of the national currency is regarded as an indisputable necessity, as it is with fixed exchange rates, politicians can resist the constant demands for cheaper credits, for avoidance of a rise in interest rates, for more expenditure on ‘public works,’ and so on. With fixed exchange rates, a fall in the foreign value of the currency, or an outflow of gold or foreign exchange reserves acts as a signal requiring prompt government action. With flexible exchange rates, the effect of an increase in the quantity of money on the internal price level is much too slow to be generally apparent or to be charged to those ultimately responsible for it. Moreover, the inflation of prices is usually preceded by a welcome increase in employment; it may therefore even be welcomed because its harmful effects are not visible until later.”
“I do not believe we shall regain a system of international stability without returning to a system of fixed exchange rates, which imposes upon the national central banks the restraint essential for successfully resisting the pressure of the advocates of inflation in their countries — usually including ministers of finance” (Hayek 1979 , 9-10).
With respect to Ludwig von Mises, it is well known that he distanced himself from his valued disciple Fritz Machlup when in 1961 Machlup began to defend flexible exchange rates in the Mont Pèlerin Society. In fact, according to R.M. Hartwell, who was the official historian of the Mont Pèlerin Society,
“Machlup’s support of floating exchange rates led von Mises to not speak to him for something like three years” (Hartwell 1995, 119).
Mises could understand how macroeconomists with no academic training in capital theory, like Friedman and his Chicago colleagues, and also Keynesians in general, could defend flexible rates and the inflationism invariably implicit in them, but he was not willing to overlook the error of someone who, like Machlup, had been his disciple and therefore really knew about economics, and yet allowed himself to be carried away by the pragmatism and passing fashions of political correctness. Indeed, Mises even remarked to his wife on the reason he was unable to forgive Machlup:
“He was in my seminar in Vienna; he understands everything. He knows more than most of them and he knows exactly what he is doing” (Margit von Mises 1984, 146).
Mises’s defence of fixed exchange rates parallels his defence of the gold standard as the ideal monetary system on an international level. For instance, in 1944, in his book Omnipotent Government, Mises wrote:
“The gold standard put a check on governmental plans for easy money. It was impossible to indulge in credit expansion and yet cling to the gold parity permanently fixed by law. Governments had to choose between the gold standard and their — in the long run disastrous — policy of credit expansion. The gold standard did not collapse. The governments destroyed it. It was incompatible with etatism as was free trade. The various governments went off the gold standard because they were eager to make domestic prices and wages rise above the world market level, and because they wanted to stimulate exports and to hinder imports. Stability of foreign exchange rates was in their eyes a mischief, not a blessing. Such is the essence of the monetary teachings of Lord Keynes. The Keynesian school passionately advocates instability of foreign exchange rates” [italics added].
Furthermore, it comes as no surprise that Mises scorned the Chicago theorists when in this area, as in others, they ended up falling into the trap of the crudest Keynesianism. In addition, Mises maintained that it would be relatively simple to re-establish the gold standard and return to fixed exchange rates:
“The only condition required is the abandonment of an easy money policy and of the endeavors to combat imports by devaluation.”
Moreover, Mises held that only fixed exchange rates are compatible with a genuine democracy, and that the inflationism behind flexible exchange rates is essentially antidemocratic:
“Inflation is essentially antidemocratic. Democratic control is budgetary control. The government has but one source of revenue — taxes. No taxation is legal without parliamentary consent. But if the government has other sources of income it can free itself from their control” (Mises 1969, 251-253).
Only when exchange rates are fixed are governments obliged to tell citizens the truth. Hence, the temptation to rely on inflation and flexible rates to avoid the political cost of unpopular tax increases is so strong and so destructive. So, even if there is not a gold standard, fixed rates restrict and discipline the arbitrariness of politicians:
“Even in the absence of a pure gold standard, fixed exchange rates provide some insurance against inflation which is not forthcoming from the flexible system. Under fixity, if one country inflates, it falls victim to a balance of payment crisis. If and when it runs out of foreign exchange holdings, it must devalue, a relatively difficult process, fraught with danger for the political leaders involved. Under flexibility, in contrast, inflation brings about no balance of payment crisis, nor any need for a politically embarrassing devaluation. Instead, there is a relatively painless depreciation of the home (or inflationary) currency against its foreign counterparts” (Block 1999, 19, italics added).
3. The Euro as a “Proxy” for the Gold Standard (or Why Champions of Free Enterprise and the Free Market Should Support the Euro While the Only Alternative Is a Return to Monetary Nationalism)
As we have seen, Austrian economists defend the gold standard because it curbs and limits the arbitrary decisions of politicians and authorities. It disciplines the behaviour of all the agents who participate in the democratic process. It promotes moral habits of human behaviour. In short, it checks lies and demagogy; it facilitates and spreads transparency and truth in social relationships. No more and no less. Perhaps Ludwig von Mises said it best:
“The gold standard makes the determination of money’s purchasing power independent of the changing ambitions and doctrines of political parties and pressure groups. This is not a defect of the gold standard, it is its main excellence” (Mises 1966, 474).
The introduction of the euro in 1999 and its culmination beginning in 2002 meant the disappearance of monetary nationalism and flexible exchange rates in most of continental Europe. Later we will consider the errors committed by the European Central Bank. Now what interests us is to note that the different member states of the monetary union completely relinquished and lost their monetary autonomy, that is, the possibility of manipulating their local currency by placing it at the service of the political needs of the moment. In this sense, at least with respect to the countries in the euro zone, the euro began to act and continues to act very much like the gold standard did in its day. Thus, we must view the euro as a clear, true, even if imperfect, step toward the gold standard. Moreover, the arrival of the Great Recession of 2008 has even further revealed to everyone the disciplinary nature of the euro: for the first time, the countries of the monetary union have had to face a deep economic recession without monetary policy autonomy. Up until the adoption of the euro, when a crisis hit, governments and central banks invariably acted in the same way: they injected all the necessary liquidity, allowed the local currency to float downward and depreciated it, and indefinitely postponed the painful structural reforms that were needed and which involve economic liberalization, deregulation, increased flexibility in prices and markets (especially the labour market), a reduction in public spending, and the withdrawal and dismantling of union power and the welfare state. With the euro, despite all the errors, weaknesses, and concessions we will discuss later, this type of irresponsible behaviour and forward escape has no longer been possible.
For instance, in Spain, in just one year, two consecutive governments have been literally forced to take a series of measures which, though still quite insufficient, up to now would have been labelled as politically impossible and utopian, even by the most optimistic observers:
- article 135 of the Constitution has been amended to include the anti-Keynesian principle of budget stability and equilibrium for the central government, the autonomous communities, and the municipalities;
- all of the projects that imply increases in public spending, vote purchasing, and subsidies, projects upon which politicians regularly based their action and popularity, have been suddenly suspended;
- the salaries of all public servants have been reduced by 5 percent and then frozen, while their work schedule has been expanded;
- social security pensions have been frozen de facto;
- the standard retirement age has been raised across the board from 65 to 67;
- the total budgeted public expenditure has decreased by over 15 percent; and
- significant liberalization has occurred in the labour market, business hours, and in general, the tangle of economic regulation.
Furthermore, what has happened in Spain is also taking place in Ireland, Portugal, Italy, and even in countries which, like Greece, until now represented the paradigm of social laxity, the lack of budget rigour, and political demagogy. What is more, the political leaders of these five countries, now no longer able to manipulate monetary policy to keep citizens in the dark about the true cost of their policies, have been summarily thrown out of their respective governments. And states which, like Belgium and especially France and Holland, until now have appeared unaffected by the drive to reform, are also starting to be forced to reconsider the very grounds for the volume of their public spending and for the structure of their bloated welfare state. This is all undeniably due to the new monetary framework introduced with the euro, and thus it should be viewed with excited and hopeful rejoicing by all champions of the free-enterprise economy and the limitation of government powers. For it is hard to conceive of any of these measures being taken in a context of a national currency and flexible exchange rates: whenever they can, politicians eschew unpopular reforms, and citizens everything that involves sacrifice and discipline. Hence, in the absence of the euro, authorities would again have taken what up to now has been the usual path, i.e. a forward escape consisting of more inflation, the depreciation of the currency to recover “full employment” and gain competitiveness in the short term (covering their backs and concealing the grave responsibility of labour unions as true generators of unemployment), and in short, the indefinite postponement of the necessary structural reforms.
Let us now focus on two significant ways the euro is unique. We will contrast it both with the system of national currencies linked together by fixed exchange rates, and with the gold standard itself, beginning with the latter. We must note that abandoning the euro is much more difficult than going off the gold standard was in its day. In fact, the currencies linked with gold kept their local denomination (the franc, the pound, etc.), and thus it was relatively easy, throughout the 1930s, to unanchor them from gold, insofar as economic agents, as indicated in the monetary regression theorem Mises formulated in 1912 (Mises 2009 , 111-123), continued without interruption to use the national currency, which was no longer exchangeable for gold, relying on the purchasing power of the currency right before the reform. Today this possibility does not exist for those countries that wish, or are obliged, to abandon the euro. Since it is the only unit of currency shared by all the countries in the monetary union, its abandonment requires the introduction of a new local currency, with unknown and much less purchasing power, and includes the emergence of the immense disturbances that the change would entail for all the economic agents in the market: debtors, creditors, investors, entrepreneurs, and workers. At least in this specific sense, and from the standpoint of Austrian theorists, we must admit that the euro surpasses the gold standard, and that it would have been very useful for mankind if in the 1930s the different countries involved had been obliged to stay on the gold standard, because as is the case today with the euro, any other alternative was nearly impossible to put into practice and would have affected citizens in a much more damaging, painful, and obvious way.
Hence, to a certain extent it is amusing (and also pathetic) to note that the legion of social engineers and interventionist politicians who, led at the time by Jacques Delors, designed the single currency as one more tool for use in their grandiose projects to achieve a European political union, now regard with despair something they never seem to have been able to predict: that the euro has ended up acting de facto as the gold standard, disciplining citizens, politicians, and authorities, tying the hands of demagogues and exposing pressure groups (headed by the unfailingly privileged unions), and even questioning the sustainability and the very foundations of the welfare state. According to the Austrian school, this is precisely the main comparative advantage of the euro as a monetary standard in general, and against monetary nationalism in particular; this and not the more prosaic arguments, like “the reduction of transaction costs” or “the elimination of exchange risk,” which were deployed at the time by the invariably short-sighted social engineers of the moment.
Now let us consider the difference between the euro and a system of fixed exchange rates, with respect to the adjustment process which takes place when different degrees of credit expansion and intervention arise between the different countries. Obviously, in a fixed-rate system, these differences manifest themselves in considerable exchange-rate tensions that eventually culminate in explicit devaluations and the high cost in terms of lost prestige which, fortunately, these entail for the corresponding political authorities. In the case of a single currency, like the euro, such tensions manifest themselves in a general loss of competitiveness, which can only be recovered with the introduction of the structural reforms necessary to guarantee market flexibility, along with the deregulation of all sectors and the reductions and adjustments necessary in the structure of relative prices. Moreover, the above ends up affecting the revenues of each public sector, and thus, of its credit rating. In fact, under the present circumstances, in the euro area, the current value in the financial markets of each country’s sovereign public debt has come to reflect the tensions which typically revealed themselves in exchange-rate crises, when rates were more or less fixed in an environment of monetary nationalism. Therefore, at this time, the leading role is not played by foreign-currency speculators, but by the rating agencies, and especially, by international investors, who, by purchasing sovereign debt or not, are healthily setting the pace of reform while also disciplining and determining the fate of each country. This process may be called “undemocratic,” but it is actually the exact opposite. In the past, democracy suffered chronically and was corrupted by irresponsible political actions based on monetary manipulation and inflation, a veritable tax of devastating consequences, which is imposed outside of parliament on all citizens in a gradual, concealed, and devious way. Today, with the euro, the recourse to an inflationary tax has been blocked, at least at the local level of each country, and politicians have suddenly been exposed, and have been obliged to tell the truth and accept the corresponding loss of support. Democracy, if it is to work, requires a framework which disciplines the agents who participate in it. And today in continental Europe that role is being played by the euro. Hence, the successive fall of the governments of Ireland, Greece, Portugal, Italy, Spain and France, far from revealing a democracy deficit, manifests the increasing degree of rigor, budget transparency, and democratic health which the euro is encouraging in its respective societies.
4. The Diverse and Motley “Anti-euro Coalition”
As it would be interesting and highly illustrative, we should now, if only briefly, comment on the diverse and motley amalgam formed by the euro’s enemies. This group includes in its ranks such disparate elements as doctrinaires of the far left and right; nostalgic or unyielding Keynesians like Krugman and Stiglitz, dogmatic monetarists in support of flexible exchange rates, like Barro and others; naive advocates of Mundell’s theory of optimum currency areas; terrified dollar (and pound) chauvinists; and in short, the legion of confused defeatists who “in the face of the imminent disappearance of the euro” propose the “solution” of blowing it up and abolishing it as soon as possible.
Perhaps the clearest illustration (or rather, the most convincing piece of evidence) of the fact that Mises was entirely correct in his analysis of the disciplining effect of fixed exchange rates, and especially of the gold standard, on political and union demagogy lies in the way in which the leaders of leftist political parties, union members, “progressive” opinion makers, anti-system “indignados,” far-right politicians, and in general, all fans of public spending, state subsidies, and interventionism openly and directly rebel against the discipline the euro imposes, and specifically, against the loss of autonomy in each country’s monetary policy, and what that implies: the much-reviled dependence on markets, speculators, and international investors when it comes to being able (or not) to sell the growing sovereign public debt required to finance continual public deficits. One need only glance at the editorials in the most leftist newspapers, or read the statements of the most demagogic politicians, or of leading unionists, to observe that this is so, and that nowadays, just like in the 1930s with the gold standard, the enemies of the market and the defenders of socialism, the welfare state, and union demagogy are protesting in unison, both in public and in private, against “the rigid discipline the euro and the financial markets are imposing on us,” and they are demanding the immediate monetization of all the public debt necessary, without any countermeasure in the form of budget austerity or reforms that boost competitiveness.
In the more academic sphere, but also with ample coverage in the media, contemporary Keynesian theorists are mounting a major offensive against the euro, again with a belligerence only comparable to that Keynes himself showed against the gold standard in the 1930s. Especially paradigmatic is the case of Krugman, who as a syndicated columnist, tells the same old story almost every week about how the euro means a “straitjacket” for employment recovery, and he even goes so far as to criticize the profligate American government for not being expansionary enough and for having fallen short in its (huge) fiscal stimulus packages. More intelligent and highbrow, though no less mistaken, is the opinion of Skidelsky, since he at least explains that the Austrian business cycle theory offers the only alternative to his beloved Keynes and clearly recognizes that the current situation actually involves a repeat of the duel between Hayek and Keynes during the 1930s.
Stranger yet is the stance taken on flexible exchange rates by neoclassical theorists in general, and by monetarists and members of the Chicago school in particular. It appears that this group’s interest in flexible exchange rates and monetary nationalism predominates over their (we presume sincere) desire to encourage economic liberalization reforms. Indeed, their primary goal is to maintain monetary policy autonomy and be able to devalue (or depreciate) the local currency to “recover competitiveness” and absorb unemployment as soon as possible, and only then, eventually, do they focus on trying to foster flexibility and free market reforms. Their naivete is extreme, and we referred to it in our discussion of the reasons for the disagreement between Mises, on the side of the Austrian school, and Friedman, on the side of the Chicago theorists, in the debate on fixed versus flexible exchange rates. Mises always saw very clearly that politicians are not likely to take steps in the right direction if they are not literally obligated to do so, and that flexible rates and monetary nationalism remove practically every incentive capable of disciplining politicians and doing away with “downward rigidity” in wages (which thus becomes a sort of self-fulfilling assumption that monetarists and Keynesians wholeheartedly accept) and with the privileges enjoyed by unions and all other pressure groups. Mises also observed that as a result, in the long run, and even in spite of themselves, monetarists end up becoming fellow travelers of the old Keynesian doctrines: once “competitiveness” has been “recovered,” reforms are postponed, and what is even worse, unionists become accustomed to having the destructive effects of their restrictionist policies continually masked by successive devaluations.
This latent contradiction between defending the free market and supporting monetary nationalism and manipulation via “flexible” exchange rates is also evident in many proponents of the most widespread interpretation of Robert A. Mundell’s theory of “optimum currency areas.” Such areas would be those in which, to begin with, all productive factors were highly mobile, because if that is not the case, it would be better to compartmentalize them with currencies of a smaller scope, to permit the use of an autonomous monetary policy in the event of any “external shock.” However, we should ask ourselves: Is this reasoning sound? Not at all: the main source of rigidity in labour and factor markets actually lies in, and is sanctioned by, intervention and state regulation of the markets, so it is absurd to think states and their governments are going to commit harakiri first, thus relinquishing their power and betraying their political clientele, in order to adopt a common currency afterward. Instead, the exact opposite is true: only when politicians have joined a common currency (the euro in our case) have they been forced to implement reforms which until very recently it would have been inconceivable for them to adopt. In the words of Walter Block:
“… government is the main or only source of factor immobility. The state, with its regulations … is the prime reason why factors of production are less mobile than they would otherwise be. In a bygone era the costs of transportation would have been the chief explanation, but with all the technological progress achieved here, this is far less important in our modern ‘shrinking world.’ If this is so, then under laissez-faire capitalism, there would be virtually no factor immobility. Given even the approximate truth of these assumptions the Mundellian region then becomes the entire globe — precisely as it would be under the gold standard–.”
This conclusion of Block’s is equally applicable to the euro area, to the extent that the euro acts, as we have already indicated, as a “proxy” for the gold standard which disciplines and limits the arbitrary power of the politicians of the member states.
We must not fail to stress that Keynesians, monetarists, and Mundellians are all mistaken because they reason exclusively in terms of macroeconomic aggregates, and hence they propose, with slight differences, the same sort of adjustment via monetary and fiscal manipulation, “fine tuning,” and flexible exchange rates. They believe that all of the effort it takes to overcome the crisis should therefore be guided by macroeconomic models and social engineering. Thus, they completely disregard the profound microeconomic distortion that monetary (and fiscal) manipulation generate in the structure of relative prices and in the capital-goods structure. A forced devaluation (or depreciation) is “one size fits all,” i.e. it entails a sudden linear percentage drop in the price of consumer goods and services and productive factors, a drop which is the same for everyone. Although in the short term this gives the impression of an intense recovery of economic activity and of a rapid absorption of unemployment, it actually completely distorts the structure of relative prices (since without monetary manipulation, some prices would have fallen more, others less, and others would not have fallen at all and might even have risen), leads to a widespread poor allocation of productive resources, and causes a major trauma which any economy would take years to process and recover from. This is the microeconomic analysis centered on relative prices and the productive structure which Austrian theorists have characteristically developed and which, in contrast, is entirely missing from the analytical toolbox of the assortment of economic theorists who oppose the euro.
Finally, outside the purely academic sphere, the tiresome insistence with which Anglo-Saxon economists, investors, and financial analysts attempt to discredit the euro by foretelling the bleakest future for it is to a certain extent suspicious. This impression is reinforced by the hypocritical position of the different US administrations (and also, to a lesser extent, the British government) in wishing (half-heartedly) that the euro zone would “get its economy in order,” and yet self-interestedly omitting to mention that the financial crisis originated on the other side of the Atlantic, i.e. in the recklessness and the expansionary policies pursued by the Federal Reserve for years, and the effects of which spread to the rest of the world via the dollar, as it is still used as the international reserve currency. Furthermore, there is almost unbearable pressure for the euro zone to introduce monetary policies at least as expansionary and irresponsible (“quantitative easing”) as those adopted in the United States, and this pressure is doubly hypocritical, since such an occurrence would undoubtedly deliver the coup de grace to the single European currency.
Might not this stance in the Anglo-Saxon political, economic, and financial world be hiding a buried fear that the dollar’s future as the international reserve currency may be threatened if the euro survives and is capable of effectively competing with the dollar in a not-too-distant future? All indications suggest that this question is becoming more and more pertinent, and though today it does not appear very politically correct, it pours salt on the wound that is most painful for analysts and authorities in the Anglo-Saxon world: the euro is emerging as an enormously powerful potential rival to the dollar on an international level.
As we can see, the anti-euro coalition brings together quite varied and powerful interests. Each distrusts the euro for a different reason. However, they all share a common denominator: the arguments which form the basis of their opposition to the euro would be exactly the same, and they might well repeat and word them even more emphatically, if instead of the single European currency, they had to come to grips with the classic gold standard as the international monetary system. In fact, there is a large degree of similarity between the forces which joined in an alliance in the 1930s to compel the abandonment of the gold standard and those which today seek (up to now unsuccessfully) to reintroduce old, outdated monetary nationalism in Europe. As we have already indicated, technically it was much easier to abandon the gold standard than it would be today for any country to leave the monetary union. In this context, it should come as no surprise that members of the anti-euro coalition often even fall back on the most shameless defeatism: they predict a disaster and the impossibility of maintaining the monetary union, and then right afterward, they propose the “solution” of dismantling it immediately. They even go so far as to hold international contests (– where else — in England, Keynes’s home and that of monetary nationalism) in which hundreds of “experts” and crackpots participate, each with his own proposals for the best and most innocuous way to blow up the European monetary union.
5. The True Cardinal Sins of Europe and the Fatal Error of the European Central Bank
No one can deny that the European Union chronically suffers from a number of serious economic and social problems. Nevertheless, the maligned euro is not one of them. Rather, the opposite is true: the euro is acting as a powerful catalyst which reveals the severity of Europe’s true problems and hastens or “precipitates” the implementation of the measures necessary to solve them. In fact, today, the euro is helping spread more than ever the awareness that the bloated European welfare state is unsustainable and needs to be substantially reformed. The same can be said for the all-encompassing aid and subsidy programs, among which the Common Agricultural Policy occupies a key position, both in terms of its very damaging effects and its total lack of economic rationality. Most of all, it can be said for the culture of social engineering and oppressive regulation which, on the pretext of harmonizing the legislation of the different countries, fossilizes the single European market and prevents it from being a genuine free market. Now more than ever, the true cost of all these structural flaws is becoming apparent in the euro area: without an autonomous monetary policy, the different governments are being literally forced to reconsider (and when applicable, to reduce) all their public expenditure items, and to attempt to recover and gain international competitiveness by deregulating and increasing as far as possible the flexibility of their markets (especially the labour market, which has traditionally been very rigid in many countries of the monetary union).
In addition to the above cardinal sins of the European economy, we must add another which is perhaps even graver, due to its peculiar, devious nature. We are referring to the great ease with which European institutions, many times because of a lack of vision, leadership, or conviction about their own project, allow themselves to become entangled in policies that in the long run are incompatible with the demands of a single currency and of a true free single market.
First, it is surprising to note the increasing regularity with which the burgeoning and stifling new regulatory measures are introduced into Europe from the Anglo-Saxon academic and political world, specifically the United States, and often when such measures have already proven ineffective or extremely disruptive. This unhealthy influence is a long-established tradition. (Let us recall that agricultural subsidies, the antitrust legislation, and regulations concerning “corporate social responsibility” have actually originated, like many other failed interventions, in the United States.) Nowadays such regulatory measures crop up repeatedly and are reinforced at every step, for example with respect to the so called “fair market value” and the rest of the International Accounting Standards, or to the (until now, fortunately, failed) attempts to implement the so-called agreements of Basel III for the banking sector and Solvency II for the insurance sector, both of which suffer from insurmountable and fundamental theoretical deficiencies as well as serious problems in relation to their practical application.
A second example of the unhealthy Anglo-Saxon influence can be found in the European Economic Recovery Plan, which the European Commission launched at the end of 2008 under the auspices of the Washington Summit, with the leadership of Keynesian politicians like Barack Obama and Gordon Brown, and on the advice of economic theorists who are enemies of the euro, like Krugman and others. The plan recommended to member countries an expansion of public spending of around 1.5 percent of GDP (some 200 billion euros on an aggregate level). Though some countries, like Spain, made the error of expanding their budgets, the plan, thank God and the euro, and much to the despair of Keynesians and their acolytes, soon came to nothing, once it became clear that it only served to increase the deficits, preclude the achievement of the Maastricht Treaty objectives, and severely destabilize the sovereign debt markets of the countries of the euro zone. Again, the euro provided a disciplinary framework and an early curb on the deficit, in contrast to the budget recklessness of countries that are victims of monetary nationalism, and specifically, the United States and especially England, which closed with a public deficit of 10.1 percent of GDP in 2010 and 8.8 percent in 2011, which on a worldwide scale was only exceeded by Greece and Egypt. Despite such bloated deficits and fiscal stimulus packages, unemployment in England and the United States remains at record (or very high) levels, and their respective economies are just not getting off the ground.
Third, and above all, there is mounting pressure for a complete European political union, which some suggest as the only “solution” that could enable the survival of the euro in the long term. Apart from the “Eurofanatics,” who always defend any excuse that might justify greater power and centralism for Brussels, two groups coincide in their support for political union. One group consists, paradoxically, of the euro’s enemies, particularly those of Anglo-Saxon origin: there are the Americans, who, dazzled by the centralized power of Washington and aware that it could not possibly be duplicated in Europe, know that with their proposal they are injecting a divisive virus deadly to the euro; and there are the British, who make the euro an (unjustified) scapegoat upon which to vent their (totally justified) frustrations in view of the growing interventionism of Brussels. The other group consists of all those theorists and thinkers who believe that only the discipline imposed by a central government agency can guarantee the deficit and public-debt objectives established in Maastricht. This is an erroneous belief. The very mechanism of the monetary union guarantees, just like the gold standard, that those countries which abandon budget rigor and stability will see their solvency at risk and be forced to take urgent measures to re-establish the sustainability of their public finances if they do not wish to suspend payments.
Despite the above, the most serious problem does not lie in the threat of an impossible political union, but in the unquestionable fact that a policy of credit expansion carried out in a sustained manner by the European Central Bank during a period of apparent economic prosperity is capable of canceling, at least temporarily, the disciplinary effect exerted by the euro on the economic agents of each country. Thus, the fatal error of the European Central Bank consists of not having managed to isolate and protect Europe from the great expansion of credit orchestrated on a worldwide scale by the US Federal Reserve beginning in 2001. Over several years, in a blatant failure to comply with the Maastricht Treaty, the European Central Bank allowed M3 to grow by even more than 9 percent per year, which far exceeds the objective of 4.5 percent growth in the money supply, an aim originally set by the ECB itself. Furthermore, even though this increase was appreciably less reckless than that brought about by the US Federal Reserve, the money was not distributed uniformly among the countries of the monetary union, and it had a disproportionate impact on the periphery countries (Spain, Portugal, Ireland, and Greece), which saw their monetary aggregates grow at a pace far more rapid, between three and four times more, than France or Germany. Various reasons can be given to explain this phenomenon, from the pressure applied by France and Germany, both of which sought a monetary policy that during those years would not be too restrictive for them, to the extreme short-sightedness of the periphery countries, which did not wish to admit they were in the middle of a speculative bubble, as is the case with Spain, and thus were also unable to give categorical instructions to their representatives in the ECB council to make an important issue of strict compliance with the monetary-growth objectives established by the European Central Bank itself. In fact, during the years prior to the crisis, all of these countries, except Greece, easily observed the 3-percent deficit limits, and some, like Spain and Ireland, even closed their public accounts with large surpluses. Hence, though the heart of the European Union was kept out of the American process of irrational exuberance, the process was repeated with intense virulence in the European periphery countries, and no one, or very few people, correctly diagnosed the grave danger in what was happening. If academics and political authorities from both the affected countries and the European Central Bank, instead of using macroeconomic and monetarist analytical tools imported from the Anglo-Saxon world, had used those of the Austrian business cycle theory — which after all is a product of the most genuine continental economic thought — they would have managed to detect in time the largely artificial nature of the prosperity of those years, the unsustainability of many of the investments (especially with respect to real estate development) that were being launched due to the great easing of credit, and in short, that the surprising influx of rising public revenue would be of very short duration. Still, fortunately, though in the most recent cycle the European Central Bank has fallen short of the standards European citizens had a right to expect, and we could even call its policy a “grave tragedy,” the logic of the euro as a single currency has prevailed, thus clearly exposing the errors committed and obliging everyone to return to the path of control and austerity. In the next section, we will briefly touch on the specific way the European Central Bank formulated its policy during the crisis and how and on what points this policy differs from that followed by the central banks of the United States and United Kingdom.
6. The Euro vs. the Dollar (and the Pound) and Germany vs. the USA (and the UK)
One of the most striking characteristics of the last cycle, which ended in the Great Recession of 2008, has undoubtedly been the differing behaviour of the monetary and fiscal policies of the Anglo-Saxon area, based on monetary nationalism, and those pursued by the member countries of the European monetary union. Indeed, from the time the financial crisis and economic recession hit in 2007-2008, both the Federal Reserve and the Bank of England have adopted monetary policies which have consisted of reducing the interest rate to almost zero; injecting huge quantities of money into the economy (euphemistically known as “quantitative easing”); and continuously, directly, and unabashedly monetizing the sovereign public debt on a massive scale. To this extremely lax monetary policy (in which the recommendations of monetarists and Keynesians concur) is added the strong fiscal stimulus involved in maintaining, both in the United States and in England, budget deficits close to 10 percent of the respective GDPs (which, nevertheless, at least the most recalcitrant Keynesians, like Krugman and others, do not consider anywhere near sufficient).
In contrast with the situation of the dollar and the pound, in the euro area, fortunately, money cannot so easily be injected into the economy, nor can budget recklessness be indefinitely maintained with such impunity. At least in theory, the European Central Bank lacks authority to monetize the European public debt, and though it has accepted it as collateral for its huge loans to the banking system, and beginning in the summer of 2010 even sporadically made direct purchases of the bonds of the most threatened periphery countries (Greece, Portugal, Ireland, Italy and Spain), there is certainly a fundamental economic difference between the behaviour of the United States and United Kingdom, and the policy continental Europe is following: while monetary aggression and budget recklessness are deliberately, unabashedly, and without reservation undertaken in the Anglo-Saxon world, in Europe such policies are carried out reluctantly, and in many cases after numerous, consecutive and endless “summits.” They are the result of lengthy and difficult negotiations between many parties, negotiations in which countries with very different interests must reach an agreement. Furthermore, what is even more important, when money is injected into the economy and support is provided to the debt of countries that are having difficulties, such actions are always balanced with, and taken in exchange for, reforms based on budget austerity (and not on fiscal stimulus packages) and on the introduction of supply-side policies which encourage market liberalization and competitiveness. Moreover, though it would have been better had it happened much sooner, the “de facto” suspension of payments by the Greek state, which has given a nearly 75-percent “haircut” to the private investors who mistakenly trusted in Greek sovereign debt holdings, has clearly signalled to markets that the other countries in trouble have no other alternative than to firmly, rigorously, and without delay carry out all necessary reforms. As we have already seen, even states like France, which until now appeared untouchable and comfortably nestled in a bloated welfare state, have lost the highest credit rating on their debt, seen its differential with the German bund rise, and found themselves increasingly doomed to introduce austerity and liberalization reforms to avoid jeopardizing what has always been their indisputable membership among the euro zone hardliners.
From the political standpoint, it is quite obvious that Germany (and particularly the chancellor Angela Merkel) has the leading role in urging forward this whole process of rehabilitation and austerity (and opposing all sorts of awkward proposals which, like the issuance of “European bonds,” would remove the incentives the different countries now have to act with rigor). Many times Germany must swim upstream. For on the one hand, there is constant international political pressure for fiscal stimulus measures, especially from the US Obama administration, which is using the “crisis of the euro” as a smokescreen to hide the failure of its own policies. And on the other hand, Germany has to contend with rejection and a lack of understanding from all those who wish to remain in the euro solely for the advantages it offers them, while at the same time they violently rebel against the bitter discipline that the European single currency imposes on all of us, and especially on the most demagogic politicians and the most irresponsible privileged interest groups.
In any case, and as an illustration which will understandably exasperate Keynesians and monetarists, we must highlight the very unequal results which until now have been achieved with American fiscal-stimulus policies and monetary “quantitative easing,” in comparison with German supply-side policies and fiscal austerity in the monetary environment of the euro: public deficit, in Germany, 1%, in the United States, over 8.20%; unemployment, in Germany, 5.9%, in the United States, close to 9%; inflation, in Germany, 2.5%, in the United States, over 3.17%; growth, in Germany, 3%, in the United States, 1.7%. (The figures for United Kingdom are even worse than those for the US.) The clash of paradigms and the contrast in results could not be more striking.
7. Conclusion: Hayek versus Keynes
Just as with the gold standard in its day, today a legion of people criticize and despise the euro for what is precisely its main virtue: its capacity to discipline extravagant politicians and pressure groups. Plainly, the euro in no way constitutes the ideal monetary standard, which, as we saw in the first section, could only be found in the classic gold standard, with a 100-percent reserve requirement on demand deposits, and the abolition of the central bank. Hence, it is quite possible that once a certain amount of time has passed and the historical memory of recent monetary and financial events has faded, the European Central Bank may go back to committing the grave errors of the past, and promote and accommodate a new bubble of credit expansion. However, let us remember that the sins of the Federal Reserve and the Bank of England have been much worse still and that, at least in continental Europe, the euro has ended monetary nationalism, and for the states in the monetary union, it is acting, even if only timidly, as a “proxy” for the gold standard, by encouraging budget rigor and reforms aimed at improving competitiveness, and by putting a stop to the abuses of the welfare state and of political demagogy.
In any case, we must recognize that we stand at a historic cross-roads. The euro must survive if all of Europe is to internalize and adopt as its own the traditional German monetary stability, which in practice is the only and the essential disciplinary framework from which, in the short and medium term, European Union competitiveness and growth can be further stimulated. On a worldwide scale, the survival and consolidation of the euro will permit, for the first time since World War II, the emergence of a currency capable of effectively competing with the monopoly of the dollar as the international reserve currency, and therefore capable of disciplining the American ability to provoke additional systemic financial crises which, like that of 2007, constantly endanger the world economic order.
Just over eighty years ago, in a historical context very similar to ours, the world was torn between maintaining the gold standard, and with it budget austerity, labour flexibility, and free and peaceful trade; or abandoning the gold standard, and thus everywhere spreading monetary nationalism, inflationary policies, labour rigidity, interventionism, “economic fascism,” and trade protectionism. Hayek, and the Austrian theorists led by Mises, made a titanic intellectual effort to analyze, explain, and defend the advantages of the gold standard and free trade, in opposition to the theorists who, led by Keynes and the monetarists, opted to blow up the monetary and fiscal foundations of the laissez-faire economy which until then had fueled the Industrial Revolution and the progress of civilization. On that occasion, economic thought ended up taking a very different route from that favored by Mises and Hayek, and we are all familiar with the economic, political, and social consequences that followed. As a result, today, well into the twenty-first century, incredibly, the world is still afflicted by financial instability, the lack of budget rigor, and political demagogy. For all these reasons, but mainly because the world economy urgently needs it, on this new occasion, Mises and Hayek deserve to finally triumph, and the euro (at least provisionally, and until it is replaced once and for all by the gold standard) deserves to survive.
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The main authors and theoretical formulations can be consulted in Huerta de Soto 2012 .
 Ibid., chapter 9.
 F.A. Hayek 1971 .
 Though Hayek does not expressly name them, he is referring to the theorists of the Chicago school, led by Milton Friedman, who in this and other areas shake hands with the Keynesians.
 Later we will see how, with a single currency like the euro, the disciplinary role of fixed exchange rates is taken on by the current market value of each country’s sovereign and corporate debt.
 To underline Mises’s argument even more clearly, I should indicate that there is no way to justifiably attribute to the gold standard the error Churchill committed following World War I, when he fixed the gold parity without taking into account the serious inflation of pound sterling banknotes issued to finance the war. This event has nothing to do with the current situation of the euro, which is freely floating in international markets, nor with those problems which affect countries in the euro zone’s periphery and which stem from the loss in real competitiveness suffered by their economies during the bubble (Huerta de Soto 2012 , 447, 622-623 in the English edition).
 In Spain, different Austrian economists, including me, had for decades been clamoring unsuccessfully for the introduction of these (and many other) reforms which only now have become politically feasible, and have done so suddenly, with surprising urgency, and due to the euro. Two observations: first, the measures which constitute a step in the right direction have been sullied by the increase in taxes, especially on income, movable capital earnings and wealth (see the manifesto against the tax increase which I and fifty other academics signed in February 2012); second, the principles of budget stability and equilibrium are a necessary, but not a sufficient, condition for a return to the path toward a sustainable economy, since in the event of another episode of credit expansion, only a huge surplus during the prosperous years would make it possible, once the inevitable recession hit, to avoid the grave problems that now affect us.
 For the first time, and thanks to the euro, Greece is facing up to the challenges its own future poses. Though blasé monetarists and recalcitrant Keynesians do not wish to recognize it, internal deflation is possible and does not involve any “perverse” cycle if accompanied by major reforms to liberalize the economy and regain competitiveness. It is true that Greece has received and is receiving substantial aid, but it is no less true that it has the historic responsibility to refute the predictions of all those prophets of doom who, for different reasons, are determined to see the failure of the Greek effort so they can retain in their models the very stale (and self-interested) hypothesis that prices (and wages) are downwardly rigid (see also our remarks in footnote 9 about the disastrous effects of Argentina’s highly praised devaluation of 2001). For the first time, the traditionally bankrupt and corrupt Greek state has taken a drastic remedy. In two years (2010-2011) the public deficit has dropped 8 percentage points; the salaries of public servants have been cut by 15 percent initially and another 20 percent after that, and their number has been reduced by over 80,000 employees and the number of town councils by almost half; the retirement age has been raised; the minimum wage has been lowered, etc. (Vidal-Folch 2012). This “heroic” reconstruction contrasts with the economic and social decomposition of Argentina, which took the opposite (Keynesian and monetarist) road of monetary nationalism, devaluation, and inflation.
 Therefore, fortunately, we are “chained to the euro,” to use Cabrillo’s apt expression (Cabrillo 2012). Perhaps the most hackneyed contemporary example Keynesians and monetarists offer to illustrate the “merits” of a devaluation and of the abandonment of a fixed rate is the case of Argentina following the bank freeze (“corralito”) that took place beginning in December of 2001. This example is seriously erroneous for two reasons. First, at most, the bank freeze is simply an illustration of the fact that a fractional-reserve banking system cannot possibly function without a lender of last resort (Huerta de Soto 2012 , 785-786). Second, following the highly praised devaluation, Argentina’s per capita GDP fell from 7,726 dollars in 2000 to 2,767 dollars in 2002, thus losing two-thirds of its value. This 65-percent drop in Argentinian income and wealth should give serious pause to all those who nowadays are clumsily and violently demonstrating, for example in Greece, to protest the relatively much smaller sacrifices and drops in prices involved in the healthy and inevitable internal deflation which the discipline of the euro is requiring. Furthermore, all the patter about Argentina’s “impressive” growth rates, of over 8 percent per year beginning in 2003, should impress us very little if at all, when we consider the very low starting point after the devaluation, as well as the poverty, paralysis, and chaotic nature of the Argentinian economy, where one-third of the population has ended up depending on subsidies and government aid, the real rate of inflation exceeds 30 percent, and scarcity, restrictions, regulations, demagogy, the lack of reforms, and government control (and recklessness) have become a matter of course (Gallo 2012). Along the same lines, Pierpaolo Barbieri states: “I find truly incredible that serious commentators like economist Nouriel Roubini are offering Argentina as a role model for Greece” (Barbieri 2012).
 Even the President of the ECB, Mario Draghi, has gone so far as to expressly state that the “continent’s social model is ‘gone’” (Blackstone, Karnitschnig, and Thomson 2012).
 I do not include here the analysis of my esteemed disciple and colleague Philipp Bagus (The Tragedy of the Euro, Ludwig von Mises Institute, Auburn, Alabama, USA 2010), since from Germany’s point of view, the manipulation to which the European Central Bank is subjecting the euro threatens the monetary stability Germany traditionally enjoyed with the mark. Nevertheless, his argument that the euro has fostered irresponsible policies via a typical tragedy-of-the-commons effect seems weaker to me, because during the bubble stage, most of the countries that are now having problems, with the only possible exception of Greece, were sporting a surplus in their public accounts (or were very close to one). Thus, I believe Bagus would have been more accurate if he had titled his otherwise excellent book The Tragedy of the European Central Bank (and not of the euro), particularly in light of the grave errors committed by the European Central Bank during the bubble stage, errors we will remark on in a later section of this article (thanks to Juan Ramón Rallo for suggesting this idea to me).
 The editorial line of the defunct Spanish newspaper Público was paradigmatic in this sense. (See also, for example, the case of Estefanía 2011, and of his criticism of the aforementioned reform of article 135 of the Spanish Constitution to establish the “anti-Keynesian” principle of budget stability and equilibrium.)
 See, for example, the statements of the socialist candidate for the French presidency, for whom “the path of austerity is ineffective, deadly, and dangerous” (Hollande 2012), or those of the far-right candidate, Marine Le Pen, who believes the French “should return to the franc and bring the euro period to a close once and for all” (Martín Ferrand 2012).
 One example among many articles is Krugman 2012; see also Stiglitz 2012.
 The US public deficit has stood at between 8.2 and 10 % over the last three years, in sharp contrast with German deficit, which stood at only 1% in 2011.
 An up-to-date explanation of the Austrian theory of the cycle can be found in Huerta de Soto 2012 , chapter 5.
 Skidelsky 2011.
 A legion of economists belong to this group, and most of them (surprise, surprise!) come from the dollar-pound area. Among others in the group, I could mention, for example, Robert Barro (2012), Martin Feldstein (2011), and President Barack Obama’s adviser, Austan Goolsbee (2011). In Spain, though for different reasons, I should cite such eminent economists as Pedro Schwartz, Francisco Cabrillo, and Alberto Recarte.
 Mundell 1961.
 Block 1999, 21.
 See Whyte’s (2011) excellent analysis of the serious harm the depreciation of the pound is causing in United Kingdom; and with respect to the United States, see Laperriere 2012.
 Huerta de Soto 2012 .
 “The euro, as the currency of an economic zone that exports more than the United States, has well-developed financial markets, and is supported by a world class central bank, is in many aspects the obvious alternative to the dollar. While currently it is fashionable to couch all discussions of the euro in doom and gloom, the fact is that the euro accounts for 37 percent of all foreign exchange market turn over. It accounts for 31 percent of all international bond issues. It represents 28 percent of the foreign exchange reserves whose currency composition is divulged by central banks” (Eichengreen 2011, 130). Guy Sorman, for his part, has commented on “the ambiguous attitude of US financial experts and actors. They have never liked the euro, because by definition, the euro competes with the dollar: following orders, American so-called experts explained to us that the euro could not survive without a central economic government and a single fiscal system” (Sorman 2011). In short, it is clear that champions of competition between currencies should direct their efforts against the monopoly of the dollar (for example, by supporting the euro), rather than advocate the reintroduction of, and competition between, “little local currencies” of minor importance (the drachma, escudo, peseta, lira, pound, franc, and even the mark).
 Such is the case with, for example, the contest held in the United Kingdom by Lord Wolfson, the owner of Next stores. Up to now, this contest has attracted no fewer than 650 “experts” and crackpots. Were it not for the crass and obvious hypocrisy involved in such initiatives, which are always held outside the euro area (and especially in the Anglo-Saxon world, by those who fear, hate, or scorn the euro), we should commend the great effort and interest shown in the fate of a currency which, after all, is not their own.
 It might be worth noting that the author of these lines is a “Eurosceptic” who maintains that the function of the European Union should be limited exclusively to guaranteeing the free circulation of people, capital, and goods in the context of a single currency (if possible the gold standard).
 I have already mentioned, for instance, the recent legislative changes that have delayed the retirement age to 67 (and even indexed it with respect to future trends in life expectancy), changes already introduced or on the way in Germany, France, Italy, Spain, Portugal, and Greece. I could also cite the establishment of a “copayment” and increasing areas of privatization in connection with health care. These are small steps in the right direction, which, because of their high political cost, would not have been taken without the euro. They also contrast with the opposite trend indicated by Barack Obama’s health-care reform, and with the obvious resistance to change when it comes to tackling the inevitable reform of the British National Health Service.
 O’Caithnia 2011.
 Booth 2011.
 See, for example, “United States’ Economy: Over-regulated America: The home of laissez-faire is being suffocated by excessive and badly written regulation,” The Economist, February 18, 2012, p. 8, and the examples there cited.
 Huerta de Soto 2003 and 2009.
 On the hysterical support for the grandiose fiscal stimulus packages of this period, see Fernando Ulrich 2011.
 Krugman 2012, Stiglitz 2012.
 Specifically, the average rise in M3 in the euro zone from 2000 to 2011 exceeded 6.3%, and we should highlight the increases that occurred during the bubble years 2005 (from 7% to 8%), 2006 (from 8% to 10%), and 2007 (from 10% to 12%). The above data show that, as has already been indicated, the goal of a zero deficit, though commendable, is merely a necessary, though not a sufficient, condition for stability: during the expansionary phase of a cycle induced by credit expansion, public-spending commitments may be made based on the false tranquility which surpluses generate, yet later, when the inevitable recession hits, these commitments are completely unsustainable. This demonstrates that the objective of a zero deficit also requires an economy that is not subject to the ups and downs of credit expansion, or at least that the budgets be closed out with much larger surpluses during the expansionary years.
 Therefore, Greece would be the only case to which we could apply the “tragedy of the commons” argument Bagus (2010) develops concerning the euro. In light of the reasoning I have presented in the text, and as I have already mentioned, I believe a more apt title for Bagus’s remarkable book, The Tragedy of the Euro, would have been The Tragedy of the European Central Bank.
 The surpluses in Spain were as follows: 0.96%, 2.02%, and 1.90% in 2005, 2006, and 2007 respectively. Those of Ireland were: 0.42%, 1.40%, 1.64%, 2.90%, and 0.67% in 2003, 2004, 2005, 2006, and 2007 respectively.
 The author of these lines could be cited as an exception (Huerta de Soto 2012 , xxxvii).
 At this time (2011-2012), the Federal Reserve is directly purchasing at least 40 percent of the newly issued American public debt. A similar statement can be made regarding the Bank of England, which is the direct holder of 25 percent of all the sovereign public debt of the United Kingdom. In comparison with these figures, the (direct and indirect) monetization carried out by the European Central Bank seems like innocent “child’s play.”
 Luskin and Roche Kelly have even referred to “Europe’s Supply-Side Revolution” (Luskin and Roche Kelly 2012). Also highly significant is “A Plan for Growth in Europe,” which was urged February 20, 2012 by the leaders of twelve countries in the European Union (including Italy, Spain, the Netherlands, Finland, Ireland, and Poland), a plan which comprises only supply-side policies and does not mention any fiscal stimulus measure. There is also the manifesto “Initiative for a Free and Prospering Europe” (IFPE) signed in Bratislava in January 2012 by, among others, the author of these lines. In short, a change of models seems a priority in countries which, like Spain, must move from a speculative, “hot” economy based on credit expansion to a “cold” economy based on competitiveness. Indeed, as soon as prices decline (“internal deflation”) and the structure of relative prices is readjusted in an environment of economic liberalization and structural reforms, numerous opportunities for entrepreneurial profit will arise in sustainable investments, which in a monetary area as extensive as the euro area are sure to attract financing. This is how to bring about the necessary rehabilitation and ensure the longed-for recovery in our economies, a recovery which again should be cold, sustainable, and based on competitiveness.
 In this context, and as I explained in the section devoted to the “Motley Anti-euro Coalition,” we should not be surprised by the statements of the candidates to the French presidency, which are mentioned in footnote 13.
 Estimated data as of December 31, 2011.
 Elsewhere I have mentioned the incremental reforms which, like the radical separation between commercial and investment banking (as in the Glass Steagall Act), could improve the euro somewhat. At the same time, it is in United Kingdom where, paradoxically (or not, in light of the devastating social damage that has resulted from its banking crisis), my proposals have aroused the most interest, to the point that a bill was even presented in the British Parliament to complete Peel’s Bank Charter Act of 1844 (curiously, still in effect) by extending the 100-percent reserve requirement to demand deposits. The consensus reached there to separate commercial and investment banking should be considered a (very small) step in the right direction (Huerta de Soto 2010 and 2011).
 My uncle by marriage, the entrepreneur Javier Vidal Sario from Navarre, who remains perfectly lucid and active at the age of ninety-three, assures me that in all his life, he had never, not even during the years of the Stabilization Plan of 1959, witnessed in Spain a collective effort at institutional and budget discipline and economic rehabilitation comparable to the current one. Also historically significant is the fact that this effort is not taking place in just one country (for example, Spain), nor in relation to one local currency (for example, the old peseta), but rather is spread throughout all of Europe, and is being made by hundreds of millions of people in the framework of a common monetary unit (the euro).
 As early as 1924, the great American economist Benjamin M. Anderson wrote the following: “Economical living, prudent financial policy, debt reduction rather than debt creation — all these things are imperative if Europe is to be restored. And all these are consistent with a greatly improved standard of living in Europe, if real activity be set going once more. The gold standard, together with natural discount and interest rates, can supply the most solid possible foundation for such a course of events in Europe.” Clearly, once again, history is repeating itself (Anderson 1924). I am grateful to my colleague Antonio Zanella for having called my attention to this excerpt.
 Moreover, this historic situation is now being revisited in all its severity upon China, the economy of which is at this time on the brink of expansionary and inflationary collapse. See “Keynes versus Hayek in China,” The Economist, December 30, 2011.
 As we have already seen, Mises, the great defender of the gold standard and 100-percent-reserve free banking, in the 1960s collided head-on with theorists who, led by Friedman, supported flexible exchange rates. Mises decried the behaviour of his disciple Machlup, when the latter abandoned the defense of fixed exchange rates. Now, fifty years later and on account of the euro, history is also repeating itself. On that occasion, the advocates of monetary nationalism and exchange-rate instability won, with consequences we are all familiar with. This time around let us hope that the lesson has been learned and that Mises’s views will prevail. The world needs it and he deserves it.
In economics as with medicine any cure must begin with a sound diagnosis. But if economists were doctors the patient would have died on the table. Despite its pretensions to scientific exactitude, the discipline has offered a bewildering array of diagnoses; the doctors still arguing.
Some diagnoses can be ruled out. The Marxist theory of economic cycles with its declining rate of profit is clearly useless; businesses were making record profits on the eve of the bust. There was no shock to Total Factor Productivity which a Real Business Cycle explanation would require. Keynesian ‘animal spirits’ are also unsatisfactory. The flight from mortgage backed assets was a totally rational response to the Federal Reserve raising interest rates between 2004 and 2007.
But there is another diagnosis which fits the symptoms quite well; Austrian Business Cycle Theory (ABCT), so called because it grows out of the Austrian School of economics founded in Vienna by Carl Menger in the nineteenth century. It describes the causes and course of the current crisis better than any other theory and offers some insights in to what lies ahead.
ABCT starts with the idea that the interest rate is a price like any other matching the supply of something to the demand for it. Funds for investment are supplied (via saving); savings are demanded (for investment). If people cut back on current consumption and save more to increase future consumption then the interest rate falls and firms are able to borrow more to invest in the means to supply that future consumption. And when people begin drawing down their savings to fund current consumption the interest rate rises and firms cut back on investing for future consumption.
The key insight is that the interest rate is a real phenomenon. As the Austrian School economist Eugen von Böhm-Bawerk put it, it reflects the ‘time preference’ of economic agents, the value they place on consumption of something now compared to the value they place on consumption of the same thing at some given point in the future. The interest rate reflects the compensation/incentive for abstinence on the part of the saver.
But in the real world we have central banks. In response to something like the bursting of the dot com bubble the Federal Reserve can lower interest rates, as it did in that instance, from 6.25% to 1.75% over the course of 2001.
However, the interest rate is not falling because of increased saving (or decreasing time preference), rather it is being forced down artificially by the expansion of credit; the creation of phony capital in other words.
As interest rates fall firms see ever more marginal investment opportunities becoming profitable. They borrow and undertake them. A boom is underway.
But eventually the inflation caused by this credit expansion starts to show even in the central bank’s cooked figures as when inflation went above 4% in the US in 2006. Interest rates are raised; the Fed Funds rate went above 5% the same year. Those marginal investments that looked viable at 1% are now scuppered.
This is the bust. All the enterprises undertaken in the expectation of catering for the demand for future consumption indicated by low interest rates discover that there is, in fact, no such demand. There never was. They are revealed as ‘malinvestments’, with no hope of ever producing a return above their borrowing costs unless interest rates are kept artificially low and cheap credit is kept flowing.
The recession is not some mysterious collapse in aggregate demand which can be stopped with a dose of government spending. It is the liquidation of these unviable credit positions and it will not be over until this process is complete.
The Austrian School economist Ludwig von Mises wrote
There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved
This is the Austrian choice; recognize the liquidation and allow zombie banks to collapse and stop soaking up scarce capital so we can get the recovery going or keep putting it off with more monetary and fiscal stimulus. And, as another Austrian Schooler, Friedrich von Hayek, warned,
The magnitude of unemployment caused by a cessation of inflation will increase with the length of the period during which such policies are pursued
True, this is a grim prospect, but that matters less than whether it’s correct. Anyone who says there is a third option, a painless way out which can be found simply by ticking a different box on a ballot paper, truly is peddling snake oil.
Two weeks ago in the Budget debate, I set out how “monetary activism”, which is one of the pillars of the Government’s strategy, could go wrong:
Steve Baker (Wycombe) (Con): I refer the House to my interest in Cobden Partners.
This is a Budget of fiscal conservatism and monetary activism. It is a Budget, above all, of economic expectations, setting out to people that we will reward work, support families, help those looking for work, back business and back aspiration. In the short time available to me, I would like to speak directly to the point of monetary activism, which is one of the Budget’s key pillars. I hope the Government will not take it as a criticism, because the Chancellor has emphasised that the Bank of England is independent and, of course, its policies are symptomatic of those followed all around the world.
Over the past 13 years under new Labour, the money supply expanded from about £700 billion in 1997 to £2.2 trillion in 2010. That was through a massive expansion of bank balance sheets—a huge amount of monetary activism led by central banks, with the Bank of England keeping interest rates too low for too long. That goes to the heart of points that Opposition Members have made. It has redistributed wealth towards the south-east and the first recipients of new money. I would say that it is at the heart of our difficulties. The scatter chart in the Red Book shows how the balance between our fiscal position and the bank balance sheet position is interlinked, and has placed us as an outlier.
When many people look at monetary activism, and quantitative easing in particular, they get worried about inflation—and why not? It would, however, be hysterical to worry about hyperinflation at this stage, when the asset purchase facility is at £325 billion—just one seventh of the money supply. I would nevertheless like to sketch out something that troubles me in my darker moments.
Right now, there is not a problem, but a housing bubble became a banking crisis—at least not a problem of inflation—which became a sovereign debt crisis, which has now been turned into an asset bubble in the bond market. The Bank of England has deliberately inflated bond prices in order to suppress long-term interest rates—interest rates that our constituents cannot do without because they are so indebted. The problem is that, as we know, all bubbles burst; the questions are when and what might burst the bond bubble. Inflation expectations might do it. If we were to look at M4 and M4ex from the Bank of England, there is no reason to doubt its inflation forecast. If we look at my preferred measure of the money supply, however, which is Kaleidic Economics MA, we can see that from July last year, year on year money supply growth was minus 2%; today, money supply is growing by that measure at plus 6%. We should thus be very cautious indeed about the Bank’s forecasts.
If the bond market bubble bursts, there will be pressure on the Bank of England to continue to prop it up. That will lead to further quantitative easing and create an expectation of rising interest rates. That could cause a flight from the bond market into cash; and it could cause the public, as they see QE continuing, to lose faith in cash itself, which could lead them to start spending.
Karl McCartney (Lincoln) (Con): Will my hon. Friend give us an idea of when he thinks this bubble might burst—in the near or the distant future?
Steve Baker: I am grateful to my hon. Friend, as this is a critical problem. It is a problem of expectations; it about the human mind, which is extremely difficult to predict.
I was saying that, as we go through, we could find that people lose faith in cash. If they do that, they will spend it, and move into real value. Keynesians could end up celebrating an apparent boom, but actually one that is a crack-up of the currency. I sketch these events not to frighten, but to set out a perspective for the House of which we should be aware when we know that the central banks and the Bank of England have deliberately inflated this bond market bubble.
We could end up facing a choice: if prices and wages are accelerating, but less quickly than the money supply, the Bank of England will have to choose whether to supply more money or whether to abandon that monetary inflation and reveal the underlying havoc created by decades of inflationary money. Perhaps new money, instead of real resources, can be used to paper over the cracks. Perhaps expectations can be managed to avoid the bubble bursting. If I were to quote with just a little adaptation something that Hayek wrote in 1932, I would say: “We must not forget that for the last 86 or 88 years, monetary policy all over the world has followed the advice of the monetary activists. It is high time that their influence, which has already done harm enough, should be overthrown.”
The quote at the end is derived from the 1932 Preface to Hayek’s Monetary Theory and the Trade Cycle, which is available in this collection (PDF). The truth is that little really new is happening in the world. The same bad ideas about monetary stabilisation which turned a correction into the Great Depression are still at the core of mainstream economics, thanks to the persuasive intellectual errors of Keynes and others. In 1932, Hayek wrote:
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.
The five-page Preface is well worth a read for an insight into how little is really new in the world. It’s true that finance and financial theory are more sophisticated now, but the fundamental laws of cooperation in society are unchanging. What changes, is how we understand them and how, Canute-like, we try to escape the consequences of our actions with ever greater interventions by authority. It’s not a healthy trajectory.
Thankfully, these ideas are becoming increasingly mainstream. Just after I spoke, the BBC Radio 4 programme Analysis transmitted What is money? featuring my colleague Gordon Kerr. Given Detlev Schlichter‘s recent appearance on Start the Week and a range of other Cobden Centre media successes, I am increasingly optimistic that we may shift the terrain of the debate on the financial crisis and, eventually, deliver reforms capable of supporting sustainable prosperity.
- Hayek, Prices and Production and Other Works (Kindle, PDF)
- Mises, The Causes of the Economic Crisis: And Other Essays Before and After the Great Depression (Kindle, PDF)
- Rothbard, The Mystery of Banking (hardcover, Kindle, PDF), especially pp66-74, which sets out how inflationary expectations can lead to hyperinflation.
- Schlichter, Paper Money Collapse: The Folly of Elastic Money and the Coming Monetary Breakdown (hardcover, Kindle)
- And the Cobden Centre Primer
This article was previously published at stevebaker.info