This has been copied from Money, Bank Credit, and Economic Cycles which can be downloaded here or bought here.
PREFACE TO THE SECOND ENGLISH EDITION
I am happy to present the second English edition of Money, Bank Credit, and Economic Cycles. Its appearance is particularly timely, given that the severe financial crisis and resulting worldwide economic recession I have been forecasting, since the first edition of this book came out ten years ago, are now unleashing their fury.
The policy of artificial credit expansion central banks have permitted and orchestrated over the last fifteen years could not have ended in any other way. The expansionary cycle which has now come to a close began gathering momentum when the American economy emerged from its last recession (fleeting and repressed though it was) in 2001 and the Federal Reserve reembarked on the major artificial expansion of credit and investment initiated in 1992. This credit expansion was not backed by a parallel increase in voluntary household saving. For many years, the money supply in the form of bank notes and deposits has grown at an average rate of over 10 percent per year (which means that every seven years the total volume of money circulating in the world has doubled). The media of exchange originating from this severe fiduciary inflation have been placed on the market by the banking system as newly created loans granted at very low (and even negative in real terms) interest rates. The above fueled a speculative bubble in the shape of a substantial rise in the prices of capital goods, real-estate assets and the securities which represent them, and are exchanged on the stock market, where indexes soared.
Curiously, like in the “roaring” years prior to the Great Depression of 1929, the shock of monetary growth has not significantly influenced the prices of the subset of consumer goods and services (approximately only one third of all goods). The last decade, like the 1920s, has seen a remarkable increase in productivity as a result of the introduction on a massive scale of new technologies and significant entrepreneurial innovations which, were it not for the injection of money and credit, would have given rise to a healthy and sustained reduction in the unit price of consumer goods and services. Moreover, the full incorporation of the economies of China and India into the globalized market has boosted the real productivity of consumer goods and services even further. The absence of a healthy “deflation” in the prices of consumer goods in a stage of such considerable growth in productivity as that of recent years provides the main evidence that the monetary shock has seriously disturbed the economic process. I analyze this phenomenon in detail in chapter 6, section 9.
As I explain in the book, artificial credit expansion and the (fiduciary) inflation of media of exchange offer no short cut to stable and sustained economic development, no way of avoiding the necessary sacrifice and discipline behind all high rates of voluntary saving. (In fact, particularly in the United States, voluntary saving has not only failed to increase in recent years, but at times has even fallen to a negative rate.) Indeed, the artificial expansion of credit and money is never more than a short-term solution, and that at best. In fact, today there is no doubt about the recessionary quality the monetary shock always has in the long run: newly-created loans (of money citizens have not first saved) immediately provide entrepreneurs with purchasing power they use in overly ambitious investment projects (in recent years, especially in the building sector and real estate development). In other words, entrepreneurs act as if citizens had increased their saving, when they have not actually done so. Widespread discoordination in the economic system exerts a harmful effect on the real economy, and sooner or later the process reverses in the form of an economic recession, which marks the beginning of the painful and necessary readjustment. This readjustment invariably requires the reconversion of every real productive structure inflation has distorted. The specific triggers of the end of the euphoric monetary “binge” and the beginning of the recessionary “hangover” are many, and they can vary from one cycle to another. In the current circumstances, the most obvious triggers have been the rise in the price of raw materials, particularly oil, the subprime mortgage crisis in the United States, and finally, the failure of important banking institutions when it became clear in the market that the value of their liabilities exceeded that of their assets (mortgage loans granted).
At present, numerous self-interested voices are demanding further reductions in interest rates and new injections of money which permit those who desire it to complete their investment projects without suffering losses. Nevertheless, this escape forward would only temporarily postpone problems at the cost of making them far more serious later. The crisis has hit because the profits of capital-goods companies (especially in the building sector and in real-estate development) have disappeared due to the entrepreneurial errors provoked by cheap credit, and because the prices of consumer goods have begun to perform relatively less poorly than those of capital goods. At this point, a painful, inevitable readjustment begins, and in addition to a decrease in production and an increase in unemployment, we are now still seeing a harmful rise in the prices of consumer goods (stagflation).
The most rigorous economic analysis and the coolest, most balanced interpretation of recent economic and financial events support the conclusion that central banks (which are true financial central-planning agencies) cannot possibly succeed in finding the most advantageous monetary policy at every moment. This is exactly what became clear in the case of the failed attempts to plan the former Soviet economy from above. To put it another way, the theorem of the economic impossibility of socialism, which the Austrian economists Ludwig von Mises and Friedrich A. Hayek discovered, is fully applicable to central banks in general, and to the Federal Reserve—(at one time) Alan Greenspan and (currently) Ben Bernanke—in particular. According to this theorem, it is impossible to organize society, in terms of economics, based on coercive commands issued by a planning agency, since such a body can never obtain the information it needs to infuse its commands with a coordinating nature. Indeed, nothing is more dangerous than to indulge in the “fatal conceit”—to use Hayek’s useful expression—of believing oneself omniscient or at least wise and powerful enough to be able to keep the most suitable monetary policy fine tuned at all times. Hence, rather than soften the most violent ups and downs of the economic cycle, the Federal Reserve and, to some lesser extent, the European Central Bank, have most likely been their main architects and the culprits in their worsening. Therefore, the dilemma facing Ben Bernanke and his Federal Reserve Board, as well as the other central banks (beginning with the European Central Bank), is not at all comfortable. For years they have shirked their monetary responsibility, and now they find themselves in a blind alley. They can either allow the recessionary process to begin now, and with it the healthy and painful readjustment, or they can escape forward toward a “hair of the dog” cure. With the latter, the chances of even more severe stagflation in the not-too-distant future increase exponentially. (This was precisely the error committed following the stock market crash of 1987, an error which led to the inflation at the end of the 1980s and concluded with the sharp recession of 1990–1992.) Furthermore, the reintroduction of a cheap-credit policy at this stage could only hinder the necessary liquidation of unprofitable investments and company reconversion. It could even wind up prolonging the recession indefinitely, as has occurred in Japan in recent years: though all possible interventions have been tried, the Japanese economy has ceased to respond to any monetarist stimulus involving credit expansion or Keynesian methods. It is in this context of “financial schizophrenia” that we must interpret the latest “shots in the dark” fired by the monetary authorities (who have two totally contradictory responsibilities: both to control inflation and to inject all the liquidity necessary into the financial system to prevent its collapse). Thus, one day the Federal Reserve rescues Bear Stearns, AIG, Fannie Mae, and Freddie Mac or Citigroup, and the next it allows Lehman Brothers to fail, under the amply justified pretext of “teaching a lesson” and refusing to fuel moral hazard. Then, in light of the way events were unfolding, a 700-billion-dollar plan to purchase the euphemistically named “toxic” or “illiquid” (i.e., worthless) assets from the banking system was approved. If the plan is financed by taxes (and not more inflation), it will mean a heavy tax burden on households, precisely when they are least able to bear it. Finally, in view of doubts about whether such a plan could have any effect, the choice was made to inject public money directly into banks, and even to “guarantee” the total amount of their deposits, decreasing interest rates to almost zero percent.
In comparison, the economies of the European Union are in a somewhat less poor state (if we do not consider the expansionary effect of the policy of deliberately depreciating the dollar, and the relatively greater European rigidities, particularly in the labor market, which tend to make recessions in Europe longer and more painful). The expansionary policy of the European Central Bank, though not free of grave errors, has been somewhat less irresponsible than that of the Federal Reserve. Furthermore, fulfillment of the convergence criteria involved at the time a healthy and significant rehabilitation of the chief European economies. Only the countries on the periphery, like Ireland and particularly Spain, were immersed in considerable credit expansion from the time they initiated their processes of convergence. The case of Spain is paradigmatic. The Spanish economy underwent an economic boom which, in part, was due to real causes (liberalizing structural reforms which originated with José María Aznar’s administration in 1996). Nevertheless, the boom was also largely fueled by an artificial expansion of money and credit, which grew at a rate nearly three times that of the corresponding rates in France and Germany. Spanish economic agents essentially interpreted the decrease in interest rates which resulted from the convergence process in the easy-money terms traditional in Spain: a greater availability of easy money and mass requests for loans from Spanish banks (mainly to finance real estate speculation), loans which these banks have granted by creating the money ex nihilo while European central bankers looked on unperturbed. When faced with the rise in prices, the European Central Bank has remained faithful to its mandate and has tried to maintain interest rates as long as possible, despite the difficulties of those members of the Monetary Union which, like Spain, are now discovering that much of their investment in real estate was in error and are heading for a lengthy and painful reorganization of their real economy.
Under these circumstances, the most appropriate policy would be to liberalize the economy at all levels (especially in the labor market) to permit the rapid reallocation of productive factors (particularly labor) to profitable sectors. Likewise, it is essential to reduce public spending and taxes, in order to increase the available income of heavily-indebted economic agents who need to repay their loans as soon as possible. Economic agents in general and companies in particular can only rehabilitate their finances by cutting costs (especially labor costs) and paying off loans. Essential to this aim are a very flexible labor market and a much more austere public sector. These factors are fundamental if the market is to reveal as quickly as possible the real value of the investment goods produced in error and thus lay the foundation for a healthy, sustained economic recovery in a future which, for the good of all, I hope is not long in coming.
We must not forget that a central feature of the recent period of artificial expansion was a gradual corruption, on the American continent as well as in Europe, of the traditional principles of accounting as practiced globally for centuries. To be specific, acceptance of the International Accounting Standards (IAS) and their incorporation into law in different countries (in Spain via the new General Accounting Plan, in effect as of January 1, 2008) have meant the abandonment of the traditional principle of prudence and its replacement by the principle of fair value in the assessment of the value of balance sheet assets, particularly financial assets. In this abandonment of the traditional principle of prudence, a highly influential role has been played by brokerages, investment banks (which are now on their way to extinction), and in general, all parties interested in “inflating” book values in order to bring them closer to supposedly more “objective” stockmarket values, which in the past rose continually in an economic process of financial euphoria. In fact, during the years of the “speculative bubble,” this process was characterized by a feedback loop: rising stock-market values were immediately entered into the books, and then such accounting entries were sought as justification for further artificial increases in the prices of financial assets listed on the stock market.
In this wild race to abandon traditional accounting principles and replace them with others more “in line with the times,” it became common to evaluate companies based on unorthodox suppositions and purely subjective criteria which in the new standards replace the only truly objective criterion (that of historical cost). Now, the collapse of financial markets and economic agents’ widespread loss of faith in banks and their accounting practices have revealed the serious error involved in yielding to the IAS and their abandonment of traditional accounting principles based on prudence, the error of indulging in the vices of creative, fair-value accounting.
It is in this context that we must view the recent measures taken in the United States and the European Union to “soften” (i.e., to partially reverse) the impact of fair-value accounting for financial institutions. This is a step in the right direction, but it falls short and is taken for the wrong reasons. Indeed, those in charge at financial institutions are attempting to “shut the barn door when the horse is bolting”; that is, when the dramatic fall in the value of “toxic” or “illiquid” assets has endangered the solvency of their institutions. However, these people were delighted with the new IAS during the preceding years of “irrational exuberance,” in which increasing and excessive values in the stock and financial markets graced their balance sheets with staggering figures corresponding to their own profits and net worth, figures which in turn encouraged them to run risks (or better, uncertainties) with practically no thought of danger. Hence, we see that the IAS act in a pro-cyclic manner by heightening volatility and erroneously biasing business management: in times of prosperity, they create a false “wealth effect” which prompts people to take disproportionate risks; when, from one day to the next, the errors committed come to light, the loss in the value of assets immediately decapitalizes companies, which are obliged to sell assets and attempt to recapitalize at the worst moment, i.e., when assets are worth the least and financial markets dry up. Clearly, accounting principles which, like those of the IAS, have proven so disturbing must be abandoned as soon as possible, and all of the accounting reforms recently enacted, specifically the Spanish one, which came into effect January 1, 2008, must be reversed. This is so not only because these reforms mean a dead end in a period of financial crisis and recession, but especially because it is vital that in periods of prosperity we stick to the principle of prudence in valuation, a principle which has shaped all accounting systems from the time of Luca Pacioli at the beginning of the fifteenth century to the adoption of the false idol of the IAS.
In short, the greatest error of the accounting reform recently introduced worldwide is that it scraps centuries of accounting experience and business management when it replaces the prudence principle, as the highest ranking among all traditional accounting principles, with the “fair value” principle, which is simply the introduction of the volatile market value for an entire set of assets, particularly financial assets. This Copernican turn is extremely harmful and threatens the very foundations of the market economy for several reasons. First, to violate the traditional principle of prudence and require that accounting entries reflect market values is to provoke, depending upon the conditions of the economic cycle, an inflation of book values with surpluses which have not materialized and which, in many cases, may never materialize. The artificial “wealth effect” this can produce, especially during the boom phase of each economic cycle, leads to the allocation of paper (or merely temporary) profits, the acceptance of disproportionate risks, and in short, the commission of systematic entrepreneurial errors and the consumption of the nation’s capital, to the detriment of its healthy productive structure and its capacity for long-term growth. Second, I must emphasize that the purpose of accounting is not to reflect supposed “real” values (which in any case are subjective and which are determined and vary daily in the corresponding markets) under the pretext of attaining a (poorly understood) “accounting transparency.” Instead, the purpose of accounting is to permit the prudent management of each company and to prevent capital consumption , by applying strict standards of accounting conservatism (based on the prudence principle and the recording of either historical cost or market value, whichever is less), standards which ensure at all times that distributable profits come from a safe surplus which can be distributed without in any way endangering the future viability and capitalization of the company. Third, we must bear in mind that in the market there are no equilibrium prices a third party can objectively determine. Quite the opposite is true; market values arise from subjective assessments and fluctuate sharply, and hence their use in accounting eliminates much of the clarity, certainty, and information balance sheets contained in the past. Today, balance sheets have become largely unintelligible and useless to economic agents. Furthermore, the volatility inherent in market values, particularly over the economic cycle, robs accounting based on the “new principles” of much of its potential as a guide for action for company managers and leads them to systematically commit major errors in management, errors which have been on the verge of provoking the severest financial crisis to ravage the world since 1929.
In chapter 9 of this book (pages 789–803), I design a process of transition toward the only world financial order which, being fully compatible with the free-enterprise system, can eliminate the financial crises and economic recessions which cyclically affect the world’s economies. The proposal the book contains for international financial reform has acquired extreme relevance at the present time (November 2008), in which the disconcerted governments of Europe and America have organized a world conference to reform the international monetary system in order to avoid in the future such severe financial and banking crises as the one that currently grips the entire western world. As is explained in detail over the nine chapters of this book, any future reform will fail as miserably as past reforms unless it strikes at the very root of the present problems and rests on the following principles:
- the reestablishment of a 100-percent reserve requirement on all bank demand deposits and equivalents;
- the elimination of central banks as lenders of last resort (which will be unnecessary if the preceding principle is applied, and harmful if they continue to act as financial central-planning agencies); and
- the privatization of the current, monopolistic, and fiduciary state-issued money and its replacement with a classic pure gold standard.
This radical, definitive reform would essentially mark the culmination of the 1989 fall of the Berlin Wall and real socialism, since the reform would mean the application of the same principles of liberalization and private property to the only sphere, that of finance and banking, which has until now remained mired in central planning (by “central” banks), extreme interventionism (the fixing of interest rates, the tangled web of government regulations), and state monopoly (legal tender laws which require the acceptance of the current, state-issued fiduciary money), circumstances with very negative and dramatic consequences, as we have seen.
I should point out that the transition process designed in the last chapter of this book could also permit from the outset the bailing out of the current banking system, thus preventing its rapid collapse, and with it the sudden monetary squeeze which would be inevitable if, in an environment of widespread broken trust among depositors, a significant volume of bank deposits were to disappear. This short-term goal, which at present, western governments are desperately striving for with the most varied plans (the massive purchases of “toxic” bank assets, the ad hominem guarantee of all deposits, or simply the partial or total nationalization of the private banking system), could be reached much faster and more effectively, and in a manner much less harmful to the market economy, if the first step in the proposed reform (pages 791–98) were immediately taken: to back the total amount of current bank deposits (demand deposits and equivalents) with cash, bills to be turned over to banks, which from then on would maintain a 100-percent reserve with respect to deposits. As illustrated in chart IX-2 of chapter 9, which shows the consolidated balance sheet for the banking system following this step, the issuance of these banknotes would in no way be inflationary (since the new money would be “sterilized,” so to speak, by its purpose as backing to satisfy any sudden deposit withdrawals). Furthermore, this step would free up all banking assets (“toxic” or not) which currently appear as backing for demand deposits (and equivalents) on the balance sheets of private banks. On the assumption that the transition to the new financial system would take place under “normal” circumstances, and not in the midst of a financial crisis as acute as the current one, I proposed in chapter 9 that the “freed” assets be transferred to a set of mutual funds created ad hoc and managed by the banking system, and that the shares in these funds be exchanged for outstanding treasury bonds and for the implicit liabilities connected with the public social-security system (pp. 796–97). Nevertheless, in the current climate of severe financial and economic crisis, we have another alternative: apart from canceling “toxic” assets with these funds, we could devote a portion of the rest, if desired, to enabling savers (not depositors, since their deposits would already be backed 100 percent) to recover a large part of the value lost in their investments (particularly in loans to commercial banks, investment banks, and holding companies). These measures would immediately restore confidence and would leave a significant remainder to be exchanged, once and for all and at no cost, for a sizeable portion of the national debt, our initial aim. In any case, an important warning must be given: naturally, and I must never tire of repeating it, the solution proposed is only valid in the context of an irrevocable decision to reestablish a free-banking system subject to a 100-percent reserve requirement on demand deposits. Any of the reforms noted above, if adopted in the absence of a prior, firm conviction and decision to change the international financial and banking system as indicated, would be simply disastrous: a private banking system which continued to operate with a fractional reserve (orchestrated by the corresponding central banks), would generate, in a cascading effect, and based on the cash created to back deposits, an inflationary expansion like none other in history, one which would eventually finish off our entire economic system.
The above considerations are crucially important and reveal how very relevant this treatise has now become in light of the critical state of the international financial system (though I would definitely have preferred to write the preface to this new edition under very different economic circumstances). Nevertheless, while it is tragic that we have arrived at the current situation, it is even more tragic, if possible, that there exists a widespread lack of understanding regarding the causes of the phenomena that plague us, and especially an atmosphere of confusion and uncertainty prevalent among experts, analysts, and most economic theorists. In this area at least, I can hope the successive editions of this book which are being published all over the world  may contribute to the theoretical training of readers, to the intellectual rearmament of new generations, and eventually, to the sorely needed institutional redesign of the entire monetary and financial system of current market economies. If this hope is fulfilled, I will not only view the effort made as worthwhile, but will also deem it a great honor to have contributed, even in a very small way, to movement in the right direction.
Jesús Huerta de Soto
November 13, 2008
 See especially F. A. Hayek, “The Maintenance of Capital,” Economica 2 (August 1934), reprinted in Profits, Interest and Investment and Other Essays on the Theory of Industrial Fluctuations(Clifton, N.J.: Augustus M. Kelley, 1979; first edition London: George Routledge & Sons, 1939). See especially section 9, “Capital Accounting and Monetary Policy,” pp. 130–32.
 Since the appearance of the first English-language edition, the third and
fourth Spanish editions have been published in 2006 and 2009. Moreover,
Tatjana Danilova and Grigory Sapov have completed a Russian translation, which has been published as Dengi, Bankovskiy Kredit i Ekonomicheskie Tsikly (Moscow: Sotsium Publishing House, 2008). Three thousand copies have been printed initially, and I had the satisfaction of presenting the book Octo- ber 30, 2008 at the Higher School of Economics at Moscow State University. In addition, Professor Rosine Létinier has produced the French translation, which is now pending publication. Grzegorz Luczkiewicz has completed the Polish translation, and translation into the following languages is at an advanced stage: German, Czech, Italian, Romanian, Dutch, Chinese, Japan- ese, and Arabic. God willing, may they soon be published.
We are indebted to Ewen Stewart of Arden Partners for permission to publish his report: A Game of Two Halves – Equities to Win. Please see that report for full detail.
2009 was a remarkable year for the global economy and a remarkable year for equities. In this note we try to explain why 2009 turned out as it did and examine the prospects for 2010 and beyond.
We have called this note ‘A Game of Two Halves – Equities to Win’ because we believe that although the short-term trends for the UK economy are improving the longer-term forecast looks troubled indeed. Despite this, we believe the outlook for UK equities remains positive.
The first few months of 2010 may well surprise on the upside in terms of employment, house prices, consumer-spend and even, ultimately, GDP. But this is no ‘V’ shaped recovery.
We argue that trend growth, longer term, is likely to significantly disappoint. We argue that the UK’s superior growth, relative to many other developed nations, in the noughties was largely an illusion and we struggle to find the dynamo for growth over the next few years. We believe that the unwinding of the extraordinary fiscal and monetary stimulus, is a necessity, but will also be very difficult to achieve painlessly.
We believe the markets are still underestimating the structural problems with the public sector deficit and that politicians of all colours will be forced to deal with it. The consequences of not doing so would result in rising interest rates and a collapse in international confidence. The deficit remains the key issue for the UK and it may well bring substantial political challenges in itself. Indeed perhaps we should not have called this ‘A Game of Two Halves’ but a ‘Back to the Future – Welcome Mr Heath and the 1970s’?
Despite this, we are not bears of equities. It is true that current valuations are not particularly cheap by historic standards but the UK stock market is fairly defensive and internationally diverse. We believe equities look attractive against cash, bonds and, ultimately, real estate. We are concerned about a potential rise in inflation and again equities are a good hedge.
We have set a year end target of 5750 for the FTSE 100. Sector valuations do not follow a clear pattern and we believe this offers a number of anomalies. We have outlined our suggested sector weights below. As a generalisation, we seek overseas earnings – especially the US$, moderate leverage and strong cash flow as the place to be in 2010 with a return to M&A being more pronounced than perhaps expected.
The extreme cannot become the norm?
It may be a blessing that Ben Bernanke made the study of the 1930s great depression his speciality. We say may because, while the unprecedented global response undoubtedly has alleviated economic implosion, it does remain to be seen if the ‘nationalisation’ of deficits, the eclipse of moral hazard and the unique policy of both near-zero global interest rates and, in many parts of the globe, with quantitative easing (QE), has succeeded in sending growth back on an inflation-free growth projectory or whether the underlying malaise has been merely kicked into the medium grass. These issues are global, with substantial government deficits, trade and growth imbalances impacting upon different regions.
Source: Bank of England Stability Report, December 2009.
The economic policy reaction in the UK has been greater and more prolonged than any G20 nation, which is partially demonstrated by the chart above. The Bank of England cut interest rates to 0.5% (the lowest since the foundation of the Bank in 1694); 2009 saw a programme of QE to the tune of £200bn (equivalent to 25% of all outstanding gilt stock) and government spending was accelerated, despite plummeting tax receipts. The fiscal deficit is forecast by the Treasury to peak at 12.6% of GDP – a figure roughly twice as large as the UK’s 1975-1977 IMF crisis, and on a par with Greece.
Read on: A Game of Two Halves – Equities to Win
By way of nakedcapitalism.com this excellent article from washingtonsblog.com on “Fictional Reserve Banking”:
But whatever you think about fractional reserve banking, whether or not you agree with its critics, the truth is that we no longer have it.
As the above-linked NY Fed article notes:
In practice, the connection between reserve requirements and money creation is not nearly as strong as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels.
And as Steve Keen notes – citing Table 10 in Yueh-Yun C. OBrien, 2007. “Reserve Requirement Systems in OECD Countries”, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, 2007-54, Washington, D.C:
The US Federal Reserve sets a Required Reserve Ratio of 10%, but applies this only to deposits by individuals; banks have no reserve requirement at all for deposits by companies.
So huge swaths of loans are not subject to any reserve requirements.
Welcome to the new financial landscape…
We are grateful to Robert Arbon for pointing out this article on Greg Mankiw’s Blog:
I just returned from the spring meeting of the Brookings Papers on Economic Activity, where I was a discussant for Alan Greenspan’s new paper on “The Crisis,” which has gotten a bit of media attention. I thought blog readers might enjoy reading my comments on the paper. Here they are:
This is a great paper. It presents one of the best comprehensive narratives about what went wrong over the past several years that I have read. If you want to assign your students only one paper to read about the recent financial crisis, this would be a good choice.
There are, however, particular pieces of the analysis about which I am skeptical. But before I get to that, let me begin by emphasizing several important points of agreement.
To begin with, Alan refers to recent events in the housing market as a “classic euphoric bubble.” He is certainly right that asset markets can depart from apparent fundamentals in ways that are often hard to understand. This has happened before, and it will happen again. When the bubble bursts, the aftershocks are never pleasant.
This post is excerpted from Mises’ “The Causes of the Economic Crisis and Other Essays Before and After the Great Depression” which is available to buy here and download here. Both Andreas Acavalos and Toby Baxendale supported the production of this book.
On covering government deficits by creating new money (pp 2-3):
If the practice persists of covering government deficits with the issue of notes, then the day will come without fail, sooner or later, when the monetary systems of those nations pursuing this course will break down completely. The purchasing power of the monetary unit will decline more and more, until finally it disappears completely. To be sure, one could conceive of the possibility that the process of monetary depreciation could go on forever. The purchasing power of the monetary unit could become increasingly smaller without ever disappearing entirely. Prices would then rise more and more. It would still continue to be possible to exchange notes for commodities. Finally, the situation would reach such a state that people would be operating with billions and trillions and then even higher sums for small transactions. The monetary system would still continue to function. However, this prospect scarcely resembles reality.
On credit expansion by banks, its effects on the economy and the ensuing crisis (pp 113-115):
The crisis breaks out only when the banks alter their conduct to the extent that they discontinue issuing any more new fiduciary media and stop undercutting the “natural interest rate.” They may even take steps to restrict circulation credit. When they actually do this, and why, is still to be examined. First of all, however, we must ask ourselves whether it is possible for the banks to stay on the course upon which they have embarked, permitting new quantities of fiduciary media to flow into circulation continuously and proceeding always to make loans below the rate of interest which would prevail on the market in the absence of their interference with newly created fiduciary media.
If the banks could proceed in this manner, with businesses improving continually, could they then provide for lasting good times? Would they then be able to make the boom eternal?
They cannot do this. The reason they cannot is that inflationism carried on ad infinitum is not a workable policy. If the issue of fiduciary media is expanded continuously, prices rise ever higher and at the same time the positive price premium also rises. (We shall disregard the fact that consideration for (1) the continually declining monetary reserves relative to fiduciary media and (2) the banks’ operating costs must sooner or later compel them to discontinue the further expansion of circulation credit.) It is precisely because, and only because, no end to the prolonged “flood” of expanding fiduciary media is foreseen, that it leads to still sharper price increases and, finally, to a panic in which prices and the loan rate move erratically upward.
Suppose the banks still did not want to give up the race? Suppose, in order to depress the loan rate, they wanted to satisfy the continuously expanding desire for credit by issuing still more circulation credit? Then they would only hasten the end, the collapse of the entire system of fiduciary media. The inflation can continue only so long as the conviction persists that it will one day cease. Once people are persuaded that the inflation will not stop, they turn from the use of this money. They flee then to “real values,” foreign money, the precious metals, and barter.
Sooner or later, the crisis must inevitably break out as the result of a change in the conduct of the banks. The later the crack-up comes, the longer the period in which the calculation of the entrepreneurs is misguided by the issue of additional fiduciary media. The greater this additional quantity of fiduciary money, the more factors of production have been firmly committed in the form of investments which appeared profitable only because of the artificially reduced interest rate and which prove to be unprofitable now that the interest rate has again been raised.
Great losses are sustained as a result of misdirected capital investments. Many new structures remain unfinished. Others, already completed, close down operations. Still others are carried on because, after writing off losses which represent a waste of capital, operation of the existing structure pays at least something.
The crisis, with its unique characteristics, is followed by stagnation. The misguided enterprises and businesses of the boom period are already liquidated. Bankruptcy and adjustment have cleared up the situation. The banks have become cautious. They fight shy of expanding circulation credit. They are not inclined to give an ear to credit applications from schemers and promoters. Not only is the artificial stimulus to business, through the expansion of circulation credit, lacking, but even businesses which would be feasible, considering the capital goods available, are not attempted because the general feeling of discouragement makes every innovation appear doubtful. Prevailing “money interest rates” fall below the “natural interest rates.”
When the crisis breaks out, loan rates bound sharply upward because threatened enterprises offer extremely high interest rates for the funds to acquire the resources, with the help of which they hope to save themselves. Later, as the panic subsides, a situation develops, as a result of the restriction of circulation credit and attempts to dispose of large inventories, causing prices [and the “money interest rate”] to fall steadily and leading to the appearance of a negative price premium. This reduced rate of loan interest is adhered to for some time, even after the decline in prices comes to a standstill, when a negative price premium no longer corresponds to conditions. Thus, it comes about that the “money interest rate” is lower than the “natural rate.” Yet, because the unfortunate experiences of the recent crisis have made everyone uneasy, the incentive to business activity is not as strong as circumstances would otherwise warrant. Quite a time passes before capital funds, increased once again by savings accumulated in the meantime, exert sufficient pressure on the loan interest rate for an expansion of entrepreneurial activity to resume. With this development, the low point is passed and the new boom begins.
Via James Tyler and zero hedge, The Fastest Growing Export of the Western Banking Industry is Fraud:
Politicians and bankers would do well to head the more than 200-year old words of Patrick Henry in his infamous “Give me liberty of give me death” speech:
“Mr. President, it is natural to man to indulge in the illusions of hope. We are apt to shut our eyes against a painful truth, and listen to the song of that siren till she transforms us into beasts. Is this the part of wise men, engaged in a great and arduous struggle for liberty? Are we disposed to be of the number of those who, having eyes, see not, and, having ears, hear not, the things which so nearly concern their temporal salvation? For my part, whatever anguish of spirit it may cost, I am willing to know the whole truth; to know the worst, and to provide for it.”
Today, if politicians and bankers merely channeled the same amount of energy that they expend in deceiving the people into fixing the monetary system, then perhaps they would have already come up with a viable solution by now. To have the slightest fighting chance of resolving this crisis with a solution that benefits the people, politicians and bankers must be courageous enough to tell the public the worst of the truth and to provide for it. But fraud, and perpetuation of an illusion seems to be their only concern today. And with good reason. After all, as illustrated by a recent Center on Budget and Policy Priorities study, they are the only ones benefiting from this fraud. From 2002 to 2007, the top 1% of Americans captured nearly 70% of the income gains in America. Today, in my opinion, today, the number one reason why the vast majority of people still cannot except the possibility that we will soon enter into a second phase of this global economic crisis that will prove to be far worse than the financial disruptions we experienced in 2008 is the following: Most people alive today have no memory of the Great Depression. For those that do, certainly they are able to identify with much greater clarity, the similarities in the patterns of fraud back then and the patterns of fraud occurring today.
A bank , building society that uses factional reserves, lends long and pays out short is only going to exist should confidence be kept in it. The “Run on the Rock” in the summer of 2007 saw people queuing to get their cash out of the Northern Rock which resulted in the first systematic run on a bank since the 1866 run on the Overend, Gurney & Company bank in the UK.
Readers of this site will know that a bank can only exist with the legal and accounting privilege that allows them to use current creditors – i.e. the depositors of the Presbyterian Mutual Society (PMS) – to lend out a multiple number of times to property loans and other entrepreneurial loans. Readers will also know that when they deposit money they in effect lend it to the bank and become a creditor to the bank. A deposit of cash into a bank/Mutual means you as the depositee lend money to the bank/Mutual That is, to be very clear, when you deposit, you cease to own the money – the bank does. This was established by law in 1811 in Carr V Carr and reaffirmed in Foley V Hill 1846.
The Society’s audited accounts for the year ended 31st March 2008 showed £305m of loans and £5m of liquid assets to pay up to £310m on demand deposits. So one can deduce that there was only £5m of cash supporting £310m IOUs to its creditors, the depositors. This means that the PMS multiplied its credit creation to the tune of 62 times! This is nearly twice the average of all the banks licensed by the Bank of England. In fairness to the Society, they did pay out £21m before they were left with only £5m of cash, so £26m of cash was in their vaults when the run happened. Thus a more conservative 12 x credit was created out of thin air or a leverage ratio of 1 part cash to 12 parts credit existed in this Society.
A quick refresher on how the banking system allows this creation of credit out of thin air can be found here http://www.cobdencentre.org/2010/02/a-day-of-reckoning/ where I say, “ It is often forgotten but when you place £1m in a savings account (in cash) in say the Royal Bank of Scotland, which has no legal reserve requirement, they then lend £970k (in credit) , keeping on average 3% of cash back in reserves, to an entrepreneur in say HSBC, who then deposits that money in HSBC. We now have one claim to the original £1m and one claim to the £970k. The money supply has moved from £1m to £1.97m – just like magic! This is credit expansion.
The reality is that across all the banks in the United Kingdom licensed by the Bank of England, we have for every £1 of money (in cash), £34 in claims to money (credit)!”
The Administrators’ report tells the sorry story of events in summary which I list underneath, but one glaring fact is omitted. This is that the very Government of the UK actually triggered the loss of confidence in this Bank. When our Prime Minister in his own words was “saving the world” he ordered a full guarantee , government backed, on all deposits. The PMS, which had 10,000 members, went into administration following a rush by savers to withdraw their money at the height of the banking crisis in October 2008. People withdrew their money as they learned the Society was not covered by the government’s bank deposit guarantee scheme. Previously they were content to leave their money in the Society. For the purposes of this article, it is not needed to debate the point: was it or was it not a bank that should have been supported by this guarantee? The salient point being that not being guaranteed scared people into making withdrawals where little existed before.
From the Administrators’ report of the12th January 2009 that can be down loaded here http://www.presbyterianmutualsociety.co.uk/files/Administrator’s%20Proposals%2012.1.09.pdf the Society was placed into Administration by the Directors on 17th November 2008. The following are selected quotes from this report which speak for themselves:
“the demand for withdrawals by members of their investments exceeded its cash reserves;”
“the members’ investments were historically withdrawable on demand but the cash was invested by the Society in longer term investments such as property and loans.”
“For the Society to allow members to withdraw their investments on demand and invest members’ money in longer term investments, the Society required a high degree of confidence among its members that their investments were secure. However this confidence has been severely tested by the current economic climate and eventually the demand by members for withdrawals exceeded the Society’s cash reserves. …I believe it will be difficult for the Society in its current form to continue as a going concern.”
“loan capital will be treated as creditors and will therefore be paid in preference to members’ shares.”
As you will be aware the Society does not benefit from the deposit guarantee scheme.
During the month of October 2008 the Society experienced an unprecedented increase in the number of requests for repayment of members’ investments. It was common practice for the Society to repay investments on receipt of a request, and payments of £21 million were made up to Friday 24th October 2008, leaving £4 million in the Society’s bank account.
An emergency meeting of the Society’s Board of Directors was convened on 25th October 2008 and it was resolved that:
…the 21 day notice period for the repayment of members’ investments be invoked in respect of requests received from members as at that date and any new requests received from members.
On 6th November 2008 the Society’s Board of Directors met again and it was reported that the demand among the Society’s members to withdraw their investments had increased which further exacerbated the Society’s liquidity. It was also reported at this meeting that legal proceedings had been commenced by three members seeking repayment of their investments. It was resolved by the Society’s Board of Directors on 6th November 2008 that the Society should be placed into Administration so that its assets could be protected, subject to enabling legislation being passed to permit the Society to go into administration.
During the period 27th October 2008 to 17th November 2008, the Society had received requests for withdrawals in excess of £50 million but the Society had cash reserves of only £4 million to meet such requests.”
Now this would have been the story of every bank in the UK if the government had not acted as it did as we were ‘panicking’ as a nation. We should also note that all banks are in the same precarious situation as the PMS was with regard to lending long and paying out short still, to this day. Do we need to live like this?
The Future Safe Way to Run Banks and Provide Interest for Savers and Lending to the needs of Trade.
If banks were mandated to hold 100% reserves of cash in their vaults, they could issue their bank statements saying what they owe you each month and you would know that you actually had cash in the vault to support your deposit that is represented by your bank statement. The bank statement after all is only a thing that would more accurately be called a “bank IOU statement.” Should you want interest you could ask for the cash you have deposited to be placed in a highly liquid government bond that could be converted into cash when you need it, paying you a rate of interest. Should you want a higher rate of interest, you can lend your money i.e. cease ownership and place in a bond that has in turn been lent to an entrepreneur for 6 months, 1 year, 2 years, 3 years, 5 years etc with the highest rate of interest being given for the longer term locked away and lent to somebody.
The Solution for Paying Out 100% of the PMS Depositors’ Lost Money- £310m – Now, Today
Following the work of 5 Nobel Prize winners and the founder of the American Chicago School, I would suggest the following written about in the Day of Reckoning article;
The Bank of England immediately issues notes to cover all the deposits i.e. redeem all the depositors for 100% cash notes and coins to be placed in their accounts. Please note, this costs the Bank of England the price of paper and the ink and nothing else and IS NOT INFLATIONARY and generates no liability to the UK taxpayer – see next point.
At the same time, get the administrator of the PMS to delete all current creditors (the depositors) as these have now been redeemed from the bank’s books by the Bank of England. The deleting of these bank obligations means that the money the depositors did lend on deposit to the PSM no longer exists, so for the sake of argument, if there was £310m of deposits, these have been redeemed in cash by the Bank of England and the equivalent amount of deposits have been removed from the money supply. Cost to the Bank of England = zero and cost to the UK tax payer = zero. Money supply stays the same.
The PMS in administration now has only assets i.e. loans from entrepreneurs /people who are repaying the loans or mortgages. These can now continue to get repaid, but instead of paying the creditors of the PMS, there are now none, so these loans can go into paying off the National Debt.
This way all parties win.
A courageous politician in Northern Ireland or in mainland GB could well put forward a Private Members’ bill which could be the first legislative move to establishing Honest Money.
The Day of Reckoning article linked to above provides the start of the legislative solution to the whole UK wide banking system whose model is sadly no different to that of the little PMS.
I went to this event today.
“22/02/2010 – Ideas Space
Quantitative Easing: Friend or Future Foe?
The Bank of England entered unchartered territory in January last year when the Treasury authorised it to begin a radical monetary policy experiment that we now know as “Quantitative Easing”. Given the unprecedented monetary conditions resulting from the liquidity crisis, the Asset Purchase Facility has been welcomed with open arms, and now stands at almost £200bn invested in UK gilts and corporate debt. But has QE had an economic impact to match its political use? Will the cure prove as dangerous as the disease? How and when should the Bank close the lid on this potential Pandora’s Box?”
Several leading economic figures including Roger Bootle, Tim Congdon and Allister Heath, chaired by Policy Exchange’s Chief Economist, Andrew Lilico, will debate and discuss the merits of quantitative easing, the exit strategies for the Bank of England, the main challenges the UK’s economy will face as a result of the program in 2010 and beyond, and how policymakers should face them.”
These are my notes:
Tim Congdon spoke first , this basic message was that unless money supply, primarily bank deposits, is kept very tight and only moderately growing, there will be trouble ahead with boom or bust. QE has kept the economy on the road and the money supply has not fallen. He acknowledges that there were some problems in measuring this.
Roger Bootle second, he opened by accusing one of our columnist, Liam Halligan of being intellectually devoid of any understanding of economics as he viewed Liam’s world to be predicated on massive inflation and a bond strike and this would never happen. He also said that QE could happen an infinitum. I tell no lie, this is what he said. In fact he was of the view that this should go on and on for whatever amount of time until we were out of trouble. People needed to believe that this policy was going to be the policy that would sort out the economy and indeed he agreed with Krugman, that crude of all the crude Keynesians, that Japan had actually done too little to stop the ongoing deflation. The UK’s risk was never going to be inflation but deflation.
Allister Heath opened with saying he reluctantly supported QE as the key thing was to stop a monetary deflation but questioned why we were having a debate in the first place about the merits of QE and should we do more etc when we should be questioning why do we inflation targeting ? As this has given us the biggest boom and bust in living memory should we not dispense with this independent Bank of England , FSA and other so called control bodies and centralise further into one overall controlling body that controls the broad money supply?
I was utterly bemused by all this tosh spoken in the name of economics with glimmers of hope only coming from Allister Heath.
The chairman asked three questions and the audience were asked three questions with one follow up.
I asked “in business I create wealth by making my factors of production work more efficiently to produce more goods and services. I invariably have to lengthen the structure of my production by saving and investing this money in new and more efficient kit to produce more of my goods and services for better prices and service level for my customers. With those goods I can exchange them with other entrepreneurs, shop keepers etc for my basic food, rent for my roof over my head etc via the medium of money. Money is bits of paper in this country and an electronic bank deposit, so having more of the bits of paper and banks deposits to exchange for the same goods and services would only mean my purchasing power had been debased, so no wealth would have been created. I thought this question go to the heart of the matter.
The second was about bond yields – had they or had they not moved up or down.
The third as about what the panel thought about the questioner’s view that we could only get out of this mess via and export related recovery.
Peter Bottomley asked a question that I cannot remember.
The Chairman then had another round of questions.
Mine was relegated to the bottom by the Chairman. Roger Bootle thought it should be answered by Tim Congdon and in the end Allister Heath did give an answer which acknowledged that no wealth could be created by paper alone and that there was a large body of work in Mises and Hayek showing that the creation of credit causes boom and bust . He was reluctant to support QE as it at least kept money supply near static as opposed to imploding, but saw no ability for it to create wealth . I was not allowed time to debate this with Allister , but did mention afterwards that as he said to me, the Austrian School was divided between those who would support a printing of money to offset a fall in V and those who would just advocate a deflation to allow the market to clear at new lower prices. Having to go I should have added, there is a third camp based around the Cobden Centre who would advocate 100% reserves as this would fix the money supply and you can never have a run on the bank with 100% reserves in place. This is explained here http://www.cobdencentre.org/2010/02/a-day-of-reckoning/ .
Allister framed his discussion in the mainstream language of the Quantity Theory of Money, more I suspect to engage with his fellow economists rather than he having any belief in it being more than a tautology. For a refutation of the Quantity Theory see here http://www.cobdencentre.org/2009/09/qe-errors/ . I did point out at the end after the event had finished that if V went down, how could me selling a house to someone, real bricks and mortar exchanging for money and having it sold back to me for the same 10 times create any wealth? Yes we can increase the velocity of the circulation of money by doing daft things like I describe, but Allister accepted nothing like wealth creation will come of it.
The medium of exchange will not create wealth on its own. It is not wealth. If you hold these bits of paper you hold claims to wealth. The retained goods and the savings we have are wealth. The whole capital infrastructure of our companies and private balance sheets are wealth . This infrastructure drives wealth creation via the dynamic entrepreneurial spirit of men of action who mix the factors of production into the most efficient combinations to satisfy the most amounts of needs. No small matter of printing paper that facilitates exchange or adding electronic reserves to banks will make that wealth creation process any easier. The second part of this article explains how wealth is created http://www.cobdencentre.org/2009/09/can-the-manipulation-of-interest-rates-create-wealth/ .
A poor day for economics!
Via Darius Guppy: our world balances on a sea of debt
What is needed is a root and branch re-evaluation of that most curious of cultural inventions – money, argues Darius Guppy.
See the enclosed article above, it could be written for this site.
I am delighted by the comments that show more and more people are questioning the madness of fractional reserve banking.
Soddy was our first Nobel price winner to suggest 100% reserves as a solution and I am delighted that Guppy is aware of this academic and his work.