“When you’re one step ahead of the crowd you’re a genius. When you’re two steps ahead, you’re a crackpot.”
-Rabbi Shlomo Riskin
Lincoln Square Synagogue, February 1998
“I hold all idea of regulating the currency to be an absurdity; the very terms of regulating the currency and managing the currency I look upon to be an absurdity; the currency should regulate itself; it must be regulated by the trade and commerce of the world; I would neither allow the Bank of England nor any private banks to have what is called the management of the currency.
I should never contemplate any remedial measure, which left to the discretion of individuals to regulate the amount of currency by any principle or standard whatever… I should be sorry to trust the Bank of England again, having violated their principle [the Palmer rule]; for I never trust the same parties twice on an affair of such magnitude.”
Report from the Select Committee on Banks of Issue
British Parliament, April 1840
It is a great privilege to write this essay on money and banking reform to mark the retirement of Dr. Paul from Congress. We in the United Kingdom have much to thank Dr. Paul for his tireless campaigning on these issues, especially those raised in the full public glare of two Presidential campaigns, making money and banking reform resonate here as well more than it otherwise would have.
At the Cobden Centre, we have two great parliamentarians, like Dr. Paul also inspired by the Austrian School of Economics: Steve Baker, Member of Parliament (MP) for High Wycombe (my co-founder of the Cobden Centre); and Douglas Carswell, MP for Clacton. Taking the idea of full-reserve free banking, currency competition, honest accounting, and full open liability for bankers, they have produced four bills in Parliament which we will discuss next in summary.
The Financial Services (Deposit and Lending) Bill – 2010
Carswell describes the Deposit and Lending bill as follows:
My bill would give account holders legal ownership of their deposits, unless they indicated otherwise when opening the account. In other words, there would henceforth be two categories of bank account: deposit-taking accounts for investment purposes, and deposit-taking accounts for storage purposes. Banks would remain at liberty to lend on money deposited in the investment accounts, but not on money deposited in the storage accounts. As such, the idea is not a million miles away from the idea of 100% gilt-backed storage accounts proposed by other hon. Members and the Governor of the Bank of England.
Currency and Banknotes (Amendment) – 2011
Carswell describes the Currency and Banknotes Amendment as follows:
That leave be given to bring in a Bill to amend the Currency and Banknotes Act 1954 to allow banknotes in addition to those issued by the Bank of England to be legal tender; and for connected purposes. … My Bill would amend the Currency and Banknotes Act 1954 to enable a range of different currencies to be used as legal tender in Britain. The idea comes from a 1989 Treasury paper from when John Major was Chancellor. What the Treasury proposed as theoretically possible 22 years ago, the internet now makes practically achievable.
The internet has given people unprecedented choice. We have access to a greater range of music, financial services, groceries and books than ever before, so why do we have legal tender laws that create a monopoly currency?
In an email to me, Carswell expressed the influence Congressman Paul has had on his work:
Reading Ron Paul’s End the Fed gave me the confidence to speak out. I suddenly realised it wasn’t just a few of us Brits who doubted the whole fiat money/candy floss currency scam. He has given hope to those of us throughout the West.
Financial Services (Regulation of Derivatives) Bill
Steve Baker compiled the Regulation of Derivatives Bill with the help of Gordon Kerr, Tim Bush, and Kevin Dowd. When he introduced the legislation on 15 March 2011, he described the Bill as requiring “certain financial institutions to prepare parallel accounts on the basis of the lower of historic cost and mark to market for their exposure to derivatives; and for connected purposes.” Baker explained how the accounting rules for banks incentivize trading in derivatives by enabling unrealized profits to be booked up-front, leading to large but unjustified bonuses and dividends.
More broadly, banks are producing accounts that grossly inflate their profits and capital in three ways:
(1) Using mark-to-market and mark-to-model accounting, banks record unrealized gains in investments as profits.
(2) International Financial Reporting Standards (IFRS) prevent banks from making prudent provision for expected loan losses by allowing recognition only of incurred losses.
(3) IFRS encourages banks not to deduct staff compensation from profits.
Taken together, these flaws mean that banks’ accounts under IFRS are at once rule-compliant and dangerously misleading. The Regulation of Derivatives Bill deals with this broad problem. For much more detail, see Gordon Kerr’s Adam Smith Institute pamphlet, “The Law of Opposites.”
Baker compiled the Financial Institutions Reform Bill with the help of Gordon Kerr and Kevin Dowd. The bill was introduced on Wednesday, 29 February 2012. The key provisions of the bill would:
(1) Enforce strict liability on directors of financial institutions;
(2) Enforce unlimited personal liability on directors of financial institutions;
(3) Require directors of financial institutions to post personal bonds as additional bank capital;
(4) Require personal bonds and bonuses to be treated as additional bank capital;
(5) Make provision for the insolvency of financial institutions; and
(6) Establish a financial crimes investigation unit.
The purpose of this Bill is to minimise moral hazard within the financial system by ensuring that those who take risks are held personally liable for the consequences. Since rules can usually be gamed by financial institutions, a principle underlying this Bill is to minimise scope for evasion.
The public are rightly incensed at the injustices we see across the financial system but our economy must have responsible, innovative and enterprising financial services. It is essential that commercial freedom is maintained while creating a system in which remuneration is a just reward for success, not the unjust product of unrealised profits and bailouts.
My Bill would make directors of financial institutions personally liable for losses. It would ensure that losses came first out of institutions’ bonus pools then directors’ personal bonds before hitting equity. Directors would also be exposed to unlimited personal liability long before any suggestion of taxpayer bailout.
With key decision makers’ own wealth at risk, they would take responsible decisions instead of expecting rewards for failure.
It’s time to tell bankers, “Yes, innovate. By all means earn large rewards for providing valuable financial services. But bear your own commercial risks. Don’t expect the rest of us to bail you out.”
Public Attitudes to Banking: A Survey Commissioned by the Cobden Centre (2010)
When we started the Cobden Centre, we all thought we knew about money and banking and all thought we knew what our fellow Brits thought about it all. To the great credit of Prof. Anthony Evans, he said let’s do some empirical testing. And so the Cobden Centre commissioned a survey. This research formed the basis of much of the work our parliamentary friends have embarked upon.
The survey was conducted by the market research company ICM with 2,000 participants. The results offer us a rather confusing array of views as to what people think banking is about.
74% of respondents thought that they were the legal owner of the money in their current account, as opposed to the bank being the legal owner.
66% of respondents answered “don’t know” when asked what proportion of their current account was used in various ways by their bank.
15% wanted safe-keeping services.
67% wanted convenient access.
8% knew correctly that they had lent money to the bank.
33% think it is wrong that the bank lends out what they view as their money.
61% said they would not mind the bank lending if it was done safely.
26% wanted reserves to match deposits.
It would seem a sizeable minority percentage would want some form of safe-keeping services. Most would want easy access, which would imply short-term borrowing matched with short-term lending, so as to avoid runs, rather than the current practice of lending long and borrowing short.
The needs of savers and borrowers would be better aligned by requiring depositors to choose, at the time of making a deposit, how much money they wished to put into plain saving (i.e., savings set aside for safe/precautionary holding as opposed to investment purposes — a distinction made by the Austrian scholar Ludwig von Mises) and how much into capitalist saving (i.e., savings set aside for investment gain as opposed to safe/precautionary savings). This would provide the setting for, and lead to, much more stable and substantial growth.
In a modern setting, the ability for banks to distinguish between plain savings, those savings that people want for safe keeping, and savings for capitalistic investment via the normal savings bonds, time deposit accounts, and so on and so forth, would allow the banking system to mediate more accurately the diverse time preferences of all savers and borrowers. (The Manchester/Lancashire system of full reserve banking and private money creation that we will discuss in the last part of this essay is a good historical example of how mediating only capitalistic savings, and not plain savings, created a system of safe credit—until it was interfered with by the Stamp Act.)
The ICM survey showed all of us that there is a need to sort out what people actually think happens with their money and banking and what actually does happen—as the two things are very different.
The Jesus Huerta De Soto Monetary Reform Proposal in Summary
Some three years ago I was fortunate enough to introduce both of our Parliamentarian friends to the greatest of all the living Austrian School economists in the full reserve tradition, Professor Jesus Huerta De Soto. His 1998 book, translated into English in 2006 as Money, Bank Credit, and Economic Cycles, is the seminal treatise on the matter.
In chapter nine, he outlines his reform proposal. (All quotes in this section are taken from chapter nine and the full book can be downloaded at http://www.cobdencentre.org/tag/downloads/.) The aims of the reform, as summarized by Prof. Huerta De Soto himself, are as follows:
[O]ur proposal is based on privatizing money in its current form by replacing it with its metallic equivalent in gold and allowing the market to resume its free development from the time of the transition, either by confirming gold as the generally accepted form of money, or by permitting the spontaneous and gradual entrance of other monetary standards.
This second element of our proposal refers to the necessity of revoking banking legislation and eliminating central banks and in general any government agency devoted to controlling and intervening in the financial or banking market. It should be possible to set up any number of private banks with complete freedom, both in terms of corporate purpose and legal form. …
Nevertheless the defense of free banking does not imply permission for banks to operate with a fractional reserve. At this point it should be perfectly clear that banking should be subject to traditional legal principles and that these demand the maintenance at all times of a 100 percent reserve with respect to demand deposits at banks. Hence free banking must not be viewed as a license to infringe this rule, since its infringement not only constitutes a violation of a traditional legal principle, but it also triggers a chain of consequences which are highly damaging to the economy. 
The crux of his reform proposal is as follows (the description is mine and made UK-specific by me — read chapter nine in full for the complete version in the Professor’s own words):
(1) All demand deposits are immaterial money, and are not the depositor’s money but a liability from the bank they deposit with to pay them back money in the same amount as deposited, on demand.
(2) Let the government back all these demand deposits for physical cash and place them as reserves against the existing demand deposits. This is virtually a costless activity on behalf of the state. It is also not inflationary, as the backing, the physical cash, cannot be spent, as it sits in reserves.
(3) The money supply can neither expand nor contract at this specific point.
(4) The banks, where they had current liabilities, now no longer have them as they are fully reserved.
(5) This generates a one-off gain to the banks in terms of their net worth. In short, so much as they had these current demand liabilities, now they have these backed with paper notes for the same value, so their net worth has gone up by the equivalent amount.
(6) The asset side of the balance sheet, their loan portfolio, stays intact.
(7) As there are over £1 trillion of demand deposits in the UK banking system, the banking system’s net worth would have risen by £1 trillion.
(8) Why give this one-off gift of largesse to the shareholders and bonus-hungry bankers? Well, don’t. Form special purpose vehicles to hold the asset side of the balance sheets of the banks to collect on these outstanding loans and you can contract out the management of this to the existing banks.
(9) By doing this, the banks’ net worth on the day after the reform is still the same as the day before the reform, but the £1 trillion loan repayments are now paying off our national debt obligations. This is a unique one-off gain and is a byproduct of this reform.
(10) The gold price would need to rise to back all the deposits with gold and then you fix all money in one of its historic anchors: gold (you could also use silver or other successful monies). Since gold increases in physical supply at the rate of approximately 2% per year, if productivity gains run at about this rate you will have stable prices; if productivity rates are greater, then a benign price deflation.
(11) Let the people spontaneously discover what their most favoured money actually is.
In short, I would have no-reserve banking, not 100% reserve. By this, I have suggested that all demand deposits should actually be swapped out for physical cash and the current liability of the bank just rubbed out. Then the people would actually own their own money on deposit and not be current creditors, thus I would question the need to perform point number two and substitute along the lines of what I just suggested.
Would 100% Reserve Free Banking be the End of Lending and the End of Commerce as We Know It?
This is the question that gets asked when most people have understood that 100% reserve banking would be the end of bank-created credit. Many credible and distinguished people attribute the creation of bank credit as the source of the Industrial Revolution itself. Such a powerful thing is alleged. The noted Daily Telegraph writer Ambrose Evans-Pritchard says in his 21 October 2012 column:
One might equally say that this opened the way to England’s agricultural revolution in the early 18th Century, the industrial revolution soon after, and the greatest economic and technological leap ever seen. But let us not quibble.
For those followers of Dr. Paul and those generally interested in monetary reform in this tradition, I did some research into the genesis of the Industrial Revolution to see if this assertion held any merit. I have focused my research into the County of Lancashire and what became the first industrial city of the world, Manchester. In this concluding historical section, I will show that in the first third of the Industrial Revolution, private credit, bills of exchange, backed by the goods and services that were being traded for and by gold and silver, was the preferred modus operandi. The taxation of this private money by the 1815 Stamp Act led to their slow decline in favour of the privileged note issue of, in particular, the Bank of England. However, by late 1874 some 45% of all credit was still private credit in the form of bills of exchange. Private credit was the preferred medium of the Industrial Revolution, and not bank-created fiduciary credit.
Early Banking in Manchester
The historian Arthur Redford in his book about merchants and foreign trade in Manchester described the early bankers of the town:
The first Manchester Bank, that of Byron, Sedgwick, Allen, and Place, was opened in 1771, in combination with an insurance office, and the Mercury welcomed it with the comment that “from the general Approbation the Scheme has met with amongst all Ranks of People, it is not questioned that it will be of infinite Utility to the Trading Part of the Town, and to the County in general.” …. It was not the only Manchester banking business, for in 1772 John Jones and Co. were “Bankers and Tea Dealers” and within thirteen years were to have offices in London from which Jones Lloyds sprang. In Liverpool also most of the early bankers, says their historian, “arose out of general merchants, some few from tea dealers, and one from linen merchants.” Even after declaring themselves bankers, the banking business was usually continued along with trading. But the use of the term banker was late, and until almost the end of our period the commerce of Liverpool, with its complex dealings in foreign exchange, and the internal trade of Lancashire seem to have been carried on mainly through the bill discounting side of the merchants’ and traders’ businesses. In Liverpool marine insurance broking was closely allied.”
The key thing I observe here is that in the first part of the Industrial Revolution the issue of notes (which were the chief means of bank fiduciary credit) was a side issue and bills of exchange were the main mechanism to facilitate this massive explosion in trade. Also, this first bank in the UK’s main industrial area was nearly 100 years behind the establishment of the Bank of England and the Scottish public banks.
Data supplied by Prof. Angus Maddison shows us that from 1700 to 1820 there is 338.38% growth in measured economic activity. The next 130 years saw 960.06% growth when the Industrial Revolution was in full flow. Nevertheless, with the initial explosion of activity in the mid- to late-1700s, to the early 1820s, we see the prime industrial county in the world exist with few or no banks and banks not providing credit services as we know them today, and clearly not to its detriment.
Economic historian T. S. Ashton quotes William Langton (a driving force behind the founding of the Manchester Statistical Society in 1833) writing later in the 19th century:
“It is exceedingly natural,” said Langton, “that those banks which still retain the privilege of issuing their own notes should desire to retain it, since it naturally adds to their profits; but it has always been recognised in the great industrial district of Lancashire that it is no essential condition to the wielding of manufacturing and commercial enterprise, and that the banks not possessing this privilege have not stinted their customers of any legitimate accommodation.”
Langton also notes their usefulness vis-a-vis other modes of money:
My personal memory of trade only extends back to the year 1820; but at that time the Liverpool merchants received nothing but bills in payment from Manchester of their cotton invoices; every such payment, if in what was called promiscuous paper, requiring a calculation of interest to make a settlement per appoint. This practice gradually disappeared with the resumption of cash payments by the Bank of England and the lowering of the standard rate of interest; but if economy of interest of money is to be taken as the special recommendation of any particular kind of circulating medium, this one surely ought to bear the palm!
W.T. Crick and J.E. Wadsworth note the significance of Manchester and the nearby City of Liverpool by observing:
Yet, in spite of Lancashire’s advanced industrial organization, banking was rather later to develop than in some other areas. No banks are recorded in Manchester until 1771 or in Liverpool until 1774, and when eventually they were formed, they do not appear to have acquired note circulations except in a few unimportant instances.
Ashton describes the special preference for bills of exchange over notes:
These are reasons explaining the ubiquity of bills of exchange at this period. The special preference of Lancashire for bills rather than notes is a matter deserving of research. It arose, no doubt, out of a high degree of commercial confidence, no less than out of a low degree of trust in note-issuers, and the fact that Lancashire bought raw material from distant places and sold products in distant markets must also have engendered a preference for a document the circulation of which was not confined to the sphere of operations of a local bank. As time went on the domestic bill came to play a smaller part in commercial transactions: the increase of the stamp duties after the Napoleonic War dealt a blow to the system; and the growth of large banks of deposits with many branches, together with the shortening of the customary terms of credit, led to a substitution of cheques for bills in inland trade during the later decades of the nineteenth century. But in the period with which we are concerned cheques were in their infancy and the bill had no serious rival as a medium of exchange between traders.
Ashton also gives us clues as to why they have almost vanished today from the commercial idiom as the stamp duty applied to them was less advantageous vis-a-vis note or chequebook issue as the latter provided quicker redemption in money possibilities.
If we dig a bit further into the historical record we see that these bills arose spontaneously to fulfill a need to be able to facilitate the smooth transmission of trade. A wonderful book written by Alfred P. Wadsworth & Julia De Lacy Mann, The Cotton Trade and Industrial Lancashire 1600-1780, documents this history quite thoroughly:
We have seen Marsden as a manufacturer, putting out cotton and yarn through his agent and debiting the materials and wages against the value of the finished goods. On the other side he maintained a London house, through which he bought his raw materials and sold his fustians, and in connection with which he conducted extensive operations as a bill discounter. Between 1688 and 1690 he was involved in a maze of lawsuits, from which some account of his business may be constructed
Having “constantly great and considerable sums of money in his hands” [Marsden] lent money to other dealers in return for their bills on London; or he “furnished them with bills of exchange for payment of considerable sums of money at London to them or their order, or to such persons as they appointed to receive the same,” either receiving cash, or, generally, giving them credit at an agreed rate of interest. When they failed to pay him for the bills he had given them, he would take an assignment of their goods at Liverpool —cotton or linen yarn, promissory notes, or bills drawn on their London debtors. But apart from his own trading credit, he had “for many years past been intrusted or employed with greate parte of the monies retorned out of the county of Lancaster to London.”
Marsden the industrialist had become the banker as well as the chief remitter of revenues back to Lancashire and the principal collector of taxes. Daniel Defoe, trader, writer, and journalist, remarked in 1727, that:
[A] very great part of the bills drawn out of the several counties in England upon the tradesmen in London, such as factors and warehousekeepers, are made payable to the General Receivers of the several taxes and duties, customs and excise, which are levied in the country in specie, and the money is remitted by those collectors and receivers on account of those duties; this generally appears by the bills or endorsements, which often mention it in these words for his Majesty’s use.
Thus credit was granted and discounted bills accepted and paid with specie, not with notes or other such fiduciary credit. The Crown accepted these bills!
In commenting upon the various inaccuracies with traders being bankers, after an extensive investigation into the disputes listed in the court records, Wadsworth and Mann conclude:
Much might be said of the use of the bill in the general system of credit, but enough, perhaps, has been suggested in earlier pages to indicate its importance. The bill on London, then as a century later the dominant form, entered at every stage, and into every form of transaction, ran from the smallest to the largest sums, and passed even more freely than cash. The financial mechanism which turned on the bill, the promissory note, and other credit instruments, and has here been summarily illustrated, bulks large in all the commercial manuals of the time. … It is apt to be forgotten that the credit machinery of industries like the textile trades was hardly less extensive before the foundation of the country banks than it became after.
Unwin, Hulme, and Taylor did a fantastic investigation into the affairs of Samuel Oldknow and his mill at Mellor. There is also some evidence to show why Lancashire rejected bills vs. notes:
Enough has been said to show the almost desperate condition of Oldknow’s affairs at the beginning of 1793. He had invested an immense capital—for those days—in the fixed forms of land, buildings, and machinery which could not yield any return without the assistance of commercial credit—and owing to the outbreak of war commercial credit had almost ceased for the time being to exist. No fewer than 872 bankruptcies were recorded between November 1792 and July 1793. The problem of credit currency became acute. The country banks, which had multiplied greatly during the previous decade, had produced an over-issue of notes, some of them for such small amounts as to provoke the derisive issue by a Newcastle cobbler of a note for two-pence. But the notes even of the sounder banks were now returned on their hands and many were obliged to close their doors.
The instability that these free banks issuing fiduciary credit afforded the industrialist in the times of crises was very destabilising, as you did not want to become a creditor to a bankrupt banker. This is one way to accelerate your own potential to become bankrupt. So commercial credit, or bills backed by real goods, was sought in preference.
Why did these Lancashire Bills Decline?
Henry Thornton, an economist, banker, and Parliamentarian, commented on the demise of bills to the favour of notes in 1802: “Some Bank of England notes have also been recently employed in the place of small bills on London, the use of which has been discouraged by the late additional duty on bills and notes.”
Redford discusses the response of Manchester merchants to the duties and taxes imposed on bills of exchange:
A much more protracted struggle, extending throughout the second quarter of the nineteenth century, was waged by the Manchester merchants against excessive stamp duties on various kinds of legal documents. … Bills of exchange and promissory notes were first subjected to stamp duties in 1782; a general Stamp Act of 1815 had increased the duties, which thenceforth discriminated between short-dated and long-dated bills. In the post-war period the average duty on all bills of less than £50 was 1/2 per cent.; but this charge was felt to be prohibitive, and had in Manchester caused bills to be almost completely replaced by bank notes. Bank notes, however, were considered to be a much more inconvenient and risky means of payment, since they were payable “to bearer” and not “to order.” The Manchester Chamber of Commerce therefore moved in 1822 for the reduction of the duties, and sent up several petitions on the subject, to the Prime Minister, the Chancellor of the Exchequer, and the Houses of Parliament. The petitioners described the serious inconvenience to business which had resulted from the virtual extinction of “a description of currency of great convenience and security”; they suggested a greatly reduced scale of duties, and argued that, if this were adopted, not only the business community but also the revenue would benefit greatly, because of the increased use of bills of exchange.
The Bank of England (BoE) was still a private bank at the time. However, as the government’s favoured bank it had certain privileges and was always lobbying for more. The 1815 Stamp Act made the reissue of bills of exchange virtually impossible. Some were taxed up to 460% higher than Bank of England note issue, or subject to great penalty that made the issue of private credit by other banks more expensive than BoE note issue. In 1825 the Bank of England set up a branch in Manchester specifically to take advantage of the terrible taxation placed on private bill issue and make sure that those pioneers of the Industrial Revolution had to take BoE credit.
The significance of Manchester as the prime industrial area of the world at the time does make it a meaningful and worthy study area from which we can extrapolate, hopefully, our findings to the wider canvas of today and I submit that in the absence of bank-created credit we, like our ancestors, have nothing to fear. Indeed, like the pioneers of the Industrial Revolution, we should embrace private money solutions such as bills of exchange and rely on the lending of real savings to provide real capital to entrepreneurs and not bank credit created out of nowhere. Full-reserve systems are not only stable, but growth enhancing. Lending does not die as many advocates of fractional reserve banking dread.
 Although the City of Manchester is now part of Greater Manchester or the Greater Manchester Urban Area, prior to 1835 it was part of the Salford Hundred of the county of Lancashire. By 1853, it had reached full City status. So for the majority of this essay’s focus, when Lancashire is referred to, it certainly should be read to be synonymous with what is the heart of Manchester City today. Also, you will see Liverpool mentioned as well, often in the same light as Manchester. This is due to their close geographic connection and the Port of Liverpool being often the import and export venue for the Manchester manufacturers.
 Dun, John. British Banking Statistics. London: E. Stanford, 1876, p. 87.
 Redford, Arthur. Manchester Merchants and Foreign Trade. Manchester: Manchester University Press, 1934, p. 248.
A challenge for 2012 – part one was to read The Theory of Money and Credit by Mises on its 100th year anniversary. The 1934 preface was sadly so pertinent to today that we reproduced it as an enticement to read the whole book.
My second challenge for 2012 is to read a book written 86 years later by Jesús Huerta de Soto in its English translation called Money, Bank Credit, and Economic Cycles, which can be downloaded here.
Like The Theory of Money and Credit in its day, this book is the most comprehensive economic text on money, capital theory, business cycles and entrepreneurship written by a modern Austrian.
Here is the preface to the second English edition, written by Huerta de Soto in November 2008.
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 newlycreated 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 results: the financial bubble (“irrational exuberance”) 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 monietarist 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 realestate 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: (1) the reestablishment of a 100-percent reserve requirement on all bank demand deposits and equivalents; (2) 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 (3) 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 Madrid November 13, 2008
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30 January 12 | Tags: Huerta de Soto, money bank credit and economic cycles | Category: Economics | 2 comments
The unexcitingly-named proposal before this obscure-sounding committee would commit an additional £10 billion of British taxpayers’ money to the IMF.
11.39 am – Steve Baker
I begin by welcoming the Minister’s resolve and composure in what are clearly historic and contentious circumstances. We have seen today that there is broad agreement across the Committee that what matters is human prosperity, and we are all deeply worried about our constituents. I am going to make three points. First, I do not believe that we have this money and that we cannot afford the liability. I do not think that my constituents will understand why they should pick up the liability. It seems to me that one way or another, this country will end up borrowing in order to lend to fund present consumption, and funding present consumption through borrowing is simply not a route to prosperity. I wish I felt that it was not necessary to expand on that point, but it seems these days that we forget. If we consume on credit, we are in fact making ourselves poorer.
I find the notion of getting the money back quite worrying. It seems to me that we will borrow some of this money, at least, from commercial banks, inevitably monetising the debt and debasing the currency further after 40 years of continuous debasement. That will involve inflation and further distortions in the structure of the economy. In short, this measure would simply kick the can down the road. We might argue that that is the job of the IMF these days, but the Greek people are already rioting and we have to ask ourselves whether they would be any more sympathetic to such austerity measures simply because they were brought forward by the IMF. I question the action itself.
Secondly, the IMF was created as part of the Bretton Woods system of currencies. We tend to talk as though our current monetary arrangements were a fixed point and had always been the same, but the present monetary orthodoxy has evolved over the years and centuries. Bretton Woods was constructed after the catastrophe of the second world war; the dollar was redeemable in gold, and all other currencies were pegged to the dollar. The job of the IMF was to stabilise exchange rates by bridging temporary gaps in nations’ balance of payments, but the IMF now seems to serve the purpose of ensuring the repayment of reckless financial institutions.
Above all, at all stages of its history the IMF has existed to bring financial stability, which I believe it has singularly failed to do. Turning to the monetary system and stability, I encourage Members to google a chart that I can make available, which shows the price of oil-index factor 1945, the origin of Bretton Woods-brought forward to today. It prices oil in dollars and in gold. I do not like to use the G-word, but I feel that since my hon. Friend the Member for Wellingborough has mentioned it already, I can continue. The price of oil has been high and volatile since 1971, but only when priced in dollars. If we price oil in gold, the price has been low and stable ever since the end of the second world war.
I simply make the point that our monetary arrangements are not fixed, that the IMF has not brought stability and that in fact many of our most important commodities are far more susceptible to the effects of our present, inflationary monetary arrangements than is generally considered. I would like to finish my point about the IMF with Hayek’s words. He said:
“monetary policy all over the world has followed the advice of the stabilisers. It is high time that their influence, which has already done harm enough, should be overthrown.”
He wrote that in 1932 in the preface to “Monetary Theory and the Trade Cycle“, which hon. Members can find by googling “prices and production.”
Thirdly, I want to talk about the contemporary mainstream. With great respect to hon. and right hon. Friends, although my right hon. Friend the Member for Wokingham foresaw many aspects of the crisis, the majority of the mainstream did not see this coming. I have sat at lunch with eminent economists who said that nobody saw this coming, to which I simply replied that they should read Huerta de Soto’s “Money, Bank Credit and Economic Cycles“. That book, which was written in 1998, clearly set out that this would happen and why, following in the footsteps of Hayek, Mises and others. The Queen asked why no one saw this coming. If she had asked me, I would have said that it was because economists pay too little attention to time-the simple matter of the importance of time. Production takes time and, in a market, interest rates should arise from people’s time preferences for consumption. In the jargon, the contemporary mainstream lacks an adequate theory of the inter-temporal structure of capital-that is, capital goods, or the means of production.
We are at the end of an extremely long credit expansion. I depart from my right hon. Friend the Member for Wokingham, but that is because I follow that particular theory of capital. Hayek, it is not often known, was a socialist and confesses as much in the preface to Mises’ book, “Socialism“, but he and Mises together worked out the theory of the trade cycle. Mises wrote:
“The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion.
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.”
That is from “Human Action“, page 572.
At this point came an intervention to delight Cobden Centre readers:
Mr Cash: My hon. Friend’s contribution is very thoughtful; he knows a great deal about such things, in the tradition of Cobden. However, is the real problem one of human nature as well as of economics? People are competing in an environment in which there is no real or comparative advantage because the new world-if I may use that expression-of the Brits has a huge advantage over the others. Good money is being thrown after bad unless the real problem is tackled: cheap credit that is not based on real, tangible economic advantage.
Steve Baker: I absolutely agree with my hon. Friend. He makes an excellent point with which I am in full agreement.
Mr Redwood: Before my hon. Friend sits down, I hope that he will give the Committee the benefit of his advice on the order, because we are not yet quite clear what he would do about the £9.5 billion sub.
Steve’s concluding remarks pull no punches (emphasis mine):
The Government should avoid committing that sum of money; my view is that it will not help. I made a second point about the IMF and our monetary arrangements. If this is not the time of all times to question the fundamental basis of our financial system, I do not know when we ever shall. My third point was that I am afraid that the contemporary mainstream of economics is missing some vital information, which leads it to justify the very measures that we are discussing today. As I explained, as Mises set out, as Hayek followed in his steps and as others have predicted, we risk a final and total catastrophe for our currency system.
To conclude, we are in danger of simply kicking a can down the road and, as my hon. Friend the Member for Clacton said, ladling water into the boat. We are looking at further credit expansion, further monetisation of debts and further socialisation of risk. Throughout the western world, we are in danger of appearing as King Canute, trying to use politics to hold back the realities of social co-operation, which we usually describe as economics. The IMF is an institutional legacy from a monetary system that failed 40 years ago, and the successor to which is even now failing as well.
I looked at IFRS and how it boosts bank capital, and we found that RBS is possibly overstating its capital by £25 billion. That must meant that RBS at least is far more susceptible to financial shocks than is generally thought. It is my view, because of the weaknesses of IFRS, that all banks are substantially more susceptible to financial shocks than is generally understood. I therefore offer three points. First, the Government should please look at cross-cancellation of debt held by sovereign nations-I refer the Government to work by ESCP Europe and Dr Anthony Evans. Secondly, let us face the reality-not optional-and look at how we restructure outstanding debt. Thirdly, at this time of all times, rather than merely increasing our liability to the IMF, let us seriously rethink the foundations of the international financial system and, in particular, start planning for how to protect the payments system.
On October 21, 2008, I conducted a radio interview with professor Jesús Huerta de Soto, Professor of Political Economy at Rey Juan Carlos University in Madrid, Spain, focused on the economic crisis. Heurta de Soto is Spain’s leading Austrian economist, and author of the authoritative 876-page book, Money, Bank Credit, and Economic Cycles (Mises Institute, 2006). Time: approximately 40 minutes.
The following is Jesús Huerta de Soto’s foreword to The Tragedy of the Euro by Philipp Bagus, a friend of The Cobden Centre. You can buy or download the book here. Philipp Bagus is a professor of economics at Universidad Rey Juan Carlos in Madrid.
It is a great pleasure for me to present this book by my colleague Philipp Bagus, one of my most brilliant and promising students. The book is extremely timely and shows how the interventionist setup of the European Monetary system has led to disaster.
The current sovereign debt crisis is the direct result of credit ex- pansion by the European banking system. In the early 2000′s, credit was expanded especially in the periphery of the European Monetary Union such as in Ireland, Greece, Portugal, and Spain. Interest rates were reduced substantially by credit expansion coupled with a fall both in inflationary expectations and risk premiums. The sharp fall in inflationary expectations was caused by the prestige of the newly created European Central Bank as a copy of the Bundesbank. Risk premiums were reduced artificially due to the expected support by stronger nations. The result was an artificial boom. Asset price bubbles such as a housing bubble in Spain developed. The newly created money was primarily injected in the countries of the periphery where it financed overconsumption and malinvestments, mainly in an overextended automobile and construction sector. At the same time, the credit expansion also helped to finance and expand unsustainable welfare states.
In 2007, the microeconomic effects that reverse any artificial boom financed by credit expansion and not by genuine real savings started to show up. Prices of means of production such as commodities and wages rose. Interest rates also climbed due to inflationary pressure that made central banks reduce their expansionary stands.
Finally, consumer goods prices started to rise relative to the prices offered to the originary factors of productions. It became more and more obvious that many investments were not sustainable due to a lack of real savings. Many of these investments occurred in the construction sector. The financial sector came under pressure as mortgages had been securitized, ending up directly or indirectly on balance sheets of financial institutions. The pressures culminated in the collapse of the investment bank Lehman Brothers, which led to a full-fledged panic in financial markets.
Instead of leading market forces run their course, governments unfortunately intervened with the necessary adjustment process. It is this unfortunate intervention that not only prevented a faster and more thorough recovery, but also produced, as a side effect, the sovereign debt crisis of spring 2010. Governments tried to prop up the overextended sectors, increasing their spending. They paid subsidies for new car purchases to support the automobile industry and started public works to support the construction sector as well as the sector that had lent to these industries, the banking sector. Moreover, governments supported the financial sector directly by giving guarantees on their liabilities, nationalizing banks, buying their assets or partial stakes in them. At the same time, unemployment soared due to regulated labor markets. Governments’ revenues out of income taxes and social security plummeted. Expenditures for unemployment subsidies increased. Corporate taxes that had been inflated artificially in sectors like banking, construction, and car manufacturing during the boom were almost completely wiped out. With falling revenues and increasing expenditures governments’ deficits and debts soared, as a direct consequence of governments’ responses to the crisis caused by a boom that was not sustained by real savings.
The case of Spain is paradigmatic. The Spanish government subsidized the car industry, the construction sector, and the bank- ing industry, which had been expanding heavily during the credit expansion of the boom. At the same time a very inflexible labor market caused official unemployment rates to rise to twenty percent. The resulting public deficit began to frighten markets and fellow EU member states, which finally pressured the government to announce some timid austerity measures in order to be able to keep borrowing.
In this regard, the single currency showed one of its “advantages.” Without the Euro, the Spanish government would have most certainly devalued its currency as it did in 1993, printing money to reduce its deficit. This would have implied a revolution in the price structure and an immediate impoverishment of the Spanish population as import prices would have soared. Furthermore, by devaluing, the government could have continued its spending without any structural reforms. With the Euro, the Spanish (or any other troubled government) cannot devalue or print its currency directly to pay off its debt. Now these governments had to engage in austerity measures and some structural reforms after pressure by the Commission and member states like Germany. Thus, it is possible that the second scenario for the future as mentioned by Philipp Bagus in the present book will play out. The Stability and Growth Pact might be reformed and enforced. As a consequence, the governments of the European Monetary Union would have to continue and intensify their austerity measures and structural reforms in order to comply with the Stability and Growth Pact. Pressured by conservative countries like Germany, all of the European Monetary Union would follow the path of traditional crisis policies with spending cuts.
In contrast to the EMU, the United States follows the Keynesian recipe for recessions. In the Keynesian view, during a crisis the government has to substitute a fall in “aggregate demand” by increasing its spending. Thus, the US engages in deficit spending and extremely expansive monetary policies to “jump start” the economy. Maybe one of the beneficial effects of the Euro has been to push all of the EMU toward the path of austerity. In fact, I have argued before that the single currency is a step in the right direction as it fixes exchange rates in Europe and thereby ends monetary nationalism and the chaos of flexible fiat exchange rates manipulated by governments, especially, in times of crisis.
My dear colleague Philipp Bagus has challenged me on my rather positive view on the Euro from the time when he was a student in my class, pointing correctly to the advantages of currency competition. His book, The Tragedy of the Euro, may be read as an elaborated exposition of his arguments against the Euro. While the single currency does away with monetary nationalism in Europe from a theoretical point of view, the question is: just how stable is the single currency in actuality? Bagus deals with this question from two angles, providing at the same time the two main achievements and contributions of the book: a historical analysis of the origins of the Euro and a theoretical analysis of the workings and mechanisms of the Eurosystem. Both analyses point in the same direction. In the historical analysis, Bagus deals with the origins of the Euro and the ECB. He uncovers the interests of national governments, politicians and bankers in a similar way that Rothbard does in relation to the origin of the Federal Reserve System in The Case against the Fed. In fact, the book could also have been analogously titled The Case against the ECB. Considering the political interests, dynamics and circumstances that led to the introduction of the Euro, it becomes clear that the Euro might in fact be a step in the wrong direction; a step towards a pan-European inflationary fiat currency aimed to push aside limits that competition and the conservative monetary policy of the Bundesbank had imposed before. Bagus’s theoretical analysis makes the inflationary purpose and setup of the Eurosystem even clearer. The Eurosystem is unmasked as a self-destroying system that leads to massive redistribution across the EMU, with incentives for governments to use the ECB as a device to finance their deficits. He shows that the concept of the Tragedy of the Commons, which I have applied to the case of fractional reserve banking, is also applicable to the Eurosystem, where different Euro- pean governments can exploit the value of the single currency.
I am glad that this book is being made available to the public by the Mises Institute. The future of Europe and the world depends on the understanding of the monetary theory and the workings of monetary institutions. This book provides strong tools toward understanding the history of the Euro and its perverse institutional setup. Hopefully, it can help to turn the tide toward a sound monetary system in Europe and worldwide.
“Toby Baxendale is an entrepreneur who built up, amongst other things, the UK's largest fresh fish supplier to the Food Service sector, see www.directseafoods.co.uk, and recently sold it. Toby is dedicated to furthering the teaching of the Austrian school of economics. He established and funded the 1st Distinguished Hayek Visiting Teaching Fellowship Program at the LSE in Honour of the Nobel Laureate F A Hayek. Toby is Chairman of The Cobden Centre. Richard Cobden's timeless principles of the abolition of legal privilege of the few at the expense of the many are worthy in this day and age to promote. | Contact us
5 November 10 | Tags: Hayek Lecture 2010, Huerta de Soto, Insight | Category: Economics | Leave a comment
We were pleased to see this thoughtful and enthusiastic write-up of Huerta de Soto’s Hayek lecture by Andreas Kuersten for the LSE student paper, The Beaver. We reproduce it here by kind permission of the editor.
Last Friday Professor Jesús Huerta de Soto, of the King Juan Carlos University of Madrid, delivered a lecture at the LSE on the recent financial crisis and economic recession. The event, hosted by Professor Tim Besley of the LSE Economics Department, was held in honor of the work of former LSE Professor and 1974 Nobel laureate Friedrich von Hayek.
Professor de Soto holds doctorates in both Economics and Law from the Complutense University of Madrid and an MBA from Stanford University. He is considered by many to be one of the principal exponents of the Austrian School of Economics, which is largely influenced by Hayek’s ideas, and some of his notable publications include the books Money, Bank Credit, and Economic Cycles and Socialism, Economic Calculation, and Entrepreneurship.
Professor de Soto began his analysis by attributing a great deal of responsibility for modern financial problems to the Bank Charter Act passed on July 19th, 1844 in the United Kingdom. This was a landmark act that sought to eliminate the boom and bust cycle of markets caused by artificial credit expansions induced by private banks which were financed not by savings but by fiduciary media issued in large amounts. In essence, credit granted without reserve backing. The Bank Charter Act required 100 per cent reserve backing for banknotes issued. Yet it did not address demand deposits, which is money created just on the books of banks but which are still part of the money supply. Banks therefore diverted their business from issuing banknotes to demand deposits and thus circumvented the act’s requirement for total reserve backing.
This sort of financial business has continued, unaddressed, since then and resulted in a six-step process which led to the recent financial crisis.
Firstly, consumers are not encouraged to save because banks can issue credit without significant reserve backing. De Soto commented that the lack of savings means that demand for consumer products remains high which causes producers of these products to compete with one another for the means of production. This, according to de Soto, causes a rise in prices of these means.
The second step results from an increase in the price of consumer goods at a faster rate than that of the means of production due to consumer producers having to compete so vastly for them.
De Soto identified the third step as accounting profits rise in the companies closest to final consumption of products by consumers due to the rising prices.
The fourth step occurs as the Ricardo Effect takes hold, an effect meant to occur in an environment of savings and reserve backing to allow production to shift from consumer to capital goods to keep jobs and wages and consumer goods production becomes more expensive. Instead real wages decrease so companies hire cheap labour rather than investing in capital to replace labour. Price of capital decreases and further decreases profits of firms further from consumption.
The fifth step is an increase in the interest rate as growth stagnates. Step six then comes as companies farther from consumption incur mounting accounting losses and investment projects are liquidated.
After identifying these six critical steps, de Soto commented that their growth ceases and the receivers of banks loans are seen to not be able to pay them back in which case the banks are discovered not to have the reserve backing to absorb and handle the losses. The banks are shown to be bankrupt and the central bank must step in to stop the collapse of the financial system.
In response to this situation Professor de Soto suggests austerity measures to decrease government need for money and then a reduction of taxes on firms which need to concentrate on paying down debt. All levels of the market also need to be liberalised in order to facilitate easier transition by companies between different sectors depending on profitability.
De Soto also outlined a three step process for recovery and prevention. To begin with, the demands of the Bank Charter Act must be put into law but this time applying to demand deposits and all transactions. 100 per cent reserve backing must be required in all banks dealings. The next step is to get rid of the inherent socialism of our current financial system by getting rid of central banks. They succumb to all of the inherent problems of a socialist system noted by Austrian School of Economics scholars. De Soto acknowledged that they are too large and unable to keep track of myriad dealings and types of dealings done by financial actors, follow changes in supply and demand, and are based on an enormous amount of privilege being given to private bankers who engage in fractional reserve dealings. They cannot coordinate the system.
The final step involves privatizing the source of money and replacing modern paper money with the classical gold standard which would ensure 100 per cent reserve backing.
One of the more interesting questions put forth by the audience was a challenge to the reversion of the financial system to once again being based on the gold standard despite its links with the Great Depression. Professor de Soto responded that it was not the gold standard which led to this crisis but the actions of private bankers in seeking to subvert this system by ignoring it and undertaking fractional reserve transactions. The gold standard system was simply blamed when it failed due to these actions by bankers because it was the system officially recognized, even though it was not being followed.
Through his lecture Professor de Soto offered some very radical changes as solutions to the current financial crisis which were quite well received, the audience applauded them loudly. This was exemplified by spontaneous applause for the suggestion of returning to the classical gold standard. De Soto presented his arguments very passionately and, overall, they were received very positively by the audience.
“Toby Baxendale is an entrepreneur who built up, amongst other things, the UK's largest fresh fish supplier to the Food Service sector, see www.directseafoods.co.uk, and recently sold it. Toby is dedicated to furthering the teaching of the Austrian school of economics. He established and funded the 1st Distinguished Hayek Visiting Teaching Fellowship Program at the LSE in Honour of the Nobel Laureate F A Hayek. Toby is Chairman of The Cobden Centre. Richard Cobden's timeless principles of the abolition of legal privilege of the few at the expense of the many are worthy in this day and age to promote. | Contact us
4 November 10 | Tags: F A Hayek, Hayek Lecture 2010, Huerta de Soto | Category: Economics | Leave a comment
The London School of Economics and Political Science
Hayek Memorial Lecture
October 28, 2010
It is a great honor for me to have been invited by the London School of Economics to deliver this Hayek Memorial Lecture. To begin, I would like to thank the school and especially Professor Timothy Besley for inviting me, Professor Philip Booth and the Institute of Economic Affairs for allowing me to also use this as an opportunity to introduce my most recent book entitled “Socialism, Economic Calculation and Entrepreneurship,” and finally Toby Baxendale for making this whole event possible.
Today I will concentrate on the recent financial crisis and the current worldwide economic recession, which I consider to be the most challenging problem we as economists must now face.
The Fatal Error of Peel’s Bank Act
I would like to start off by stressing the following important idea: all the financial and economic problems we are struggling with today are the result, in one way or another, of something that happened precisely in this country on July 19, 1844… What happened on that fateful day that has conditioned up to the present time the financial and economic evolution of the whole world? On that date, Peel’s Bank Act was enacted after years of debate between Banking and Currency School Theorists on the true causes of the artificial economic booms and the subsequent financial crises that had been affecting England especially since the beginning of the Industrial Revolution.
The Bank Charter Act of 1844 successfully incorporated the sound monetary theoretical insights of the Currency School. This school was able to correctly discern that the origin of the boom and bust cycles lay in the artificial credit expansions orchestrated by private banks and financed not by the prior or genuine savings of citizens, but through the issue of huge doses of fiduciary media (in those days mainly paper banknotes, or certificates of demand deposits issued by banks for a much greater amount than the gold originally deposited in their vaults). So, the requirement by Peel’s Bank Act of a 100 percent reserve on the banknotes issued was not only in full accordance with the most elementary general principles of Roman Law regarding the need to prevent the forgery or the over-issue of deposit certificates, but also was a first and positive step in the right direction to avoid endlessly recurring cycles of booms and depressions.
However Peel’s bank Act, not withstanding the good intentions behind it, and its sound theoretical foundations, was a huge failure. Why? Because it stopped short of extending the 100 percent reserve requirement to demand deposits also (Mises 1980, 446-448). Unfortunately, by Peel’s day, some ideas originally hit upon by the Scholastics of the Spanish Golden Century had been entirely forgotten. The Scholastics had discovered at least three hundred years earlier that demand deposits (which they called in Latin “chirographis pecuniarium,” or money created only by the entries in banks’ accounting books) were part of the money supply (Huerta de Soto 2009, 606). They had also realized that from a legal standpoint, neglecting to maintain a 100 percent reserve on demand deposits is a mortal sin and a crime not of forgery, as is the case with the over-issue of banknotes, but of misappropriation.
This error of Peel’s Bank Act, or rather, of most economists of that period, who were ignorant of something already discovered much earlier by the Spanish Scholastics, proved to be a fatal error: after 1844 bankers did continue to keep fractional reserves, not on banknotes of course, because it was forbidden by the Bank Charter Act, but on demand deposits. In other words, banks redirected their activity from the business of over-issuing banknotes to that of issuing demand deposits not backed by a 100 percent reserve, which from an economic point of view is exactly the same business. So, artificial credit expansions and economic booms did continue, financial crises and economic recessions were not avoided, and despite all the hopes and good intentions originally put into Peel’s Bank Act, this piece of legislation soon lost all of its credibility and popular support. Not only that, but the failure of the Bank Act conditioned the evolution of financial matters up to the present time and fully explains the faulty institutional design that afflicts the financial and monetary system of the so-called free market economies, and the dreadful economic consequences we are currently suffering.
When we consider the failure of Peel’s Bank Act, the evolution of events up to now makes perfect sense: bubbles did continue to form, financial crises and economic recessions were not avoided, bank bailouts were regularly demanded, the lender of last resort or central bank was created precisely to bail out banks and to permit the creation of the necessary liquidity in moments of crisis, gold was abandoned and legal tender laws and a purely fiduciary system were introduced all over the world. So as we can see, the outcome of this historical process sheds light on the faulty institutional design and financial mess that incredibly is still affecting the world at the beginning of the second decade of the 21st century!
The healthy process of capital accumulation based on true savings
Now it is important that we quickly review the specifics of the economic processes through which artificial credit expansions created by a fractional-reserve banking system under the direction of a Central Bank entirely distort the real productive structure, and thus generate bubbles, induce unwise investments and finally trigger a financial crisis and a deep economic recession. But before that, and in honor of Hayek, we must remember the fundamental rudiments of capital theory which up to the present time and at least since the Keynesian revolution, have been almost entirely absent from the syllabus of most university courses on economic theory. In other words, we are first going to explain the specific entrepreneurial, spontaneous and microeconomic processes that in an unhampered free market tend to correctly invest all funds previously saved by economic agents. This is important, because only this knowledge will permit us to understand the huge differences with respect to what happens if investment is financed not by true savings, but by the mere creation out of thin air of new demand deposits which only materialize in the entries of banks’ accounting books. What we are going to explain now is nothing more and nothing less than why the so-called “paradox of saving” is entirely wrong from the standpoint of economic theory (Hayek 1975, 199-263). Unfortunately this is something very few students of economic theory know even when they finish their studies and leave the university. Nevertheless this knowledge applies without any doubt to one of the most important spontaneous market processes that every economist should be highly familiar with.
In order to understand what will follow, we must visualize the real productive structure of the market as a temporal process composed of many very complex temporal stages in which most labor, capital goods and productive resources are not devoted to producing consumer goods maturing this year, but consumer goods and services that will mature, and eventually be demanded by consumers, two, three, four, or even many more years from now… For instance, a period of several years elapses between the time engineers begin to imagine and design a new car, and the time the iron ore has already been mined and converted into steel, the different parts of the car have been produced, everything has been assembled in the auto factory, and the new cars are distributed, marketed and sold. This period comprises a very complex set of successive temporal productive stages. So, what happens if the subjective time preference of economic agents suddenly decreases and as a result the current consumption of this year decreases, for example, by ten percent? If this happens, three key spontaneous microeconomic processes are triggered and tend to guarantee the correct investment of the newly saved consumer goods.
The first effect is the new disparity in profits between the different productive stages: immediate sales in current consumer goods industries will fall and profits will decrease and stagnate compared with the profits in other sectors further away in time from current consumption. I am referring to industries which produce consumer goods maturing two, three, five or more years from now, their profitability not being affected by the negative evolution of short term current consumption. Entrepreneurial profits are the key signal that moves entrepreneurs in their investment decisions, and the relatively superior profit behavior of capital goods industries which help to produce consumer goods that will mature in the long term tells entrepreneurs all around the productive structure that they must redirect their efforts and investments from the less profitable industries closer to consumption to the more profitable capital goods industries situated further away in time from consumption.
The second effect of the new increase in savings is the decrease in the interest rate and the way it influences the market price of capital goods situated further away in time from consumption: as the interest rate is used to discount the present value of the expected future returns of each capital good, a decrease in the interest rate increases the market price of capital goods, and this increase in price is greater the longer the capital good takes to reach maturity as a consumer good. This significant increase in the market prices of capital goods compared with the relatively lower prices of the less demanded consumer goods (due to the increase in savings) is a second very powerful microeconomic effect that signals all around the market that entrepreneurs must redirect their efforts and invest less in consumer goods industries and more in capital goods industries further from consumption.
Finally, and third, we should mention what Hayek called The Ricardo Effect (Hayek 1948, 220-254; 1978, 165-178), which refers to the impact on real wages of any increase in savings: whenever savings increase, sales and market prices of immediate consumer goods relatively stagnate or even decrease. If factor incomes remain the same, this means higher real wages, and the corresponding reaction of entrepreneurs, who will try in the margin to substitute the now relatively cheaper capital goods for labor. What the Ricardo Effect explains is that it is perfectly possible to earn profits even when sales (of consumer goods) go down, if costs decrease even more via the replacement of labor, which has become more expensive, with machines and computers, for instance. Who produces these machines, computers, and capital goods that are newly demanded? Precisely the workers who have been dismissed by the stagnating consumer goods industries and who have relocated to the more distant capital goods industries, where there is new demand for them to produce the newly demanded capital goods. This third effect, the Ricardo Effect, along with the other two mentioned above, promotes a longer productive process with more stages, which are further away from current consumption. And this new, more capital-intensive productive structure is fully sustainable, since it is fully backed by prior, genuine real savings. Furthermore, it can also significantly increase, in the future, the final production of consumer goods and the real income of all economic agents. These three combined effects all work in the same direction; they are the most elementary teachings of capital theory; and they explain the secular tendency of the unhampered free market to correctly invest new savings and constantly promote capital accumulation and the corresponding sustainable increase in economic welfare and development.
The unsustainable nature of the Bubbles induced by artificial credit expansions created by the fractional-reserve banking industry.
We are now in a position to fully understand, by contrast with the above process of healthy capital accumulation, what happens if investments are financed not by prior genuine savings but by a process of artificial credit expansion, orchestrated by fractional-reserve banks and directed by the lender of last resort or Central Bank.
Unilateral credit expansion means that new loans are provided by banks and recorded on the asset side of their balance sheets, against new demand deposits that are created out of thin air as collateral for the new loans, and are automatically recorded on the liability side of banks’ balance sheets. So new money, or I should say new “virtual money” because it only “materializes” in bank accounting book entries, is constantly created through this process of artificial credit expansion. And in fact roughly only around ten percent of the money supply of most important economies is in the form of cash (paper bills and coins), while the remaining 90 percent of the money supply is this kind of virtual money that only exists as written entries in banks’ accounting books. (This is precisely what the Spanish Scholastics termed, over 400 years ago, “chirographis pecuniarum” or virtual money that only exists in writing in an accounting book.)
It is easy to understand why credit expansions are so tempting and popular and the way in which they entirely corrupt the behavior of economic agents and deeply demoralize society at all levels. To begin with, entrepreneurs are usually very happy with expansions of credit, because they make it seem as if any investment project, no matter how crazy it would appear in other situations, could easily get financing at very low interest rates. The money created through credit expansions is used by entrepreneurs to demand factors of production, which they employ mainly in capital goods industries more distant from consumption. As the process has not been triggered by an increase in savings, no productive resources are liberated from consumer industries, and the prices of commodities, factors of production, capital goods and the securities that represent them in stock markets tend to grow substantially and create a market bubble. Everyone is happy, especially because it appears it would be possible to increase one’s wealth very easily without any sacrifice in the form of prior saving and honest hard individual work. The so-called “virtuous circle of the new economy” in which recessions seemed to have been avoided forever, cheats all economic agents: investors are very happy looking at stock market quotes that grow day after day; consumer goods industries are able to sell everything they carry to the market at ever increasing prices; restaurants are always full with long waiting lists just to get a table; workers and their unions see how desperately entrepreneurs demand their services in an environment of full employment, wage increases and immigration; political leaders benefit from what appears to be an exceptionally good economic and social climate that they invariably sell to the electorate as the direct result of their leadership and good economic policies; state budget bureaucrats are astonished to find that every year public income increases at double digit figures, particularly the proceeds from Value Added tax, which, though in the end is paid by the final consumer, is advanced by the entrepreneurs of the early stages newly created and artificially financed by credit expansion.
But we may now ask ourselves: how long can this party last? How long can there continue to be a huge discoordination between the behavior of consumers (who do not wish to increase their savings) and that of investors (who continually increase their investments financed by banks’ artificial creation of virtual money and not by citizens’ prior genuine savings)? How long can this illusion that everybody can get whatever he wants without any sacrifice last?
The unhampered market is a very dynamically efficient process (Huerta de Soto 2010a, 1-30). Sooner or later it inevitably discovers (and tries to correct) the huge errors committed. Six spontaneous microeconomic reactions always occur to halt and revert the negative effects of the bubble years financed by artificial bank credit expansion.
The spontaneous reaction of the market against the effects of credit expansions: first the financial crisis and second the deep economic recession.
In my book on Money, Bank Credit and Economic Cycles (Huerta de Soto 2009, 361-384) I study in detail the six spontaneous and inevitable microeconomic causes of the reversal of the artificial boom that the aggression of bank credit expansion invariably triggers in the market. Let us summarize these six factors briefly:
1st The rise in the price of the original means of production (mainly labor, natural resources, and commodities). This factor appears when these resources have not been liberated from consumer goods industries (because savings have not increased) and the entrepreneurs of the different stages in the production process compete with each other in demanding the original means of production with the newly created loans they have received from the banking system.
2nd The subsequent rise in the price of consumer goods at an even quicker pace than that of the rise in the price of the factors of production. This happens when time preference remains stable and the new money created by banks reaches the pockets of the consumers in an environment in which entrepreneurs are frantically trying to produce more for distant consumption and less for immediate consumption of all kinds of goods. This also explains the 3rd factor which is
3rd The substantial relative increase in the accounting profits of companies closest to final consumption, especially compared with the profits of capital goods industries which begin to stagnate when their costs rise more rapidly than their turn over.
4th “The Ricardo Effect” which exerts an impact which is exactly opposite to the one it exerted when there was an increase in voluntary saving. Now the relative rise in the prices of consumer goods (or of consumer industries’ turnover in an environment of increased productivity) with respect to the increase in original-factor income begins to drive down real wages, motivating entrepreneurs to substitute cheaper labor for machinery, which lessens the demand for capital goods and further reduces the profits of companies operating in the stages furthest from consumption.
5th The increase in the loan rate of interest even exceeding pre-credit expansion levels. This happens when the pace of credit expansion stops accelerating, something that sooner or later always occurs. Interest rates significantly increase due to the higher purchasing power and risk premiums demanded by the lenders. Furthermore, entrepreneurs involved in malinvestments start a “fight to the death” to obtain additional financing to try to complete their investment projects (Hayek 1937).
These five factors provoke the following sixth combined effect:
6th Companies which operate in the stages relatively more distant from consumption begin to discover they are incurring heavy accounting losses. These accounting losses, when compared with the relative profits generated in the stages closest to consumption, finally reveal beyond a doubt that serious entrepreneurial errors have been committed and that there is an urgent need to correct them by paralyzing and liquidating the investment projects mistakenly launched during the boom years.
The financial crisis begins the moment the market, which as I have said is very dynamically efficient (Huerta de Soto 2010a, 1-30), discovers that the true market value of the loans granted by banks during the boom is only a fraction of what was originally thought. In other words, the market discovers that the value of bank assets is much lower than previously thought and, as bank liabilities (which are the deposits created during the boom) remain constant, the market discovers the banks are in fact bankrupt, and were it not for the desperate action of the lender of last resort in bailing out the banks, the whole financial and monetary system would collapse. In any case, it is important to understand that the financial and banking crisis is not the cause of the economic recession but one of its most important first symptoms.
Economic recessions begin when the market discovers that many investment projects launched during the boom years are not profitable. And then consumers demand liquidation of these malinvestments (which, it is now discovered, were planned to mature in a too-distant future considering the true wishes of consumers). The recession marks the beginning of the painful readjustment of the productive structure, which consists of withdrawing productive resources from the stages furthest from consumption and transferring them back to those closest to it.
Both the financial crisis and the economic recession are always unavoidable once credit expansion has begun, because the market sooner or later discovers that investment projects financed by banks during the boom period were too ambitious due to a lack of the real saved resources that would be needed to complete them. In other words, bank credit expansion during the boom period encourages entrepreneurs to act as if savings had increased when in fact this is not the case. A generalized error of economic calculation has been committed and sooner or later it will be discovered and corrected spontaneously by the market. In fact all the Hayekian theory of economic cycles is a particular case of the theorem of the impossibility of economic calculation under socialism discovered by Ludwig von Mises, which is also fully applicable to the current wrongly designed and heavily regulated banking system.
The specific features of the 2008 Financial Crisis and the current economic recession.
The expansionary cycle which has now come to a close was set in motion when the American economy emerged from its last recession in 2001 and the Federal Reserve embarked again on a major artificial expansion of credit and investment, an expansion unbacked by a parallel increase in voluntary household saving. In fact, for several years the money supply in the form of banknotes and deposits has been growing at an average rate of over ten 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 extremely low (and even negative in real terms) interest rates. This 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 enough, like in the “roaring” years prior to the Great Depression of 1929, the shock of monetary growth has not significantly influenced the unit prices of the subset of consumer goods and services (which are only approximately one third of the total number of goods that are exchanged in the market). 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 “money and credit injection,” would have given rise to a healthy and sustained reduction in the unit price of the goods and services all citizens consume. Moreover, the full incorporation of the economies of China and India into the globalized market has gradually raised 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 whole economic process. And let us remember the “Antideflationist Hysteria” of those who, even during the years of the bubble, used the slightest symptoms of this healthy deflation, to justify even greater doses of credit expansion.
As we have already seen, artificial credit expansion and the (fiduciary) inflation of media of exchange offer no shortcut to stable and sustained economic development, no way of avoiding the necessary sacrifice and discipline behind all high rates of voluntary saving. (In fact, before the crisis and particularly in the United States, voluntary saving not only failed to increase, but even fell to a negative rate for several years.)
The specific factors that trigger 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 this crisis, the most obvious triggers were first, the rise in the price of commodities and raw materials, particularly oil, second, 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 debts exceeded that of their assets (mainly mortgage loans erroneously granted).
If we consider the level of past credit expansion and the quality and volume of malinvestment produced by it, we could say that very probably in this cycle the economies of the European Monetary Union are in comparison in a somewhat less poor state (if we do not consider the relatively greater Continental 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 for the monetary union involved at the time a healthy and significant rehabilitation of the chief European economies. Only some countries on the periphery, like Ireland and 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 (like the liberalizing structural reforms which originated with José María Aznar’s administration). Nevertheless, the boom was also largely fueled by an artificial expansion of money and credit, which grew at a rate nearly three times 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 Spanish banks granted by creating the money ex nihilo while European central bankers looked on unperturbed. Once the crisis hit Spain the readjustment was quick and efficient: In less than a year more than 150,000 companies -mainly related with the building sector- have disappeared, almost five million workers who were employed in the wrong sectors have been dismissed, and nowadays we can conclude that although still very weak, the economic body of Spain has been already healed. We will later come back to the subject of what economic policy is most appropriate to the current circumstances. But before that, let us make some comments on the influence of the new accounting rules on the current economic and financial crisis.
The negative influence of the new accounting rules.
We must not forget that a central feature of the long past 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 most countries 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 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.
It is easy to realize that the new accounting rules 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, when assets are worth the least and financial markets dry up. Clearly, accounting principles which have proven so disturbing must be abandoned as soon as possible, and the recent accounting reforms recently enacted, 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 till the adoption of the false idol of the International Accounting Rules.
It must be emphasized 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, as Hayek already established as early as 1934 in his article “The Maintenance of Capital” (Hayek 1934). This requires the application of strict standards of accounting conservatism (based on the prudence principle and the recording of either historical cost or market value, whichever is lower), 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 each company.
Who is responsible for the current situation?
Of course the spontaneous order of the unhampered market is not responsible for the current situation. And one of the most typical consequences of every past crisis and of course of this current one, is how many people are blaming the market and firmly believing that the recession is a “market failure” that requires more government intervention. The market is a process that spontaneously reacts in the way we have seen against the monetary aggression of the bubble years, which consisted of a huge credit expansion that was not only allowed but even orchestrated and directed by central Banks, which are the institutions truly responsible for all the economic sufferings from the crisis and recession that are affecting the world. And paradoxically central banks have been able to present themselves to the general public not only as indignant victims of the list of ad hoc scapegoats they have been able to put together (stupid private bankers, greedy managers receiving exorbitant bonuses, etc.), but also as the only institutions which, by bailing out the banking system as a last resort, have avoided a much greater tragedy.
In any case, it is crystal clear that the world monetary and banking system has chronically suffered from wrong institutional design at least since Peel’s Bank Act of 1844. There is no free market in the monetary and banking system but just the opposite: private money has been nationalized, legal tender rules introduced, a huge mess of administrative regulations enacted, the interest rate manipulated and most importantly, everything is directed by a monetary central-planning agency: The Central Bank.
In other words, real socialism, represented by state money, Central banks and financial administrative regulations, is still in force in the monetary and credit sectors of the so-called free market economies.
As a result of this fact we experience regularly in the area of money and credit all the negative consequences established by the Theorem of the Impossibility of Socialism discovered by those distinguished members of the Austrian School of Economics: Ludwig von Mises and Friedrich Hayek.
Specifically, the central planners of state money are unable to know, to follow and to control the changes in both the demand for and supply of money. Furthermore, as we have seen, the whole financial system is based on the legal privilege given by the state to private bankers, who can use a fractional-reserve ratio with respect to the demand deposits they receive from their customers. As a result of this privilege, private bankers are not true financial intermediaries, but are mainly creators of deposits materializing in credit expansions that inevitably end in crisis and recession.
The most rigorous economic analysis and the coolest, most balanced interpretation of past and recent economic and financial events lead inexorably to the conclusion that central banks (which, again, are true financial central-planning agencies) cannot possibly succeed in finding the most convenient monetary policy at every moment. This is exactly the kind of problem that became evident 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 and (at one time) Alan Greenspan and (currently) Ben Bernanke in particular. According to this theorem, it is impossible to organize any area of the economy and especially the financial sector, via 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. This is precisely what I analyze in Chapter 3 of my book on Socialism, Economic Calculation and Entrepreneurship, which has been published by Edward Elgar in association with the Institute of Economic Affairs, and which we present today (Huerta de Soto, 2010b).
Indeed, nothing is more dangerous than to indulge in the “fatal conceit” – to use Hayek’s useful expression (Hayek, 1990) – 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 softening the most violent ups and downs of the economic cycle, the Federal Reserve and, to a lesser extent, the European Central Bank, have 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 up a blind alley. They can either allow the recessionary process to follow its course, and with it the healthy and painful readjustment, or they can escape forward toward a “renewed inflationist” cure. With the latter, the chances of an even more severe recession (even stagflation) in the not-too-distant future increase dramatically. (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 the artificially 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 happened in the case of the Japanese economy, which, though all possible interventions have been tried, has ceased to respond to any stimulus involving either monetarist credit expansions or Keynesian methods.
It is in this context of “financial schizophrenia” that we must interpret the “shots in the dark” fired in the last two years 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 Fed rescues Bear Stearns, AIG, Fannie Mae, Freddie Mac or City Group, and the next it allows Lehman Brothers to fail, under the amply justified pretext of “teaching a lesson” and refusing to fuel moral hazard. Finally, in light of the way events were unfolding, the US and European governments launched multi-billion-dollar plans to purchase illiquid (that is, worthless) assets from the banking system, or to monetize the public debt, or even to buy bank shares, totally or partially nationalizing the private banking system. And considering all that we have seen, which are now the possible future scenarios?
Possible future scenarios and the most appropriate economic policy.
Theoretically, under the wrongly designed current financial system, once the crisis has hit we can think of four possible scenarios:
The first scenario is the catastrophic one in which the whole banking system based on a fractional reserve collapses. This scenario seems to have been avoided by central banks which, acting as lenders of last resort, are bailing out private banks whenever it is necessary.
The second scenario is just the opposite of the first one but equally tragic: it consist of an “inflationist cure” so intense, that a new bubble is created. This forward escape would only temporarily postpone the solution of the problems at the cost of making them far more serious later (this is precisely what happened in the crisis of 2001).
The third scenario is what I have called the “japanization” of the economy: it happens when the reintroduction of the cheap-credit policy together with all conceivable government interventions entirely blocks the spontaneous market process of liquidation of unprofitable investments and company reconversion. As a result, the recession is prolonged indefinitely and the economy does not recover and ceases to respond to any stimulus involving monetarist credit expansions or Keynesian methods.
The fourth and final scenario is currently the most probable one: It happens when the spontaneous order of the market, against all odds and despite all government interventions, is finally able to complete the microeconomic readjustment of the whole economy, and the necessary reallocation of labor and the other factors of production toward profitable lines based on sustainable new investment projects.
In any case, after a financial crisis and an economic recession have hit it is necessary to avoid any additional credit expansion (apart from the minimum monetary injection strictly necessary to avoid the collapse of the whole fractional-reserve banking system). And 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 measures 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, sustainable economic recovery.
However, once the economy recovers (and in a sense the recovery begins with the crisis and the recession themselves which mark the discovery by the market of the errors committed and the beginning of the necessary microeconomic readjustment), I am afraid that, as has happened in the past again and again, no matter how careful central banks may be in the future (can we expect them to have learned their lesson? For how long will they remember what happened?), nor how many new regulations are enacted (as in the past all of them and especially Basel II and III have attacked only the symptoms but not the true causes), sooner or later new cycles of credit expansion, artificial economic boom, financial crisis and economic recession will inevitably continue affecting us until the world financial and banking systems are entirely redesigned according to the general principles of private property law that are the essential foundation of the capitalist system and that require a 100 percent reserve for any demand deposit contract.
I began this lecture with Peel’s Bank Act, and I will also finish with it. On June 13 and 24, 1844 Robert Peel pointed out in the House of Commons that in each one of the previous monetary crises “there was an increase in the issues of country bank paper” and that “currency without a basis (…) only creates fictitious value, and when the bubble bursts, it spreads ruin over the country and deranges all commercial transactions”.
Today, 166 years later, we are still suffering from the problems that were already correctly diagnosed by Robert Peel. And in order to solve them and finally reach the only truly free and stable financial and monetary system that is compatible with a free market economy in this 21st century, it will be necessary to take the following three steps:
First, to develop and culminate the basic concept of Peel’s Bank Act by also extending the prescription of a 100 percent reserve requirement to demand deposits and equivalents. Hayek states that this radical solution would prevent all future crises (Hayek 1984, 29) as no credit expansions would be possible without a prior increase in real genuine saving, making investments sustainable and fully matched with prior voluntary savings. And I would add to Hayek’s statement the most important fact that 100 percent banking is the only system compatible with the general principles of the law of property rights that are indispensable for the capitalist system to work: there is no reason to treat deposits of money differently from any other deposit of a fungible good, such as wheat or oil in which nobody doubts the need to keep the 100 percent reserve requirement.
In relation to this first step of the proposed reform it is most encouraging to see how two Tory MPs, Douglas Carswell and Steve Baker, were able to introduce in the British Parliament on September the 15th and under the 10 minute rule the first reading of a Bill to reform the banking system extending the prescriptions of Peel’s Bank Act to demand deposits. This “customer Choice Disclosure and Protection Bill” will be discussed in its second reading, three weeks from now, on November the 19th, and has two goals: first to fully and effectively defend citizens’ right of ownership over money they have deposited in checking accounts at banks; and second, to once and for all put an end to the recurrent cycles of artificial boom, financial crisis and economic recession. Of course this first draft of the bill still needs to be completed with some important details, for instance the time period (let us say a month) under which all deposits should be considered demand deposits for storage and not for investment, and any contract that guarantees full availability of its nominal value at any moment should be considered at all effects a demand deposit for storage. But the mere discussion of these matters in the British Parliament and by the public at large is, in itself, of huge importance. In any case it is exciting that a handful of MPs have taken this step against the tangle of vested interests related to the current privileged fractional-reserve banking system. If they are successful in their fight against what we could call the current “financial slavery” that grips the world they will go down in history like William Wilberforce –with the abolition of the slave trade- and other outstanding British figures to which the whole world owes so much.
Second, if we wish to culminate the fall of the Berlin wall and get rid of the real socialism that still remains in the monetary and credit sector, a priority would be the elimination of Central Banks, which would be rendered unnecessary as lenders of last resort if the above 100 percent reserve reform is introduced, and harmful if they insist on continuing to act as financial central-planning agencies.
And third, who will issue the monetary base? Maurice Allais, the French Nobel Prize winner who passed away two weeks ago, proposed that a Public Agency print the public paper money at a rate of increase of 2 percent per year. I personally do not trust this solution as any emergency situation in the state budget would be used, as in the past, as a pretext for issuing additional doses of fiduciary media. For this reason, and this is probably my most controversial proposal, in order to put an end to any future manipulation of our money by the authorities, what is required is the full privatization of the current, monopolistic, and fiduciary state-issued paper base money, and its replacement with a classic pure gold standard.
There is an old Spanish saying: “A grandes males, grandes remedios”. In English, “great problems require radical solutions”. And though of course any step toward these three measures would significantly improve our current economic system, it must be understood that the reforms proposed and taken by governments up to now (including Basel II and III) are only nervously attacking the symptoms but not the real roots of the problem, and precisely for that reason they will again miserably fail in the future.
Meanwhile, it is encouraging to see how a growing number of scholars and private institutions like the “Cobden Centre” under the leadership of Toby Baxendale, are studying again not only the radical reforms required by a truly honest private money, but also very interesting proposals for a suitable transition to a new banking system, like the one I develop in chapter 9 of my book on Money, Bank Credit and Economic Cycles. By the way, in this chapter I also explain a most interesting by-product of the proposed reform, namely the possibility it offers of paying off, without any cost nor inflationary effects, most of the existing public debt which in the current circumstances is a very worrying and increasingly heavy burden in most countries.
Briefly outlined, what I propose and the Cobden Centre has developed in more detail for the specific case of the United Kingdom, is to print the paper banknotes necessary to consolidate the volume of demand deposits that the public decides to keep in the banks. In any case, the printing of this new money would not be inflationary, as it would be handed to banks and kept entirely sterilized, so to speak, as 100 percent asset collateral of bank liabilities in the form of demand deposits. In this way, the basket of bank assets (loans, investments, etc.) that are currently backing the demand deposits would be “freed”, and what I propose is to include these “freed” assets in mutual funds, swapping their units at their market value for outstanding treasury bonds. In any case, an important warning must be given: naturally, and one must never tire of repeating it, the solution proposed is only valid in the context of an irrevocable decision to re-establish a free-banking system subject to a 100 percent reserve requirement on demand deposits. However, no matter how important this possibility is considered under the current circumstances, we must not forget it is only a by-product (of “secondary” importance) compared to the major reform of the banking system we have outlined.
And now to conclude, should in this 21st century a new Robert Peel be able to successfully push for all these proposed reforms, this great country of the United Kingdom would again render an invaluable service not only to itself but also to the rest of the world.
Thank you very much.
HAYEK, Friedrich A. (1937), “Investment that Raises the Demand for Capital”, Review of Economics and Statistics, 19, no. 4. Reprinted in Profits, Interest and Investment, pp. 73-82.
HAYEK, Friedrich A. (1948), “The Ricardo Effect” in Individualism and Economic Order, Chicago: University of Chicago Press, pp. 250-54.
HAYEK, Friedrich A. (1975), “The ‘Paradox’ of Saving” in Profits, Interest and Investment and other Essays on the Theory of Industrial Fluctuations, Clifton, N.J.: Augustus M. Kelly.
HAYEK, Friedrich A. (1978), “Three Elucidations of the Ricardo Effect” in New Studies in Philosophy, Politics and the History of Ideas, London: Routledge and Kegan Paul, pp. 165-78.
HAYEK, Friedrich A. (1984), “The Monetary Policy of the United States after the Recovery from the 1920 Crisis”, Chapter 1 in Money, Capital and Fluctuations: Early Essays, R.M. McCloughry, ed., Chicago: University of Chicago Press.
HAYEK, Friedrich A. (1990), The Fatal Conceit: The Errors of Socialism, W.W. Bartley, III (ed.), London: Routledge and Chicago, Il.: The University of Chicago Press.
HUERTA DE SOTO, Jesús (2009), Money, Bank Credit and Economic Cycles, Auburn, Al.: Mises Institute (2nd English edition). First Spanish edition 1998.
HUERTA DE SOTO, Jesús (2010a), The Theory of Dynamic Efficiency, London and New York: Routledge.
HUERTA DE SOTO, Jesús (2010b), Socialism, Economic Calculation and Entrepreneurship, Cheltenham, UK and Northampton, Massachusetts, USA: Edward Elgar.
MISES, Ludwig von (1980), The Theory of Money and Credit, Indianapolis, Ind.: Liberty Classics. First German edition 1912, 2nd German edition 1924.
The fallacy of composition misleads you into thinking that you can infer the property of the whole by the property you can observe in its parts considered individually. This fallacy leads you to think that what is true for the parts must be true for the whole.
In economics, one of the most popular examples of the fallacy of composition is the “paradox of thrift,” popularized by Keynesian economics. If thrift is good for an individual, it should be good for the economy as a whole. Wrong, because if everyone saves more, this will bring down consumption, cause aggregate demand to fall, hamper any economic growth and, paradoxically, a rise in individuals’ thrift would lead to less saving on the whole and harm the economy. Policymakers believing in the paradox of thrift, particularly in times of recession, would look in horror at people saving more while trying to find their way out of the hole. Yet, despite what we can argue using curves that sometimes saving is equal to investment and sometimes is not, sound capital theory reminds us of the basic fact that an economy needs a boost in real saving for capital formation to bring about a real recovery (not a nominal or a statistical one). For those critics of Keynesian economics, the paradox of thrift is not an example of the fallacy of composition but one of bad economics.
Recently, the fallacy of composition has been also widely argued as a theoretical flaw in public policies that explains the current financial crisis. As the argument goes, regulators were misled since they assumed that recommending what seemed right for a single bank should be right for the whole banking sector. Supervisors were also misled by this same fallacy: checking individual banks’ soundness made them infer that the system was sound as a whole. This misconception left traditional regulators and supervisors, solely focused on the safety and soundness of individual banks, ill-equipped to prevent the systemic collapse seen at the end of 2008. Thus, a fresh conception of “macro-prudential supervision and regulation” is needed: a system-wide, top-down approach to regulation and supervision.
However, does this fallacy of composition really apply to the banking sector? If we look at other industries, a fallacy of composition does not seem to be the case. For example, if all individual fishing companies run their business in a safe and sound manner, we can infer that the fishing industry is safe and sound on the whole. The issue is, what do we mean by running an individual fishing company in a safe and sound manner. Even if it were profitable for an individual company to go carelessly about polluting waters, fishing out of season and in non-fishing areas, we could not call this a safe and sound way of running an individual business, so it would be unfounded to infer that the fishing industry is safe and sound on the whole.
In the banking industry something similar happens and the fallacy of composition might not be obvious at first sight. The two distinctive activities of banks are cash and payment services and credit intermediation. It is not easy to grasp how individual safe and sound “cash and payment agents” and individual safe and sound “credit intermediaries” can become a source of global systemic collapse when compounded as a whole.
Fierce critics of how banking operates today would argue that there is no such fallacy of composition, but a big misconception of what a sound individual bank should be. These critics would question whether we can call “sound” institutions that systematically borrow short-term and lend long-term, hold low capital, and intermingle socially-essential “utility” activities with highly risky trading and credit operations. Banks, for them, are so unsound in their present form that they can only operate if they are heavily propped up by the State. Without central banks’ ability to print as much money as needed, and in the absence of State-funded implicit and explicit deposit guarantees and State-promoted “too-big-to-fail” doctrines, modern banking industry simply could not exist.
Modern banking theory, however, would have it that there is little we can do. Banks have a social function of maturity transformation. They are expected “to allow individuals ready access to their money, while at the same time allowing most of that money to be invested in illiquid assets” (P. Krugman). For this Nobel Laureate the way to go with this intrinsically but economically desirably unstable banking industry is through “Government backing — the 21st -century version of deposit insurance — plus regulation so that the backed institutions don’t abuse the privilege”. Fierce critics would argue that maturity transformation is not a function for banks to do but for the society itself. Time preferences of savers and investment projects of entrepreneurs simply fall into banks’ hands. Their essential social function is to intermediate credit according to savers’ time preferences and borrowers’ funding needs.
Modern banking theory would continue saying that bank credit has to remain “flexible enough” to promote economic growth. Nobody questions the fact that bank credit is vital for capital accumulation that promotes economic growth. The question is when “flexible credit” stops promoting economic growth and starts creating a global financial meltdown. Our fierce critics, following Mises’ and Hayek’s business cycle theories, would argue that enough is enough when credit expansion does not follow the sustainable path marked by real savings. Cobden Center’s Senior Fellow Prof Huerta de Soto sets all of this out in great detail in his must-read book “Money, Bank Credit, and Economic Cycles”.
Milder critics, on the other hand, would also argue that there was no such fallacy of composition, but a systematic distortion of how to assess individual banks’ risk. They accept current unstable banking characteristics and State support, but question whether criteria to assess individual banks’ level of risk were correct. For them, regulators, supervisors and bankers simply failed to include a system-wide perspective in the individual assessment of risk. As a result, systemic risk was not the consequence of a fallacy of composition, but rather of poor assessment of individual banks’ risk, which failed to consider the fact that the collective behaviour of financial institutions was an important driver of risk.
No doubt there are good reasons to change many of the current approaches to banking regulation and supervision, but maybe the fallacy of composition is not one of them. And we should not be oblivious to the fact that in the financial system its opposite, ”fallacy of division”, would have even more damaging effects if policymakers were misled by assuming that, if the whole looks sound, all individual banks should be sound as well.
In September of last year, I placed this article up on our web site detailing the theoretical errors behind the policy of quantitative easing. Clearly, as the MPC has now been given the green light by our chancellor, we expect this currency debasement to be starting soon. All it will “achieve” is a wealth transfer from those lucky enough to get the newly minted money, from those not luckily enough. I aimed to expose the faulty crank-economics that lies behind such thought processes last year and did not think a Tory government would be so foolish to let this happen under their watch, especially as they condemned it under a Labour government. Sadly, articles like this one need to be reproduced so that a new set of readers can hopefully have influence on the present administration.
The mainstream economists hold that the volume of money in circulation, times its velocity is equal to the prices of all goods and services added up. This is the famous Theory of Exchange, MV=PT, or the mechanistic Quantity Theory of Money, where:
M is the stock of money,
V is the velocity of circulation: the number of times the monetary unit changes hands in a certain time period,
P is the general price level,
and T is the “aggregate” of all quantities of goods and services exchanged in the period.
It is held by the overwhelming majority of all economists, that if the velocity of money falls, the price level will fall and thus it is the duty of government, the monopoly issuer of money, the chief Central Planner of the Money Supply, to create more money to keep the price level where it is and thus preserve the existing spending habits of the nation.
Error One — the stock of money
It is held that if you can count the monetary units in the economy and their velocity, you can say what the price level is. As people find it very difficult to count the money in an economy, they cannot see the statistical relationship showing up mechanistically in the price level as expected: the authorities do not have a measure of the money supply which correlates to economic activity.
Working from a sound theoretical basis, I and my colleague Anthony Evans can show you how to count money exactly and how that measure of the money stock correlates to economic activity:
Note that changes in the mainstream measures — M0 and M4 — are quite different to changes in our measure — MA. However, it is MA which shows the best correlation to economic activity and not the measures used by the Bank of England and HM Treasury:
The monetary authorities do not have an adequate measure of the money supply.
Error Two — the velocity of circulation
Velocity is defined as the average number of times during a period that a monetary unit (I will call this MU) is exchanged for a good or service. It is said that a 5% increase in money does not necessarily show itself up with a 5% increase in the price level. It is argued that this is because the velocity of money changes. The trick is to measure by how much the velocity has declined and then create new money — cross your fingers, pray to the Good Lord, do a rain dance around a fire, and hope that the new money will be spent — to fill in this gap left by the fall in velocity.
When you buy a house, we do not say it “circulates”: money is exchanged against real bricks and mortar. The printer who sold me books would have had to sell printed things (i.e. real goods) and saved (forgone consumption) for the future purchase (act of consumption) of the house. Imagine selling your house backwards and forwards between say you and your wife 10 times: the mainstream would argue that the velocity of circulation had risen!
Yes as daft as it sounds, this is the present state of economics.
Thus, if the velocity has gone up by a factor of 10, the price level has increased by the same factor. Here is the suggested rub: therefore, when the velocity of circulation falls, if you increase the money supply by the same factor that the velocity of circulation has fallen by, the price level will stay the same.
Note, as explained above and in detail here, the mainstream do not actually know what money is. Well, let us be clear: it is the final good for which (all) other goods exchange. All of us who are productive make things for sale or sell services, even if it is only our own labour. We sell goods and services which we produce or offer for other goods and services we need. The most marketable of all commodities, money, is accepted by you and other citizens and facilitates exchange of your goods and services for other goods and services. Note that, at all times, money facilitates the exchange of real goods for other real goods.
Party one and a counterparty exchanging or “selling” the house between one another 10 times causing an “increase in velocity” and thus an increase in the price level as an idea is utter garbage. If one party had sold real goods and saved in anticipation of buying the house — real bricks and mortar via the medium of money — this would facilitate a transaction of something (the party’s saved real goods) for something (the counterparty’s real house). Printing money to make sure the price level stays stable to facilitate the “circulating” house in the first example will facilitate a transfer of nothing (the paper) for something (the house). This is commonly called counterfeiting.
This may be another helpful example of why velocity is utterly meaningless. Consider a dinner party: Guest A has a £1. He lends it to Guest B at dinner, who lends it to Guest C who lends it to Guest D. If Guest D pays it back to Guest C, who pays it back to Guest B pays Guest A, the £1 is said to have done £4’s worth of work. The bookkeeping of this transaction shows that £1 was lent out 4 times and they all cancel each other out! Just to be clear, £1 has done £1’s work and not £4’s work. No real wealth or value is created.
The velocity of circulation makes no economic sense.
Error Three — the general price level
Since the monetary authorities have no means to sum the price and quantity of every individual transaction, they must work instead with the “general price level”, ignoring the vital role of changes in relative prices.
As early as 1912, Ludwig von Mises demonstrated that new money must change the structure of relative prices. As anyone who has lived through the past year could tell you, new money is not distributed equally to everyone in the economy. It is injected over time and in specific locations: new money redistributes income to those who receive it first. This redistribution of income not only alters people’s subjective perception of value, it also alters their weight in the marketplace. These factors can only lead to changes in the structure of relative prices.
Mainstream economists believe that “money is neutral in the long run”. They do not have a theory of the capital structure of production which can account for the effects of time and relative prices. They believe increases in the money supply affect all sectors uniformly and proportionately. This is manifestly untrue: look at changes in the Bank of England’s balance sheet and your bank statement.
Hayek wrote that his chief objection to this theory was that it paid attention only to the general price level and not to the structure of relative prices. He indicated that, in consequence, it disregarded the most harmful effects of increasing the money supply: the misdirection of resources and specifically unemployment. Furthermore, this wilful ignorance of relative prices explains the mainstream’s lack of an adequate theory of business cycles, something Hayek provided.
The general price level aggregates away a vital factor: the relative structure of prices.
Error Four — the aggregate quantities of goods and services sold
Since the sum of price times quantity for every individual transaction is not available, the authorities must use the “aggregate quantity of goods and services sold”. This is nonsense: the quantities to be added together are incompatible. It makes no sense to add a kilogram of potatoes to a kilogram of copper to a litre of petrol to a day’s software consultancy to a 30-second television advert.
The aggregate quantity of goods and services sold is an impossible sum.
Error Five — the equation is no more than a tautology
Consider this, if I buy 10 copies of Adam Smith’s Wealth of Nations from a printing company for 7 monetary units (or MU), an exchange has been made: I gave up 7 MU’s to the printer, and the printer transferred 10 sets of printed works to me. The error that the mainstream make is that “10 sets of printed works have been regarded as equal to 7 MU, and this fact may be expressed thus: 7 MU = 10 printed works multiplied by 0.7 MU per set of printed works.” But equality is not self-evident.
There is never any equality of values on the part of the two participants in exchange. The assumption that an exchange presumes some sort of equality has been a delusion of economic theory for many centuries. We only exchange if each party thinks he is getting something of greater value from the other party than he has already. If there was equality in value, no exchange would happen! Value is subjective and utility is marginal: each party values the other’s goods or services more highly than their own.
Thus, while the mainstream believe that there is a causal link between the “money side” of the equation and the “value of goods and services side”, it is just a tautology from which no economic knowledge can be gained. All we are saying, if the Quantity Theory holds, is that “7 MU’s = 10 sets of printed works X 0.7 MU’s per set of printed works”: in other words, “7 MU = 7 MU”. Thus what is paid is what is received. This is like announcing to the world that you have discovered the fabulous fact that 2=2.
The mechanistic Quantity Theory of Money is not a causal relation but a tautology.
The mechanistic Quantity Theory only provides us with a tautology and every term of “MV = PT” is seriously flawed. Public policy should not rest on the foundation of this bad science.
If the money supply contracts as it has done so spectacularly since late 2008 (see the chart above), you will have less goods and services supporting less economic activity. This for sure is bad. We now have less money and less exchanging of real goods and services for other real goods and services.
The only way to get more goods and services offered for exchange is if entrepreneurs get hold of their factors of production — land, labour and capital — and reorganise them to meet the new demands of the consumers in a more efficient way than before. The only thing that the government can do is to make sure it provides as little regulatory burden as possible and the lightest tax regime that it can run in order to allow entrepreneurs to facilitate this correction.
Certainly in my business of the supply of fish and meat to the food service sector — www.directseafoods.co.uk — I have never witnessed such an abrupt change in consumption patterns as people have traded down from more expensive species and cuts to less expensive ones. Thus I have to reorganise my offer to my customers and potential customers. No amount of fiddling about with the level of newly minted money in the economy will help this reorganisation of my factors of production: they need to be retuned to the new needs and desires of my customers.
Quantitative easing, as I have said before, is firmly based on a belief in the so called “internal truths” held in the Quantity Theory of Money. I hope any reader can see that this belief is based on very faulty logic. Bad logic gives us bad policy. A policy of QE says that because the velocity of circulation has fallen, we can print newly minted money, out of thin air, at the touch of a computer key, and create more demand for the exchange of goods and services.
Money has been historically rooted in gold and silver because these cannot “vanish” overnight as we are seeing under our present state monopoly of money — fiat money, money by decree, i.e. bits of paper we are forced to use as legal tender. Remember, since 1971 when Nixon broke the gold link, money is just bits of paper, notwithstanding a promise to pay the bearer on demand. In the near future, this will no doubt remain the case. Indeed, anyone who dares to mention that the final good, for which all goods exchange, should be a real good that is scarce (hard to manipulate it, hard to destroy it) unlike paper and electronic journal entries (easy to manipulate, easy to destroy) is considered a lunatic!
On a point of history, it is worthwhile remembering that, as we have mentioned here, the 1844 Peel Act did remove the banks’ practice of issuing promissory notes (paper money) over and above their reserves of gold (the most marketable commodity i.e. money) as this was causing bank runs, “panic”, boom and bust. They did not resolve the issues of demand deposits to be drawn by cheque. Both features allow banks to issue new money — i.e. certificates that have no prior production of useful economic activity such as our printer printing books or my selling of meat and fish — while retaining real money — claims to the printing of books and selling of my meat and fish — only to a percentage of the deposited money, i.e. the Reserve Requirement of the bank. In the UK, there is no Reserve Requirement anymore as far as I am aware, hence banks going for massive levels of leverage. It is no surprise that the house of cards has fallen down.
Our proposal for a 100% reserve requirement is offered for discussion as the only sure-fire way of delivering lasting stability. Listening to economists talking about the “velocity of circulation” falling and thus suggesting that we should conduct large scale Quantitative Easing to hold the price level is not economics, but the policy of the Witch Doctor and the Mystic.
It is staggering that so much garbage, posing as sound knowledge, hinges on these grave errors.