The gold standard was an international standard. It safeguarded the stability of foreign exchange rates. It was a corollary of free trade and of the international division of labor. Therefore those who favored etatism and radical protectionism disparaged it and advocated its abolition. Their campaign was successful.
Even at the height of liberalism governments did not give up trying to put easy money schemes into effect. Public opinion is not prepared to realize that interest is a market phenomenon which cannot be abolished by government interference. Everybody values a loaf of bread available for today’s consumption higher than a loaf which will be available only ten or a hundred years hence. As long as this is true, every economic activity must take it into account. Even a socialist management would be forced to pay full regard to it.
In a market economy the rate of interest has a tendency to correspond to the amount of this difference in the valuation of future goods and present goods. True, governments can reduce the rate of interest in the short run. They can issue additional paper money. They can open the way to credit expansion by the banks. They can thus create an artificial boom and the appearance of prosperity. But such a boom is bound to collapse sooner or later and to bring about a depression.
The gold standard put a check on governmental plans for easy money. It was impossible to indulge in credit expansion and yet cling to the gold parity permanently fixed by law. Governments had to choose between the gold standard and their—in the long run disastrous—policy of credit expansion. The gold standard did not collapse. The governments destroyed it. It was as incompatible with etatism as was free trade. The various governments went off the gold standard because they were eager to make domestic prices and wages rise above the world market level, and because they wanted to stimulate exports and to hinder imports. Stability of foreign exchange rates was in their eyes a mischief, not a blessing.
No international agreements or international planning is needed if a government wants to return to the gold standard. Every nation, whether rich or poor, powerful or feeble, can at any hour once again adopt the gold standard. The only condition required is the abandonment of an easy money policy and of the endeavors to combat imports by devaluation.
The question involved here is not whether a nation should return to the particular gold parity that it had once established and has long since abandoned. Such a policy would of course now mean deflation. But every government is free to stabilize the existing exchange ratio between its national currency unit and gold, and to keep this ratio stable. If there is no further credit expansion and no further inflation, the mechanism of the gold standard or of the gold exchange standard will work again.
All governments, however, are firmly resolved not to relinquish inflation and credit expansion. They have all sold their souls to the devil of easy money. It is a great comfort to every administration to be able to make its citizens happy by spending. For public opinion will then attribute the resulting boom to its current rulers. The inevitable slump will occur later and burden their successors. It is the typical policy of après nous le déluge. Lord Keynes, the champion of this policy, says: “In the long run we are all dead.” But unfortunately nearly all of us outlive the short run. We are destined to spend decades paying for the easy money orgy of a few years.
Inflation is essentially antidemocratic. Democratic control is budgetary control. The government has but one source of revenue—taxes. No taxation is legal without parliamentary consent. But if the government has other sources of income it can free itself from this control.
If war becomes unavoidable, a genuinely democratic government is forced to tell the country the truth. It must say: “We are compelled to fight for our independence. You citizens must carry the burden. You must pay higher taxes and therefore restrict your consumption.” But if the ruling party does not want to imperil its popularity by heavy taxation, it takes recourse to inflation.
The days are gone in which most persons in authority considered stability of foreign exchange rates to be an advantage. Devaluation of a country’s currency has now become a regular means of restricting imports and expropriating foreign capital. It is one of the methods of economic nationalism. Few people now wish stable foreign exchange rates for their own countries. Their own country, as they see it, is fighting the trade barriers of other nations and the progressive devaluation of other nations’ currency systems. Why should they venture to demolish their own trade walls?
Some of the advocates of a new international currency believe that gold is not fit for this service precisely because it does put a check on credit expansion. Their idea is a universal paper money issued by an international world authority or an international bank of issue. The individual nations would be obliged to keep their local currencies at par with the world currency. The world authority alone would have the right to issue additional paper money or to authorize the expansion of credit by the world bank. Thus there would be stability of exchange rates between the various local currency systems, while the alleged blessings of inflation and credit expansion would be preserved.
These plans fail, however, to take account of the crucial point. In every instance of inflation or credit expansion there are two groups, that of the gainers and that of the losers. The creditors are the losers; it is their loss that is the profit of the debtors. But this is not all. The more fateful results of inflation derive from the fact that the rise in prices and wages which it causes occurs at different times and in different measure for various kinds of commodities and labor. Some classes of prices and wages rise more quickly and to a higher level than others. While inflation is under way, some people enjoy the benefit of higher prices on the goods and services they sell, while the prices of goods and services they buy have not yet risen at all or not to the same extent. These people profiteer by virtue of their fortunate position. For them inflation is good business. Their gains are derived from the losses of other sections of the population. The losers are those in the unhappy situation of selling services and commodities whose prices have not yet risen at all or not in the same degree as the prices of things they buy for their own consumption. Two of the world’s greatest philosophers, David Hume and John Stuart Mill, took pains to construct a scheme of inflationary changes in which the rise of prices and wages occurs at the same time and to the same extent for all commodities and services. They both failed in the endeavor. Modern monetary theory has provided us with the irrefutable demonstration that this disproportion and nonsimultaneousness are inevitable features of every change in the quantity of money and credit.
Under a system of world inflation or world credit expansion every nation will be eager to belong to the class of gainers and not to that of the losers. It will ask for as much as possible of the additional quantity of paper money or credit for its own country. As no method could eliminate the inequalities mentioned above, and as no just principle for the distribution could be found, antagonisms would originate for which there would be no satisfactory solution. The populous poor nations of Asia would, for instance, advocate a per capita allotment, a procedure which would result in raising the prices of the raw materials they produce more quickly than those of the manufactured goods they buy. The richer nations would ask for a distribution according to national incomes or according to the total amount of business turnover or other similar standards. There is no hope that an agreement could be reached.
The crypto-currency Bitcoin is still merely a speck on the global monetary landscape. It is young, experimental, and for all we know, it may ultimately fail to break into the monetary mainstream. However, on a conceptual level I am willing to call it a work of genius and arguably the most exciting development in the field of money for more than 130 years. Let’s say since the start of the Classical Gold Standard in 1879. Does this sound like hyperbole? Well, let me explain.
The Decline and Fall of Capitalist Money
The 20th century was, broadly speaking, a period of almost constant monetary decay. At around 1900 most economists, politicians and bankers would have correctly stated that global capitalism – an international market economy facilitating the free exchange of goods and services across political borders and thus allowing extensive human cooperation through trade – required an international, apolitical, and hard form of money. Such money was gold. It was the basis of the capitalist economy and it imposed strict discipline on all market participants. Crucially, that included governments and banks. Governments had to operate pretty much like private businesses. They had to balance their books, i.e. live within the means provided by taxation, and if they borrowed money in the marketplace their lenders were at full risk of default as no government could print money (gold) to repay loans or even meet interest payments on loans. Banks, of course, issued banknotes or bank-deposits that were not backed by gold but still used by the public as if they were money proper – these were and still are ‘money-derivatives’ – but again they did so at full risk of default as nobody could ‘print’ bank-reserves (gold again) to bail out the banks in case the public tired of the ‘derivatives’ and wanted to hold gold instead.
Over the course of the 20th century – or to be precise, from 1914 to 1971 – the monetary system was completely changed as a consequence of a number of entirely political maneuvers, all of them undermining the quality of money. Today, hard, international and apolitical money has everywhere been replaced with entirely elastic, national and politicized money, with money that central banks issue under a territorial monopoly at no cost and with no meaningful constraints on issuance, and that the central bankers use to ‘manage’ the ‘national’ economy (itself increasingly an out-of-date-concept), and to fund the state and grow the domestic banks (which, under the protection of a lender-of-last-and-first-resort, now issue unprecedented amounts of money derivatives).
Today the global monetary map resembles a patchwork of local, “nationalistic” paper monies, each of which is a political tool, often openly manipulated in an attempt to benefit the local export industry at the expense of foreign competitors or to ‘stimulate’ the ethereal concept of ‘aggregate demand’. Not surprisingly, the global economy is drowning in debt (increasingly public sector debt), suffers from a bloated financial sector and international trade tensions, and stumbles from one crisis to another, each one worse than its predecessor.
Bizarrely – but not entirely surprisingly – politicians, bankers and modern ‘enlightened’ economists now tell us that this unhinged financial system is to our benefit, really, just trust us.
Truth be told, the present monetary system is a hindrance to free trade, properly functioning markets and human cooperation across borders, and it might already be on its last leg. Yet a powerful but entirely misguided, consensus seems to have taken hold of public opinion, namely that ‘elastic’ money could be beneficial if money’s supply was only managed astutely by some clever monetary central planners.
I wrote Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown to challenge that consensus, to show that ‘elasticity’ of supply is always a negative for money. Elastic money is not needed. It is entirely superfluous. Moreover, elastic money is always disruptive. A monetary system based on an inherently elastic and constantly expanding supply of money is unstable and ultimately unsustainable. The reason why gold made such good money for thousands of years is precisely its essentially inelastic supply.
The word ‘Bitcoin’ does not even appear in my book. The reason is simply that I had not heard of Bitcoin by the time I handed in my final manuscript in early 2011. But when I learnt about Bitcoin soon afterwards I was immediately fascinated. Like many others, I could conceive of ‘internet money’ or ‘virtual money’. As I had explained in the book, money does not have to exist in physical form and the fact that most money today is electronic money poses no problem for the monetary theoretician. The problem with this type of money is not that it is immaterial but that its supply is completely elastic, and I simply could not see how money that was not based on a nature-given and strictly limited commodity could have an entirely inelastic supply. It was Bitcoin’s inelasticity by design that I saw immediately as one of its greatest strengths and its true genius.
My work rehabilitates the gold standard. It shows that it was a mistake to abandon gold as the basis of our financial system and replace it with entirely elastic state fiat money. When (not if) the present fiat money system finally ends we could and should return to gold. The only alternative I now see, at least on a purely conceptual level, is Bitcoin, or something like Bitcoin: hard, apolitical, immaterial, virtual money.
Bitcoin is cryptographic gold
By now most readers will probably have heard of Bitcoin and have some notion of what it is. But in any case, let me give you a quick run-down. The economist Nikolay Gertchev, in a blog on the Mises Institute website (republished here), explains it quite well, although Gertchev, like many other members of the “Austro-Libertarian” movement, is somewhat reserved when it comes to embracing Bitcoin. I am surprised by the extent of scepticism in that community and believe that in general it is unfounded. But first the description:
“A bitcoin is a unit of a nonmaterial virtual currency, also called crypto-currency, by the same name. (Bitcoin is a medium of exchange that only exists in the virtual world. DS) They are stored in anonymous “electronic wallets,” described by a series of about 33 letters and numbers. Bitcoins can travel from a wallet to a wallet, by means of an online peer-to-peer network transaction. Any inter-wallet transfer is registered in the code of the bitcoin, so that the record of its entire transaction history clearly identifies its owner at any single moment, thereby preventing potential ownership conflicts. Bitcoins can be further divided into increments as small as one 100 millionth of a bitcoin. The current outstanding volume of bitcoins is above 10 million and is projected to reach 21 million in the year 2140.”
“This brings us to the truly fascinating production process of the bitcoins. They are “mined” based on a pre-defined mathematical algorithm, and come in a bundle, currently of 25 units, as a reward for carrying out a large number of computational operations that aim at discovering the solution to what could be described as a randomized mathematical puzzle. The role of the algorithm is to ensure a declining progression of the overall stock of bitcoins, by halving the reward every four years. Thus, somewhere in the beginning of 2017, the reward bundle will consist of 12.5 units only. Also, the more bitcoins are produced, the harder are the randomized mathematical puzzles to be solved.”
Bitcoin is immaterial money yet strictly limited in its supply. Once 21 million units are in existence, probably in 2140, that’s it. No more Bitcoin can be issued. In fact, the supply of Bitcoin is more inelastic than the supply of gold. Also, the available supply of Bitcoin at any moment in time is substantially more transparent than that of gold.
If Bitcoin ever became money in its own right (how it could do so, I will discuss below), then it would be international, hard and entirely inelastic money. Like gold it also does not decay, is homogenous and (almost) perfectly divisible. Bitcoin fulfils all the requirements of good money. In the long run, gold does not have to fear fiat money, which is always suboptimal as it always is national, politicized, manipulated, unstable and inflationary money. For one thousand years, state paper monies have come and gone. Gold (and silver) stayed. Gold just has to sit still and wait for this, the latest and most audacious and arrogant, experiment with global free-floating paper money to fail, and it will come back. But now it faces, potentially, its first meaningful challenger: inelastic crypto-currency, Bitcoin.
Money of no authority
There is no central authority that issues Bitcoin and can manipulate its supply for its own gain or for any alleged ‘greater good’ of society. Positively cringe-inducing, although sometimes unintentionally funny, are the embarrassing attempts by establishment spokespeople to discredit Bitcoin on account that, unlike all that astutely managed state fiat money, Bitcoin would not constantly be losing purchasing power. In fact, just as in the case of gold, Bitcoin’s purchasing power can reasonably be expected to constantly appreciate over time.
But, so we hear the assorted ‘enlightened’ economists of the Keynesian persuasion exclaim in horror, that would mean we would all suffer from dreadful deflation, from which only an elite of highly-qualified government-appointed central bank bureaucrats and a well-oiled printing press can save us. Apart from the fact that these self-appointed money masters have neither proper economic theory nor the experience of a thousand years of financial history on the side of their destructive agenda, they obviously do not even comprehend how far their system of manipulated funny money has already discredited itself.
Inelastic money can satisfy ANY demand
As I have explained in Paper Money Collapse no society (not even a healthily growing one) needs a constantly expanding supply of money. Money is a unique economic good. Because it is the medium of exchange, money is the only good that is demanded exclusively for its exchange value, not for any use-value its substance (if it has a substance at all) may also have.
Nobody who has demand for money has demand for a certain quantity of paper notes, or a certain weight of gold, or a certain number of digits on a computer hard-drive. Money-users have demand for the exchange value that these items contain in exchange for other goods and service, i.e. qua being accepted by others as money. Demand for money is always demand for readily exercisable purchasing power.
Once a good is widely accepted as a medium of exchange (whether that good is gold, paper tickets, or sequences of digital ones and noughts), the public can, at any moment in time, hold precisely the amount of money – readily exercisable purchasing power – it wants to hold. If the demand for money goes up, the public will sell non-money goods for money or reduce money-outlays for non-money goods. As a result, the money-prices of non-money goods fall and the purchasing power of each monetary unit (whether gold, paper tickets, or digital code) will rise. This process satisfies – automatically, instantly and naturally – the higher demand for money. The public now holds more readily exercisable purchasing power in the form of money, not because a clever, über-prescient money producer has created new money units, but simply and much more straightforwardly, because the exchange-value of the existing money stock has increased.
Once a good is widely accepted as money, no further production of that good is required. In fact, as I also demonstrated in Paper Money Collapse, any attempt to flexibly inject money into the economy in order to ‘stabilize’ money’s purchasing power, or, as is declared policy today, to constantly debase it at an officially sanctioned rate, must not only fail in its primary objective (‘price level stability’) but must cause grave distortions in the wider economy. Furthermore, the steady secular deflation that is to be expected under inelastic money, such as gold or Bitcoin, is not only not economically disruptive, it is even beneficial. Just consider one aspect: as money will then have a moderate positive real return, people who have no knowledge of financial markets and investing, and who do not have the resources to hire professional advisors, can save by simply holding money. This is impossible in our fiat money economy of constant inflation and increasing monetary instability.
Truly international
As Bitcoin has no issuing authority it has no country of residence or origin. It is truly global money. It can be used for payment anywhere in the world without going through banking systems or foreign-exchange markets. It is undeniable that the multitude of local paper monies poses a considerable hindrance to free trade and thus the rise of living standards in large parts of the world as this system necessarily introduces an element of partial barter into international trade relations. Today’s massive foreign-exchange markets are nothing but a make-shift, a crutch to deal with the suboptimal and politically motivated arrangement of various local currencies. This market ties up capital (both financial and human) without adding any real wealth to society.
If Bitcoin were to get widely accepted – and that is still a big if – it could become a great platform for connecting potentially any two counterparties in the world in direct financial transactions. It is the ultimate disintermediator: no banks needed.
At this point it might be objected that it only connects people who have access to the internet or smartphones but this is obviously a rapidly shrinking barrier. On my travels in Africa last year, I found that internet access was usually more ubiquitous than bank branches. And by the way, Kenya and Tanzania already have M-Pesa, the world’s most developed mobile payment system that uses the mobile phone network to facilitate money transfers. These countries could easily make the transition to smartphone-based payment systems without ever making the detour through clunky bank branch networks.
On the issue of tying down capital, Bitcoin wins hands-down against any other financial system, including a gold standard. Bitcoin does not require any physical storage, which naturally is always expensive. Bitcoin is monetary raw material and payment system in one. (Although, fascinatingly, the free market has already created physical Bitcoins.)
Money requires trust. We presently do not live under a gold standard but, as Jim Grant has observed so astutely, a PhD-standard, a system of flexible, state-sponsored money, managed by people like Ben Bernanke and his team at the Fed, who enjoy the privilege of implementing policies based on their own faulty monetary theories and hair-raising interpretations of economic history, while a cheap-money-addicted class of speculators plays them like a fiddle and laughs all the way to the bank. The appeal of gold has always been that it does not require the public to put trust in a ‘money elite’ but that it only has to trust gold’s creator: mother nature. With Bitcoin you only have to trust the algorithm, and as this is open software, there cannot even be a hidden agenda. Bitcoin, just like a proper gold standard, is hard, capitalist money with no politics, no Federal Open Market Committee meetings, no monetary policy, no central banking bureaucracy. It is free market money.
Common objections to Bitcoin
Given its free market and ultra-hard-currency credentials, the scepticism towards Bitcoin in parts of the Austro-Libertarian community is somewhat surprising. I think some of the objections are easily refuted. There is, first of all, the idea that Bitcoin could have many imitators, which would undermine its uniqueness and reduce its attractiveness. If Bitcoin itself cannot be inflated, what about the concept of crypto-currencies, could it be inflated by too many different currencies on offer?
This argument strikes me as weak. By all accounts Bitcoin’s design and cryptographic robustness are an exceptional accomplishment. It is not as if any hacker of medium talent could pull off something similar tomorrow. But even if he could, the argument completely underestimates first-mover advantage in the area of goods and services with substantial network effects. How many people have launched a second Facebook or a second Twitter since these inventions kicked-off the social media craze, although technologically, these inventions are much simpler than crypto-currency? – Nobody. The network effects of these goods are immense. Once they have a certain acceptance it is hard, if not impossible, for late-comers to break in. These goods and services have value for their users predominantly because others use them too, and the more people use them, the more valuable they get. There is no good for which this is truer than money – the general medium of exchange. Customized money is an oxymoron. Consequently, once a form of money is accepted, it is very difficult to take business away from it.
This feature of money is obviously a problem for Bitcoin in its fight against established state paper monies but is equally a big plus when it comes to keeping potential new entrants into the crypto-currency arena at bay. Bitcoin now dominates the market for crypto-currencies (it pretty much IS the market for crypto-currencies, in my view) and I believe that only the discovery of major flaws in Bitcoin – none seem to have surfaced in its four-year life up to now, and every day they are less likely to appear – or if some vastly superior crypto-currency came along but I am hard-pressed to see in which aspect it could outperform Bitcoin. But just launching another crypto-currency – a Bitcoin clone – is certainly not going to put a dent into Bitcoin.
Menger and Mises would love Bitcoin
Many ‘Austrians’ get thrown off by Menger’s theory of the origin of money and Mises’ so-called ‘regression theorem’, and somewhat rashly conclude that Bitcoin can never achieve money-status because it did not originate from a non-money commodity. Mises was correct when he stated that something could only become money if it had previously, that is, before it was used by somebody as a medium of exchange in its own right for the first time, established some value in trade. For if that had not been the case, how could the first person to employ the commodity as money have any point of reference by which to assess its value and determined its exchange value for the first monetary transaction? However, this theorem, which remains unrefuted in my view, does not apply to Bitcoin. Bitcoin can simply piggyback on established forms of money that already have exchange-value and derive its original value from them before it does, over time, establish its own value.
The same has, in fact, happened in the case of paper money. The paper notes that are used as money today did not start their ascent to widely used and generally accepted monetary assets from humble beginnings as commodities – that is, as mere paper – but started out as paper-claims on physical gold. Gold was money and the paper tickets simply a technology to transfer ownership of gold. When the first banknote was used it did not derive its exchange value from its paper content but from the fact that it could be exchanged for a fixed amount of gold. That was the necessary reference point – in accordance with Mises’ regression theorem. Paper money started as payment technology and as the public got used to paying with paper rather than with gold coins and gold bars, the underlying gold content could be reduced over time and ultimately the link to gold completely severed. What gives value to these paper tickets today? – The fact that the public still accepts these paper tickets in exchange for goods and services. That is all. And in fact, it is all that is needed. Any form of money – even gold, which still retains some functionality as industrial commodity or consumption good (jewellery), although that functionality is now irrelevant for its role as monetary asset – any form of money derives its money-value from the trading public and the public’s willingness to exchange the monetary asset for goods and services.
And herein lies in fact Bitcoin’s biggest challenge. However, this challenge is not of a conceptual nature. The concept of Bitcoin as money is, as I have tried to show above, extremely compelling. But Bitcoin has to offer something to the average money-user that state paper money cannot offer. Just as the banknote bestowed an instant and discernible benefit to each money-user relative to heavy gold coins, that allowed it to become a widely used medium of exchange in its own right and ultimately even operate without any link to gold, so Bitcoin has to set itself apart from fiat money and overcome fiat money’s powerful network advantage. The fact that fiat money is suboptimal in terms of its inflation characteristics and its disruptive effects on the broader economy is not something that bothers the average money user at the moment he desires to engage in monetary transactions, and do so as conveniently, securely and easily as possible. The state paper money system today offers easily useable ‘computer money’ and the broader public is still happy to use it. Why switch to Bitcoin?
Will Bitcoin get accepted by the wider public?
It is my impression that the community of Bitcoin users, although apparently growing strongly, is still largely composed of those who are fascinated by the technology as such and who want to be part of something new, and those who like it for ‘ideological’ reasons, i.e. those who detest state paper money or dislike the banking system. Thus, there is apparently still a big contingent of computer ‘nerds’, hackers, crypto-anarchists, anti-government libertarians and Occupy-Wall-Street-types among its user base (which is not to say that there are not many who do not fall into any of these categories). How could Bitcoin attract a broader base of money-consumers beyond these groups?
One powerful aspect is cost. Bitcoin transactions are free, so Bitcoin could become – or maybe it is already – the Skype of payment systems. Another attraction could simply be the usually reasonable, and with some effort potentially considerable, anonymity and untraceability that Bitcoin offers. This seems to be a hotly debated topic. On the one hand, Bitcoin is incredibly transparent. All transactions are literally in the open domain. However, each ‘user’ is only identified by his ‘address’ and the number of addresses is practically unlimited. One could use a new address for each transaction. This may not mean instant untraceability from ‘the authorities’ but then again, certain techniques and add-ons, some of which are still being developed, have the potential to increase anonymity and untraceability even further. Additionally, it is possible to acquire Bitcoin for cash – rather than via the established and already regulated exchanges – and thus anonymously.
This means Bitcoin could be used, as is a frequent charge against it already, for illegal transactions involving drugs and guns. But people do not have to be drug or arms dealers, or even ordinary tax cheats, to appreciate a certain degree of financial privacy. As bank secrecy laws disappear everywhere and as almost all governments are waging a ‘war on cash’, by which any transaction that involves more than just petty cash is to be moved to electronic systems within the state’s fiat money network, so that ‘the authorities’ achieve full ‘transparency’ as to what the citizenry is up to at any moment, there could well be a widespread demand for ‘outside’ electronic payment systems offering privacy. For example, a range of ‘activities’ exist engaging in which may not be, or not yet be, illegal but considered a major potential embarrassment to the parties involved if made public (gambling, pornography, escort services), so that many people would not want to have payment for them on their permanent records. This potential development is not lacking in irony: our modern information society with its trends towards the ‘transparent citizen’ and unlimited data storage holds many threats to a free society, privacy and individual liberty. It would be fitting if countermoves to these trends emanated from the same technology.
An additional boost to Bitcoin may come straight from the crumbling state paper money infrastructure itself. The cases of Iceland and in particular Cyprus have driven home the point that ‘money in the bank’ is far from safe, and even if your deposits have survived the bank collapse and the ‘bail-in’, you may not get them out of the country any time soon as capital controls are likely be imposed. As the overstretched paper money economy staggers towards its inevitable demise, more of these instances will occur providing an additional opening for Bitcoin. To the best of my knowledge, Bitcoins cannot be confiscated and Bitcoin accounts cannot be frozen Additionally, you store Bitcoin yourself rather than put them into a fractional-reserve bank that would conveniently use them as ‘reserves’ for its own ‘money derivative’ production.
What are Bitcoins worth?
I agree with Jon Matonis that nobody can give a reasonable answer but that the outcome is probably binary: Either Bitcoin ultimately fails and the individual Bitcoins end up worthless. Or Bitcoin takes off and Bitcoins are worth hundreds of thousands of paper dollars, paper yen, paper euros, or paper pounds. Maybe more. Those who buy Bitcoin as a speculative investment should consider it an option on the future success of the crypto-currency. At time of writing, Bitcoins are trading at $127 and £83 at Bitcoin-exchange Mt. Gox.
On a personal note, my biggest ‘liquid’ asset continues to be physical gold. As I explained on numerous occasions, I consider gold to be the essential self-defense asset in the ongoing paper money crisis. Gold is not being used presently by the wider public as a medium of exchange either but its two-thousand-plus year history as global money means that it retains monetary asset status and that its historic function as a liquid and lasting store of value – a function that fiat money cannot fulfil – remains unrivalled. By comparison, the brand-new crypto-currency Bitcoin has to first earn its stripes as a monetary asset by proving itself as a ‘common’ medium of exchange. That is why I view Bitcoin very differently from gold, although the attraction of both has its origin in the demise of entirely elastic, politicized state fiat money. I will certainly continue to follow the Bitcoin revolution with interest and sympathy.
In the meantime, the debasement of paper money continues.
The following is a transcript of the “Adam Smith Lecture” I gave at a private gathering in London on 19 February.
For a long time governments have been redistributing peoples’ income and wealth in the name of fairness. They provide for the unemployed, the sick, and the elderly. The state provides. You can depend on the state. The result is nearly everyone in all advanced countries now depends on the state.
Unfortunately citizens are running out of accessible wealth. Having run out of our money, Governments are now themselves insolvent. They started printing money in a misguided attempt to manage our affairs for us and now have to print it just to survive. The final and inevitable outcome will be all major paper currencies will become worthless.
To appreciate the scale of these problems, we must understand the errors in economic and monetary policies. I shall start with economics.
Economics
Modern economists retreat into two comfort zones: empirical evidence and mathematics. They claim that because something has happened before, it will happen again. The weakness in this approach is to substitute precedence for the vagaries of human nature. We can never be sure of cause and effect. Human action is after all subjective and therefore inherently unpredictable.
The mathematicians like to think that economics is a physical science and is not a slippery social science. Economics is a branch of human psychology. It is plainly nonsensical to apply maths to human psychology.
The result is that much of the good work done by the classical economists like Adam Smith has been destroyed by modern economics. The classical economists explained the benefits of doing away with tariffs and the guilds. This revelation was instrumental to the industrial revolution. Then along came Marx who persuaded people that economics was a class interest, that free market economists were promoting the interests of the bourgeois businessman to the disadvantage of the worker. That became the justification for communism and socialism. Keynes and those that followed him never properly challenged Marxian fallacies. They were never involved in what became known as the socialist calculation debate.
It is not generally appreciated that Keynes was strongly socialistic. In the concluding remarks to his General Theory, Keynes looks forward to the euthanasia of the rentier (or saver) and that the State will eventually supply the resources for capital investment. He wanted the state to control profits.
Keynes was primarily a mathematician. Keynes was no more an economist than Karl Marx, whose beliefs led to the economic destruction of Russia and China; or John Law, who bankrupted France, with similar fallacies to those of Keynes.
The misconceptions of Keynesianism are so many that the great Austrian economist von Mises said that the only true statement to come out of the neo-British Cambridge school was “in the long run we are all dead”.
Let me define economics for you at the simplest level. We divide our labour. Each one of us is a consumer; an entrepreneur whether for wages or profit; and a saver for the future. We invest savings to improve production. Each of us discharges these three functions in the proportions we choose as individuals, we interact with others doing the same thing. We exchange our goods at mutually agreed prices using money to facilitate the exchange. We use money to keep score, and that money has to be sound for our calculations to mean anything. Together we are society itself, each providing things others want and will pay for.
The state has no role in this process. Instead it is a cost to society, because it takes some of our spending and savings to support itself. The more the state takes the greater the burden. It destroys society’s potential wealth. But it has not stopped there. Socialism forces the vast majority of people to give up saving and rely on the state to provide. Governments everywhere are now encumbered with obligations they cannot possibly discharge.
Money
On the money side our mistakes go back to the Bank Charter Act of 1844.
The Bank Charter Act gave the Bank of England a note-issuing monopoly backed by gold and government debt. It failed to stop other banks issuing bank credit. This led to credit-driven business cycles which were socially destabilising, adding fuel to the various brands of communism and socialism that developed in the late nineteenth century.
Gold backing for the Bank of England’s notes was gradually eroded, starting in the late 1890s, with a number of countries, including Britain, abandoning it altogether in the interwar years. A gold-exchange standard was adopted for central banks at Bretton Woods. And finally President Nixon in August 1971 abandoned gold altogether.
Ever since then, the expansion of money supply has been increasing exponentially. Quantitative easing is now required to keep the pace of printing up, lest interest rates begin to rise.
Monetary policy from the 1920s has been used to manage an increasingly unstable global economy. The irony is that this instability has its origins in the expansion of money and credit itself. The growth of money supply and bank credit has as its counterpart debt. Few are the assets not encumbered with this debt. Asset prices need more money and credit to sustain them. It is a finite process that ended with the credit crunch five years ago.
That is the background. Now I shall look at the situation today, five years on from the credit crunch. There are four interlinked problems that cannot be resolved: the economy, the banks, government finances and population demographics.
The economy
The advanced economies have been progressively undermined by government intervention and unsound money. They are taxed and regulated to such a degree that laissez-faire hardly exists anymore.
Government spending typically amounts to 50% of GDP in the advanced economies; sometimes more, sometimes less. For productive businesses it is like running a marathon carrying a bureaucrat on your back who tells you how to run.
The misallocation of economic resources which is the result of decades of increasing government intervention cannot go on indefinitely. Businesses have stopped investing, which is why big business’s cash reserves are so high. Money is no longer being invested in production; it is going into asset bubbles. Dot-coms, residential property, and now on the back of zero interest rates government bonds and equities. These booms have hidden the underlying malaise. There can be no economic recovery. Our bureaucrat-carrying marathon runner is finally collapsing under his burden.
The burden of government is now too great to be sustained.
Banks
Banks are geared 25 to 30 times, which is fine if you can grow your way out of problems. That is no longer the case. They are vulnerable to existing but unrecognised bad debts, and now a fall in government bond prices. All that’s needed to trigger a collapse in the banks is absence of economic recovery. If we have a downturn it will be quicker. All that’s needed is a rise in interest rates, to reduce collateral values. All that’s needed is a fall in asset prices.
Then there is the shadow banking system, which the Bank for International Settlements reckoned amounts to over $60 trillion, of which $9 trillion is in the UK. If an investment bank goes under, the shadow banking system could make it virtually impossible to ring-fence the others.
Another area of risk is cross-border exposure. Cross border loans in Europe amount to EUR3.5tr. France is 1.2tr. Italy 700bn. Spain 500bn. These are only the obvious risks. Much of this is cross-border within the eurozone, meaning a default in any of those three is certain to wipe out the European banking system, and then everyone else’s.
For this not to happen requires the central banks to make available unlimited funds in the form of credit and raw money. As Mario Draghi said, whatever it takes. His solution is to print enough fiat currency to save the system.
Government finances.
From the time of the banking crisis, government finances have deteriorated sharply, and their debts rocketed. No country, except some in the Eurozone has managed to cut government spending, and only those which did, did so under extreme financial pressure and because they couldn’t print money. The fact is that everywhere government spending is increasingly mandated into pensions, social services and healthcare, which makes spending cuts extremely difficult.
Until recently it was assumed that economic recovery would generate the taxes to balance the books. That has not happened, nor can it happen. In the Eurozone governments are now taking on average over half of every working man’s income and deploying it unproductively. Take France. Government is 57% of GDP. The population is 66m, of which the employed working population is about 25m, 17m in the productive private sector. The taxes collected on 17m pay for the welfare of 66m. The taxes on 17m pay all government’s finances. The private sector is simply over-burdened and is being strangled.
The interest rates at which governments borrow are entirely artificial, made artificial by their own intervention in the debt markets. They are financing themselves by printing money to buy their own debt. The moment this ends, and it will, money will flow out of bonds, equities and even property priced on the back of low interest rates. The pressure for interest rates to rise will have to be met with yet more money printing, because governments cannot afford to pay higher interest rates, nor can they afford to see private sector asset values fall. Price inflation will create a real crisis, perhaps later this year.
Population demographics
Populations in the US, the UK, Japan and Europe are growing older. This is bad news for government finances. When someone retires, he stops paying income taxes and becomes a cost. High unemployment is also costly, because the unemployed are not funding future liabilities. Professor Kotlikoff of Boston University has calculated that in fiscal 2012 the net present value of the US Government’s future liabilities increased $11 trillion to $212tr. The whole US economy is only $15 trillion. Europe is worse, far worse: Europe has more pensioners as a proportion of the working population, high rates of unemployment and a large government relative to the private sector, which funds it all. The UK, taking these factors into account, is slightly worse off than the US. Japan has worse birth rates and longevity. They sell more nappies for the incontinent than they do for new-borns. The solution already is to issue increasing amounts of unsound currency.
Conclusion
The world’s economic problems have been building for a long time. Economic fallacies have been pursued first by Marx and then by Keynes in the 20th century, and monetary policy first took a wrong turn with the Bank Charter Act of 1844. The progressive replacement of sound money by fiat currency has destroyed economic calculation, and has destroyed private sector wealth. These policies were deliberate. We have now run out of accessible wealth to transfer from private individuals to governments. That is our true condition.
Governments will still seek to save themselves at the continuing expense of their citizens, and in the process destroy what wealth is left.
There can only be one outcome: the bankruptcy of governments. This means that their fiat currencies will inevitably lose all their purchasing power.
How soon? I’m afraid sooner than most people think. Japan is already entering the black hole, with her currency beginning its collapse. The UK is on the precipice and cannot afford further falls in sterling without triggering the rise in inflation that will force a rise in interest rates and a spiral into insolvency. Europe could go at any time. The US is probably the best of a very bad bunch, but even her economy is looking bad.
I do not make these statements because I am gloomy. I make them because I approach economics without emotion and without political bias. I make them because I have considered our true economic and monetary position using as far as I am able sound aprioristic theory applied to our current position.
Thank you.
This transcript was previously published at GoldMoney.com.
On Friday, I spoke against monetary activism once again, complaining about the use of expectation management and new monetary instruments in an attempt to defibrillate the economy. It’s a mistake, not least because a failure to contain inflationary expectations could be catastrophic, as I set out last year. Mark Carney understands the argument that monetary activism will cause a damaging “intertemporal misallocation of capital” but he chooses to believe wise intervention elsewhere can compensate. I am sure this is wrong.
This morning, I rediscovered Mises’ short 1951 essay Inflation Must End in a Slump. The essential characteristics of the real world have not changed since but currency debasement subsequently became much worse. Here’s the article:
This country [the USA], and with it most of the Western world, is presently going through a period of inflation and credit expansion. As the quantity of money in circulation and deposits subject to check increases, there prevails a general tendency for the prices of commodities and services to rise. Business is booming.
Yet such a boom, artificially engineered by monetary and credit expansion, cannot last forever. It must come to an end sooner or later. For paper money and bank deposits are not a proper substitute for non-existing capital goods.
Economic theory has demonstrated in an irrefutable way that a prosperity created by an expansionist monetary and credit policy is illusory and must end in a slump, an economic crisis. It has happened again and again in the past, and it will happen in the future, too.
If one wants to avoid the recurrence of periods of economic depression, one must start by preventing the emergence of artificial booms. One must prevent the governments from embarking upon a policy of cheap interest rates, deficit spending, and borrowing from the commercial banks.
This is, of course, a very difficult task. Governments are in this regard very obstinate. They long for the popularity that booming business conditions seldom fail to win for the party in power. The Unavoidable crash, they think, will appear only later; then the other party will be in power and will have to account to the voters for the evils which their predecessors have sown.
Thus there is no doubt that we shall one day have to face again an economic recession, although it is impossible to determine the date of its outbreak and the degree of its severity. It will be bad indeed. But worse than the crisis itself could prove the psychological and ideological consequences of an erroneous interpretation of its causes.
For the spokesmen of the artificial expansionist policy are busy denying that economic crises are the inevitable effect of the preceding expansionist policy. They are anxious to exonerate the governments. As they see it, inherent shortcomings of the capitalist mode of production cause the periodical recurrence of bad business. There is no other means, they conclude, to avoid a crisis than to put the economic system under the full tutelage of a central planning board.
This is essentially the doctrine of Karl Marx. Those supporting it, those passionately attacking the insight that it is the policy of inflation and credit expansion which produces economic depressions are – sometimes unwittingly – serving the cause of the Communists. When the slump comes, people indoctrinated by their teachings will argue precisely as Stalin expects them to. They will think: The efforts to preserve capitalism have proved vain; capitalism necessarily results in the recurrence of economic catastrophes; if we want stability, we must turn toward Communism.
In the antagonism between the doctrine of the economists who ascribe the emergence of economic crises to the policy of credit expansion and the official doctrine that ascribes them to alleged inherent defects of capitalism there is much more at stake than a merely doctrinal quarrel. The way in which people will react to the – unfortunately hardly avoidable – letdown of business that will follow the end of the present armament boom may decide the fate of our civilization.
People must learn in time what the inevitable consequences are of the monetary and credit policies adopted by the present administration. They must realize that what the collapse of the artificial boom will establish will not be any insufficiency of capitalism, private enterprise, and the market economy, but the failure of the methods of financing public expenditure as practiced by the New Deal and the Fair Deal.
A comprehension of the nature of the boom will also make people more cautious in their business dealings. They will not fall victim to the deception that the boom will go on forever.
“Politics, as hopeful men practice it in the world, consists mainly of the delusion that a change in form is a change in substance,” as the incomparable H.L. Mencken observed more than 80 years ago. His observation applies to the United States of today in two ways. On one level, and the level Mencken intended, it reminds us of the fact that any form of government, whether democratic- republican or monarchical, is ultimately oppressive at heart. Every state is, qua state, a central depository of legalized violence, and thus stands in direct and unending opposition to individual freedom. Or, in the words of Ludwig von Mises: Government is essentially the negation of liberty.
But Mencken happened to use the words ‘hopeful’ and ‘change’ in this sentence, and the choice of words brings us quickly to the administration of Barack Obama and his promise – proclaimed particularly noisily for his first term – that his policies would mark a distinct change from the policies of his predecessor, George W. Bush. Assessing the situation now at the start of his second term, there is no escaping the fact that whatever change Obama brought was predominantly in appearances rather than in fundamentals, and that the most worrisome and offensive trend that characterized the Bush administration not only continued under President Obama, it even accelerated.
This trend is the rise of the American leviathan, the rapid expansion of state power and the ubiquitous curtailment of individual rights, whether they are rights to fair and open trial, property rights, or rights to privacy. The trend, everywhere in U.S politics, has been and still is towards big and interventionist government. While the media keep droning on about the apparently insurmountable divisions in US politics, the fact remains that a substantial de-facto consensus exists in Washington when it comes to giving the state more power. The increasingly expansive and expensive warfare-welfare state has been growing under Republican and Democrat presidents alike and is the one project that enjoys vast support across ‘the aisle’. The idea of limited government under the rule of law, historically a defining feature of America’s image of itself, lies dying, critically wounded by Baby Bush and now finished off by Obama. What Americans are destined for is an increasingly unconstrained government largely accountable to nobody but itself.
Leviathan rises
After 9/11, the Bush-Cheney White House considerably expanded the powers of the executive branch, mainly via the Patriot Act, arguing that the nation was now at war and that specific war-powers had to be granted, among them detention without trial and surveillance without warrants. These enlargements of state authority coupled with the hyper-interventionist economic policy that began after the financial crisis hit in 2007, have fundamentally changed the relationship of the American state with its citizenry.
Under Bush, Americans witnessed the weakening, if not outright suspension, of habeas corpus, the legal requirement that a prisoner be brought in front of a court or judge. This essential safeguard against unlawful detention without evidence has been a cornerstone of English common law for 800 years and of American law since the birth of the nation. Furthermore, Americans saw their country engage in new overseas wars, saw the launch of a new major federal agency, the unapologetically-Orwellian ‘Department of Homeland Security’ which now has a staff of 240,000 and an annual budget of $60 billion. They witnessed the arrival of the $1 trillion dollar federal deficit, the ongoing expansion of the federal payroll, massive bank-bailouts and the nationalization of car companies and home finance, the injection of taxpayer funds into Wall Street, in some cases by force. They witnessed the arrival of zero interest rates and large-scale debt-monetization by the US central bank.
This vast accumulation of state power came with a slogan, the belligerent ‘We will do whatever it takes’. Hardly any proclamation could be more at odds with the American tradition of a strictly limited state, of individual freedom and free markets. Besides, all the grave problems facing America today are the result of politics, of previous policy errors committed by the very same Washington elites that are now robustly demanding more power from the American people ‘to fix this,’ and that want us to believe that ‘the ends justify the means’.
Any hope that Obama would take a different road, or any notion that, as his numerous supporters keep telling themselves, he simply needs more time to fix the mess that Bush left behind, now lies in tatters, destroyed by four years of actions that tell a different story: In the case of habeas corpus, the Obama administration has generously granted itself the wide interpretation of powers that Bush-Cheney had probably implicitly assumed but never spelled out. Since Obama signed the National Defence Authorization Act of 2012, it should be clear to every American that the U.S. military has indeed the right to indefinite detention — or detention until the end of hostilities, but as the War on Terror is as open-ended as ‘quantitative easing’ or the War on Drugs – or, as Doug Casey calls it more accurately, The War on Some Drugs – this means for all practical purposes indefinite detention without trial. Americans must also realize that this includes detention of American citizens on American soil. Additionally, the Obama administration has granted itself extensive freedoms for the surveillance of U.S. citizens. Thus, dear reader, 11 years after 9/11 and with Osama bin Laden dead, the US government keeps giving itself more powers to spy on its citizens, to detain them and interrogate them.
In the field of economic policy we also see nothing but a continuation of the policies of hyper-active interventionism. Zero interest rates and debt-monetization by the US central bank have, of course, continued, and not only have they continued they are now officially declared ‘open-ended’. Continued, too, has the mad Keynesian ‘stimulus’ policy of deficit-spending with Democrat hack, Paul Krugman, formerly known as a Nobel-prize winning economist, shouting, ‘more, more, more’ from the sidelines. Naturally, the $1 trillion budget deficits have also continued|. Indeed, Obama implemented even bigger ‘stimulus’ packages than Bush.
Of course, none of this has ended America’s depression, although short-term statistical growth spurts of barely 2 percent that persistent 8-10-percent deficits may help generate from time to time have allowed bean-counting economic statisticians to proclaim that a recovery was indeed in place. Only a handful of die-hard Keynesians, such as Krugman and Richard Koo, and a few financial writers believe in this absurd policy. Most business people know better, which is why they keep hunkering down. These policies are as likely to end America’s economic malaise as the War on Terror is likely to end terrorism, or the War on Drugs to end drug taking and thus the creation and distribution of drugs.
However, I suspect that the ends are no longer what matters. The means have become ends in themselves. Vast federal bureaucracies obtain resources, power and influence through the pursuit of these policies. These policies will not end because the people who are in charge of them do not want them to end. Their income, their power, their prestige, their careers depend on them.
Appearances
I do not want to advance conspiracy theories here but if you just imagine, simply as a mental exercise, the existence of a Big-Government-War-Party that operates in the background, you would have to agree that, if such a party existed, it would be the party that had been calling the shots in the United States for the past 11 years and the party still in ascendancy today. Furthermore, it seems that such a party does better in many ways when fronted by a well-spoken cool African-American lawyer from Chicago than a rich, white and angry born-again Christian from Texas, or a white, rich Mormon ex-Wall Streeter. After all, there are many people to whom appearances seem to matter more than substance, not least among them the ‘liberal’ Hollywood crowd.
About 8 or 9 years ago, I was invited to the Baftas awards ceremony in London. For those of you who are not into movies, the Baftas is an awards ceremony as close to the Oscars as Britain got. Filmmakers and actors from Europe and plenty of movie royalty from Hollywood were in attendance, and as the Iraq war had just started, it was fashionable among the glitterati to demonstrate their sorrow, concern and disapproval at every opportunity. Pedro Almodovar treated us to a rendition of his most beloved Spanish poem. I think you get the idea. But all of this self-important indignation has now stopped. Since the Obamassiah has landed and has taken over the war effort, Hollywood has made peace with American militarism. George Clooney is a fan, so is Sarah Jessica Parker. Obama enjoys the support of Jay-Z and Beyonce. In 2010, at a time when Obama had already received the Nobel Peace prize for not being George W. Bush, the Washington Post reported that “Obama has ordered a dramatic increase in the pace of CIA drone-launched missile strikes into Pakistan in an effort to kill al-Qaeda and Taliban members in the ungoverned tribal areas along the Afghan border. There were more such strikes in the first year of Obama’s administration than in the last three years under President George W. Bush, […].” But let us not quibble over such details. For Hollywood, Obama is still our ‘Lord and Savior’, as actor Jamie Foxx proclaimed only last week.
Of course, none of these policies would have changed – in essence – if Romney had won. His supporters may tell themselves that a Romney vote was a vote for liberty and capitalism, as Romney wanted to cut taxes and attack the budget deficit. Yet, Romney promised to not cut military spending (of course not), and also to adopt a hard line on Iran, a potential next step to yet another war. By the same token, Obama supporters might believe that they voted for tolerance and freedom by rejecting Romney’s social conservatism. But I fear that political tribalism prevents most voters from seeing the big-government forest for all the gay-rights and abortion-rights trees.
If you are of a neo-con persuasion, you might want to argue that the militarism of presidents of all political stripes is only proof of the severity of the terrorist menace, that whatever their previous notions and beliefs, once they get into the White House and receive their first CIA briefing they realize how grave the threat really is, that all of us lesser mortals “can’t handle the truth”, and that it is therefore up to the president and his Col. Nathan R. Jessups to do what is needed, and by the way, sod those civil liberties.
Maybe. Maybe not.
One thing is certain: that the executive branch would ever have such vast powers was never part of the original idea of American government, the concept of a limited state, and of the American people living under the rule of laws and not the rule of men. If you want to argue along the lines that the reality of today’s world requires extensive government privileges, you have to argue that America’s political principles and founding ideas are now outdated and that they should be openly discarded. I am not convinced that this is necessary but this is certainly what is happening.
But then ask yourself, if you really believe that everlasting peace requires everlasting war, and that prosperity comes from printing money and accumulating debt, and that individual freedom has to be curtailed to be protected.
But maybe there is another explanation:
The military-industrial complex
When I grew up in Germany and became politically aware in the late 70s, I always thought that the term ‘military-industrial complex’ was an invention of the Left, mainly used to tar capitalist enterprise with the brush of warmongering and war-profiteering. I was surprised to learn that the phrase had been coined and most effectively used by an American president, Dwight D. Eisenhower, who was a Republican, a West Point graduate and a general. Eisenhower was no Lefty and he wasn’t a small-state libertarian conservative either, having opposed the isolationism of Taft and then, as president, expanding social security and the interstate highway system. Yet, when he left office, he warned his fellow Americans in a televised farewell address of the rise of what he termed the military-industrial complex, the sizable military infrastructure that the wars of the 20th century had bestowed on American society, consisting of the military itself and the sprawling defence industry. You can see excerpts of his speech on YouTube. Here is one quote:
“In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military-industrial complex. The potential for the disastrous rise of misplaced power exists and will persist.”
The recent 18-month, $6 billion mega-version of American Idol, also known as the U.S. presidential election, had to do without a general, as it pitched the Community-Organizer-in-Chief against the slick ex-private-equity millionaire. Yet, notably, the military didn’t have to fear anything from either candidate. At this stage, the US military is all but untouchable, and I suspect that a majority of Americans are in sympathy with this. One can easily envision that as America continues to decline economically, the US public will embrace the military even more, as one last glorious reminder of the nation’s former vitality and global superiority. There is a ready analogy in Britain: Although nothing provides better short-hand for the type of hopelessly statist policies that killed British industry in the decades after the Second World War than the country’s socialist National Health Service, born in 1948 out of the then widespread belief that anything can be solved by the victorious British state organizing it centrally, the NHS is to this day the one institution that stirs national pride in the hearts of Britons, even those belonging to a younger generation. It has become an unmovable part of the British political landscape, and any reform-minded Prime Minister will attack it at his peril. The US military and the NHS are not just symptoms of their respective country’s maladies, they are among the causes, yet have moved beyond the reproach of serious political debate.
Arbitrary government
Speaking of socialist health services, the beginning nationalization of health care in America under Obama fits rather seamlessly into the overall picture of an increasingly assertive, hyperactive federal government that gets involved in every part of its citizens’ lives. It is simply another addition to the welfare-warfare-big-state project and not the ‘progressive’ policy outlier and symbol of a more caring and empathic government that Obamacare supporters want to see in it. This is naïve but maybe not as naïve as the hope that this project will make health care cheaper for the public. Nothing ever got cheaper by having the federal bureaucracy take control of it.
As part of Obamacare the state now boldly assumes the power to force citizens into commercial transactions, the purchases of health insurance, under a rather generous interpretation of the constitution that was recently approved by the Supreme Court. And while the government forces Americans to enter some contracts it also appropriates to itself the power to arbitrarily rip up others. When Obama bailed out Chrysler he simply tossed aside the legal rights of a group of bondholders that – entirely legally and perfectly justifiably – wanted to enact bankruptcy proceedings to protect their investments. Rather than protecting private property and securing legally binding contracts, as is one of the acknowledged primary tasks of any civil government, Obama chose to break contracts and to take money from bondholders to give it to the auto workers union. Political expediency and the wishes of the executive branch of government now trump the sanctity of private contracts in America.
What is coming
Wars, extensive surveillance, bailouts, ‘stimulus’, nationalized health care – all of this costs money, and the American state increasingly sees its citizenry as cash cows. The signs are everywhere. The US is the only country I know that has worldwide taxation for all its citizens. As long as you are a US citizen you have to file a US tax return, even if you live abroad and have not set foot in the country for years or decades. It remains your obligation to keep abreast of all changes to the tax code and those changes are numerous. As of recently, Americans have to report all foreign bank accounts – even if they are not income-generating – to the Internal Revenue Service, the powerful US tax authority. But it doesn’t stop there. As of next year, the infamous Foreign Account Tax Compliance Act (FATCA) will come into effect, which requires any bank anywhere in the world that invests in US securities or conducts business in the US to collect data on American customers overseas and pass this on to the IRS.
Doug Casey made an excellent observation: If you want to get an idea of what our future society will look like you can easily do so by visiting your nearest airport. The modern airport is the model-village of our society, the Orwellian theme park that gives you a glimpse into what will take shape in society at large in coming years, not only in the US, of course, but also in the EUSSR and elsewhere. It is a controlled environment, pleasingly temperate with lots of opportunities for harmless and pointless consumption but where you are under constant surveillance, where your every move is being monitored and recorded forever, increasingly with the use of face-recognition technology, where you will occasionally be searched, where you can’t smoke, and where the calming background music is frequently interrupted by loudspeaker messages that remind you to stay alert and to report any suspicious behaviour to the authorities.
So far, the public is happy to go along with this. I am frequently amazed by the sheepish obedience on display at airports where long lines of travellers stand quietly and patiently, taking off their shoes, calmly observing security personnel rummaging through their luggage, carefully making the prescribed moves in the new scanners as if they are about to enter a nuclear plant. If you see movies of the 1970s or 1980s, or even 1990s, with scenes at airports in them, you will find that they give you an impression of almost frivolous free-spiritedness by comparison. These procedures could not have been introduced in one big swoop. The public would have objected. They had to be introduced piecemeal, one new regulation and procedure at a time.
The same procedure applies to tax surveillance and capital controls. The screws will be tightened slowly so that the public gets used to ever tighter monitoring and ever closer controls. And fear remains an important factor. Large sections of the public believe that their prosperity and their economic future are at risk from unregulated bankers and tax-cheating millionaires who do not pay ‘their fair share’, and they believe that their very lives are constantly at risk from terrorist attacks. They see the government as their guardian and as the necessary regulator, and being under the democratic delusion that as voters they ultimately remain in control of the government, they are happy to sign their freedoms away. As Frank Karsten and Karel Beckman astutely observed, voting is the illusion of influence in exchange for the loss of freedom.
Maybe this statist nightmare will end at some point. Maybe Americans will rediscover their tradition of independence, self-reliance and personal freedom, and of suspicion of any form of state authority. Germany does not have a great sense of personal freedom in its national DNA. Britain has, and America even more so. Maybe recent developments will one day look in retrospect as strange as the prohibition era or the confiscation of private gold in 1933 and the suppression of gold ownership until 1974 do today: blots on the CV of a nation that sees itself as the land of the free. Maybe. But for the foreseeable future I remain pessimistic. For our generation the American Dream may be dead.
Episode 63: 2012 marks the centennial of the publication of one of the Austrian School of economics’ most important books on monetary theory: The Theory of Money and Credit by Ludwig von Mises. GoldMoney’s Andy Duncan interviews Professor Guido Hülsmann about his forthcoming special book – a “Festschrift” honouring Mises which will be published to mark this centennial.
They discuss the importance of The Theory of Money and Credit, along with the impact of a 1912 review of the book by a then little-known scholar by the name of John Maynard Keynes. Hülsmann uses Austrian theory as a basis for his predictions of how the global financial situation will develop. He thinks Germany will stay in the eurozone come what may, and also comments on the interesting case of two German members of parliament who were recently refused entry to the Bank of England and the Bank of France, after they requested to inspect German gold reserves stored at these institutions.
You cannot escape an all-pervasive sense of crisis these days. Impending doom does not only announce itself in actual events but also via the proliferation of ever more hair-raising schemes that claim to solve our problems. Maybe it should not surprise us if, at a time when the world’s most powerful central banks keep interest rates at zero for years on end and keep printing quantities of money that are simply outside the facilities of human imagination (trillions? quadrillions?), bravely hoping it will end differently this time, people get the impression that economics holds no certainties, that it is merely an exercise in limitless creativity. In his excellent speech to the New York Fed, Jim Grant reminded us that when the Financial Times first explained to their readers what QE was, back in 2009, one of those readers wrote in a letter to the editor: “I can now understand the term ‘quantitative easing, but . . . realize I can no longer understand the meaning of the word ‘money’.” – This gentleman is not alone. The basics of monetary economics have been tossed out the window and a merry ‘anything goes’ of policy proposals has descended on us. Otherwise sane-looking men and women now propose that, although years of zero interest rates have not solved our problems, everything will change once interest rates are negative. We should all get checks from the central bank with free money to spend, and government bonds at the central bank should be cancelled. Grown men dream of money from helicopters and money buried in bottles in the ground. “Whom the gods would destroy, they first make mad.”
Just when you thought it could not get any madder there comes a policy proposal that sets a new low in monetary policy discussion. Of course, in the current climate it is being hailed as ‘epic’ and ‘revolutionary’. The easily excitable Ambrose Evans-Pritchard, a tireless campaigner for man’s exploration of the unknown in the field of money, could not believe his eyes: “So there is a magic wand after all,” he writes in the Daily Telegraph, “one could eliminate the net public debt of the US at a stroke and, by implication, do the same for Britain, Germany, Italy or Japan.” It gets better all the time. No longer are we confined to debating arduous strategies for crawling slowly back to sustainable growth, no, we can now simply wipe out all our debt.
Harry Potter meets Irving Fisher
The proposal under discussion is the IMF’s Working Paper 12/202 by Jaromir Benes and Michael Kumhof (a link to a PDF version is provided in this article). It is titled “The Chicago Plan Revisited” and presents itself as a restatement of the ideas of Irving Fisher and Henry Simons of the University of Chicago from the 1930s and 40s, and an application of these ideas to the present crisis. It suggests the following:
‘Private money’ creation is the root of all economic evil. Most money today is created by ‘private’ banks through fractional-reserve banking. This means money-creation is linked to loan creation and debt accumulation. A hundred-percent reserve system is to be established by the state and the state will forthwith crack down on any attempt by the private sector to issue liquid financial instruments – near monies – that could be accepted by the public as cash equivalents. Money creation is put under the full control of the state. The new system is to be implemented right away in one big swoop: the banks are forced to borrow the needed reserves from the government (Treasury) to achieve the new 100 percent reserve ratios instantly. The government creates these reserves – as is usual in a fiat money system – out of thin air. In the US, this plan would amount to new reserves to the tune of 184 percent of GDP, according to Benes/Kumhof, which means $27.6 trillion or 15 times the combined size of QE1 and QE2. With the new 100% reserve requirement, this money will not circulate and not allow for further bank credit creation, which – it is expected by the authors – makes this intervention not inflationary. (A portion of the new reserves will also be cancelled in the next step.) The new reserves allow the government/central bank to ultimately transfer ownership of the bank assets to itself.
Importantly, these new reserves are issued in a process very different from how reserves are issued and placed with the banks today, for example through ‘quantitative easing’, and how it was suggested by Irving Fisher in 1935 (“100% Money”), or Milton Friedman in 1960 (“A Program for Monetary Stability”). These more ‘conventional’ procedures do not allow for any large-scale elimination of debt. Central banks acquire bank assets by exchanging them for newly created reserve money, which they issue as a claim against themselves (a liability), and under normal accounting principles, any write-down of the new assets (debt ‘forgiveness’) would necessarily cause the extinction of the bank reserves as well. Writing down debt shortens the balance sheet of the central bank and thus reduces the central bank’s liabilities, which are the banking system’s reserves.
Benes and Kumhof circumvent this by simply claiming that the new fiat reserves are not just a new liability of the central bank but that they are assets as well, Treasury Credit or ‘commonwealth equity’. Through this accounting gimmick, the state can issue new assets, simply as an administrative act. Thus, the new reserve money lengthens the balance sheets of BOTH central bank and ‘private’ banks in a first step, that is, the new reserve money is simultaneously an asset AND a liability for both. This novel approach then allows balance sheet reduction later on and debt forgiveness without elimination of the new reserves that now back bank deposits by 100%. (See model balance sheets on pages 64 to 66 of the Benes/Kumhof paper and compare them to the model balance sheet presented by Irving Fisher on page 57 of “100% Money”, 1935, which is much more conventional.)
At the end of this process, not only has a lot of debt disappeared, the separation of the ‘credit’ and the ‘money’ sphere of the economy is now total, and so is the state’s control over the monetary economy. This, Benes and Kumhof, make perfectly clear, is the ultimately goal of the exercise, and they claim it is to our benefit. Why? Here (very differently from Fisher and Friedman or, for that matter, any monetary theorist) they do not argue as economists, but quote anthropologists and certain monetary historians who claim that 1) money originated not spontaneously from direct exchange but is a creation of the state, or rather the state’s early precursors, such as priests and religious masters of ceremony; this is deemed important because the origin of money determines the “nature of money” (page 12) and therefore determines who should best control its issuance. 2) They argue that thousands of years of monetary history confirm that the state can be trusted fully with the monetary privilege. (If you remember history somewhat differently, then according to Benes and Kumhof you have to rethink. The paper follows a select group of maverick anthropologists and monetary activists that have simply rewritten monetary history. Needless to say, none of this was ever claimed by Irving Fisher or Milton Friedman, and to my knowledge, not even Henry Simons.)
Finally, the paper presents an elaborate econometric model that shows that all of this will work in reality.
In this essay I will do four things: I will put the proposed paper in the context of ‘Austrian ’ and Monetarist monetary theory, and show that it is not only outside these intellectual traditions but that its main argument is not even economic in nature. I will show that the core problem Benes and Kumhof claim to have identified is bogus, and that they do not understand money creation in our economy. I will then look at the paper’s peculiar historical, and non-economic, justification of complete state control of money, and show that this argumentation is highly dubious but also irrelevant. I will then show that the proposal presented relies on unprecedented forms of state intervention and crucially advances the notion that the state can create vast new assets – commonwealth equity – by decree, which allows it to claim to have no net debt and thus engage in loan acquisition and ‘debt forgiveness’.
What this paper is not: it is neither ‘Austrian’ nor Monetarist
Benes and Kumhof, early in their paper, claim that fractional-reserve banking increases the risk of bank runs, causes boom-bust cycles, and that a 100 percent reserve system would ensure greater stability. These observations are, in principle, correct. But this is, sadly, where it stops. Benes and Kumhof do not build on these insights. In fact, for their further argument these insights are completely irrelevant. Their paper does not bother to investigate the full range of effects of bank credit expansion, and ask, for example, if the expansion of base money by the central bank under a 100%-reserve system could not have similar or even the same adverse effects that deposit-money expansion has in a fractional-reserve system.
The Austrian School has provided the most comprehensive analysis of the effects of bank credit expansion and has shown most conclusively why more inelastic (‘harder’) monetary systems offer greater stability. Expanding the money supply always has disruptive effects as the inflow of new money must distort interest rates, and interest rates are crucial for the coordination of investment activity with voluntary saving. The question the ‘Austrians’ ask is not, who should control money creation, but should anybody control money creation? Should anybody even create money on an ongoing basis? Once a commodity of reasonably inelastic supply, such as gold, is widely accepted as money, any quantity of this monetary asset – within reasonable limits – is sufficient, and indeed optimal, to satisfy any demand for money. Demand for money is demand for purchasing power in the form of money, and can always be met by allowing the market to adjust the price of the monetary asset relative to non-money goods. No money creation is needed, and any ongoing money creation is in fact disruptive.
‘Austrians’ tend to be critical of fractional-reserve banking but they are equally critical – in fact, even more critical – of fiat money and central banking. The problems they studied would also occur – and are even more likely to occur – if the fractional-reserve-banking system was replaced with one gigantic state central bank.
But Benes and Kumhof did not call their paper ‘The Austrian Plan Revisited’ but ‘The Chicago Plan Revisited’. The approach and the goals of the Chicago School were different. But it is still worth mentioning that in his 1935 book “100% Money” Irving Fisher suggested that his plan could be combined with the gold standard, something that is impossible with the Benes/Kumhof plan and that Benes and Kumhof show no interest in. Here is Fisher, page 16:
Furthermore, a return to the kind of gold standard we had prior to 1933 [before the domestic gold standard was abolished by Roosevelt and private gold confiscated, DS] could, if desired, be just as easily accomplished under the 100% system as now; in fact, under the 100% system, there would be a much better chance that the old-style gold standard, if restored, would operate as intended to operate.
This would indeed be the 100% gold standard that many ‘Austrians’ propose, and a system immeasurably more stable than what we have today. However, it was certainly not Fisher’s primary objective to restore the gold standard. Fisher wanted to maintain the fiat money system and consolidate the control of the central bank over the banking system by eliminating any remaining discretion by ‘private’ banks. Fisher was a big proponent of price index numbers. He believed the purchasing power of money could be measured accurately through statistics – a fallacy that is still widely believed today and still causes confusion and harm – and he was an early advocate of inflation-targeting. (For an Austrian School response to Fisher’s original plan see Ludwig von Mises, Human Action, 1949, Chapter XVII, 12. The Limitation on the Issuance of Fiduciary Media)
25 years later, Fisher’s fellow Chicagoan Milton Friedman also proposed a version of the 100% plan, this time with even less reference to boom-bust cycles or the potential for a gold standard. Friedman was an advocate of central banking because he believed that monetary and economic stability could be achieved by guaranteeing a stable, persistent and moderate expansion of the money supply, which is at the core of Friedman’s Monetarism. In a 100% system the state central bank – so he argued – can make sure that this would happen.
Importantly, both Fisher and Friedman had an asymmetrical view of monetary expansion. The ongoing expansion of the money supply – and therefore persistent injections of new money into the economy – were not considered harmful (quite to the contrary), as long as the money inflow remained moderate, but any contraction of the money supply (shrinking of bank balance sheets and destruction of money) was seen as a major problem and to be avoided at almost all cost. Their plans for full reserve banking was largely motivated by a desire to avoid the destruction of previously created deposit money. Of course, ‘Austrians’ see this very differently. The expansion of money – even if moderate and controlled – must already cause problems (capital misallocations), and when these problems come to the surface they cannot be suppressed with yet more money creation, at least not forever (although this is attempted under Friedman’s proposal for very easy monetary policy in crises).
It should now be clear why the Austrian School is enjoying a revival in the present crisis, not the Chicago School. Fisher and Friedman did not get their 100%- system with complete control over money creation for the central bank but whatever power central banks had in recent decades – and that power was formidable – was used in ways that were strongly influenced by the Chicago School. Fisher and Friedman have shaped modern central bank orthodoxy to this day. As long as inflation is moderate central bankers believe that no monetary problem exists, in line with Fisher. Even in the run-up to the present, spectacular financial crisis, inflation remained moderate in most major countries, at least in the common (and dangerously narrow) CPI definition. And for the past two decades, any crisis that, if left unchecked, could have caused bank balance sheet deleveraging and credit contractions was aggressively fought with low interest rates and base-money injections from the central bank, according to Friedman. In fact, the Bernanke Fed has repeatedly referred to Friedman’s policy descriptions as a blueprint for its own actions. However, none of this has prevented major financial imbalances to build, and these policies have even helped create these imbalances, as Austrian theory would suggest.
But I digress. None of this makes any impression on Benes and Kumhof. In fact, Benes and Kumhof seem decidedly uninterested in monetary theory, business cycle theory, or the Austrian School. There is no mention of Mises or Hayek, and only Carl Menger is mentioned – in a footnote and disapprovingly.
Instead, the paper sets up an entirely new and I believe bogus problem based on the premise that in our monetary system money is supposedly provided ‘privately’, that is, by ‘private’ banks, and ‘state-issued’ money only plays a minor role. From this rather confused observation, the paper derives its key allegation that ‘state-issued money’ ensures stability, while ‘privately-issued money’ leads to instability. This claim is not supported by economic theory and certainly not by anything in the Austrian School or, for that matter in Friedman’s Monetarism or Irving Fisher’s original plan. Monetary theory does not distinguish between ‘state-controlled money’ and ‘privately produced’ money, it is a nonsensical distinction for any monetary theorist. An attempt to give credence to this distinction and its alleged importance is made in a later chapter in the Benes/Kumhof paper but, tellingly, this attempt is not based on monetary theory but on an ambitious, if not to say bizarre, re-writing of the historical record.
Benes and Kumhof create an artificial problem
For any analysis of the present financial system a distinction between state-created money and privately created money is entirely artificial and of no help whatsoever, because in our system money is created in a process in which ‘private’ banks are intimately connected with the state central bank. Any distinction between ‘private’ and ‘state’ is thus arbitrary and for an analysis of the economic consequences of such a system meaningless. Yes, most money in circulation today is deposit money and sits on the balance sheets of nominally ‘private’ banks, but the reserves are state fiat money, only to be created by the state central bank, which the nominally private banks have to have an account with in order to receive a banking license. Fractional-reserve-banks rely crucially on state-sponsored and state-controlled central banks that have a lender-of-last-resort function and that can – in a fiat money system – create bank reserves at will, no cost, and without limit, and are, under normal circumstances willing to do so to backstop the banks. Without this crucial backstop fractional-reserve banking on the scale on which it has been practiced in recent years and decades would be inconceivable. In their description of the present system, Benes and Kumhof take no account of any of this. Frankly, they do not appear to understand it.
Here are two statements from the IMF paper that may at first appear sensible but that on closer inspection reveal the grave misunderstanding of our present system by Benes and Kumhof:
“In a financial system with little or no reserve backing for deposits, and with government-issued cash having a very small role relative to bank deposits, the creation of a nation’s broad monetary aggregates depends almost entirely on banks’ willingness to supply deposits.” (page 5)
But what determines the willingness of the banks to supply deposits? Fractional-reserve banking (supplying deposits) is lucrative but also risky for the banks as the public can demand redemption of deposits in cash or in transfers to other banks, and banks cannot create cash or the reserve money required to facilitate transfers. These forms of money remain the prerogative of the state central bank. It is the certainty, or high probability, under present institutional arrangements that the central bank will support the banks and continue to supply whatever amount of cash and reserves is needed, that allows the banks to supply – very profitably, of course – vast amounts of deposit money on the basis of small reserve money. Should the public demand payment in cash, the central bank can reasonably be expected to stand by the banks and supply the needed cash.
In recent decades, the global banking system found itself on numerous occasions in a position in which it felt that it had taken on too much financial risk and that a deleveraging and a shrinking of its balance sheet was advisable. I would suggest that this was the case in 1987, 1992/3, 1998, 2001/2, and certainly 2007/8. Yet, on each of these occasions, the broader economic fallout from such a de-risking strategy was deemed unwanted or even unacceptable for political reasons, and the central banks offered ample new bank reserves at very low cost in order to discourage money contraction and encourage further money expansion, i.e. additional fractional-reserve banking. It is any wonder that banks continued to produce vast amounts of deposit money – profitably, of course? Can the result really be blamed on ‘private’ initiative?
Fractional-reserve banking on today’s scale requires two things: 1) a state-sponsored central bank that has the monopoly of bank reserve-provision and that has a lender-of-last resort function for the banking industry; 2) the central bank must have complete control over bank reserves and be able to create them at no cost and without limit. In short, the precondition for large-scale fractional-reserve banking is a complete, unrestricted fiat money system. By contrast, the ability of the central bank to create reserves is fundamentally restricted under a gold standard.
The gold standard was abolished and replaced with a system of entirely unconstrained state fiat money through an act of politics. The state established monopolistic central banks that have a lender-of-last-resort function for the banking sector. The state thus created the infrastructure that allows banks to supply vast amounts of deposits, and over the decades has repeatedly subsidized this activity and socialized its risks.
Here is the second statement by Benes and Kumhof:
“The control of credit growth would become much more straightforward because banks would no longer be able, as they are today, to generate their own funding, deposits, in the act of lending, an extraordinary privilege that is not enjoyed by any other type of business.” (page 5)
But what exactly constitutes the privilege? – In a free society, you are, of course, free to issue your own fiduciary media – just issue checks against yourself and have them circulate as money surrogates. You will probably have to convince the public that you will convert these checks into money proper on demand in order to persuade the public to use the checks as money equivalents, and even then you may not succeed. But if the public believes you and your endeavor is successful, you have indeed become a money-producer and can fund your own lending with your checks. In fact, this is pretty much how fractional-reserve-banking originated. So far no privilege. It only becomes a privileged business, and possible on the scale we see it today, once the state supports it. The ‘Austrian’ solution is straightforward: remove the privilege! Without fiat money, central banks and state-sponsored deposit insurance, let us see how much ‘private’ money creation there really is!
No theory but revisionist history
Benes and Kumhof try to argue in a separate part of the paper that the distinction between ‘privately produced’ money and ‘state-produced’ money is meaningful and important. Here, they completely depart from any traditional analysis of money or even any that could still be called ‘economic’. An economic analysis of money understands money as a useful social institution and thus starts with an inquiry of what money is used for in general, including today by today’s money users (that includes you and me), and tries to explain, based on reasoning, what would therefore make for good money in a general context, including the present one. Benes and Kumhof, however, do not argue conceptually as economic theoreticians but as (re-)interpreters of history. History can tell us what is good money and how it comes about. The anthropologists and monetary historians Benes and Kumhof quote claim that because money originated – supposedly – with the state its issuance is best controlled by the state. Again, no economic – conceptual, logical, theoretical – explanation is given for why that should be the case and why this could be upheld as a general rule. Allegedly, history tells us that the state is a responsible issuer of money and the private sector an irresponsible one. And that’s that.
The interpretation of the historical record that is provided in support of this allegation ranges from the adventurous to the outright bizarre. Instances in which the redeemability of deposit money in gold and silver was abandoned by official decree and vast amounts of fiat money were created to fund wars, revolutions or other state expenditures, such as during the Revolutionary War in America, the Civil War in America, or 1920s Weimar Germany, are reinterpreted to show that the ensuing inflations and outright currency disasters cannot be blamed on the state but are entirely the result of the involvement of ‘private’ money issuers.
“Colonial paper monies issued by individual states were of the greatest economic advantage to the country…The Continental Currency issued during the revolutionary war was crucial for allowing the Continental Congress to finance the war effort. There was no over-issuance by the colonies,… The Greenbacks issued by Lincoln during the Civil War were again a crucial tool for financing the war effort, [Hooray! Another war courtesy of paper money! DS] … The one blemish on the record of government money issuance was deflationary rather than inflationary in nature.”
Really? – The ‘colonials’ that were issued to fund the war with Britain ended up worthless, and to this day there is the idiom “worthless as a continental” in the American language. The period of the Civil War, too, was one of unusually high inflation, and in 1879 the USA decided to go back on a gold standard, at which point a period of considerable growth and rising prosperity set in.
While the enthusiasm for paper-money-funded wars on the part of Benes and Kumhof is already a bit disturbing, what is particularly striking is that Benes and Kumhof, and the ‘historians’ they quote (in particular the activists David Graeber, an anthropologist and leading figure of the Occupy Wall Street movement, and Stephen Zarlenga, founder and director of the American Monetary Institute), try nothing short of a complete re-writing of economic history and suggest conclusions – not only in one instance but throughout ALL of monetary history – that not only fly in the face of the generally accepted historical record but also common sense. The state as a monopoly-issuer of money with no restriction whatsoever becomes a trusted guardian of the common weal – simply by being a state!
Their whole argument gets kooky in the extreme when they address more recent instances of fiat money currency disasters, for which we not only have ample documentation that supports the opposite interpretation but which some of the most distinguished monetary theorists actually lived through themselves and experienced first hand – and which they explained succinctly.
Ludwig von Mises wrote a seminal book on monetary theory in 1912 (Theories des Geldes und der Umlaufmittel), in which he laid the foundations for the Austrian Business Cycle Theory and in which he predicted (!) the European hyperinflations of the 1920s. He lived through the hyperinflation in Austria in 1923, and, as the chief economist of the Vienna Chamber of Commerce, was in direct contact with the key players in government and central bank. He later wrote his memoirs.
Benes and Kumhof now claim that all these accounts are simply wrong. The main culprit was not the state but the private sector. We only have to ask state officials (!) and they can tell us what really happened. Here is the IMF working paper, page 17:
“The Reichsbank president at the time, Hjalmar Schacht, put the record straight on the real causes of that episode in Schacht (1967).”
According to Benes/Kumhof, Schacht blames the inflation on aggressive money creation by the private sector but his account also suggests that this was only possible because the Reichsbank generously redeemed deposit money in Reichsmark, that is, the central bank provided essential support for money expansion. With a generous backstop from the state the private sector will, of course, create money. But does that mean the state had nothing to do with the whole debacle? Kumhof, Benes and their prime source, Zarlenga, seem to not understand the role of central banks and the essential ingredient of state-backing for large-scale fractional-reserve banking. Furthermore, Schacht is a source of a somewhat dubious reliability in this debate. Schacht became a Hitler supporter later on, introduced socialist New-Deal-type policies in Germany, and helped the Nazis with re-armament and plans for German autarky. I am not saying this to discredit Schacht as an economic observer, only to highlight that he had – and this is probably an understatement – a considerable pro-state bias in all his economic views and is hardly an objective observer on the question of whether the state can be trusted with money. (As an aside, all totalitarian ideologies are anti-gold and pro-paper money and central banks. The Socialists, the Communists, the National-Socialists, the Fascists – they all hated to see the state restrained in its manoeuvrability by a gold standard.)
Benes and Kumhof’s case simply ignores the numerous historical accounts that paint a very different picture, such as the work by English historian Adam Ferguson whose seminal book “When Money Dies” has recently found a wide new readership. It ignores the eye-witness reports of one of the most distinguished economists of the 20th century, Ludwig von Mises, or the work of Swiss monetary historian Peter Bernholz.
I am not a historian and I want to be careful in dismissing challenges to the established historical record out of hand, but the account presented here strikes me as simply ridiculous, unscientific, mystical pro-state propaganda. As a scientific argument it is without merit.
But almost the worst aspect of it is this: where are the economics, where is conceptual analysis and reasoning? Even if we accepted – simply for argument’s sake and contrary to the overwhelming evidence to the contrary – that the state has more often than not been a good guardian of the money privilege, what are the explanations for this, what are the theoretical and conceptual arguments that underpin this historical pattern? Could we rely on this always being the case? If it is in the “nature of money” (Benes/Kumhof) to be provided by the state, is it therefore in the “nature of the state” to always provide good money, or would we need specific institutional arrangements, legal frameworks, or some ‘good-money’-culture or tradition for this to be the case? Of course, Benes and Kumhof provide no answers.
This part of the paper is simply unscientific because the argument is essentially mystical. The whole idea that a socially useful institution such as money can only be understood if we understand its “nature”, which does not derive from how people use it (including you and me today) but from how it came into being thousands of years ago, is nothing if not rooted in mysticism.
Money is a tool, and so are hammers. If I asked you to tell me what a hammer is for, what makes for a good hammer and a bad hammer, and what type of hammer I need for a specific purpose, would you tell me that I first have to understand the “nature” of the hammer, and to do so I would have to ask anthropologists how the first hammers came into being and what the first hammers or hammer-like tools were used for?
Mystical assets
Remember what I said above about circulating your own checks as fiduciary media? That is a pretty good description of paper money issuance. The newly circulated paper money is accounted for as a liability on the balance sheet of the paper money creator, and the things he acquires through issuing/spending this new paper money become the corresponding assets. By issuing paper money the money creator lengthens his balance sheet, while those who transact with the money-creator neither lengthen nor shorten their balance sheets but exchange positions on the asset side of their balance sheets, they replace other, previously held assets with new money.
This can also be observed in the creation of base money (extra bank reserves) by central banks today. When the Federal Reserve creates an extra $1 trillion as part of ‘quantitative easing’ and decides to buy mortgage-backed securities from its member-banks, then the Fed’s balance sheet expands by $1 trillion dollars. The new bank reserves are on the liability-side of its balance sheet, while the mortgage-backed securities are on the asset-side. The balance sheets of the banks do not expand as a result of the Fed operation. The banks simply replace mortgages with new reserves. Both are on the asset side of their balance sheets. Their asset-mix has changed. They now have more reserves.
This process could be extended until almost all bank assets have moved to the central bank and the banks are fully reserved and thus cease to be fractional-reserve banks. This was precisely the process that Irving Fisher had in mind when he wrote “100% Money” in 1935 (see page 57), and Milton Friedman when he wrote “A Program For Monetary Stability” in 1960.
At no point did any of these economists suggest, nor does any central bank today suggest, that the creation of new paper money enhances the overall wealth of society, that there is now more property in this society. It is also clear from this process that ‘debt forgiveness’ by the central bank is difficult. The central bank can issue enough reserve money to acquire all bank assets but whenever it writes down the book value of any of these assets it also has to shrink the liability side of its balance sheet, it has to destroy reserve money.
Benes and Kumhof now come up with an entirely novel approach. The state simply declares that its new reserve money is also an asset in its own right. Per decree the state creates wealth: Treasury Credit or commonwealth equity. The central bank books the new reserves on its liability side, just as in a conventional money creation process but now does not book existing assets against it that it acquires from whoever books the new reserves as assets (the banks). The corresponding asset is now ‘Treasury Credit’, which did not exist before but now comes into being per government decree. At this stage, the central bank’s balance sheet lengthens without any acquisition of new assets – the offsetting asset is created simultaneously with the reserve money liability!
The balance sheets of the banks now also lengthen: the banks book the new reserves on their asset side without (at this stage) transferring other assets to the money-issuer. The asset-side of their balance sheets lengthens. The corresponding lengthening of the liability side is achieved by booking ‘Treasury Credit’ as a liability.
It is this slight-of-hand that allows, in the following steps, various bank assets to get written off without a corresponding shrinking of reserve money. Only via the accounting gimmick of creating central bank assets out of thin air (and not just new central bank liabilities) and thus claiming that overall wealth – new assets – have been created administratively by the government can the large-scale debt write-off that is the paper’s allegedly strongest selling point, proceed.
All of this is state intervention in private contracts and property rights on a gigantic scale. The state may have the power to rewrite accounting rules and simply claim the existence of mysterious ‘government wealth’. Stranger things were claimed by governments in the 20th century. But what are the consequences? How will the public react? What confidence will it have in the new 100% state controlled monetary system?
Simply writing off all household debt is a mixed blessing. How would you feel if you worked hard and saved and did pay down your debt to give your family financial security, only to find out that your irresponsible and reckless neighbors, living high on the hog on credit cards, just saw all their debt wiped out by the Benes/Kumhof plan?
All power to the state!
This whole plan is nonsense on the greatest scale. Benes and Kumhof have thoroughly embarrassed themselves. Maybe we should simply look the other way and ignore this ill-conceived rubbish, maybe excuse it as the confused musings of two state-worshipping econometricians who fell under the spell of the New Age historicism of Graeber and Zarlenga, which they saw as a great opportunity for some fancy econometric modeling. But this comes with endorsement from the IMF, a major state-organization. Could it be that those who benefit from the accumulation of more state power feel that all the widespread banker-bashing and the erroneous but skillfully planted notion of the failure of capitalism can be turned even more to their advantage? Even the otherwise intervention-happy Ambrose Evans-Pritchard has his doubts:
Arguably, it would smother freedom and enthrone a Leviathan state. It might be even more irksome in the long run than rule by bankers.
Ambrose, for once I agree.
In the meantime, the debasement of paper money continues.
In a truly remarkable piece for the Financial Times yesterday, Wolfgang Münchau took another swipe at the Euro-sceptic and ECB-critical community in Germany, which he accuses of inflation-paranoia and of simply not getting ‘modern central banking’. Well, I know of many qualified commentators – many non-German – who swallow a tad harder when reflecting on the new reality of unlimited and open-ended QE in the US and unlimited bond buying by the ECB. As the central bank bureaucrats declare that they will not stop printing base money until the economy grows faster and the unemployment rate drops, damn it, some of us may be excused for wondering what the long-term and unintended consequences of this might be. But, according to Münchau, we are entirely mistaken as we have evidently been “fed misinformation about the functioning of a modern economy.”
Unlimited QE is, according to Münchau, the result of new theories of how central banking works. You see, with open-ended QE the Fed “has become much more determined in guiding future expectations,” which is supposedly what the economy needs: bureaucrats that centrally and administratively guide expectations. Strangely, though, this does not sound all that modern to me.
There is no denying that, of late, things have not been going according to plan but this is no reason for Münchau to question the role of central banks in this crisis, let alone the very concept of monetary central planning, of the idea that some ‘wise men and women’ in Frankfurt, Washington or London, fix the supply of base money and certain prices (interest rates) in order to control, guide and manage overall economic performance. Like many of his FT colleagues, Münchau is in awe of the power elite that supposedly runs our economies and our societies to our benefit. Difficult times only seem to require more determined politicians and more determined central bankers. And when central planning fails, the central planners simply need a new plan. Or a new target.
Not surprisingly, Münchau is an advocate of nominal GDP targeting, the new fad in monetary central planning. There is allegedly nothing wrong with monetary policy. The central bankers only need a new target, and, naturally, a more comprehensive one. The trained mathematician Münchau lectures us how this works:
“This is a debate about nominal income targeting, where a central bank no longer stabilises the inflation rate directly but focuses instead on stabilising nominal gross domestic product. You can think of nominal GDP as the sum of real GDP and inflation. If real growth falls, the central bank would thus have to drive up inflation. Conversely, if real growth rises, the central bank would have to bear down on inflation much harder than it would do under the pure inflation targeting regime used by central banks such as the ECB.”
There is a dangerous naivete about all of this, a blindness toward real-life complexity. There is also a kind of narrow-mindedness, of which Münchau accuses the central bank critics, but of which he himself is the prime example. Münchau and other advocates of GDP-targeting are consistent macro-economists, which means they necessarily ignore many important micro-economic phenomena.
Here is the prime fallacy behind the nominal GDP target and, in fact, all of Münchaus’ argument: It tacitly assumes that money is neutral, which money never is. Let me explain.
The idea that central banks should target nominal GDP presupposes firstly, that stability in nominal GDP is in fact desirable and possible, and that we can ascertain what the ‘right’ level of nominal GDP should be, and what the appropriate relationship between inflation and real GDP is. Such stability rarely exists in human affairs and in particular in economic phenomena, and such a static and non-dynamic view of the economy strikes me as rather – well, not modern. Secondly, and even more importantly, it presupposes that there are direct and stable links between the quantities that the central bank does indeed control directly – that is the monetary base, bank reserves, and certain interest rates – and the macro-economic variables, growth and inflation, which are the ultimate target of its policies. This relationship – between base money and inflation and growth – is, however, very complex and far from stable, and many things can and must happen on the way from changing one to changing the other. And not all of these things are pretty.
Let us assume the central bank fears that real GDP is running too low and that the central bank now has to, according to Münchau, ‘drive up inflation’. How does the central bank do it? – The answer is, it does what it always does, just more of it. The central bank buys certain financial assets from the banks and credits the banks’ accounts at the central bank with newly created bank reserves. Thus, the banks have more – and, we can assume, cheaper – reserves than before, which means they now have an incentive to lend more money. Loan rates on credit markets should drop as more credit gets extended. Investment projects that were previously shunned due to relatively high costs of funding are now profitable. New lending and new borrowing occurs. This may indeed lift real GDP – although only temporarily – and ultimately lift the average of prices, the price level, an effect that, in contrast to the GDP boost, is usually permanent. However, it is clear that many other things must have changed as well as a consequence of what the central bank just did: certain financial assets will have gone up in price and down in yield; bank balance sheets will have expanded; financial leverage will have increased; capital has been reallocated; the relationship between voluntary saving and investment in the economy has been altered; relative prices have changed; income and wealth distribution have changed. It takes either incredible naivete to assume that all these changes are so benign that we can safely ignore them, or childlike optimism in the wisdom and farsightedness of central bankers to assume that all these effects can be anticipated and incorporated in the design of these policies.
The macroeconomic fallacy is to believe that an expansion of the money supply has two effects and two effects only: it lifts growth (good) and it lifts inflation (sometimes good, sometimes bad, sometimes unimportant). That this is too narrow a view, we know since Richard Cantillon invented modern economics. Cantillon lived 300 years ago, so Münchau may object that he did not understand the ‘modern economy’, and besides, Cantillon did not obtain a PhD from MIT, as did Bernanke and Draghi, Münchau’s heros. But in Cantillon’s defence we may say that he experienced first-hand – and indeed actively participated in – one of the most remarkable experiments with paper money in all of history. I am talking about the famous John Law scheme in France from 1716 to 1720. Cantillon knew Law and invested in his paper money scheme. In fact, Cantillon achieved what most modern hedge fund managers dream about. He rode the bubble – the famous Mississippi bubble – to its peak and took his profits before the bubble collapsed. In contrast to Law who ended impoverished and had to flee France, Cantillon retired a wealthy man and recorded his astute observations about the effects of monetary expansion. One of his most notable discoveries was the fundamental non-neutrality of money. As Cantillon stated, when new money is injected into the economy, it does not raise all prices simultaneously and to the same degree but some faster than others, and some more than others.
This is important and has far-reaching consequences. ‘Easy money’ does not just directly affect growth and inflation, or any desired combination of the two. It does not just affect the statistical average of prices, the price level, or the statistical aggregate of economic transactions, real GDP, or any other statistical macro-variable. ‘Easy money’ always means changes in relative prices, changes in resource allocation, and changes in income and wealth distribution. In particular, ‘easy money’ lowers interest rates, which are crucial in a market economy for coordinating investment activity with the public’s time preference, i.e. the public’s propensity to save and thereby support and sustain the capital stock. Monetary expansion means distorted interest rate signals and thus necessarily capital misallocation. This fundamental insight is the basis of all monetary theories of the business cycle, that is, of the insight that monetary expansion leads to booms that must be followed by busts. Every monetary expansion creates distortions, the liquidation of which cause the next recession. Every monetary expansion creates economic instability. This was already the basis of the business cycle theories of the British Classical economists of the Currency School in the 19th century, but more importantly, it was the basis of the so far most convincing business cycle theory, the one developed byLudwig von Mises in 1912 and 1924, a theory that is now widely known as the Austrian Theory of the Business Cycle.
This theory explains why modern fiat money central banks can never be a source of ‘stability’, whether that means the stability of the inflation rate or the stability of nominal GDP. Central banking, whether old fashioned or modern, is always a source of instability. This theory also explains why modern central banking has now maneuvered us into a veritable economic cul de sac. Repeated attempts over the past decades to buy near-term economic growth at the price of persistent marginal debasement of money has now left us with such a distorted and over-indebted economy that any further monetary expansion has to be ever more scarily aggressive to even cut through the thicket of accumulated imbalances and have any effect on inflation and GDP, whether real or nominal. This policy will ultimately end in hyperinflation when the public loses confidence in this charade.
I don’t know if those German ECB critics who get Münchau all riled up know anything about Cantillon or Mises. For all I know, they may suffer from the same macroeconomic tunnel-vision that afflicts Münchau. The difference is this: In the final assessment they are correct and Münchau is wrong. The road to economic hell is paved with easy money.
In the meantime, the debasement of paper money continues.
I am not holding my breath over the Republicans’ plans for another gold commission to investigate the possibility of returning the USA to a gold standard in the case of the Romney-Ryan ticket winning.
Of course, I like the Classical Gold Standard, which existed from about 1880 to 1914, and I am convinced it was a humongous mistake to do away with it, a mistake that was further compounded by the abandonment of its weak successor, Bretton Woods, in 1971. And you know what I think of our present unconstrained fiat money system: It is suboptimal, unstable and unsustainable. It is fundamentally incompatible with capitalism, and it has now amassed so many colossal imbalances, from overstretched banks to a gigantic and never to be repaid public debt load, that it is firmly beyond repair. It is in its endgame.
But I don’t believe the best solution would be to go back to a government-run gold standard. We should not trust politicians and bureaucrats with money, certainly never again with entirely unconstrained fiat money, but probably not even with a monetary system that comes with the strait jacket of an official gold standard. I would argue instead for the complete separation of money and state, and for an entirely private monetary system. Let the market decide what should be money and how much there should be of it. I do strongly believe that gold would again play an important role in such a system. After all, gold and silver have been chosen forms of money for thousands of years, in all cultures and societies. That is what the trading public always went for when it was free to choose.
Nevertheless, I would agree that even an ‘official gold standard’, such as the US had before 1933, and in particular before the Federal Reserve was established in 1913, would still be much better than anything we have today. But the chances of such a system being reintroduced are slim.
Political obstacles are immense
Remember, there already was a gold commission under Ronald Reagan in the early 1980s, and it rejected the idea. And I think the chances for a return to gold through the established political process were considerably better 30 years ago than they are today.
For all his faults, Reagan was a much more libertarian politician than Romney, with incomparably better free market credentials, a stronger philosophical core, and a superior talent for communication. I don’t trust today’s Republican Party implementing a truly libertarian program.
Also, in the early 1980s, it would have been much easier to transition to a gold standard. Constant fiat money expansion had not yet created the massive imbalances and the illusions of prosperity that characterize our economies today. Back then the total debt of the US government was less than $1,000 billion. Today, the annual budget deficit is bigger than that. Today, the withdrawal symptoms would be considerably larger for the state, the financial industry and the distorted and hugely inflated asset markets, all of which are now thoroughly addicted to the crack cocaine of a never-ceasing flow of super-easy money. In the early 1980s, then-Fed chairman Paul Volcker had in fact stopped the printing press for a while and allowed higher interest rates to cleanse the system of some of the accumulated distortions. There was in fact a discernible political will to implement hard money. Compare that to the situation today!
So if Romney wins the election (a very big if), then it is still likely that the commission will reject the idea, in my opinion. Nobody wants to take the short-term pain of turning off the monetary tap, even if the long run benefits are considerable. Wall Street, the media, academia, and, of course the Fed, are strongly on the side of fiat money. I don’t see any commission overruling these powerful factions.
In many ways, the worst outcome would be some watered down, pseudo-gold standard under the management of the Fed. If the crisis then persisted, which it would, the easy-money advocates would blame everything on the ‘gold standard’ tying the hands of ‘our saviour, the central bank’. This is also a problem for a Romney-win in general, which is unlikely to bring the pro-market changes America needs although his policies will be branded ‘free market’ by the statist media. If Obama remains in office, at least nobody will call his program ‘capitalism’.
Media and academia are mainly pro-state, pro-politics, anti-gold
So I guess, we hard-money nutcases will have to wait for the crisis to get worse, while the advocates of fiat money and central banking can relax and happily cheer on the Printmaster-in-chief as he creates good and lasting jobs with QE5 and QE6. What has, however, been interesting in recent days has been the response in the mainstream media. Commentators have been in a state of apoplectic fit over the gold commission, writing dismissive pieces against gold that are as full of hysterical rage as they are void of economic reasoning.
I am fully aware, of course, that the present easy-money system controlled by educated bureaucrats has its adherents, in particular among people who perceive every problem in society to be best solved by politicians and the state. But the extent of economic nonsense and disinformation that was disseminated in these tirades, and the strenuous, laboured defence of the present system, I still found remarkable.
Bloomberg diagnosed that the critics of Fed activism, zero-interest rates and unlimited QE, suffer from an “anti-inflation obsession” that borders on “derangement”, while Robin Banerji in a piece for the BBC website remarks that advocating the gold standard had been the domain of “economic eccentrics” and followers of “folksy” libertarian Ron Paul, in short, ill-adjusted people who have not gone with the times, who are nostalgic, longing “for a simpler age”. You see, if you are an advocate of the gold standard you may suffer from psychological problems. Fittingly, Banerji’s article for the BBC is titled: ‘Gold standard: Could it return in the US?’, which make it sound like a disease. ‘Cholera: Could it return in the US?’.
Unfortunately, Mr. Banerji’s article does not give the economic layman a clear comparison of the key features of the two systems, fiat money and gold standard. Instead, the reader is left with the vague sense that a gold standard would either collapse instantly or lead to grave instability. The present system is, by comparison, described as successful and inherently stable.
To this effect, the article quotes three mainstream economists – Kenneth Rogoff, Anil Kashyap (return to gold “incredibly crazy”) and Charles Wyplosz – all opponents of a return to gold. Wyplosz provides this remarkable insight:
There has been no significant inflation in the advanced economies for the last 25 years, so the need for gold to defeat inflation seems unnecessary.
Hmmm. From 1997 to 2007, that is, the ten years that preceded the start of the present crisis, house prices in the US appreciated 3 times faster than in the preceding 100 years. We had drastic asset price inflations and various asset price bubbles around the world over the past 25 years, plus explosions in general indebtedness and massive bank balance sheet expansions, and these inflations set us up for the present crisis. Real estate booms that ended in banking crises occurred in Japan, Scandinavia, South East Asia, the US, the UK, Ireland and Spain, to name just the examples that come to mind immediately. But I guess, as long as a pint of milk in the supermarket only goes up by 3 percent a year, there is ‘no significant inflation’ for Mr. Wyplosz. Remarkable.
“Stable paper money versus unstable gold money.” – Really?
While the present system is supposedly doing swell, the gold standard is a source on instability. Harvard-man Rogoff has this to say:
The price of gold fluctuates a lot and therefore the price of your currency would fluctuate a lot.
This is a popular fear about the gold standard, and it is without any substance whatsoever, and any foundation in economic theory or history. Today’s gold price is volatile because gold has been (partially) demonetized and is now fluctuating against state-issued paper money, and the resulting price movements tell us more about the instability of fiat money than of gold.
Take a look at history: whenever gold was money, fluctuations in the purchasing power of money, or fluctuations in the ‘value of money’, if you like, were extremely small to almost non-existent. Inflations and deflations as problematic macro-economic phenomena were largely unknown when gold was money. Inflation and (corrective) deflation only became problems when the state introduced paper money. If you look at long-dated charts of the purchasing power of the world’s oldest currencies – the British pound and the US dollar – you can spot easily when these currencies were taken off gold or silver, and when they were later put back on gold or silver.
Gold has been stable money, while paper money has always been – without exception – unstable money. Paper money has always led to inflations, usually followed, at some point, by corrective deflations. Abandoning commodity money always increased uncertainty over money’s purchasing power for the money-user.
The pound and the dollar have, in their very long history, never lost as much purchasing power as quickly as they have since 1971, when Nixon closed the gold window.
To imply that gold could be unstable money is putting the historical record on its head. If we judge the two monetary alternatives, fiat money and gold standard, purely on purchasing power stability, there can be no question that the gold standard wins easily. The historical record is not even mixed on this. Also remember that at no point in history was gold or silver replaced with fiat money, because the public demanded an end to ‘volatile commodity money’ and craved ‘stable fiat money’. This never happened, to my knowledge. But on the other hand, monetary systems have repeatedly gone back from paper money to commodity money, such as gold, in an effort to restore economic stability. Britain did it in 1821 and the US in 1879. I find it hard to believe that Rogoff does not know this. Why he is happy to portray it otherwise, I can only guess. And the journalist Banerji is evidently uninterested in checking the facts.
In a similar direction go statements like these, again from Rogoff:
[The effect on the US economy of a return to a gold standard] could either be inflationary or deflationary depending on the initial rate.
Again this is highly misleading as it falsely associates the gold standard with uncertainty and instability. Based on history and economic theory, we can predict with reasonable certainty that a return to a gold standard would be deflationary in the near-term – almost regardless of the initial rate – as the preceding inflationary boom is unwound, but provide monetary stability in the long run. Under a gold standard the supply of (core) money would be essentially fixed or could only be expanded very slowly. There would no longer be any monetary policy, and banks would no longer enjoy the privilege of a “lender of last resort”. These are the key differences to the present system. Because of our fiat money system, the relative prices of many assets are distorted by constant monetary expansion, which does not – contrary to widespread misconception – lift all prices uniformly but some prices more than others. Additionally, banks are running low capital and reserve ratios because of the safety net provided by the printing press. The change of monetary regime would cause many prices to adjust, many probably to decline, and many banks to shrink their balance sheets to protect reserves. Once we are through this deflationary adjustment – which is, in my view, unavoidable at some stage anyway – we can expect the gold standard to give us money of superior purchasing power stability, as I explained above.
Over time, a proper gold standard can be expected, on conceptual grounds, to even deliver moderate deflation. Prices would have a slight tendency to decline over time. Statistically and historically, this phenomenon has been very minor, indeed, and such secular deflation, if it occurs at all, is never an obstacle to strong growth.
The problems of transition
Rogoff is, however, correct to highlight the general importance of the initial dollar-gold rate established by the new gold standard. The US has a sizable gold hoard but at the present gold price it is worth ‘only’ about $440 billion when years and decades of paper money creation have caused the monetary base to balloon to $2,600 billion, and M2 to more than $10,000 billion. For the official gold stock to back the entire monetary base the dollar would have to be devalued versus gold to a new price of $10,000 per once of gold, compared to $1,690 per ounce now; and if M2 was to be backed completely with gold, the new gold price would have to be $38,000 per ounce! Such a drastic revaluation of the dollar could have various knock-on effects, certainly in the international gold and commodity markets but probably elsewhere. Rogoff is right to point this out.
However, these are problems with the transition from one system to another. I am the first to admit that after 40 years of unrestricted fiat money creation a smooth and friction-free transition back to sound money is anything but straightforward. This is also my biggest criticism of present-day easy-money policies: they create illusions of stability by creating more imbalances and making a return to a stable system more difficult. But such a return will one day be necessary and unavoidable.
None of these objections mean that a transition to sound money is ultimately not possible and the long run benefits of it not highly desirable. Remember that transitions from paper systems back to gold were achieved repeatedly throughout history. More importantly, these points say little about the workings of a gold standard versus the operation of a fiat money system. The reader must wonder why anybody in his right mind would even contemplate going back to gold when all a gold standard could ever give us was volatility, uncertainty and chaos.
Well, in fairness to Banerji, he had this to say about the gold standard:
From 1945-1971, the period of the “gold exchange standard”, the US fixed the dollar to gold at $35 an ounce. Growth rates were higher and rises in wealth were more equitably shared across society than in the years that followed. Unemployment has been higher, growth lower, and wealth more unevenly distributed since the US dollar came off gold in 1971.
But then he hastens to add: “This could have been coincidence, however.”
What are the effects of money creation?
The Bloomberg opinion piece is equally hostile to the gold standard idea but it is less confusing and misleading, and instead provides the reader with a clear and rousing endorsement – incredibly naive and misguided, in my opinion – of fiat money and central bank activism, an apparently wonderful system that we would have to do without if the mad Republicans brought the gold standard back.
Contrary to what gold bugs and other Fed-bashers say, the Fed’s dual mandate and its policy of quantitative easing — buying bonds to nudge down interest rates– have been vital strengths, not weaknesses. They have helped to support demand and bring unemployment down, albeit slowly. Fiscal paralysis in Washington made the Fed’s unorthodox measures all the more necessary. Far from being reckless, the Fed has been too timid and needs to embark on the third round of QE that Chairman Ben S. Bernanke keeps hinting is on the way.
The key argument is a familiar one, and it goes something like this: economic crises occur, they just happen, gold standard or no gold standard, but under our present system we at least have a central bank that can lower interest rates and print lots of money to stimulate demand and get us out of the crisis.
Behind it lies a dangerous simplification, namely that fiat money creation has two effects and two effects only: all else being equal, injections of money lift the price level (i.e. they cause inflation) and lift GDP. Rising prices are sometimes good and sometimes bad. You can, of course, have too much inflation. But the growth-boosting effect of more money is always welcome. So, whenever inflation is not a problem (or when there is even a risk of deflation) the printing of money is an unequivocal positive. Who can be against it?
But injections of new money into the economy have many other effects than just lifting two entities of national account statistics. Have those who hold this simplistic macro-economic view ever thought about how the micro-economic act of injecting a certain amount of new money into the economy at a specific point, namely the banking sector, is supposed to translate directly, smoothly, and instantly into the macro-economic phenomena of higher prices all around and more economic activity all around? Alas, the whole thing is slightly more complicated.
Thankfully, but still unbeknown to the folks at Bloomberg, for centuries many high-caliber economists have worked hard to understand and explain the full range of effects of money injections. Indeed, one of the very first economists ever, Richard Cantillon, already made it an important aspect of his work, and his insights – almost 300 years ago – were already superior to what you can read in most financial market commentary today. For Cantillon already stressed that an inflow of new money will not lift all prices simultaneously and by the same extent but some prices more than others and some sooner than others. And that is as true today as it was in the early 18th century.
An inflow of new money into the economy must always change relative prices. Therefore, it must affect the use of scarce resources, the structure of production, and the distribution of income. Every inflow of new money must therefore create winners and losers. As a rule, the early recipients of the money (today, those are mainly to be found in the financial industry) benefit at the expense of the later recipients.
Inflows of new money tend to lower interest rates and also change the structure of interest rates, which in turn will affect the extent of investment and the structure of investment in the economy. In short, the delicate co-ordination between voluntary saving and capital investment that, in a free market, is conducted by market interest rates, is systematically distorted. The artificial cheapening of credit through money injections leads to capital misallocations and mal-investment.
For 200 years, many economists have blamed the business cycle on monetary expansion, usually as a result of artificial bank credit creation, often encouraged by the abandonment of a commodity anchor. The effects of money inflows listed above tend to create near-term booms that must be followed by corrective recessions later on. This phenomenon has to date been analyzed most comprehensively and convincingly by the Austrian School economists Ludwig von Mises and F.A. Hayek.
Mises called it the fundamental non-neutrality of money. Money can never be neutral. This means that any monetary economy, including a gold standard economy, will be subject to occasional disruptions emanating from the use of money, but the more elastic the supply of money is, and the more the supply of money is constantly expanded, the more severe these disruptions must be. Elastic money is also unstable and destabilizing money.
The crisis that the Fed is fighting today with easy money is the result of a housing bubble that the Fed itself inflated when it provided easy money to fight the previous recession, and that recession was the result of the collapse of the internet-bubble in 2001 which had previously been inflated by the Fed itself when it provided easy money to fight the consequences of the Asian debt crisis and the collapse of the hedge fund, LTCM, in 1999, which…. you get the idea.
Fact is, our unrestricted fiat money system is moving us progressively away from monetary stability and economic sanity. The Fed and other central banks have become serial bubble-blowers, and they have now created such vast imbalances that they are all on zero interest rates and repeated rounds of asset purchases to keep the system from collapsing. It requires such a naïve and simplistic macro-economic viewpoint as the one espoused by the Bloomberg editors to not see that this system is simply unsustainable.
I do not think that the US Republican Party will bring us back to a gold standard anytime soon. Sadly, I think the crisis will have to get much worse before this will be achieved. But there can be no question that we will have to transition to a hard money system eventually. The future of capitalism and a free society depends on it.
As Ludwig von Mises wrote in 1965:
If our civilization will not in the next years or decades completely collapse, the gold standard will be restored.
On page two of today’s Wall Street Journal Europe you will find the result of a readers’ poll from last Friday; Question: will the ECB’s rate cut help restore confidence in the bloc’s economy? Answer: 81 percent of readers say no; 19 percent yes.
Last week’s round of global monetary easing – another ECB rate cut, another round of debt monetization from the BoE, another rate cut from the People’s Printing Press of China – is, of course, more of the same old same old. It has a discernible touch of desperation about it and this is not lost on the public. Monetary policy is ineffective. Or, to be precise, it is only effective in delaying a bit further the much-needed liquidation of the massive imbalances that previous monetary policy helped create, and thereby is contributing, on the margin, towards making the inevitable endgame even more painful. It is counterproductive and destructive. It is certainly not restoring confidence.
Yet, many commentators and many of the establishment economists out there are not giving up. If only the ECB had cut by 0.5 percent instead of 0.25 percent, the equity market could have responded more optimistically. Maybe this would then have restored confidence? — Really? We are now below 1 percent in official interest rates, having cut by a full 400 basis points since the crisis started. How realistic is it to assume that another 0.25 percent is the difference between confidence-enhancing monetary stimulus and dread-inducing disappointment?
The advocates of ever more ‘stimulus’ are grasping at straws. What else can they do? Their pretty little world-view according to which, in a system of unlimited fiat money, the central bank can always create some additional ‘aggregate demand’ by giving a bit more artificially cheap funding to the banks lies in tatters.
Money is never neutral
That monetary policy would finally end in this cul-de-sac is no surprise. It only surprises those who share the mainstream’s simplistic view of monetary stimulus. Phrases such as “the ECB is attempting to unlock the flow of credit in the Eurozone”, are masking the complexity of the true effects of money creation and interest rate manipulation, and they make ongoing monetary stimulus look unduly harmless and straightforwardly positive. Who could object to unlocking credit, to liquefying markets or stimulating activity?
One of the major contributions of Ludwig von Mises’s monetary theory was his proof of the categorical non-neutrality of money. He demonstrated “that changes in purchasing power of money cause prices of different commodities and services to change neither simultaneously nor evenly, and that it is incorrect to maintain that changes in the quantity of money, yield simultaneous and proportional changes in the ‘level’ of prices.” (Ludwig von Mises, Memoirs, page 47).
A monetary stimulus never affects GDP and inflation directly and exclusively, these two statistical aggregates to which the mainstream assigns overwhelming importance. Every monetary stimulus affects and changes many other things as well, and these other effects have often more far-reaching consequences: monetary policy always changes relative prices, it always alters the allocation and the use of scarce resources, and it changes income and wealth distribution. Every monetary stimulus creates winners and losers.
This is being ignored by the mainstream. In his defence of QE, Martin Wolf argues in the FT that the central banks print money in the public interest. The assumption is that we all benefit from the boost to growth, short-lived as it must be, and that we all suffer the effects of higher inflation – if higher inflation materializes at all. But the new money does not reach everybody in the economy at the same time, and therefore does not affect prices ‘evenly and simultaneously’. As a general rule, the early recipients of the newly printed money benefit at the expense of the later recipients. Those who, in the chain of money distribution, are located closest to the money producer (the central bank) are always the winners. These are usually the banks and other financial market participants. They can spend the new money before it has dispersed through the economy and lifted a whole range of prices, and before the new money’s purchasing power has thus been impaired. At the present stage of the credit mega-cycle, more monetary accommodation helps the banks fund overpriced assets and bad loans on their balance sheets. Various ‘bubbles’ – which are uniformly the result of past monetary expansion – are thus sustained and even inflated further. Market forces that would adjust prices, reallocate assets and bring the economy back to balance are thus weakened or impaired completely.
Moreover, accommodative monetary policy can only lead to more economic activity by encouraging somebody to take out more loans, to take on more debt. The mechanisms by which ‘easy money’ leads to more GDP-growth is through the lengthening of balance sheets of banks and of more financial risk-taking, generally. We are in the present pickle precisely because this kind of stimulus policy has been conducted – on and off – for decades. That is what brought us to the point of a banking and debt crisis. Presently, authorities are fighting a debt crisis by encouraging more debt accumulation. They are fighting a banking crisis by encouraging the banks to take more risk. You do not lower interest rates and conduct QE and then realistically expect deleveraging and balance sheet repair.
In this context, I find it particularly bizarre that some economists argue that an even bolder intervention by the ECB, such as a deeper rate cut, another LTRO (funding operation for banks), or a commitment to more purchases of sovereign bonds, would have restored confidence. Do these experts really believe that the public will feel more confident if overstretched banks grow even more quickly with the help of the printing press? Will uncertainty over excessive government debt be laid to rest if the central bank promises to support these governments with essentially unlimited money-printing and bond purchases, thus making it easier for these governments to run deficits? Will that be seen as a solution or just a politically convenient postponement of the day of reckoning?
What causes loss of confidence is this: people do not know any longer what is and can be funded privately and voluntarily, and what is simply propped up by central bank intervention. They do not know the true prices of assets and the sustainable level of interest rates because everything is massively distorted through various central bank policies. Printing yet more money will not make anybody feel more confident.
Unintended consequences
Monetary accommodation is a form of market intervention, and like every other form of intervention it creates a whole range of unintended consequences, many of which are difficult to identify clearly and even more difficult to quantify but they are nevertheless real. My colleague at the Cobden Centre, Gordon Kerr, provided a good example during a recent discussion:
In supermarkets in London there is a trend towards replacing personnel at the check-out counters with new self-service machines that allow customers to scan their purchases and handle the payment process themselves. It is another incident of human labour being replaced with machines. We may say that this is a sign of the times, a consequence of technological progress, and thus inevitable. But such a development is, in each case, not only a consequence of what is doable technologically. It is also a result of economic calculation by the entrepreneur, in this case the owners and managers of the supermarkets. The expenditure for the machines, the capital they tie up and the interest charges that are associated with them, and any potential future losses from inappropriate handling by customers or even theft of produce due to reduced oversight will have to be compared with the cost savings from employing fewer personnel in the check-out area.
In modern-day Britain this calculation seems to work in favour of the machines but would it do so in a free market? The short answer is we do not know. But we do know that the supermarket workers and the check-out machines do currently not compete in a free market. Through the country’s numerous welfare-state regulations, among them minimum wages, social insurance, maternity- and paternity leave, health-and-safety legislation and other rules to ‘protect the worker’, the government has lifted the cost of employing people, it has made human labour expensive, while at the same time, the country’s monetary policy in favour of super-low interest rates and more bank lending has made capital cheap. From both angles, the worker is being squeezed out of the market. Legislation to protect him makes his work expensive; efforts to cheapen credit make capital investment a much easier alternative.
Do not get me wrong: our high standard of living is the result of a high ratio of productive capital to worker. If we want to increase our standard of living further we will have to keep increasing this ratio. This is the only way to enhance human productivity. But there is a right way of going about this, and there is a wrong way. The right way is to save, to put real resources aside, to redirect real resources from forms of employment that are close to present consumption and transform them into capital for future-oriented investment. How much we invest should not be the result of the decisions of central bank bureaucrats and their monetary manipulations but the result of voluntary saving decisions. That may well set a lower speed limit on capital investment but such a lower speed limit would be entirely appropriate. The resulting capital structure would be much more stable and sustainable, while investment that is funded by money creation rather than saving must lead to capital misallocations, which remains the primary source of boom-bust cycles. The apparent need of large parts of our present capital structure for near-zero interest rates and further doses of monetary stimulus simply to be sustained in their current size is a clear indication that accommodative monetary policy has already created grave dislocations. How much more of these do we want? How much more of these can the system live with?
The point I am making here is this: It is either naïve or a sign of incredible hubris to believe that the central bankers can anticipate the myriad of consequences their monetary interventions will have. To say that they are simply, in aggregate, in the interest of the public is simply incorrect. We are dealing here with a financial bureaucracy that has lost touch with the complexity of economic reality but that has now dug itself such a deep hole that any self-motivated turn-around can safely be ruled out.
As my friend Tim Evans says, the system has check-mated itself, and so has the mainstream and the policy bureaucracy. Their policies are failing but they cannot consider the alternative, which would be a complete stop to monetary intervention and money-printing, and would mean finally allowing the market to liquidate what is unsustainable anyway. This would realign asset prices with economic reality and bring valuable assets into the hands of entrepreneurs rather than have them funded at unrealistic book-prices on bank balance sheets forever. Can they imagine this alternative but not dare to implement it? I am not so sure. I fear they may not even grasp it.
Will the ECB cut again? Will the ECB underwrite the bond purchases of the ESM via the printing press? – Yes and yes again. Of course, they will. Just give the ECB some time. Will it solve the problem? Of course, it will not.
We will see more rounds of QE, more rate cuts where this is still possible, and further expansions of central bank balance sheets. Pension funds and insurance companies will be forced by regulators to hold assets that the state wants them to hold (government bonds anyone?), and the reintroduction of capital controls appears a near certainty at this stage. Remember, a toxic mix of stubbornness and desperation rules policy making at present. It is best to be prepared for everything but the sensible solution.
Come to think of it, the title of this essay may be misleading. The central banks have reached the end of the conventional road but they will push their policies further.
