It was not too surprising that there is going to be no tapering for some very good reasons. The commencement of tapering would have led deliberately to bond yields rising, triggered by an increase in sales of government bonds to the public and at the same time escalating sales by foreign governments as they attempt to retain control over their own currencies and interest rates. This was the important lesson from floating the rumour of tapering in recent months.
The reason tapering was not going to happen is summarised as follows:
1. Monetarists and therefore central bankers believe that rising bond yields and interest rates will strangle economic recovery. They want to see more robust evidence of recovery before permitting that to happen.
2. Rising bond yields would have required the Fed to raise interest rates sooner rather than later to stem the flight of bank deposits from the Fed’s own balance sheet held as excess reserves, which only earn 0.25%.
3. Importantly, the global banking system has too much of its collective balance sheet invested in fixed-interest bonds, and is also exposed to rising interest rates through interest rate swap derivatives. Tapering would almost certainly have precipitated a second bank crisis starting at the system’s weakest point.
4. The cost of funding the US Government’s deficit would have risen, difficult when the debt ceiling has to be renegotiated yet again.
5. Rising US interest rates will most probably destabilise emerging market currencies, risking a new Asian crisis.
6. It is a bad time to shift the burden of government funding back into the markets, because foreign holders have shown they will sell into rising yields.
The Fed has reaffirmed that zero interest rates will be with us for some time to come. It simply has no choice: it has to play down the risk of inflation. The result will be more price inflation, which is bad for the dollar and good for gold. This was reflected in the US Treasury yield curve, where prices of long maturities fell yesterday relative to the short end.
The markets had wrongly talked themselves into believing that tapering was going to happen, when the rumour was no more than an experiment. In the process precious metals were sold, driven by increasingly bearish technical talk every time a support level was breached. It is hardly surprising therefore that the recovery in gold and silver prices last night was dramatic, with gold moving up $70 and silver by $2 from intra-day lows. It looks like a significant second bottom is now in place above the June lows and the bear position, coupled with the shortage of physical metal will drive prices in the coming weeks.
The implications of the Fed not going ahead with tapering are bad for the dollar and won’t stop bond yields at the long end from rising. It shows that the whole US economy is in a massive debt trap that cannot be addressed for powerful reasons. The reality is the expansion of cash and deposits in the US banking system is tending towards hyperinflation and is proving impossible to stop. That is the message from this week’s FOMC meeting, and I expect it to gradually dawn on investors world-wide in the coming weeks.
Continued from Et in Arcadia ego
Here we come full circle, for what this essentially presumes is that there exist no means by which to achieve the ready monetization of credit since that insidious process – which is one favoured equally by the fractional free bankers as much as by the central banking school and the chartalists – breaks the critical linkage of sacrifice today for satisfaction tomorrow which is what ensures that we do not overstretch our resources or overextend the timelines pertaining to their employment.
Though we have already touched upon the basis for this affirmation, it is so pivotal to the argument, that I will test your indulgence in trying to bring home the point, once and for all.
When credit is not erroneously transmuted into money, it means that I, the lender, cede temporary control over my property to you, the borrower, postponing my enjoyment of the satisfactions it confers because you have made it plain to me that your desire for it is currently greater than mine. This difference in preference is – like all such disparities – an exploitable opportunity for us both and, recognising this, my existing claim over a specified quantum of current goods is voluntarily transferred to you, meaning I must abstain from its consumption (whether productive or exhaustive) while you partake of it in my place in what is a wholly co-operative and, moreover, a logically and physically coherent exchange.
You, in return, promise to render me a somewhat larger service some specified time hence, as the reward for my forbearance and the price of your exigency. That surplus – what we regard as the interest payable – will therefore be seen to be the price of time not of money, much less of ‘liquidity’ as the Keynesians would have us believe. Hence, it emerges as a phenomenon much more fundamental to our psychology as mortals and to the Out of Eden impatience with which this afflicts us than to any happenstance of the ‘market for loanable funds’. Once you accept this interpretation, you are at once made aware of just what an abomination is an officially-sanctioned zero – or in some cases, a negative – interest rate and you are presumably one step from wondering whether this monstrosity can be anything other than unrelievedly counter-productive.
Next, however, imagine that I take your IOU to the bank and that peculiar institution registers my claim upon its (largely intangible) resources in the form of a demand liability of the kind which – by custom, if not by legal privilege – routinely passes in the marketplace as money. Your promissory note – a title to a batch of future goods not yet in being – has now undergone what we might facetiously call an ‘extreme maturity transformation’ which it has conferred upon me the ability to bid for any other batch of present goods of like value without further delay. It should, however, be obvious that no such goods exist since you have not had time to generate any replacements for the ones whose use I, their lender, supposedly forswore until such time as your substitutes are ready to used to fulfil your obligations, something we agreed would be the case only at some nominated point in the future.
More claims to present goods than goods themselves now exist (strictly speaking, the proportion of the first relative to the second has been artificially increased) and thus the actions we may now simultaneously undertake have become dangerously incongruous. Our initially co-ordinated and therefore unexceptionable plans have become instead a cause of what is an inflationary conflict no less than would be the case if I had sold you my place at the head of the queue for the cinema only to try to barge straight past you in a scramble for the seat in question.
What is worse, is that this disharmony will not be limited to us two consenting adults – indeed, we may both actually derive an undiminished benefit from it – but by dint of the very fact that the disturbance we have caused will ripple through the monetary aether to inflict its pain upon some wholly innocent third party who is blithely unaware of the shift in the monetary relation which we have occasioned with the aid of the bank. In our cinema analogy, the bank has given me a duplicate ticket which will allow me to bump some uncomprehending late-arrival out of the place for which he has paid and denying him his right to see the show.
Monetization in this manner has done nothing less than scramble the economic signals regarding the availability of goods in time and space. Thus it confounds rational economic calculation in the round and so begins to render honest entrepreneurial ambition moot. Such a legalised misdemeanour is bad enough in isolation, but we know that this will be anything but an isolated infraction. When banks can monetize debts, they will: when they can grant credit in the absence of prior acts of saving, they will – indeed, we demand that they do no less out of the misplaced fear that otherwise economic expansion will be derailed.
The truth is, of course, that the greater the number of economic decisions which come to be conducted on such a falsified basis, the higher and more unstable is the house of cards we are constructing on the credulity of the masses, the conjuring tricks of their bankers, and the connivance of the authorities who are charged with their supervision. Worse yet, the feedbacks at work are such that each new card we add to the pile appears to justify the installation of every other card beneath it and the more imposing the edifice grows, the more eagerly we rush to make our own contribution to this financial Tower of Babel and the more frenetically the banking system works to assist us until it finally collapses under the weight of its own contradictions.
To modern ears, more attuned to the rarefied talk of the exotica of credit default swaps, payment-in-kind junk bonds, and barrier options, this may all seem rather laboured and old-fashioned with its parallels to the classical treatment of the ‘wage fund’ and its echoes of the hard money Currency School which fought the great controversy of the 19th Century with its loose credit, Banking School challengers.
For this I make no apology, for much of what we Austrians stand for can trace its roots back to the reasoning first laid out by Overstone, McCulloch, and Torrens in that grand debate, just as our opponents tonight can trace their lineage back to the likes of Tooke, Fullarton, and Gilbart (I might here blushingly recommend to you a modest little tome entitled ‘Santayana’s Curse’ in which I deal with the relevance of the background to that debate to modern-day finance).
It is also important to bear in mind that the game of finance cannot be conducted in a vacuum, to always be clear that its workings exert a profound effect on everyday decision making and that finance is a force for good when the rules of that game are in harmony with those laws of scarcity and opportunity which govern what is loosely termed the ‘real’ economy of men and materials.
Moreover, the elision of these two types of claims – money and credit – by what must be a fractional reserve bank has dramatically raised the stakes. The near limitless, fast-breeder proliferation of credit which this enables and the facile transformation of this credit into money breaks all sorts of self-regulating, negative feedback mechanisms between supply, demand, price, and discount rate. Greater, credit-fuelled demand leads to higher prices.
Higher prices should discourage further demand, but instead encourage more people to borrow in order to play for a further rise in prices, just as it flatters the banking decision to grant such loans since the earlier ones now appear to be over-collateralized and their risk consequently diminished. Divorced from a grounding in the world of Things and no longer intermediators of scarce savings but simply keystroke creators of newly negotiable claims, our modern machinery is all too prone to unleash a spiral of destabilizing – and ultimately disastrous – speculation in place of what should be a mean-reverting arbitrage which effortlessly and naturally reduces rather than exacerbates untoward economic variation.
Sadly, my monetarist and Keynesian rivals see nothing but positives in this arrangement and given their unanimity on the issue, I would hazard a guess that the complex adaptive system types are happy enough to bow to this consensus and to accept that this is simply the way things are when they construct their models and run their simulations. The laymen – even the expert laymen, if I may be allowed such an oxymoron – have been even more united in bemoaning anything which might inhibit banks’ ability to shower credit upon everyone and anyone who asks them for it. If we had no shadow banks, who would give the aspiring taxi-driver the price of his medallion or the wannabe nest-maker her mortgage, one participant asked, as if we all took it for granted that to enjoy goods for which one has not earned the means to pay was their god-given right.
Nor do the free-fractional types, as eloquently represented here by Professor George Selgin, have any objection to the mechanism itself, being, on the contrary, keen to suggest it will do far more good than harm by dampening down fluctuations which they fear may emanate from a suddenly increased to desire to hold money for its own sake. All they ask is that the ‘free’ banks they advocate are forced to come out from under the aegis of a central bank of issue and away from the current fiction of government deposit insurance and so have no-one to shield them from the consequences of any excess or imprudence into which they might stray.
It will probably not now surprise you to learn that while we agree that banks should indeed stand on their own two feet like those involved in any other branch of business, very few of us Austrians share his sanguinity on this issue, either on theoretical grounds or as a result of our own somewhat different interpretation of the (mainly Scottish) historical record.
For our part, we would rather that the kernel of money-proper around which all other obligations are arrayed is both unable to be near-costlessly expanded at political or commercial will or shrunk as a consequence of any wider calamity. Given this fixity, we trust that any change in economic circumstances will see prices adjust to reflect that without occasioning any major harm (our model economy has undergone a radical Auflockerung by now to ensure this). Nor do we believe that credit will be denied all flexibility, certainly not within the dictates of what the saver can be persuaded to accord to the investor, or the vendor to the buyer.
It is true that this would be a world characterized by the slow decline of most prices as human ingenuity and honest entrepreneurship were continuously brought to bear on the eternal problem of scarcity, but neither would this hold for us any terrors. After the initial transition, people would soon become acclimatized to such a benign environment and would adjust their expectations and their capital structures to best fit it.
As for Professor Selgin’s bogeyman of a sudden tumultuous rush to hold money for its own sake – which apocalypse he fears above all should we prohibit his Free Banks from printing up such liabilities, willy-nilly – we see little reason to believe such impulses could reach very far up the pecuniary Richter scale in a society which had wisely denied itself the volatile mix of massive fictitious capital, extreme leverage, inflationary gambling, morally-hazardous speculation, soft-budget public choice profligacy, and reckless maturity mismatches with which we are so afflicted in our present era of easy-money, chronic price-appreciation, and the granting of overarching central-bank ‘put-options’.
Sound money is more likely to prove conducive to sound business practice and hence to a sound night’s sleep for all.
To sum up then, the only valid economics is micro, not macro; individual, not aggregate. Value is subjective not objective. The consumer is sovereign in the choice of where he spends his dollar – and all values can be imputed from where he does so – but he should first earn that dollar through his prior contribution to production.
Entrepreneurial discovery is the evolutionary mainspring which drives our secular material advance and the entrepreneurial profit motive – in an honest-money, rent-free world – is the ‘selfish gene’ of that ascent. That same motivation mobilizes the set-aside of thrift in the form of capital and capital – to risk pushing the biological metaphor beyond the point of useful illustration – is the enzyme pathway leading to the synthesis of what it is we most urgently want at the lowest possible cost.
In all of this, the workings of a sound money should be so seamless and subliminal that we pay it no more attention than we do the fibre-optic networks or 4G radio waves used for the transmission of our digital data. Finance should be based on funding – i.e., the sequencing and surrender of the right to employ real resources through time.
That economics is an Austrian economics, not a monetarist one, a Keynesian one, nor a complex-adaptive system one and I heartily recommend it to your consideration.
Continued from The Divinity School debate.
The devotees of monetarism start from the observation that what they call ‘money’ tends to move in a loose correspondence with a statistical chimera called ‘National Income’ and then proceed to reverse the usual order of the harnessing of cart to horse to suggest that this income is best controlled by manipulating the quantity of ‘money’ ex ante (and here let us spare ourselves an examination of the exact definition of that beast, in keeping with the monetarists’ own proclivity to flit promiscuously between whichever of the likes of M1, M2, M3… M(n) currently best fits the econometric bill).
Leaving aside the vexed question of what exactly comprises ‘national income’ or of whether the near infinite richness of the interactions taking place between tens – if not hundreds – of millions of people can be boiled down into one simple numerical entity, it is not really surprising that, in a horizontally-diverse, vertically-separated, modern economy, the multifarious business of accumulating, transforming, and delivering a wide array of goods and services involves the generation of a commensurate number of claims so that each individual’s part in the creation of this bounty can be duly recorded and ultimately encashed.
But it is a long way from recognising that a degree of correlation might exist between money and credit on the one hand and material wealth on the other to insisting that the forcing of extra claims upon the system can somehow encourage an increase in genuine business, an augmentation of prosperity, or a sustainable improvement in the common weal.
To believe that wonders can be enacted merely by tinkering with the availability of the medium of exchange which is our economic system’s basic plumbing is a bit like the brewer who thinks that his beer can be made to ferment quicker and taste better if only he can lengthen the span and widen the bore of his pipe-work, or like a would-be author who thinks his magnum opus is more likely to be recognised as a literary masterpiece if he doubles the spacing between the lines of his typescript and so uses twice the number of reams of paper to set it down.
This is not to say that we Austrians deny that such jiggery-pokery can have very real effects on the economy – we are, after all, the ones who are noted for our own, unique, Monetary Theory of the Business Cycle – but we do doubt that its effects are either so mechanically predictable or so universally benign as our esteemed Chicagoan colleagues suppose.
Furthermore, we are all too aware that the monotonic and comprehensive inflation of values which results from the kind of carpet-bombing, ‘helicopter drops’ which loom so large in the dark fantasises of our central banking chiefs are not the norm, but that money creation takes place at specific times and specific places and so raises some prices and enhances some demands before it effects others, thus causing all manner of largely incalculable disruptions to the all-important relative price relations which are the means by which we can determine how scarce one good is compared to another. Thus, each of their successive interventions is only likely to introduce further strains into what the earlier ones have made an already highly dislocated structure to the point that the malign effect of such distortions seems to require yet further acts of interference with the natural order.
As for the Keynesians – one almost fails to know where to begin with a hodge-podge of obscurantism which is at best a rehashed version of the old under-consumptionist fallacies, shot through with a dash of equally antediluvian mercantilism, and at worst a cynical excuse for central planning and an assault upon the sphere of private decision making.
Not the least of the sins of dear Maynard was his role as a ‘terrible simplificateur’ in his championing of a school of accounting tautology that too many of us have come to revere as ‘macroeconomics’ – a many-headed monster of a thing which all too often tends to controvert the eminently sound insights of micro-economics once the latter’s transaction count crosses some strange, reverse quantum threshold of weirdness.
We have heard some of the peculiar effects of this tendency here tonight in being assured, among other things, that the only salvation of a people brought low by borrowing too recklessly is to find another agency – Burckhardt’s arch ‘swindler-in-chief’, the state, if no one else – to take their place at the high table of prodigality.
We have also been told that public debt is an ‘asset’ that we owe to ourselves – a contention which not only flies in the face of logic, but also of much of history – and that we cannot all export our way out of difficulty, when the very marvels of modern society have been exactly so built up by each man, much less each nation, ‘exporting’ as much value as he can to his fellows, thereby earning the right to ‘import’ as much as he would like from them as his due reward.
Above all, we have been enjoined to assume that everything wrong in the outmoded world of laissez-faire is the consequence of someone – usually someone assumed to reprehensibly better-off than the norm – failing either to exhaust the entirety of his income on fripperies – so triggering a nonsensical ‘paradox of thrift’ – or to spend any such surplus of income over outgo on fixed income securities – so delivering us to the legendary Château d’If of the ‘liquidity trap’ instead.
Needless to say, we hold the opposite to be true. We hold that thrift fuels, rather than frustrates, material progress and that the only ‘liquidity trap’ we have to fear is the snare that results from the provision of too excessive a supply of ‘liquidity’ – i.e., of a great superfluity of money and the promise of artificially cheap credit for ‘as long as it takes’ – in the aftermath of the Bust. This utterly wrong-headed approach only attenuates the purgative effect of the crash and so leaves too many men, machines, and minerals locked into too many failed endeavours at what are still too-elevated prices for their redeployment to alternative uses to promise a decent return on the undertaking, this preventing economic rejuvenation.
In the authorities’ Humpty Dumpty compulsion to validate every sunk cost by suppressing interest rates – and thereby suppressing a good deal of the useful risk appetite and channelling too much of it into the narrow field of financial speculation – they only succeed in sapping the survivors of their remaining vitality. On the one hand denying the least afflicted (among whom are to be found, by definition, our potential saviours, the wiser, the more resilient, and the more flexible) the opportunity to rebuild amid the rubble, they thereby hand the reins instead over to an enervating alliance of extractive, public-choice parasites, skulking subsidy-grubbers, feckless leverage jockeys, and special-pleading, sub-marginal zombie companies
Among other enormities, the fact that production must necessarily precede consumption and that it is the first which comprises the creation of wealth and the second which encompasses its destruction, was far beyond the ken of the spoiled Bloomsbury elitist who exhibited a life-long contempt of the aspirations and mores of the bourgeoisie and who hence imagined that policy was at its finest when, like an over-indulgent aunt, it was pliantly accommodating the otherwise ‘ineffective’ demand being volubly expressed by the old dame’s petulant nephew as he stamped his foot in the tantrum he was throwing up against the sweet-shop window.
This article is the second in a series. Continue to Part 3: Been there, done that, bought the T-shirt.
“…the stoppage of issue in specie at the Bank [in 1797] made no real addition to the financial powers of the country. On the contrary, it diminished considerably the real efficiency of those powers, while it introduced a facility in money-transactions, which has cost the country more in real comfort, and will probably cost it more in lasting expense, than any circumstance that has ever occurred.”
“If there had been less facility, there probably would have been more utility in those transactions; money would have been more valuable and more valued. The [fixed income] stocks probably would have been lower in price, but certainly no less deserving of confidence. There would have perhaps been a larger discount on floating [short-dated] securities; but there would have been fewer complaints of the expense of living; and, above all, the country would have had the unimpaired glory of having resisted all dangers from without, as well as within, without the sacrifice or suspension of any one principle of public faith.”
Reply of Walter Boyd to a letter from a friend sent 9th January, 1801
‘The Future of Finance’ was a conference convened in May by the Knowledge Transfer Network with the support of, among others, the Institute for New Economic Thinking and Oxford’s Said Business School. As part of the programme, a debate was staged between the representatives of four ‘schools’ of economic thought – the Monetarists, as represented by the former ‘Wise Man’ Professor Tim Congdon; the Keynesians, as championed by Christopher Allsopp, formerly of the BoE’s MPC; the Complex Adaptive Systems approach of Professor Doyne Farmer of ‘Newtonian Casino’ fame, and the Austrians whose corner was fought by yours truly.
The following essay attempts to expand upon the arguments I made that night in what was obviously a much more concise form, together with some more general thoughts thrown up by the conference at large. Since the event in question was deliberately – if courteously – adversarial and given that it was consciously staged as a species of entertainment, rather than one of deep academic debate, it will be apparent that none of us protagonists were fully able to develop our views beyond what could be incorporated into a few minutes’ pitch to our audience.
Moreover, none of us were allowed any subsequent opportunity for further attack or rebuttal, but could only respond, in the round, to a sampling of questions posed by the audience. In the circumstances, if the arguments of my opponents seem in anyway superficial as I summarize them here, I trust they will be gracious enough to accept, by way of an apology, the acknowledgement that my own propositions on the night will have seemed no less denuded of context or justification than perhaps did theirs.
Their bloody sign of battle is hung out
Ladies and Gentlemen, if you have heard of us ‘Austerians’ at all, you probably have in mind a caricature of us as loony liquidationists, eager for a Bonfire of the Vanities in which to purge the sins of all those who seem to have enjoyed the late Boom rather more than we did as we paced up and down outside the party, weighed down with our sandwich boards on which were emblazoned the injunction, “Repent Ye now for the End is nigh!”
Naturally, I don’t quite see it like that, nor do I feel shy about proclaiming our virtues over those supposedly possessed by the Tweedledee and Tweedledum of macromancy – the monetarists and the Keynesians – whose alternating and often overlapping policy prescriptions have, in the immortal words of Oliver Hardy, gotten us into one nice mess after another.
The monetarists – or perhaps we should call them the ‘creditists’, since they are not often overly clear about the crucial distinctions which exist between money, the medium of exchange, and credit, a record of deferred contractual obligation – tend to be children of empiricism. I hasten to add that, for an Austrian, there are few greater insults that can be bandied about: Mises himself once waspishly observed that the modern dean of monetarism, Milton Friedman, was not an economist at all, but merely a statistician.
To digress a moment, ‘money’ is different from ‘credit’ and the refusal to consider how, or in what manner is what leads to many errors, not just of thought but also of deed, for if there is one thing that modern finance is pre-eminently equipped to do, it is to transform the second into the first and thereby pervert the subtle webs of economic signalling which are so fundamental to our highly dissociated yet profoundly inter-dependent way of life.
We could of course come over all philosophical about money being a ‘present good’ – indeed, the archetypical present good – and about credit being a postponed claim to such a good. We could then go on to point out that, far from being a scholastic quibble, such a distinction is of great import to the smooth functioning of that vast assembly line which we call the ‘structure of production’ and that to subvert their separation is to call up from the vasty deep the never-quite exorcised demons of the ‘real bills’ fallacy and to begin to set in train the juggernaut of malinvestment which will soon induce a widespread incompatibility among the individually-conceived, yet functionally holistic schemes of which we are severally part and so lead us through the specious triumph of the Boom and into that grim realm of wailing and the gnashing of teeth we know as the Bust.
Later, we shall have more detail to add to this, our Austrian diagnosis of the role of monetized credit in the cycle, but for now let us instead point out that money is a universal means of settlement of debts and thus acts as a much-needed extinguisher of credit. In making this assertion, I have no wish to deny that the latter cannot be novated, put through some kind of clearing mechanism, and hence cross-cancelled, in the absence of money – as was the often nearly attained ideal aim at the great mediaeval fairs, for example – simply that the presence of a readily accepted medium of exchange greatly facilitates this reckoning. Furthermore, though a new crop of expositors has sprung up to make claims that credit is historically antecedent to money (though the plausible use of polished, stone axe-heads as a proto-money which was current all along the extensive Neolithic trade routes of 5,000 years ago might give us renewed cause to doubt this now-fashionable denial), this is hardly to the point in the present discussion.
Money may or may not have sprung up, as is traditionally suggested, to avoid the well-known problems of barter, but, however it arose, what it did do was obviate the even more glaring impediments of credit – namely that, as the etymology of the word reminds us, ‘credit’ requires the establishment of a bond of trust between lender and borrower, a trust whose validation is, moreover, subject to the vicissitudes of an ever-changing world by being a temporally protracted arrangement.
Thus, while money’s joint qualities of instantaneity and finality may confer decided advantages upon its users, its main virtue indisputably lies in the impersonal nature of its acceptance in trade for it is this which frees us from the limited confines of our networks of trust and kinship and so greatly magnifies the division of labour and deepens the market beyond all individual comprehension in a mutually beneficial, ‘I, Pencil’ fashion.
For its part, credit certainly may help us get by with less money, never moreso than when we have become drunk on its profusion and giddy at the possibilities this abundance seems to offer amid the boom. Then, we may truck and barter more and more by swapping one claim for another almost to the exclusion of the involvement of money proper but, as the great Richard Cantillon pointed out almost three centuries before Lehman’s sudden demise forcefully impressed the lesson upon us modern sophisticates once more,
…the paper and credit of public and private Banks may cause surprising results in everything which does not concern ordinary expenditure… but that in the regular course of the circulation the help of Banks and credit of this kind is much smaller and less solid than is generally supposed…
Silver alone is the true sinews of circulation.
This article is the first in a series. Continue to Part 2: Scylla & Charybdis.
“The Checklist Manifesto – How to get things right”, is a masterful book for its narrative and practical application. Written by Atul Gawande, an acclaimed surgeon based in the US, he takes us on a journey of how the simple checklist helps individuals deal with immensely complex situations, where risks can be calculated and often lives protected – skyscraper construction, medicine and investment banking.
First introduced into the US Air Force to assist pilots, the humble checklist in all its simplicity has helped generations of pilots navigate the complexity of flying modern aeroplanes. Gawande himself has introduced the concept into operating theatres and hospitals around the world with astounding success.
At Hinde Capital we have embraced such a concept almost naturally in an attempt to codify both our objective and subjective observations of the market place. Our hope is to eliminate behavioural biases that can lead to a misdiagnosis of events before an investment decision.
It has long been our contention that central bankers have misdiagnosed the dynamics of the global economy, particularly in this last decade. Right up until the implosion of equity markets in 2007 and 2008 Bernanke said there was no housing bubble, that inflation was benign, even though almost every asset price from equities to gold was trending in a succession of levitating new highs. When considering how to guide a system as complex as the global economy with so many independent countries and decision makers, we often wonder what type of checklist a modern central bank was actually employing. The crucial ingredient, though, is not only a checklist but the correct checklist.
Central Bank Checklist Manifesto
In a hospital one of the most basic but effective checklists deployed since the 1960s as introduced by nurses was a vital signs chart – every few hours or so nurses would check the following:
- Blood pressure
Likewise a central bank observes certain vital signs to observe the state of the economy – their patient. To have an understanding of what the ‘vital signs’ checklist is for the Fed, let’s look at their duties as outlined in their manifesto ‘The Federal Reserve System – Purposes & Functions.’
The Federal Reserve’s duties fall into four general areas:
• conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates
• supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers
• maintaining the stability of the financial system and containing systemic risk that may arise in financial markets
• providing financial services to depository institutions, the US government, and foreign official institutions, including playing a major role in operating the nation’s payments system
Let’s focus on the first point. The Fed’s objectives include economic growth in line with the economy’s potential to expand; a high level of employment; stable prices (that is, stability in the purchasing power of the dollar); and moderate long-term interest rates. So their vital signs checklist may go something like this:
- Interest rates
Alan Blinder, a former Fed governor and Vice Chairman (1994-96) wrote an insightful working paper called ‘Monetary Policy Today: Sixteen Questions and about Twelve Answers’. These questions in many ways are a checklist questioning parts of the Fed manifesto. Blinder himself resigned as Vice Chairman under Greenspan as he was in disagreement with his diagnosis of the US and global economy.
Central banks have tried to be omnipotent in guiding economic behaviour rather like a surgeon accustomed to holding centre stage in his ‘operatic’ theatre. The central banker can’t enforce his will on agents in the economy because it does not allow for human beings’ subjective preferences on how to spend and live. Using a policy of market expectations to direct human action, based on assumptions of some rational expectation, has been proven to be flawed. Besides which, who leads? The marketplace or the central bank? – the dog or the dog’s tail?
The great US humourist of the Depression era, Will Rogers once famously said, “There have been three great inventions since the beginning of time: fire, the wheel, and central banking”. His comment, laced with no small amount of irony, may have well been uttered today.
Central Bank CAnniBALism
Central banks are the devil. They are like drug dealers except they administer regular doses of supposedly legally prescribed barbiturates to their addicts. The ‘easy money’ or ‘credit’ they create is an opiate, and like all addictions there is a payback for the addicts, one exacted only in loss of health, misery, and death.
Our reliance on ‘easy money’ as facilitated by credit has become terminal. Like drug users we continue to attempt to find a heightened state of nirvana. We continue to hark for the utopian days prior to the eruption of the post-2008 crisis, even though our well-being was fallacious and based on an illusion of wealth paid for by credit – a creditopia. The abuse of credit is what defined the Great Financial crisis and one that still defines our economic system and one which will define a much worse crisis to come.
Central bankers have begun a concerted effort to fight the global debt problem which has been stifling growth as tax revenues merely serve to finance debt servicing rather than addressing the repayment of principal outstanding. Omnipotent governors, Bernanke, Carney, Draghi, Svensson and Iwata or Kuroda (either are likely to replace Shirakawa at the BoJ) are to take a far more aggressive and activist role in pursuing a new framework for growth and inflation by seeking an alternative way to conduct monetary policy. It’s called Nominal GDP Level targeting (NGDPLT) and it is in our opinion as significant a moment as Volcker’s appointment to the Federal Reserve governorship in 1978.
Many will recall Volcker’s moment was to engineer a swift monetary contraction and deceleration of the money velocity to try and reign in excessively high inflation and stabilise growth. It worked. Today we are witnessing an ‘Inverse Volcker’ moment, whereby the opposite is likely true.
The question remains: are they all still ‘inflation nutters’ as Mervyn King, the BoE Governor glibly referred to those central bankers who focussed solely on inflation targets to the potential detriment of stable growth, employment and exchange rates.
Are central bankers merely expanding the boundaries of monetary largesse by focusing on a broader mandate and merely evolving the singular variable approach of inflation targeting, or have they finally found a solution to eradicating boom-bust business cycles? This is a question we need to answer as we are currently witnessing a Central Bank Revolution which could portend severe consequences for prices in our economies, and all the attendant misery that comes with very high inflation.
Nominal GDP Level targeting advocates believe they have a plausible case for a change of mandate by central banks and one which is being gradually adopted, but we believe that like central banks they have misdiagnosed the cause of the crisis by failing to examine the impact of credit creation in our global economy. Money matters, but credit matters more.
In our latest HindeSight Investor Letter – The Central Bank Revolution I (Well ‘Nominally’ So) – we explore and counter this new wave of economics called Market Monetarism, which advocates NGDPLT and which appears to be revolutionising central bank monetary policy.
This article was previously published at HindeCapital.com.
The Japanese government for the last twenty three years has employed the Keynesian tools of deficit spending and more recently the monetarist policies of expanding money supply in an attempt to stop the economy from sliding into recession and to develop some growth. On paper, it has only achieved the former objective; in reality it has emasculated the productive capability of her domestic economy.
Before the speculative bubble of the late-1980s the Japanese economy was driven by savings. Her strong savings flow gave Japanese industry access to a stable low-cost source of real capital with which it was able to produce high-quality goods for export at competitive prices. While there was, in the free market sense, much wrong with Japan this characteristic more than compensated for her economic sins. However, the bubble came along, fuelled by the institutional greed of the Zaibatsu which through their banks sanctioned a spectacular expansion of credit, and as bubbles go this one went pop spectacularly. Since then the government has done everything it can to stop banks folding and industrial malinvestments from being liquidated.
The result is an economy which has barely progressed since. Japanese investment in manufacturing has been directed elsewhere, particularly other South-east Asian states and China. So the result of deficit spending has been a mountain of public sector debt with no domestic economic progress to show for it. Now that government debt-to-GDP is at 240%, or over one quadrillion yen, Japan is resorting to accelerated money-printing as the only and final solution.
This will destroy her currency; and Japan also has another problem with its aging population. Those savers of yesteryear are now drawing down on their nest-eggs at an accelerating rate. This means the genuine capital for Japanese industry to use for industrial investment is no longer there. The switch from accumulating savings to savings drawdown is also beginning to be reflected in the Japanese trade figures. They are now moving into deficit, a reflection of the change from net private-sector saving accumulation, to net private sector consumption.
This is bound to lead to a growing pool of yen in weak foreign hands, and a need for the government to import capital to cover its deficit. No longer is Japan self-financing. This implies that interest rates will have to rise, but think of the cost for the world’s most indebted nation.
There is little new in my analysis, and it should certainly come as no surprise. Her detractors have cited Japan’s deteriorating age demographics for at least the last decade, and it has been obvious to the markets that Keynesian and monetarist solutions have made no positive difference. After all, the Nikkei Index is still bumping along at about a quarter of its December 1989 peak. The economy has simply been in a prolonged slump.
The difference today is the move towards a trade deficit, which will put increasing amounts of yen into weak foreign hands. For this reason 2013 is likely to be the year when the accumulation of government deficits and the ramping-up of money supply between them finally undermine the yen.
This article was previously published at GoldMoney.com.
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?
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.
This article was previously published at DetlevSchlichter.com.
This is a documentary that is long overdue, written from the perspective of the Austrian School. These are the economists of Business Cycle Theory — the theory that predicted our boom and bust.
I invite you to watch this film and make up your own mind. Austrian School views were prevalent up to the 1930s, when politicians embraced the ideas of John Maynard Keynes. Tested to destruction, Keynesian policies were finally dropped by policymakers all over the globe, only to be replaced by an economic framework that used the same methodological tools.
Stressing money as the Alpha and the Omega, Monetarism came to prominence in the 1980s. By the 90s it had faded into the void, replaced by politicised central bank interest rate manipulation and attempts at “demand management”. The failure of this latest form of economic central planning is what we observe today.
The Austrian School, being the only school showing the errors of all of the approaches above, is slowly regaining its influence. This film will do its bit to spread our ideas. It is a crowd-funded documentary, so if you enjoy the film I urge you make a donation.
With a Critique of the Errors of the ECB and the Interventionism of Brussels
1. Introduction: The Ideal Monetary System
Theorists of the Austrian school have focused considerable effort on elucidating the ideal monetary system for a market economy. On a theoretical level, they have developed an entire theory of the business cycle which explains how credit expansion unbacked by real saving and orchestrated by central banks via a fractional-reserve banking system repetitively generates economic cycles. On a historical level, they have described the spontaneous evolution of money and how coercive state intervention encouraged by powerful interest groups has distanced from the market and corrupted the natural evolution of banking institutions. On an ethical level, they have revealed the general legal requirements and principles of property rights with respect to banking contracts, principles which arise from the market economy itself and which, in turn, are essential to its proper functioning.
All of the above theoretical analysis yields the conclusion that the current monetary and banking system is incompatible with a true free-enterprise economy, that it contains all of the defects identified by the theorem of the impossibility of socialism, and that it is a continual source of financial instability and economic disturbances. Hence, it becomes indispensable to profoundly redesign the world financial and monetary system, to get to the root of the problems that beset us and to solve them. This undertaking should rest on the following three reforms: (a) the re-establishment of a 100-percent reserve requirement as an essential principle of private property rights with respect to every demand deposit of money and its equivalents; (b) the abolition of all central banks (which become unnecessary as lenders of last resort if reform (a) above is implemented, and which as true financial central-planning agencies are a constant source of instability) and the revocation of legal-tender laws and the always-changing tangle of government regulations that derive from them; and (c) a return to a classic gold standard, as the only world monetary standard that would provide a money supply which public authorities could not manipulate and which could restrict and discipline the inflationary yearnings of the different economic agents.
As we have stated, the above prescriptions would enable us to solve all our problems at the root, while fostering sustainable economic and social development the likes of which have never been seen in history. Furthermore, these measures can both indicate which incremental reforms would be a step in the right direction, and permit a more sound judgement about the different economic-policy alternatives in the real world. It is from this strictly circumstantial and possibilistic perspective alone that the reader should view the Austrian analysis in relative “support” of the euro which we aim to develop in the present paper.
2. The Austrian Tradition of Support for Fixed Exchange Rates versus Monetary Nationalism and Flexible Exchange Rates
Traditionally, members of the Austrian school of economics have felt that as long as the ideal monetary system is not achieved, many economists, especially those of the Chicago school, commit a grave error of economic theory and political praxis when they defend flexible exchange rates in a context of monetary nationalism, as if both were somehow more suited to a market economy. In contrast, Austrians believe that until central banks are abolished and the classic gold standard is re-established along with a 100-percent reserve requirement in banking, we must make every attempt to bring the existing monetary system closer to the ideal, both in terms of its operation and its results. This means limiting monetary nationalism as far as possible, eliminating the possibility that each country could develop its own monetary policy, and restricting inflationary policies of credit expansion as much as we can, by creating a monetary framework that disciplines as far as possible economic, political, and social agents, and especially, labour unions and other pressure groups, politicians, and central banks.
It is only in this context that we should interpret the position of such eminent Austrian economists (and distinguished members of the Mont Pèlerin Society) as Mises and Hayek. For example, there is the remarkable and devastating analysis against monetary nationalism and flexible exchange rates which Hayek began to develop in 1937 in his particularly outstanding book, Monetary Nationalism and International Stability. In this book, Hayek demonstrates that flexible exchange rates preclude an efficient allocation of resources on an international level, as they immediately hinder and distort real flows of consumption and investment. Moreover, they make it inevitable that the necessary real downward adjustments in costs take place via a rise in all other nominal prices, in a chaotic environment of competitive devaluations, credit expansion, and inflation, which also encourages and supports all sorts of irresponsible behaviours from unions, by inciting continual wage and labour demands which can only be satisfied without increasing unemployment if inflation is pushed up even further. Thirty-eight years later, in 1975, Hayek summarized his argument as follows:
“It is, I believe, undeniable that the demand for flexible rates of exchange originated wholly from countries such as Great Britain, some of whose economists wanted a wider margin for inflationary expansion (called ‘full employment policy’). They later received support, unfortunately, from other economists who were not inspired by the desire for inflation, but who seem to have overlooked the strongest argument in favour of fixed rates of exchange, that they constitute the practically irreplaceable curb we need to compel the politicians, and the monetary authorities responsible to them, to maintain a stable currency” [italics added].
To clarify his argument yet further, Hayek adds:
“The maintenance of the value of money and the avoidance of inflation constantly demand from the politician highly unpopular measures. Only by showing that government is compelled to take these measures can the politician justify them to people adversely affected. So long as the preservation of the external value of the national currency is regarded as an indisputable necessity, as it is with fixed exchange rates, politicians can resist the constant demands for cheaper credits, for avoidance of a rise in interest rates, for more expenditure on ‘public works,’ and so on. With fixed exchange rates, a fall in the foreign value of the currency, or an outflow of gold or foreign exchange reserves acts as a signal requiring prompt government action. With flexible exchange rates, the effect of an increase in the quantity of money on the internal price level is much too slow to be generally apparent or to be charged to those ultimately responsible for it. Moreover, the inflation of prices is usually preceded by a welcome increase in employment; it may therefore even be welcomed because its harmful effects are not visible until later.”
“I do not believe we shall regain a system of international stability without returning to a system of fixed exchange rates, which imposes upon the national central banks the restraint essential for successfully resisting the pressure of the advocates of inflation in their countries — usually including ministers of finance” (Hayek 1979 , 9-10).
With respect to Ludwig von Mises, it is well known that he distanced himself from his valued disciple Fritz Machlup when in 1961 Machlup began to defend flexible exchange rates in the Mont Pèlerin Society. In fact, according to R.M. Hartwell, who was the official historian of the Mont Pèlerin Society,
“Machlup’s support of floating exchange rates led von Mises to not speak to him for something like three years” (Hartwell 1995, 119).
Mises could understand how macroeconomists with no academic training in capital theory, like Friedman and his Chicago colleagues, and also Keynesians in general, could defend flexible rates and the inflationism invariably implicit in them, but he was not willing to overlook the error of someone who, like Machlup, had been his disciple and therefore really knew about economics, and yet allowed himself to be carried away by the pragmatism and passing fashions of political correctness. Indeed, Mises even remarked to his wife on the reason he was unable to forgive Machlup:
“He was in my seminar in Vienna; he understands everything. He knows more than most of them and he knows exactly what he is doing” (Margit von Mises 1984, 146).
Mises’s defence of fixed exchange rates parallels his defence of the gold standard as the ideal monetary system on an international level. For instance, in 1944, in his book Omnipotent Government, Mises wrote:
“The gold standard put a check on governmental plans for easy money. It was impossible to indulge in credit expansion and yet cling to the gold parity permanently fixed by law. Governments had to choose between the gold standard and their — in the long run disastrous — policy of credit expansion. The gold standard did not collapse. The governments destroyed it. It was incompatible with etatism as was free trade. The various governments went off the gold standard because they were eager to make domestic prices and wages rise above the world market level, and because they wanted to stimulate exports and to hinder imports. Stability of foreign exchange rates was in their eyes a mischief, not a blessing. Such is the essence of the monetary teachings of Lord Keynes. The Keynesian school passionately advocates instability of foreign exchange rates” [italics added].
Furthermore, it comes as no surprise that Mises scorned the Chicago theorists when in this area, as in others, they ended up falling into the trap of the crudest Keynesianism. In addition, Mises maintained that it would be relatively simple to re-establish the gold standard and return to fixed exchange rates:
“The only condition required is the abandonment of an easy money policy and of the endeavors to combat imports by devaluation.”
Moreover, Mises held that only fixed exchange rates are compatible with a genuine democracy, and that the inflationism behind flexible exchange rates is essentially antidemocratic:
“Inflation is essentially antidemocratic. Democratic control is budgetary control. The government has but one source of revenue — taxes. No taxation is legal without parliamentary consent. But if the government has other sources of income it can free itself from their control” (Mises 1969, 251-253).
Only when exchange rates are fixed are governments obliged to tell citizens the truth. Hence, the temptation to rely on inflation and flexible rates to avoid the political cost of unpopular tax increases is so strong and so destructive. So, even if there is not a gold standard, fixed rates restrict and discipline the arbitrariness of politicians:
“Even in the absence of a pure gold standard, fixed exchange rates provide some insurance against inflation which is not forthcoming from the flexible system. Under fixity, if one country inflates, it falls victim to a balance of payment crisis. If and when it runs out of foreign exchange holdings, it must devalue, a relatively difficult process, fraught with danger for the political leaders involved. Under flexibility, in contrast, inflation brings about no balance of payment crisis, nor any need for a politically embarrassing devaluation. Instead, there is a relatively painless depreciation of the home (or inflationary) currency against its foreign counterparts” (Block 1999, 19, italics added).
3. The Euro as a “Proxy” for the Gold Standard (or Why Champions of Free Enterprise and the Free Market Should Support the Euro While the Only Alternative Is a Return to Monetary Nationalism)
As we have seen, Austrian economists defend the gold standard because it curbs and limits the arbitrary decisions of politicians and authorities. It disciplines the behaviour of all the agents who participate in the democratic process. It promotes moral habits of human behaviour. In short, it checks lies and demagogy; it facilitates and spreads transparency and truth in social relationships. No more and no less. Perhaps Ludwig von Mises said it best:
“The gold standard makes the determination of money’s purchasing power independent of the changing ambitions and doctrines of political parties and pressure groups. This is not a defect of the gold standard, it is its main excellence” (Mises 1966, 474).
The introduction of the euro in 1999 and its culmination beginning in 2002 meant the disappearance of monetary nationalism and flexible exchange rates in most of continental Europe. Later we will consider the errors committed by the European Central Bank. Now what interests us is to note that the different member states of the monetary union completely relinquished and lost their monetary autonomy, that is, the possibility of manipulating their local currency by placing it at the service of the political needs of the moment. In this sense, at least with respect to the countries in the euro zone, the euro began to act and continues to act very much like the gold standard did in its day. Thus, we must view the euro as a clear, true, even if imperfect, step toward the gold standard. Moreover, the arrival of the Great Recession of 2008 has even further revealed to everyone the disciplinary nature of the euro: for the first time, the countries of the monetary union have had to face a deep economic recession without monetary policy autonomy. Up until the adoption of the euro, when a crisis hit, governments and central banks invariably acted in the same way: they injected all the necessary liquidity, allowed the local currency to float downward and depreciated it, and indefinitely postponed the painful structural reforms that were needed and which involve economic liberalization, deregulation, increased flexibility in prices and markets (especially the labour market), a reduction in public spending, and the withdrawal and dismantling of union power and the welfare state. With the euro, despite all the errors, weaknesses, and concessions we will discuss later, this type of irresponsible behaviour and forward escape has no longer been possible.
For instance, in Spain, in just one year, two consecutive governments have been literally forced to take a series of measures which, though still quite insufficient, up to now would have been labelled as politically impossible and utopian, even by the most optimistic observers:
- article 135 of the Constitution has been amended to include the anti-Keynesian principle of budget stability and equilibrium for the central government, the autonomous communities, and the municipalities;
- all of the projects that imply increases in public spending, vote purchasing, and subsidies, projects upon which politicians regularly based their action and popularity, have been suddenly suspended;
- the salaries of all public servants have been reduced by 5 percent and then frozen, while their work schedule has been expanded;
- social security pensions have been frozen de facto;
- the standard retirement age has been raised across the board from 65 to 67;
- the total budgeted public expenditure has decreased by over 15 percent; and
- significant liberalization has occurred in the labour market, business hours, and in general, the tangle of economic regulation.
Furthermore, what has happened in Spain is also taking place in Ireland, Portugal, Italy, and even in countries which, like Greece, until now represented the paradigm of social laxity, the lack of budget rigour, and political demagogy. What is more, the political leaders of these five countries, now no longer able to manipulate monetary policy to keep citizens in the dark about the true cost of their policies, have been summarily thrown out of their respective governments. And states which, like Belgium and especially France and Holland, until now have appeared unaffected by the drive to reform, are also starting to be forced to reconsider the very grounds for the volume of their public spending and for the structure of their bloated welfare state. This is all undeniably due to the new monetary framework introduced with the euro, and thus it should be viewed with excited and hopeful rejoicing by all champions of the free-enterprise economy and the limitation of government powers. For it is hard to conceive of any of these measures being taken in a context of a national currency and flexible exchange rates: whenever they can, politicians eschew unpopular reforms, and citizens everything that involves sacrifice and discipline. Hence, in the absence of the euro, authorities would again have taken what up to now has been the usual path, i.e. a forward escape consisting of more inflation, the depreciation of the currency to recover “full employment” and gain competitiveness in the short term (covering their backs and concealing the grave responsibility of labour unions as true generators of unemployment), and in short, the indefinite postponement of the necessary structural reforms.
Let us now focus on two significant ways the euro is unique. We will contrast it both with the system of national currencies linked together by fixed exchange rates, and with the gold standard itself, beginning with the latter. We must note that abandoning the euro is much more difficult than going off the gold standard was in its day. In fact, the currencies linked with gold kept their local denomination (the franc, the pound, etc.), and thus it was relatively easy, throughout the 1930s, to unanchor them from gold, insofar as economic agents, as indicated in the monetary regression theorem Mises formulated in 1912 (Mises 2009 , 111-123), continued without interruption to use the national currency, which was no longer exchangeable for gold, relying on the purchasing power of the currency right before the reform. Today this possibility does not exist for those countries that wish, or are obliged, to abandon the euro. Since it is the only unit of currency shared by all the countries in the monetary union, its abandonment requires the introduction of a new local currency, with unknown and much less purchasing power, and includes the emergence of the immense disturbances that the change would entail for all the economic agents in the market: debtors, creditors, investors, entrepreneurs, and workers. At least in this specific sense, and from the standpoint of Austrian theorists, we must admit that the euro surpasses the gold standard, and that it would have been very useful for mankind if in the 1930s the different countries involved had been obliged to stay on the gold standard, because as is the case today with the euro, any other alternative was nearly impossible to put into practice and would have affected citizens in a much more damaging, painful, and obvious way.
Hence, to a certain extent it is amusing (and also pathetic) to note that the legion of social engineers and interventionist politicians who, led at the time by Jacques Delors, designed the single currency as one more tool for use in their grandiose projects to achieve a European political union, now regard with despair something they never seem to have been able to predict: that the euro has ended up acting de facto as the gold standard, disciplining citizens, politicians, and authorities, tying the hands of demagogues and exposing pressure groups (headed by the unfailingly privileged unions), and even questioning the sustainability and the very foundations of the welfare state. According to the Austrian school, this is precisely the main comparative advantage of the euro as a monetary standard in general, and against monetary nationalism in particular; this and not the more prosaic arguments, like “the reduction of transaction costs” or “the elimination of exchange risk,” which were deployed at the time by the invariably short-sighted social engineers of the moment.
Now let us consider the difference between the euro and a system of fixed exchange rates, with respect to the adjustment process which takes place when different degrees of credit expansion and intervention arise between the different countries. Obviously, in a fixed-rate system, these differences manifest themselves in considerable exchange-rate tensions that eventually culminate in explicit devaluations and the high cost in terms of lost prestige which, fortunately, these entail for the corresponding political authorities. In the case of a single currency, like the euro, such tensions manifest themselves in a general loss of competitiveness, which can only be recovered with the introduction of the structural reforms necessary to guarantee market flexibility, along with the deregulation of all sectors and the reductions and adjustments necessary in the structure of relative prices. Moreover, the above ends up affecting the revenues of each public sector, and thus, of its credit rating. In fact, under the present circumstances, in the euro area, the current value in the financial markets of each country’s sovereign public debt has come to reflect the tensions which typically revealed themselves in exchange-rate crises, when rates were more or less fixed in an environment of monetary nationalism. Therefore, at this time, the leading role is not played by foreign-currency speculators, but by the rating agencies, and especially, by international investors, who, by purchasing sovereign debt or not, are healthily setting the pace of reform while also disciplining and determining the fate of each country. This process may be called “undemocratic,” but it is actually the exact opposite. In the past, democracy suffered chronically and was corrupted by irresponsible political actions based on monetary manipulation and inflation, a veritable tax of devastating consequences, which is imposed outside of parliament on all citizens in a gradual, concealed, and devious way. Today, with the euro, the recourse to an inflationary tax has been blocked, at least at the local level of each country, and politicians have suddenly been exposed, and have been obliged to tell the truth and accept the corresponding loss of support. Democracy, if it is to work, requires a framework which disciplines the agents who participate in it. And today in continental Europe that role is being played by the euro. Hence, the successive fall of the governments of Ireland, Greece, Portugal, Italy, Spain and France, far from revealing a democracy deficit, manifests the increasing degree of rigor, budget transparency, and democratic health which the euro is encouraging in its respective societies.
4. The Diverse and Motley “Anti-euro Coalition”
As it would be interesting and highly illustrative, we should now, if only briefly, comment on the diverse and motley amalgam formed by the euro’s enemies. This group includes in its ranks such disparate elements as doctrinaires of the far left and right; nostalgic or unyielding Keynesians like Krugman and Stiglitz, dogmatic monetarists in support of flexible exchange rates, like Barro and others; naive advocates of Mundell’s theory of optimum currency areas; terrified dollar (and pound) chauvinists; and in short, the legion of confused defeatists who “in the face of the imminent disappearance of the euro” propose the “solution” of blowing it up and abolishing it as soon as possible.
Perhaps the clearest illustration (or rather, the most convincing piece of evidence) of the fact that Mises was entirely correct in his analysis of the disciplining effect of fixed exchange rates, and especially of the gold standard, on political and union demagogy lies in the way in which the leaders of leftist political parties, union members, “progressive” opinion makers, anti-system “indignados,” far-right politicians, and in general, all fans of public spending, state subsidies, and interventionism openly and directly rebel against the discipline the euro imposes, and specifically, against the loss of autonomy in each country’s monetary policy, and what that implies: the much-reviled dependence on markets, speculators, and international investors when it comes to being able (or not) to sell the growing sovereign public debt required to finance continual public deficits. One need only glance at the editorials in the most leftist newspapers, or read the statements of the most demagogic politicians, or of leading unionists, to observe that this is so, and that nowadays, just like in the 1930s with the gold standard, the enemies of the market and the defenders of socialism, the welfare state, and union demagogy are protesting in unison, both in public and in private, against “the rigid discipline the euro and the financial markets are imposing on us,” and they are demanding the immediate monetization of all the public debt necessary, without any countermeasure in the form of budget austerity or reforms that boost competitiveness.
In the more academic sphere, but also with ample coverage in the media, contemporary Keynesian theorists are mounting a major offensive against the euro, again with a belligerence only comparable to that Keynes himself showed against the gold standard in the 1930s. Especially paradigmatic is the case of Krugman, who as a syndicated columnist, tells the same old story almost every week about how the euro means a “straitjacket” for employment recovery, and he even goes so far as to criticize the profligate American government for not being expansionary enough and for having fallen short in its (huge) fiscal stimulus packages. More intelligent and highbrow, though no less mistaken, is the opinion of Skidelsky, since he at least explains that the Austrian business cycle theory offers the only alternative to his beloved Keynes and clearly recognizes that the current situation actually involves a repeat of the duel between Hayek and Keynes during the 1930s.
Stranger yet is the stance taken on flexible exchange rates by neoclassical theorists in general, and by monetarists and members of the Chicago school in particular. It appears that this group’s interest in flexible exchange rates and monetary nationalism predominates over their (we presume sincere) desire to encourage economic liberalization reforms. Indeed, their primary goal is to maintain monetary policy autonomy and be able to devalue (or depreciate) the local currency to “recover competitiveness” and absorb unemployment as soon as possible, and only then, eventually, do they focus on trying to foster flexibility and free market reforms. Their naivete is extreme, and we referred to it in our discussion of the reasons for the disagreement between Mises, on the side of the Austrian school, and Friedman, on the side of the Chicago theorists, in the debate on fixed versus flexible exchange rates. Mises always saw very clearly that politicians are not likely to take steps in the right direction if they are not literally obligated to do so, and that flexible rates and monetary nationalism remove practically every incentive capable of disciplining politicians and doing away with “downward rigidity” in wages (which thus becomes a sort of self-fulfilling assumption that monetarists and Keynesians wholeheartedly accept) and with the privileges enjoyed by unions and all other pressure groups. Mises also observed that as a result, in the long run, and even in spite of themselves, monetarists end up becoming fellow travelers of the old Keynesian doctrines: once “competitiveness” has been “recovered,” reforms are postponed, and what is even worse, unionists become accustomed to having the destructive effects of their restrictionist policies continually masked by successive devaluations.
This latent contradiction between defending the free market and supporting monetary nationalism and manipulation via “flexible” exchange rates is also evident in many proponents of the most widespread interpretation of Robert A. Mundell’s theory of “optimum currency areas.” Such areas would be those in which, to begin with, all productive factors were highly mobile, because if that is not the case, it would be better to compartmentalize them with currencies of a smaller scope, to permit the use of an autonomous monetary policy in the event of any “external shock.” However, we should ask ourselves: Is this reasoning sound? Not at all: the main source of rigidity in labour and factor markets actually lies in, and is sanctioned by, intervention and state regulation of the markets, so it is absurd to think states and their governments are going to commit harakiri first, thus relinquishing their power and betraying their political clientele, in order to adopt a common currency afterward. Instead, the exact opposite is true: only when politicians have joined a common currency (the euro in our case) have they been forced to implement reforms which until very recently it would have been inconceivable for them to adopt. In the words of Walter Block:
“… government is the main or only source of factor immobility. The state, with its regulations … is the prime reason why factors of production are less mobile than they would otherwise be. In a bygone era the costs of transportation would have been the chief explanation, but with all the technological progress achieved here, this is far less important in our modern ‘shrinking world.’ If this is so, then under laissez-faire capitalism, there would be virtually no factor immobility. Given even the approximate truth of these assumptions the Mundellian region then becomes the entire globe — precisely as it would be under the gold standard–.”
This conclusion of Block’s is equally applicable to the euro area, to the extent that the euro acts, as we have already indicated, as a “proxy” for the gold standard which disciplines and limits the arbitrary power of the politicians of the member states.
We must not fail to stress that Keynesians, monetarists, and Mundellians are all mistaken because they reason exclusively in terms of macroeconomic aggregates, and hence they propose, with slight differences, the same sort of adjustment via monetary and fiscal manipulation, “fine tuning,” and flexible exchange rates. They believe that all of the effort it takes to overcome the crisis should therefore be guided by macroeconomic models and social engineering. Thus, they completely disregard the profound microeconomic distortion that monetary (and fiscal) manipulation generate in the structure of relative prices and in the capital-goods structure. A forced devaluation (or depreciation) is “one size fits all,” i.e. it entails a sudden linear percentage drop in the price of consumer goods and services and productive factors, a drop which is the same for everyone. Although in the short term this gives the impression of an intense recovery of economic activity and of a rapid absorption of unemployment, it actually completely distorts the structure of relative prices (since without monetary manipulation, some prices would have fallen more, others less, and others would not have fallen at all and might even have risen), leads to a widespread poor allocation of productive resources, and causes a major trauma which any economy would take years to process and recover from. This is the microeconomic analysis centered on relative prices and the productive structure which Austrian theorists have characteristically developed and which, in contrast, is entirely missing from the analytical toolbox of the assortment of economic theorists who oppose the euro.
Finally, outside the purely academic sphere, the tiresome insistence with which Anglo-Saxon economists, investors, and financial analysts attempt to discredit the euro by foretelling the bleakest future for it is to a certain extent suspicious. This impression is reinforced by the hypocritical position of the different US administrations (and also, to a lesser extent, the British government) in wishing (half-heartedly) that the euro zone would “get its economy in order,” and yet self-interestedly omitting to mention that the financial crisis originated on the other side of the Atlantic, i.e. in the recklessness and the expansionary policies pursued by the Federal Reserve for years, and the effects of which spread to the rest of the world via the dollar, as it is still used as the international reserve currency. Furthermore, there is almost unbearable pressure for the euro zone to introduce monetary policies at least as expansionary and irresponsible (“quantitative easing”) as those adopted in the United States, and this pressure is doubly hypocritical, since such an occurrence would undoubtedly deliver the coup de grace to the single European currency.
Might not this stance in the Anglo-Saxon political, economic, and financial world be hiding a buried fear that the dollar’s future as the international reserve currency may be threatened if the euro survives and is capable of effectively competing with the dollar in a not-too-distant future? All indications suggest that this question is becoming more and more pertinent, and though today it does not appear very politically correct, it pours salt on the wound that is most painful for analysts and authorities in the Anglo-Saxon world: the euro is emerging as an enormously powerful potential rival to the dollar on an international level.
As we can see, the anti-euro coalition brings together quite varied and powerful interests. Each distrusts the euro for a different reason. However, they all share a common denominator: the arguments which form the basis of their opposition to the euro would be exactly the same, and they might well repeat and word them even more emphatically, if instead of the single European currency, they had to come to grips with the classic gold standard as the international monetary system. In fact, there is a large degree of similarity between the forces which joined in an alliance in the 1930s to compel the abandonment of the gold standard and those which today seek (up to now unsuccessfully) to reintroduce old, outdated monetary nationalism in Europe. As we have already indicated, technically it was much easier to abandon the gold standard than it would be today for any country to leave the monetary union. In this context, it should come as no surprise that members of the anti-euro coalition often even fall back on the most shameless defeatism: they predict a disaster and the impossibility of maintaining the monetary union, and then right afterward, they propose the “solution” of dismantling it immediately. They even go so far as to hold international contests (– where else — in England, Keynes’s home and that of monetary nationalism) in which hundreds of “experts” and crackpots participate, each with his own proposals for the best and most innocuous way to blow up the European monetary union.
5. The True Cardinal Sins of Europe and the Fatal Error of the European Central Bank
No one can deny that the European Union chronically suffers from a number of serious economic and social problems. Nevertheless, the maligned euro is not one of them. Rather, the opposite is true: the euro is acting as a powerful catalyst which reveals the severity of Europe’s true problems and hastens or “precipitates” the implementation of the measures necessary to solve them. In fact, today, the euro is helping spread more than ever the awareness that the bloated European welfare state is unsustainable and needs to be substantially reformed. The same can be said for the all-encompassing aid and subsidy programs, among which the Common Agricultural Policy occupies a key position, both in terms of its very damaging effects and its total lack of economic rationality. Most of all, it can be said for the culture of social engineering and oppressive regulation which, on the pretext of harmonizing the legislation of the different countries, fossilizes the single European market and prevents it from being a genuine free market. Now more than ever, the true cost of all these structural flaws is becoming apparent in the euro area: without an autonomous monetary policy, the different governments are being literally forced to reconsider (and when applicable, to reduce) all their public expenditure items, and to attempt to recover and gain international competitiveness by deregulating and increasing as far as possible the flexibility of their markets (especially the labour market, which has traditionally been very rigid in many countries of the monetary union).
In addition to the above cardinal sins of the European economy, we must add another which is perhaps even graver, due to its peculiar, devious nature. We are referring to the great ease with which European institutions, many times because of a lack of vision, leadership, or conviction about their own project, allow themselves to become entangled in policies that in the long run are incompatible with the demands of a single currency and of a true free single market.
First, it is surprising to note the increasing regularity with which the burgeoning and stifling new regulatory measures are introduced into Europe from the Anglo-Saxon academic and political world, specifically the United States, and often when such measures have already proven ineffective or extremely disruptive. This unhealthy influence is a long-established tradition. (Let us recall that agricultural subsidies, the antitrust legislation, and regulations concerning “corporate social responsibility” have actually originated, like many other failed interventions, in the United States.) Nowadays such regulatory measures crop up repeatedly and are reinforced at every step, for example with respect to the so called “fair market value” and the rest of the International Accounting Standards, or to the (until now, fortunately, failed) attempts to implement the so-called agreements of Basel III for the banking sector and Solvency II for the insurance sector, both of which suffer from insurmountable and fundamental theoretical deficiencies as well as serious problems in relation to their practical application.
A second example of the unhealthy Anglo-Saxon influence can be found in the European Economic Recovery Plan, which the European Commission launched at the end of 2008 under the auspices of the Washington Summit, with the leadership of Keynesian politicians like Barack Obama and Gordon Brown, and on the advice of economic theorists who are enemies of the euro, like Krugman and others. The plan recommended to member countries an expansion of public spending of around 1.5 percent of GDP (some 200 billion euros on an aggregate level). Though some countries, like Spain, made the error of expanding their budgets, the plan, thank God and the euro, and much to the despair of Keynesians and their acolytes, soon came to nothing, once it became clear that it only served to increase the deficits, preclude the achievement of the Maastricht Treaty objectives, and severely destabilize the sovereign debt markets of the countries of the euro zone. Again, the euro provided a disciplinary framework and an early curb on the deficit, in contrast to the budget recklessness of countries that are victims of monetary nationalism, and specifically, the United States and especially England, which closed with a public deficit of 10.1 percent of GDP in 2010 and 8.8 percent in 2011, which on a worldwide scale was only exceeded by Greece and Egypt. Despite such bloated deficits and fiscal stimulus packages, unemployment in England and the United States remains at record (or very high) levels, and their respective economies are just not getting off the ground.
Third, and above all, there is mounting pressure for a complete European political union, which some suggest as the only “solution” that could enable the survival of the euro in the long term. Apart from the “Eurofanatics,” who always defend any excuse that might justify greater power and centralism for Brussels, two groups coincide in their support for political union. One group consists, paradoxically, of the euro’s enemies, particularly those of Anglo-Saxon origin: there are the Americans, who, dazzled by the centralized power of Washington and aware that it could not possibly be duplicated in Europe, know that with their proposal they are injecting a divisive virus deadly to the euro; and there are the British, who make the euro an (unjustified) scapegoat upon which to vent their (totally justified) frustrations in view of the growing interventionism of Brussels. The other group consists of all those theorists and thinkers who believe that only the discipline imposed by a central government agency can guarantee the deficit and public-debt objectives established in Maastricht. This is an erroneous belief. The very mechanism of the monetary union guarantees, just like the gold standard, that those countries which abandon budget rigor and stability will see their solvency at risk and be forced to take urgent measures to re-establish the sustainability of their public finances if they do not wish to suspend payments.
Despite the above, the most serious problem does not lie in the threat of an impossible political union, but in the unquestionable fact that a policy of credit expansion carried out in a sustained manner by the European Central Bank during a period of apparent economic prosperity is capable of canceling, at least temporarily, the disciplinary effect exerted by the euro on the economic agents of each country. Thus, the fatal error of the European Central Bank consists of not having managed to isolate and protect Europe from the great expansion of credit orchestrated on a worldwide scale by the US Federal Reserve beginning in 2001. Over several years, in a blatant failure to comply with the Maastricht Treaty, the European Central Bank allowed M3 to grow by even more than 9 percent per year, which far exceeds the objective of 4.5 percent growth in the money supply, an aim originally set by the ECB itself. Furthermore, even though this increase was appreciably less reckless than that brought about by the US Federal Reserve, the money was not distributed uniformly among the countries of the monetary union, and it had a disproportionate impact on the periphery countries (Spain, Portugal, Ireland, and Greece), which saw their monetary aggregates grow at a pace far more rapid, between three and four times more, than France or Germany. Various reasons can be given to explain this phenomenon, from the pressure applied by France and Germany, both of which sought a monetary policy that during those years would not be too restrictive for them, to the extreme short-sightedness of the periphery countries, which did not wish to admit they were in the middle of a speculative bubble, as is the case with Spain, and thus were also unable to give categorical instructions to their representatives in the ECB council to make an important issue of strict compliance with the monetary-growth objectives established by the European Central Bank itself. In fact, during the years prior to the crisis, all of these countries, except Greece, easily observed the 3-percent deficit limits, and some, like Spain and Ireland, even closed their public accounts with large surpluses. Hence, though the heart of the European Union was kept out of the American process of irrational exuberance, the process was repeated with intense virulence in the European periphery countries, and no one, or very few people, correctly diagnosed the grave danger in what was happening. If academics and political authorities from both the affected countries and the European Central Bank, instead of using macroeconomic and monetarist analytical tools imported from the Anglo-Saxon world, had used those of the Austrian business cycle theory — which after all is a product of the most genuine continental economic thought — they would have managed to detect in time the largely artificial nature of the prosperity of those years, the unsustainability of many of the investments (especially with respect to real estate development) that were being launched due to the great easing of credit, and in short, that the surprising influx of rising public revenue would be of very short duration. Still, fortunately, though in the most recent cycle the European Central Bank has fallen short of the standards European citizens had a right to expect, and we could even call its policy a “grave tragedy,” the logic of the euro as a single currency has prevailed, thus clearly exposing the errors committed and obliging everyone to return to the path of control and austerity. In the next section, we will briefly touch on the specific way the European Central Bank formulated its policy during the crisis and how and on what points this policy differs from that followed by the central banks of the United States and United Kingdom.
6. The Euro vs. the Dollar (and the Pound) and Germany vs. the USA (and the UK)
One of the most striking characteristics of the last cycle, which ended in the Great Recession of 2008, has undoubtedly been the differing behaviour of the monetary and fiscal policies of the Anglo-Saxon area, based on monetary nationalism, and those pursued by the member countries of the European monetary union. Indeed, from the time the financial crisis and economic recession hit in 2007-2008, both the Federal Reserve and the Bank of England have adopted monetary policies which have consisted of reducing the interest rate to almost zero; injecting huge quantities of money into the economy (euphemistically known as “quantitative easing”); and continuously, directly, and unabashedly monetizing the sovereign public debt on a massive scale. To this extremely lax monetary policy (in which the recommendations of monetarists and Keynesians concur) is added the strong fiscal stimulus involved in maintaining, both in the United States and in England, budget deficits close to 10 percent of the respective GDPs (which, nevertheless, at least the most recalcitrant Keynesians, like Krugman and others, do not consider anywhere near sufficient).
In contrast with the situation of the dollar and the pound, in the euro area, fortunately, money cannot so easily be injected into the economy, nor can budget recklessness be indefinitely maintained with such impunity. At least in theory, the European Central Bank lacks authority to monetize the European public debt, and though it has accepted it as collateral for its huge loans to the banking system, and beginning in the summer of 2010 even sporadically made direct purchases of the bonds of the most threatened periphery countries (Greece, Portugal, Ireland, Italy and Spain), there is certainly a fundamental economic difference between the behaviour of the United States and United Kingdom, and the policy continental Europe is following: while monetary aggression and budget recklessness are deliberately, unabashedly, and without reservation undertaken in the Anglo-Saxon world, in Europe such policies are carried out reluctantly, and in many cases after numerous, consecutive and endless “summits.” They are the result of lengthy and difficult negotiations between many parties, negotiations in which countries with very different interests must reach an agreement. Furthermore, what is even more important, when money is injected into the economy and support is provided to the debt of countries that are having difficulties, such actions are always balanced with, and taken in exchange for, reforms based on budget austerity (and not on fiscal stimulus packages) and on the introduction of supply-side policies which encourage market liberalization and competitiveness. Moreover, though it would have been better had it happened much sooner, the “de facto” suspension of payments by the Greek state, which has given a nearly 75-percent “haircut” to the private investors who mistakenly trusted in Greek sovereign debt holdings, has clearly signalled to markets that the other countries in trouble have no other alternative than to firmly, rigorously, and without delay carry out all necessary reforms. As we have already seen, even states like France, which until now appeared untouchable and comfortably nestled in a bloated welfare state, have lost the highest credit rating on their debt, seen its differential with the German bund rise, and found themselves increasingly doomed to introduce austerity and liberalization reforms to avoid jeopardizing what has always been their indisputable membership among the euro zone hardliners.
From the political standpoint, it is quite obvious that Germany (and particularly the chancellor Angela Merkel) has the leading role in urging forward this whole process of rehabilitation and austerity (and opposing all sorts of awkward proposals which, like the issuance of “European bonds,” would remove the incentives the different countries now have to act with rigor). Many times Germany must swim upstream. For on the one hand, there is constant international political pressure for fiscal stimulus measures, especially from the US Obama administration, which is using the “crisis of the euro” as a smokescreen to hide the failure of its own policies. And on the other hand, Germany has to contend with rejection and a lack of understanding from all those who wish to remain in the euro solely for the advantages it offers them, while at the same time they violently rebel against the bitter discipline that the European single currency imposes on all of us, and especially on the most demagogic politicians and the most irresponsible privileged interest groups.
In any case, and as an illustration which will understandably exasperate Keynesians and monetarists, we must highlight the very unequal results which until now have been achieved with American fiscal-stimulus policies and monetary “quantitative easing,” in comparison with German supply-side policies and fiscal austerity in the monetary environment of the euro: public deficit, in Germany, 1%, in the United States, over 8.20%; unemployment, in Germany, 5.9%, in the United States, close to 9%; inflation, in Germany, 2.5%, in the United States, over 3.17%; growth, in Germany, 3%, in the United States, 1.7%. (The figures for United Kingdom are even worse than those for the US.) The clash of paradigms and the contrast in results could not be more striking.
7. Conclusion: Hayek versus Keynes
Just as with the gold standard in its day, today a legion of people criticize and despise the euro for what is precisely its main virtue: its capacity to discipline extravagant politicians and pressure groups. Plainly, the euro in no way constitutes the ideal monetary standard, which, as we saw in the first section, could only be found in the classic gold standard, with a 100-percent reserve requirement on demand deposits, and the abolition of the central bank. Hence, it is quite possible that once a certain amount of time has passed and the historical memory of recent monetary and financial events has faded, the European Central Bank may go back to committing the grave errors of the past, and promote and accommodate a new bubble of credit expansion. However, let us remember that the sins of the Federal Reserve and the Bank of England have been much worse still and that, at least in continental Europe, the euro has ended monetary nationalism, and for the states in the monetary union, it is acting, even if only timidly, as a “proxy” for the gold standard, by encouraging budget rigor and reforms aimed at improving competitiveness, and by putting a stop to the abuses of the welfare state and of political demagogy.
In any case, we must recognize that we stand at a historic cross-roads. The euro must survive if all of Europe is to internalize and adopt as its own the traditional German monetary stability, which in practice is the only and the essential disciplinary framework from which, in the short and medium term, European Union competitiveness and growth can be further stimulated. On a worldwide scale, the survival and consolidation of the euro will permit, for the first time since World War II, the emergence of a currency capable of effectively competing with the monopoly of the dollar as the international reserve currency, and therefore capable of disciplining the American ability to provoke additional systemic financial crises which, like that of 2007, constantly endanger the world economic order.
Just over eighty years ago, in a historical context very similar to ours, the world was torn between maintaining the gold standard, and with it budget austerity, labour flexibility, and free and peaceful trade; or abandoning the gold standard, and thus everywhere spreading monetary nationalism, inflationary policies, labour rigidity, interventionism, “economic fascism,” and trade protectionism. Hayek, and the Austrian theorists led by Mises, made a titanic intellectual effort to analyze, explain, and defend the advantages of the gold standard and free trade, in opposition to the theorists who, led by Keynes and the monetarists, opted to blow up the monetary and fiscal foundations of the laissez-faire economy which until then had fueled the Industrial Revolution and the progress of civilization. On that occasion, economic thought ended up taking a very different route from that favored by Mises and Hayek, and we are all familiar with the economic, political, and social consequences that followed. As a result, today, well into the twenty-first century, incredibly, the world is still afflicted by financial instability, the lack of budget rigor, and political demagogy. For all these reasons, but mainly because the world economy urgently needs it, on this new occasion, Mises and Hayek deserve to finally triumph, and the euro (at least provisionally, and until it is replaced once and for all by the gold standard) deserves to survive.
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The main authors and theoretical formulations can be consulted in Huerta de Soto 2012 .
 Ibid., chapter 9.
 F.A. Hayek 1971 .
 Though Hayek does not expressly name them, he is referring to the theorists of the Chicago school, led by Milton Friedman, who in this and other areas shake hands with the Keynesians.
 Later we will see how, with a single currency like the euro, the disciplinary role of fixed exchange rates is taken on by the current market value of each country’s sovereign and corporate debt.
 To underline Mises’s argument even more clearly, I should indicate that there is no way to justifiably attribute to the gold standard the error Churchill committed following World War I, when he fixed the gold parity without taking into account the serious inflation of pound sterling banknotes issued to finance the war. This event has nothing to do with the current situation of the euro, which is freely floating in international markets, nor with those problems which affect countries in the euro zone’s periphery and which stem from the loss in real competitiveness suffered by their economies during the bubble (Huerta de Soto 2012 , 447, 622-623 in the English edition).
 In Spain, different Austrian economists, including me, had for decades been clamoring unsuccessfully for the introduction of these (and many other) reforms which only now have become politically feasible, and have done so suddenly, with surprising urgency, and due to the euro. Two observations: first, the measures which constitute a step in the right direction have been sullied by the increase in taxes, especially on income, movable capital earnings and wealth (see the manifesto against the tax increase which I and fifty other academics signed in February 2012); second, the principles of budget stability and equilibrium are a necessary, but not a sufficient, condition for a return to the path toward a sustainable economy, since in the event of another episode of credit expansion, only a huge surplus during the prosperous years would make it possible, once the inevitable recession hit, to avoid the grave problems that now affect us.
 For the first time, and thanks to the euro, Greece is facing up to the challenges its own future poses. Though blasé monetarists and recalcitrant Keynesians do not wish to recognize it, internal deflation is possible and does not involve any “perverse” cycle if accompanied by major reforms to liberalize the economy and regain competitiveness. It is true that Greece has received and is receiving substantial aid, but it is no less true that it has the historic responsibility to refute the predictions of all those prophets of doom who, for different reasons, are determined to see the failure of the Greek effort so they can retain in their models the very stale (and self-interested) hypothesis that prices (and wages) are downwardly rigid (see also our remarks in footnote 9 about the disastrous effects of Argentina’s highly praised devaluation of 2001). For the first time, the traditionally bankrupt and corrupt Greek state has taken a drastic remedy. In two years (2010-2011) the public deficit has dropped 8 percentage points; the salaries of public servants have been cut by 15 percent initially and another 20 percent after that, and their number has been reduced by over 80,000 employees and the number of town councils by almost half; the retirement age has been raised; the minimum wage has been lowered, etc. (Vidal-Folch 2012). This “heroic” reconstruction contrasts with the economic and social decomposition of Argentina, which took the opposite (Keynesian and monetarist) road of monetary nationalism, devaluation, and inflation.
 Therefore, fortunately, we are “chained to the euro,” to use Cabrillo’s apt expression (Cabrillo 2012). Perhaps the most hackneyed contemporary example Keynesians and monetarists offer to illustrate the “merits” of a devaluation and of the abandonment of a fixed rate is the case of Argentina following the bank freeze (“corralito”) that took place beginning in December of 2001. This example is seriously erroneous for two reasons. First, at most, the bank freeze is simply an illustration of the fact that a fractional-reserve banking system cannot possibly function without a lender of last resort (Huerta de Soto 2012 , 785-786). Second, following the highly praised devaluation, Argentina’s per capita GDP fell from 7,726 dollars in 2000 to 2,767 dollars in 2002, thus losing two-thirds of its value. This 65-percent drop in Argentinian income and wealth should give serious pause to all those who nowadays are clumsily and violently demonstrating, for example in Greece, to protest the relatively much smaller sacrifices and drops in prices involved in the healthy and inevitable internal deflation which the discipline of the euro is requiring. Furthermore, all the patter about Argentina’s “impressive” growth rates, of over 8 percent per year beginning in 2003, should impress us very little if at all, when we consider the very low starting point after the devaluation, as well as the poverty, paralysis, and chaotic nature of the Argentinian economy, where one-third of the population has ended up depending on subsidies and government aid, the real rate of inflation exceeds 30 percent, and scarcity, restrictions, regulations, demagogy, the lack of reforms, and government control (and recklessness) have become a matter of course (Gallo 2012). Along the same lines, Pierpaolo Barbieri states: “I find truly incredible that serious commentators like economist Nouriel Roubini are offering Argentina as a role model for Greece” (Barbieri 2012).
 Even the President of the ECB, Mario Draghi, has gone so far as to expressly state that the “continent’s social model is ‘gone’” (Blackstone, Karnitschnig, and Thomson 2012).
 I do not include here the analysis of my esteemed disciple and colleague Philipp Bagus (The Tragedy of the Euro, Ludwig von Mises Institute, Auburn, Alabama, USA 2010), since from Germany’s point of view, the manipulation to which the European Central Bank is subjecting the euro threatens the monetary stability Germany traditionally enjoyed with the mark. Nevertheless, his argument that the euro has fostered irresponsible policies via a typical tragedy-of-the-commons effect seems weaker to me, because during the bubble stage, most of the countries that are now having problems, with the only possible exception of Greece, were sporting a surplus in their public accounts (or were very close to one). Thus, I believe Bagus would have been more accurate if he had titled his otherwise excellent book The Tragedy of the European Central Bank (and not of the euro), particularly in light of the grave errors committed by the European Central Bank during the bubble stage, errors we will remark on in a later section of this article (thanks to Juan Ramón Rallo for suggesting this idea to me).
 The editorial line of the defunct Spanish newspaper Público was paradigmatic in this sense. (See also, for example, the case of Estefanía 2011, and of his criticism of the aforementioned reform of article 135 of the Spanish Constitution to establish the “anti-Keynesian” principle of budget stability and equilibrium.)
 See, for example, the statements of the socialist candidate for the French presidency, for whom “the path of austerity is ineffective, deadly, and dangerous” (Hollande 2012), or those of the far-right candidate, Marine Le Pen, who believes the French “should return to the franc and bring the euro period to a close once and for all” (Martín Ferrand 2012).
 One example among many articles is Krugman 2012; see also Stiglitz 2012.
 The US public deficit has stood at between 8.2 and 10 % over the last three years, in sharp contrast with German deficit, which stood at only 1% in 2011.
 An up-to-date explanation of the Austrian theory of the cycle can be found in Huerta de Soto 2012 , chapter 5.
 Skidelsky 2011.
 A legion of economists belong to this group, and most of them (surprise, surprise!) come from the dollar-pound area. Among others in the group, I could mention, for example, Robert Barro (2012), Martin Feldstein (2011), and President Barack Obama’s adviser, Austan Goolsbee (2011). In Spain, though for different reasons, I should cite such eminent economists as Pedro Schwartz, Francisco Cabrillo, and Alberto Recarte.
 Mundell 1961.
 Block 1999, 21.
 See Whyte’s (2011) excellent analysis of the serious harm the depreciation of the pound is causing in United Kingdom; and with respect to the United States, see Laperriere 2012.
 Huerta de Soto 2012 .
 “The euro, as the currency of an economic zone that exports more than the United States, has well-developed financial markets, and is supported by a world class central bank, is in many aspects the obvious alternative to the dollar. While currently it is fashionable to couch all discussions of the euro in doom and gloom, the fact is that the euro accounts for 37 percent of all foreign exchange market turn over. It accounts for 31 percent of all international bond issues. It represents 28 percent of the foreign exchange reserves whose currency composition is divulged by central banks” (Eichengreen 2011, 130). Guy Sorman, for his part, has commented on “the ambiguous attitude of US financial experts and actors. They have never liked the euro, because by definition, the euro competes with the dollar: following orders, American so-called experts explained to us that the euro could not survive without a central economic government and a single fiscal system” (Sorman 2011). In short, it is clear that champions of competition between currencies should direct their efforts against the monopoly of the dollar (for example, by supporting the euro), rather than advocate the reintroduction of, and competition between, “little local currencies” of minor importance (the drachma, escudo, peseta, lira, pound, franc, and even the mark).
 Such is the case with, for example, the contest held in the United Kingdom by Lord Wolfson, the owner of Next stores. Up to now, this contest has attracted no fewer than 650 “experts” and crackpots. Were it not for the crass and obvious hypocrisy involved in such initiatives, which are always held outside the euro area (and especially in the Anglo-Saxon world, by those who fear, hate, or scorn the euro), we should commend the great effort and interest shown in the fate of a currency which, after all, is not their own.
 It might be worth noting that the author of these lines is a “Eurosceptic” who maintains that the function of the European Union should be limited exclusively to guaranteeing the free circulation of people, capital, and goods in the context of a single currency (if possible the gold standard).
 I have already mentioned, for instance, the recent legislative changes that have delayed the retirement age to 67 (and even indexed it with respect to future trends in life expectancy), changes already introduced or on the way in Germany, France, Italy, Spain, Portugal, and Greece. I could also cite the establishment of a “copayment” and increasing areas of privatization in connection with health care. These are small steps in the right direction, which, because of their high political cost, would not have been taken without the euro. They also contrast with the opposite trend indicated by Barack Obama’s health-care reform, and with the obvious resistance to change when it comes to tackling the inevitable reform of the British National Health Service.
 O’Caithnia 2011.
 Booth 2011.
 See, for example, “United States’ Economy: Over-regulated America: The home of laissez-faire is being suffocated by excessive and badly written regulation,” The Economist, February 18, 2012, p. 8, and the examples there cited.
 Huerta de Soto 2003 and 2009.
 On the hysterical support for the grandiose fiscal stimulus packages of this period, see Fernando Ulrich 2011.
 Krugman 2012, Stiglitz 2012.
 Specifically, the average rise in M3 in the euro zone from 2000 to 2011 exceeded 6.3%, and we should highlight the increases that occurred during the bubble years 2005 (from 7% to 8%), 2006 (from 8% to 10%), and 2007 (from 10% to 12%). The above data show that, as has already been indicated, the goal of a zero deficit, though commendable, is merely a necessary, though not a sufficient, condition for stability: during the expansionary phase of a cycle induced by credit expansion, public-spending commitments may be made based on the false tranquility which surpluses generate, yet later, when the inevitable recession hits, these commitments are completely unsustainable. This demonstrates that the objective of a zero deficit also requires an economy that is not subject to the ups and downs of credit expansion, or at least that the budgets be closed out with much larger surpluses during the expansionary years.
 Therefore, Greece would be the only case to which we could apply the “tragedy of the commons” argument Bagus (2010) develops concerning the euro. In light of the reasoning I have presented in the text, and as I have already mentioned, I believe a more apt title for Bagus’s remarkable book, The Tragedy of the Euro, would have been The Tragedy of the European Central Bank.
 The surpluses in Spain were as follows: 0.96%, 2.02%, and 1.90% in 2005, 2006, and 2007 respectively. Those of Ireland were: 0.42%, 1.40%, 1.64%, 2.90%, and 0.67% in 2003, 2004, 2005, 2006, and 2007 respectively.
 The author of these lines could be cited as an exception (Huerta de Soto 2012 , xxxvii).
 At this time (2011-2012), the Federal Reserve is directly purchasing at least 40 percent of the newly issued American public debt. A similar statement can be made regarding the Bank of England, which is the direct holder of 25 percent of all the sovereign public debt of the United Kingdom. In comparison with these figures, the (direct and indirect) monetization carried out by the European Central Bank seems like innocent “child’s play.”
 Luskin and Roche Kelly have even referred to “Europe’s Supply-Side Revolution” (Luskin and Roche Kelly 2012). Also highly significant is “A Plan for Growth in Europe,” which was urged February 20, 2012 by the leaders of twelve countries in the European Union (including Italy, Spain, the Netherlands, Finland, Ireland, and Poland), a plan which comprises only supply-side policies and does not mention any fiscal stimulus measure. There is also the manifesto “Initiative for a Free and Prospering Europe” (IFPE) signed in Bratislava in January 2012 by, among others, the author of these lines. In short, a change of models seems a priority in countries which, like Spain, must move from a speculative, “hot” economy based on credit expansion to a “cold” economy based on competitiveness. Indeed, as soon as prices decline (“internal deflation”) and the structure of relative prices is readjusted in an environment of economic liberalization and structural reforms, numerous opportunities for entrepreneurial profit will arise in sustainable investments, which in a monetary area as extensive as the euro area are sure to attract financing. This is how to bring about the necessary rehabilitation and ensure the longed-for recovery in our economies, a recovery which again should be cold, sustainable, and based on competitiveness.
 In this context, and as I explained in the section devoted to the “Motley Anti-euro Coalition,” we should not be surprised by the statements of the candidates to the French presidency, which are mentioned in footnote 13.
 Estimated data as of December 31, 2011.
 Elsewhere I have mentioned the incremental reforms which, like the radical separation between commercial and investment banking (as in the Glass Steagall Act), could improve the euro somewhat. At the same time, it is in United Kingdom where, paradoxically (or not, in light of the devastating social damage that has resulted from its banking crisis), my proposals have aroused the most interest, to the point that a bill was even presented in the British Parliament to complete Peel’s Bank Charter Act of 1844 (curiously, still in effect) by extending the 100-percent reserve requirement to demand deposits. The consensus reached there to separate commercial and investment banking should be considered a (very small) step in the right direction (Huerta de Soto 2010 and 2011).
 My uncle by marriage, the entrepreneur Javier Vidal Sario from Navarre, who remains perfectly lucid and active at the age of ninety-three, assures me that in all his life, he had never, not even during the years of the Stabilization Plan of 1959, witnessed in Spain a collective effort at institutional and budget discipline and economic rehabilitation comparable to the current one. Also historically significant is the fact that this effort is not taking place in just one country (for example, Spain), nor in relation to one local currency (for example, the old peseta), but rather is spread throughout all of Europe, and is being made by hundreds of millions of people in the framework of a common monetary unit (the euro).
 As early as 1924, the great American economist Benjamin M. Anderson wrote the following: “Economical living, prudent financial policy, debt reduction rather than debt creation — all these things are imperative if Europe is to be restored. And all these are consistent with a greatly improved standard of living in Europe, if real activity be set going once more. The gold standard, together with natural discount and interest rates, can supply the most solid possible foundation for such a course of events in Europe.” Clearly, once again, history is repeating itself (Anderson 1924). I am grateful to my colleague Antonio Zanella for having called my attention to this excerpt.
 Moreover, this historic situation is now being revisited in all its severity upon China, the economy of which is at this time on the brink of expansionary and inflationary collapse. See “Keynes versus Hayek in China,” The Economist, December 30, 2011.
 As we have already seen, Mises, the great defender of the gold standard and 100-percent-reserve free banking, in the 1960s collided head-on with theorists who, led by Friedman, supported flexible exchange rates. Mises decried the behaviour of his disciple Machlup, when the latter abandoned the defense of fixed exchange rates. Now, fifty years later and on account of the euro, history is also repeating itself. On that occasion, the advocates of monetary nationalism and exchange-rate instability won, with consequences we are all familiar with. This time around let us hope that the lesson has been learned and that Mises’s views will prevail. The world needs it and he deserves it.
In recent weeks, while the eurozone has suffered escalating levels of systemic stress in government bond markets and its banking system, the gold price has fallen under $1,600. One would have thought that – but for the occasional fat-finger trade – gold would rise in all this instability, not fall. Putting aside short-term considerations, the simple reason has to be that the investment establishment, which has bought into the bond market bubble, does not believe that gold is any longer an alternative to paper money.
We can understand why they think this. Though the Keynesian vs Austrian economic debate is attracting increasing attention, financial services companies recruit economists who have been trained in the traditions of Keynes and Friedman. They are thus immersed in economic disciplines that assume gold is old-fashioned and has no meaningful place in a modern economy. While they might accept that gold has an historical attraction for some investors, they see it as a “risk-on” investment. This is jargon for something you buy when you want to take risks, the opposite of gold’s traditional role.
For further proof, you need look no further than the average level of portfolio exposure, which across the global investment management industry is said to average less than one per cent. This is certainly not compatible with the level of risk in today’s markets, with many nations on the edge of bankruptcy. The result is that flaky gold bulls are experiencing the discomfort of rising panic.
Let us go back to fundamentals. The Keynesians and Friedmanites are oblivious to the debt trap faced by all major currencies. Central banks are printing money to fund government deficits at the lowest possible interest cost. The inevitable consequence of printing money is price inflation, and price inflation always leads to higher interest rates. Higher interest rates exacerbate budget deficits.
You cannot put it more simply than that. The alternative is to stop printing the money and jack up interest rates, but in that event at the head of the insolvency queue is government itself, so this can be ruled out as a deliberate policy. That is what a debt trap is all about: whichever way you turn, there is only one outcome: bankruptcy.
When a government goes bust, its paper is valueless: not just its bonds, but its fiat currency as well. On the surface it is different in Euroland, because the nation states do not issue their own currency. On this basis the demise of the euro is an event one step removed from the bankruptcy of individual nation states. The relationship with the other major fiat currencies is direct.
The destruction of fiat currencies themselves is becoming more likely by the day. Meanwhile, the weakness of “risk-on” gold has led to a serious mispricing in the market. This has happened because the financial community, sucked into the bond market bubble, has not even begun to discount the debt threat to government paper from sovereign bankruptcies.
When this mispricing is inevitably resolved, it is unlikely to be gradual. It will be so swift that those old-fashioned enough to own gold for insurance purposes will have the protection they sought. Those that fall for modern neo-classical economics will learn a very sudden lesson about what gold is actually for.
This article was previously published at GoldMoney.com.