Money and Banking: Recent Episodes
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Money and Banking includes works, historical and theoretical, on monetary systems and the operation of banks and other financial institutions.
While FedNow seems benign, there is the larger problem of the entire banking system itself being built on a foundation of sand. FedNow can only make that problem worse.
Original Article: "FedNow Isn't a CBDC, but It Is Dangerous"
By corrupting the meaning of inflation, mainstream economists have given a false picture of what happens when monetary authorities expand the money supply. Mises and Rothbard understood.
Original Article: "Taking Back the Meaning of "Inflation""
As Fed staffers no longer predict an impending recession, economists on social media are all assuring themselves that Americans are in store for a "soft landing." Mises Fellow Jonathan Newman joins Bob to explain why the data still support the case for recession and point out the eerie similarity to the calm before the storm in 2008.
Robert Lucas' Nobel Prize Winning Lecture: Mises.org/HAP407a Bob's Eerie Article from 2007 on the Recession: Mises.org/HAP407b 'Bernanke Was Wrong' Compilation: Mises.org/HAP407c 'Peter Schiff Was Right' Compilation: Mises.org/HAP407d
Join us in Nashville on September 23rd for a no-holds-barred discussion against the regime: Mises.org/Nashville23
David Brady Jr. discusses his recent article at Mises.org, in which he argues that the newly launched "FedNOW" system isn't a CBDC. Even so, there are dangers from FedNOW, such as exacerbating bank runs. David also explains the new Mises Apprenticeship program, of which he is a member.
David's Article on Mises.org: Mises.org/HAP406a George Selgin Cato Article on FedNow: Mises.org/HAP406b
Join us in Nashville on September 23rd for a no-holds-barred discussion against the regime: Mises.org/Nashville23
Loan banking versus deposit banking, how deposit banking affects the money supply, how free banking limits credit expansion, the money multiplier process, and more.
Download the slides from this lecture at Mises.org/MU23_PPT_08.
Recorded at the Mises Institute in Auburn, Alabama, on 24 July 2023.
How can a bank “create money out of thin air”? We must enter the magical kingdom of “fractional-reserve banking,” where deposits are turned into loans, loans are turned into money, and so on, to find out.
Original Article: "Banks Create Money out of Thin Air. What Could Possibly Go Wrong?"
Monetarists believe there is an optimum growth rate of money. However, a fiat money system itself is unstable, so there is no optimum growth rate.
Original Article: "Is There an Optimum Growth Rate of Money?"
On Sunday morning, March 12, Treasury Secretary Janet Yellen told CBS there would be no bailouts. Later in the day the Fed declared quantitative easing to infinity and beyond.
What’s going on?
Quite simply, the Fed is willing to overpay for debt (again). They call it the Bank Term Funding Program (BTFP), and as far as one can tell, its dollar value is limitless. The term sheet reads:
Program: To provide liquidity to U.S. depository institutions, each Federal Reserve Bank would make advances to eligible borrowers, taking as collateral certain types of securities.
And who is eligible?
Any U.S. federally insured depository institution (including a bank, savings association, or credit union) or US branch or agency of a foreign bank…
Basically everyone (i.e., not you or main street, just financial institutions) can take part in this legal counterfeiting operation.
So what’s being traded for newly created Federal Reserve notes?
Eligible collateral includes any collateral eligible for purchase by the Federal Reserve Banks in open market operations … provided that such collateral was owned by the borrower as of March 12, 2023.
Meaning: Practically any bank can exchange US Treasury (or even mortgage-backed securities, should they have held any on their books) with the Federal Reserve.
This program will be offered for one year at no charge to banks, and of course with no recourse!
The Fed explains:
Recourse: Advances made under the Program are made with recourse beyond the pledged collateral to the eligible borrower.
Now here’s the rub:
Collateral Valuation: The collateral valuation will be par value. Margin will be 100% of par value.
Therefore, if Wells Fargo or Bank of America owns US debt that is trading at fifty cents on the dollar, they can trade it with the Fed which will pay one dollar. In theory, it’s only an unrealized and temporary loss for the Fed because once the debt comes due, it will be paid in full. So the Fed won’t suffer a loss, nor will the bank.
The Fed will purposely pay an amount above market value on debt held by banks. The banks will receive this newly created money and get rid of their unrealized losses. Afterward, the banks will have to do something with this new money, such as buy more debt. We can only guess, but whatever the banks do with the money, it will most certainly be highly lucrative for them, push asset prices up, and further erode whatever is left of the middle class. It will also offer a new way for banks to make even riskier bets that will land them in more trouble in the future.
It is theft, a moral hazard, anti-capitalistic, and even antagonistic to those forced to pay taxes and work for a living. But still more questions remain, specifically: How large is this program? Are we talking a few billions or trillions of dollars? At one extreme, this program serves as a confidence booster more than anything; it’s public messaging. Very few banks will accept the generous offer. But it will provide public assurance that the Fed will insure deposits, keep banks from panic selling bonds at a loss, and quell any ideas of a bank run.
If this is the case, then the Fed has bought a little more time until the next panic sets in.
At the other extreme, every bank in America lines up to receive free money from America’s central bank. The Fed will eventually expand its balance sheet by trillions of dollars more, and they’ll tell us that it would have been worse if it weren’t for the Fed.
As for the Fed’s commitment to reducing the balance sheet, we’ll know the answer to this soon enough! Few things are certain at the moment, but it sure is a good day to be a banker.
Recorded in Birmingham, Alabama on April 22, 2023.
From the Mises Institute's recent event in Birmingham, Alabama dedicated to the global threat of "The Great Reset".
Money proper is not artifice. It is a physical "thing" of value, acquired through labor and emerging out of the needs of individuals, who through voluntary exchanges determine its value.
Original Article: "Is It Real Money or Just Artifice?"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The story of the failure of Silicon Valley Bank is the story of nearly every bank failure. Fractional reserve banking invites the risky behavior that brings down the banking system.
Original Article: "Silicon Valley Bank and the Failure of Fractional Reserve Banking"
This Audio Mises Wire is generously sponsored by Christopher Condon.
People are innovative—if government doesn't get in the way. Entrepreneurs in developing countries find alternatives for people cut off from commercial banking services.
Original Article: "Poor People in Developing Countries Find Alternatives to Commercial Banking"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Money is simple. The political program of monetary "policy" is not.
Original Article: "Money versus Monetary Policy"
This Audio Mises Wire is generously sponsored by Christopher Condon.
—from the Summary ...
Democratic socialism—the ideology that dominates the world today—aspires to become a world state. The route toward it requires a single world currency to be created. That would undoubtedly create a dystopia. Might this become a reality? And if so, how can it be averted? This book aims to find answers to these questions.
Part 11. Concerning Right Thinking: LogicThe arguments in this book claim to be strictly logical. For a better understanding, a few basics of logic—the doctrine of correct thinking—are presented. These show the possibility of making use of the incorruptible power of judgment.
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What We Know for a Fact: Humans ActThe phrase “humans act” is logically undeniably true; it applies a priori. From it further true statements can be derived—so-called action categories—which help to think through the political-economic questions raised in this book with impartiality.
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What is Indispensable for Human Action: Private PropertyPrivate property is not an arbitrary variable, as many believe. It is a category of human action and cannot be denied without contradiction; unconditional respect for property also proves to be an ethically convincing norm of action.
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Interpreting History: The Role of TheoryTo understand history, one must necessarily resort to theories; without theory, there is no grasp of reality. The insights provided by a priori theory are an indispensable ingredient in the unbiased interpretation of historical events.
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Driving Force of Civilization: InequalityThe prerequisite for peaceful and productive cooperation, and economic and cultural human progression, is humans’ inequality with regard to their abilities and goals. This is also a logical insight regarding action, and it explains the process of civilizing humanity.
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The Perfection of Exchange: MoneyThe modern economy and society based on the division of labor are particularly fostered when people use money. Money developed spontaneously in the free market without the intervention of a state, and having a currency for the whole world would be economically optimal.
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The Decivilizing Force: The StateThe state is a territorial monopolist with ultimate decision-making power over all conflicts in its territory. It doesn’t solve interpersonal conflicts; rather, it is the cause of many and increasing numbers of social disputes.
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The State and the Deterioration of Money: From Commodity to Fiat MoneyOut of self-interest, the state obtains the monopoly over the production of money, and by force it replaces commodity money with its own fiat money. As a result, its power expands enormously, thereby becoming basically uncontrollably large.
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Anatomy of Disruption: What Fiat Money CausesState fiat money suffers from economic and ethical defects: it hampers economic progress and is socially unjust. Fiat money leads to a “transvaluation of all values.” It is not compatible with a liberal and prosperous economy and society.
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A Destructive Ideology: Democratic SocialismDemocratic socialism has become the dominant ideology worldwide. It relativizes and undermines property in many ways, making the state increasingly powerful, thus destroying the conditions for free and prosperous social and economic life.
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Impact Assessment: A Case for the A Priori TheoryThe a priori theory can be used to reliably estimate the consequences of human actions: it can be used to derive conditional statements about the future that are valid under specific conditions, and it can also be used to trace action—logical path dependencies.
Part 212. The Progression Theorem: Toward a World GovernmentStates want to expand their power internally and externally. This applies above all to states that follow democratic socialism: they are working toward creating a worldwide uniform democratic socialism, a uniform world state with a uniform fiat world currency.
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The Nation: Community of Language and ValuesThe nations—the language and value communities—are an impediment to democratic socialism’s aspiration of establishing a unified world state. Therefore, democratic socialists try to vanquish the nations, and especially the principle of nationality.
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Migration: Natural and UnnaturalThe proponents of democratic socialism use migration as a means to abolish nations and the nation-state and to pave the way for a worldwide democratic socialism under a unified leadership. But this will not be achieved by a politicized migration.
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The Illusion of Democracy: The “Iron Law of Oligarchy”As in every democracy, an oligarchic elite rule is also formed in democratic socialism. It has a particularly strong incentive to create a uniform fiat world currency in order to come closer to the goal of creating a uniform world government, a world state.
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US Dollar Imperialism: The Bretton Woods SystemThe Bretton Woods system was the first attempt to establish a single politicized world currency. It was doomed to fail because the nations had sufficient room for maneuver to escape the abuse made possible by the Bretton Woods system.
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The Campaign against Currency Choice: The EuroIn Europe, states have succeeded in abolishing the last remnants of monetary competition and introducing a single currency. This example shows how a political world currency can be created: with the irrevocable fixing of exchange rates between national currencies.
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The Secret and Sinister Power: The World Central Bank CartelThe national central banks form an international cartel in line with the democratic socialists’ ideas. Their monetary policy is making the global financial and economic system increasingly dependent on a globally unified monetary policy, the logical end of which is a unified world currency.
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Blueprints for a Single World Currency:Bancor, Unitas, US Dollar, INTOR, and the LibraThere are many specific proposals to create a single world currency—brought about by a political decision, not by free market forces, for the democratic socialists want a monopolized single fiat world currency.
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The Dystopia: A Single Fiat World CurrencyA single fiat world currency would threaten freedom and prosperity on this planet to an extent that many probably cannot even imagine: with a single fiat world currency, the path would be open to a totalitarian world state.
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Technological Disruption: CryptocurrenciesThe emergence of cryptocurrencies could prove to be the crucial disruption and achieve what economic and ethical insight has not yet been able to achieve: the opening of a free market for money, and making it impossible to establish a world state.
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A Ray of Hope: Free Market for Money and Private Law SocietyA free market for money provides people with the best possible money. It would also effectively put an end to the freedom-destroying program of democratic socialism and make possible a private law society, in which the same law applies to all.
EPILOGUE: A Better World Is PossibleWe have been walking the ominous path toward a world state with a fiat world currency for decades. It is not an inevitable result, but to prevent it, essential things have to change. These will include rejecting false doctrines in modern social and economic theory and firmly reestablishing the a priori theory.
The "True" Money Supply (TMS), developed by Professor Murray Rothbard and myself,Professor Rothbard presents the theoretical framework for this statistic in the following works: Murray N. Rothbard, America's Great Depression (Princeton, NJ: D. Van Nostrand, 1963), pp. 83–86; idem, "Austrian Definistions of the Supply of Money," in Louis M. Spardaro, ed., New Directions in Austrian Economics (Kansas City: Sheed Andrews & McMeel, 1978), pp. 143–56; and idem, The Mystery of Banking (New York: Richardson & Snyder, 1983), pp. 254–62. is an admitted imperfect attempt to provide a statistical measure of money that is consistent with the theoretical definition of money as the general medium of exchange in society.For a sample of recent contributions that have emphasized general acceptability in exchange as the defining characteristic of money, see: Lawrence H. White, "A Subjective Perspective on the Definition and Identification of Money," in Israel M. Kirzner, ed., Subjectivism, Intelligibility and Economic Understanding: Essays in Honor of Ludwig M. Lachmann on His Eightieth Birthday (London: The Macmillan Press, 1986), pp. 301–14; Dale K. Osborne, "What Is Money Today?" Federal Reserve Bank of Dallas Economic Review (January 1985), pp. 1–15; idem, "Ten Approaches to the Definition of Money," Federal Reserve Bank of Dallas Economic Review (March 1984), pp. 1–23; Leland Yeager, "What Are Banks?" Atlantic Economic Journal 6 (December 1978): 1–14. Also see the classic article, Leland Yeager, "The Medium of Exchange" in R.W. Clower, ed., Monetary Theory: Selected Readings (Baltimore, MD: Penquin Books, 1970), pp. 37–60.
Measure of the U.S. money stock in current use in economic and business forecasting and in applied economics and historical research are flawed precisely because they are not based on an explicit and coherent theoretical conception of the essential nature of money. Given the all-pervasive role of money in the modern market economy, existing money-supply measures therefore tend to impede, rather than to facilitate, a clear understanding of the past or future development of actual economic events. Each one of the familiar set of M's calculated by the Federal Reserve System, for example, both excludes some items that are identifiable as money by our definition and includes other items that lack the essential properties of general medium of exchange.
As the general medium of exchange, money is a good universally and routinely accepted in exchange by market participants; or, put another way, it is the one good that is traded for all other goods on the market. One important implication of this fact—and an important empirical test of whether or not a thing can be counted as money—is that money serves as the final means of payment in all transaction. For instance, credit cards are not counted as part of the TMS, because use of a credit card in the purchase of a good does not finally discharge the debt created in the current transaction. Instead, it gives rise to a second credit transaction that involves present and future monetary payments. Thus the issuer of the card or lender is now bound to pay the seller of the good immediately with money on behalf of the card-holder or borrower. The latter, in turn, is obliged to make a monetary repayment of the load to the issuer at the end of the month or at a later date, at which time the transaction is finally completed.For a similar view of credit cards see: Paul A. Meyer, Monetary Economics and Financial Markets (Homewood, IL: Richard D. Irwin, 1982), p. 34; and White, "Definition and Idenfication of Money," pp. 310–11.
In the case of a paper fiat money, such as the current U.S. dollar, there is a second test that can be applied to determine whether a particular item should be counted in money supply statics. Unlike any good produced in the market, including a commodity money, whose quantities are ultimately determined by the interaction of supply and demand, On this property of a pure commodity money, see, for example, Milton Friedman, "Commodity-Reserve Currency" in Milton Friedman, Essays in Positive Economics (Chicago: The University of Chicago Press, 1953), pp. 206–10. the quantity of government fiat money (but not its purchasing power) at any point in time is determined solely by decisions if suppliers of the good, i.e., government central banks, without respect to the desires and actions of the demanders. The fact that money is routinely accepted as the final means of payment by all participants in the market means that fiat money can be literally lent and spent into existence regardless of the public's existing demand for it. For example, if an additional quantity of Fed notes is printed up and spent by government on various goods and services, an excess supply of money will temporarily be created in the economy. The initial recipients of the new money will quickly get ride of the excess cash simply by increasing their own spending on goods; those who eagerly receive the new money as payments in the second or later rounds of spending will do likewise, in the process bidding up the prices of goods, reducing the purchasing power of the dollar, and consequently, increasing the quantities of dollars that each individual desire to keep on hand to meet expected future payments or for other purposes. In summary, any excess supply of fiat money does not go out of existence, but is spent and respent and continually passed on like a "hot potato" throughout the economy until the surplus money is finally and fully absorbed by the resulting increase in general prices and in desired dollar holdings.For a description of the unique process by which, in nominal terms, "the supply of money creates its own demand," see Yeager, "The Medium of Exchange," pp. 42–43; and idem, "What Are Banks?" pp. 6–7. It is this criterion which is applied below in resolving the apparent inconsistency of including demand deposits and money market accounts (MMDAs) in the TMS, while excluding checkable money market mutual fund (MMMF) equity shares.
In what follows, I explain briefly why various items have been included in or excluded from the TMS. To simplify the exposition, I organize my explanation around the several Fed definitions of the money supply and of total liquid assets.
Components of M1Currency in the hands of the nonbank public, i.e., excluding currency held by the U.S. Treasury, the Fed, and in the vaults of commercial banks, is counted in the TMS, precisely because it is the physical embodiment of the generally accepted medium of exchange in the U.S. economy. Federal Reserve notes of various dollar denominations (as well as token coins and paper notes issued by the U.S. Treasury) are the "standard money" or ultimate "cash" of the U.S. monetary system, having replaced gold in this function, at least for American citizens, in 1933.
Demand deposits or checking account balances at commercial banks and other checkable deposits, such as NOW accounts held at S&Ls, are included in the TMS by virtue of the fact that they are claims to the standard money redeemable at par on demand by the depositor or by a third party designated by the depositor. Despite the fact that these deposits are only fractionally backed by cash or immediately cashable reserve deposit at the Fed, their instantaneous redemption at par is effectively guaranteed by two factors. First, there is federal deposit insurance, which legally insures up to $100,000 of each and every depositor at a given bank or thrift against loss, hue which, in practice, has almost always guaranteed the full worth of all deposits, usually by subsidizing the merger of an ailing institution with a healthy one.As a former FDIC Chairman has recently written: "The pendulum has swung once again toward 100 percent protection of depositors and creditors. Despite the fact that Congress made it clear in the 1950 Act that FDIC was not created to insure all deposits in all banks, in the years since Congress has gradually increased the insured amount to $100,000. In addition, the regulators have devised solutions that protect even the uninsured in the preponderance of cases." (Irving H. Sprague, Bailout: An Insider's Account of Bank Failure and Rescues [New York: Basic Books, 1986], p. 32.) Moreover, the uninsured depositors who incurred losses in a dandful of recent bank failires were mainly holders of deposits in the category of "large time deposits," which, for the reasons stated below, are not included in the TMS definition of the money supply. The FDIC's recent attempt to enforce market discipline on the banking industry by leaving the uninsured holders of large time deposits in small (but not large) banks unprotected appears to have had little substantive effect. One this, see R. Alton Gilbert, "Recent Changes in Handling Bank Failures and Their Effects on the Banking Industry," The Federal Reserve Bank of St. Louis Review 67 (June/July 1985): 21–28. Second and more importantly, there is the Fed itself, which, in its much-publicized function as the "lender of last resort," always stands ready to head off a banking panic by simply printing up and lending the needed quantities of Fed notes to banks or thrifts unable to meet their demand liabilities.In his refusal to include "transactions balances," including demand deposits, in his statistical definition of the U.S. money supply, because they allegedly all cannot be spent simultaneously in any conceivable pattern of payments, Osborne ignores these institutional considerations. Thus, contrary to Osborne's contention, demand deposits in the U.S. today are indeed "means of simultaneous payment," precisely because, as the lender of last resort, the Fed is empowered to created base money ad libitum and would exercise this power to prevent a wholesale collapse of the fractional-reserve, multibank system. By neglecting this momentous institutiona factor, the strict application of Shackle's "simultaneity" criterion to the empirical identification of the money stock leaves Osborne with only the monetary baseas the "generally acceptable means of exchange," i.e. money, in the U.S. See Osborne, "What Is Money Today?" pp. 3–5. For reasons, checkable deposits held at federally-insured banks and thrifts are readily acceptable in exchange as perfect substitutes, dollar for dollar, for Federal Reserve notes.As Barger observers, "... it is the bank deposit which is money—not the check which transfers the deposit. Bank deposits are always acceptable: checks may not be, for sometimes they turn out to be make of rubber. If your creditor refuses your check, it's not doubt because he's not convinced he's getting title to a bank deposit." (Harold Barger, Money, Banking and Public Policy, 2nd ed. [Chicago: Rand McNally, 1968], pp. 16–17.) This is an obvious point, but White appears to overlook it in the significance he attaches to the limited "sphere of acceptance" of "ordinary bank checks [emphasis mine]." (White, "Definiation and Identification of Money," p. 305.)
In contrast, travelers' checks issued by nonbank financial institutions, such as American Express, are excluded from the TMS because they neither are riskfree claims to immediate cash nor serve as final means of payment in transactions. What a travelers' check represents from an economic point of view is a credit claim on the investment portfolio of the issuing company. The purchase of travelers' checks from American Express involves, in effect, a "call" loan by the purchaser to American Express, which the latter pledges to repay to the purchaser or to a designated third party at an unspecified date in the future. In the meantime, most of the proceeds of such loans are invested by American Express on its own account in interest bearing assets, while a fraction is held in the for of demand deposits to meet anticipated payments of its travelers' check liabilities they "mature." In exchange for the foregone interest (an a small fee) the purchaser receives access to an alternative payments system which avoids the risk of loss associated with carrying cash payments and the potential delay or nonacceptance involved with payment by personal check drawn on a distant bank. But the travelers' checks themselves are not the final means of payment in a transaction;Meyer is inconsistent in counting nonbank travelers' checks as part of the money supply merely because they are "means of payments." As Meyer recognizes in his discussion of credit cards, however, it is not enough that an item is able to serve as a means of payment in most transactions for it to be considered money; it must also serve, in his words, "to extinguish obligations between two parties," that is, serve as the final means of payment, to deserve the classification of money. See Meyer, Monetary Economics, pp. 33–34. the sellers who receive travelers' checks in exchange quickly and routinely present them for final payment at a bank and obtain either cash or a credit to their demand deposit accounts, with the sums paid out ultimately being debited to the demand deposit account of American Express. Moreover, in the highly unlikely event that financial reverses force the issuing company into institutional liquidation, the holders of its outstanding stock of travelers' checks would be, economically and legally, in the same boat as debtholders of any insolvent business firm, having no political guarantee of a dollar-for-dollar payoff of their debt claims, such as that provided by federal deposit insurance and privileged access to the lender of last resort.
Components of M2 Not Included in M1Savings deposits, whether at commercial banks or thrift institutions, are economically indistinguishable from demand deposits and are therefore included in the TMS. Both demand and savings deposits are federally insured under the same conditions and, consequently, both represent instantly cashable, par value claims to the general medium of exchange. The objection that claims on dollars held in savings deposits typically do not circulate in exchangeFor example, White argues that, because time deposits "... are not directly transferable, they do not serve as media of exchange, let alone as generally accepted media." (White, "Definition and Identification of Money," p. 310.) Yeager holds that the liabilities of nonbank financial intermediaries, such as deposits at S&Ls, are not money because they are not "routinely exchange." (Yeager, "The Medium of Exchange," pp. 40–46, 53–56.) (although certified or cashier's checks may be readily drawn against such deposits and are certainly generally acceptable in exchange), while not unimportant for some purposes of analysis, is here beside the point. The essential , economic point is that some or all of the dollars accumulated in, e.g., passbook savings accounts are effectively withdrawable on demand by depositors in the form of spendable cash.As Rothbard pertinently remarks, "... the 30-day notice [of withdrawal of savings deposits] is a dead letter; it is practically never imposed, and, if it were, there would be a prompt and devasting run on the bank. Everyone acts as if his time deposits were redeemable on demand, and the banks pay out their deposits in the same way they redeem demand deposits. The necessity for personal withdrawsl is merely a technicality; it may take a little longer to go down to the bank and withdraw the cash than to pay by check, but the essence of the process is the same. In both cases, a deposit at the bank is the course of monetary payment." (Rothbard, America's Great Depression, p. 84.) In addition, savings deposits are at all times transferable,Today, many institutions permit such transfer to be effected by means of telephone. lnterestingly, one weighted aggregate of "transactions assets," the "MQ" measure, includes "savings deposits subject to telephone transfer" while excluding conventional savings deposits. See Dallas S. Batten and Daniel L. Thornton, "Are Weighted Monetary Aggregates Better Than Simple-Sum Ml?" The Federal Reserve Bank of St. Louis Review 67 (June/July 1985): 29–40. dollar for dollar, into "transactions" accounts such as demand deposits or NOW accounts.ln an early, though unfortunately neglected, contribution, Lin clearly recognized the economic equivalence of currency, demand deposits, and savings deposits, based on their "interchangeability" within the modern banking system. Thus, according to Lin, The term "means of payment" describes but one phase of the meaning of money. It indicates only in what form money is "spent," but not in what form it may be 'kept.' In the modern banking and monetary system money may be kept in one form and spent in another. This is possible and is always done today [1937] because all forms of money issued either by banks or by the state must be interchangeable to maintain parity.... Money in whatever form it is kept and spent must be of general acceptability and of free interchangeability. By these criteria, all other credit devices are automatically eliminated because they are not generally acceptable and cannot be freely interchanged into one another. Treasury currency, bank notes, time and demand deposits are ... constantly interchanging into one another unit per unit without altering the total supply of money. (Lin Lin, "Are Time Deposits Money?" American Economic Review 27 [March 1937]:85.)For one of the earliest hints of recognition of the monetary function of time deposits, see Frank A. Fetter, Economics, vol. 2: Modem Economic Problems, 2nd ed. (New York: The Century Co., 1923), pp. 102–103.
The common-sense case for the inclusion of savings deposits in the stock of general media of exchange was cogently presented by the eminent German banker and economist, Melchior Palyi:
In their own minds, money is what people consider as purchasing power, available at once or shortly. People's "Liquidity" status and financial disposition are not affected by juristic subtleties and technicalities. One kind of deposit is as good as another, provided it is promptly redeemable into legal tender at virtual face value and is accepted in settling debts. The volume of total demand for goods and services is not affected by the distribution of purchasing power among the diverse reservoirs into which that purchasing power is placed. As long as free transferability obtains from one reservoir to the other, the deposits cannot differ in function or value ...
A source of confusion is the identification of savings deposits with savings. The former are no more and no less "saved" than are the funds put on a checking account or the currency held in stocks. In all three cases, someone is refraining from consumption (for the time being); in all three, the funds constitute actual purchasing power. And it makes no difference in this context how the purchasing power is generated originally: dug out of a gold mine, "printed" by a government agency, or "created" by a bank loan. As a matter of fact, savings banks and associations do exactly what commercial banks do: they build a credit structure on fractional reserves.Melchior Palyi, An Inflation Primer (Chicago: Henry Regnery, 1961), pp. 137–38.
Overnight repurchase agreements or "RPs" were devised in the mid-1970s as a means of evading the legal prohibition against the payment of interest on demand deposits. They are, in essence, interest bearing demand deposits held by business firms at commercial banks and therefore are included in the TMS. In a repurchase agreement, a firm, in effect, makes a loan to a bank which is collateralized by government securities. The bank "sells" government securities to the firm with an agreement to "repurchase" them the following day at a slightly higher price, i.e., repay the loan plus interest. When the purchase or loan is initially made, the bank debits the firm's demand deposit balance and credits its RP account by the amount of the loan. On the following day the bank repays the loan with interest by reversing the process and crediting the firm's demand deposit with a sum that exceeds the previous day's debit by the amount of the interest payment. Since the loans are mating daily, the firm has virtually instant access to the full amount of its dollars on deposit with the bank.For a discussion of overnight RPs, see Meyer, Monetary Economics, p. 28.
Overnight eurodollars are counted in the TMS for the same reason as overnight RPs: they are basically an accounting fiction that permit U.S. banks to pay interest on their business demand deposits and are therefore virtually redeemable on demand. In the case of overnight eurodollars, deposits are made by U.S. firms in interest bearing accounts at the Caribbean bank of a U.S. bank, where U.S. interest-rate regulations have no legal force. The dollars thus deposited plus interest earned are credited daily to the firms' demand deposit accounts held at the parent bank.On overnight eurodollars, see ibid., pp. 28–29.
Money market deposit accounts, as a hybrid of demand and savings deposits, are considered pare of the TMS. MMDAs are federally insured up to $100,000 per account, feature limited checking privileges, and offer par value cashability upon demand of the depositor.
Although MMMF share accounts at first glance look like MMDAs, they are clearly excludable from.the TMS, because they are neither instantly redeemable, par value claims to cash, nor final means of payment in exchange. This requires a brief explanation of the nature of MMMFs.The next three paragraphs, with some alterations are drawn from Joseph T. Salerno, "What Investors and Depositors Should Know about Banks and the Financial Services Revolution," Jerome Smith's Investment Perspectives 2 (June 1984): 3–4. A more detailed analysis of the nature of MMMFs and their relationship to the supply and demand for money under the gold standard may be found in Joseph T. Salerno, "Gold Standards: True and False," The Cato Journal 3 (Spring 1983): 255–58.
Each MMMF share represents a claim to a pro rata share of a managed investment portfolio containing shore-term financial assets, such as high-grade commercial paper, certificates of deposit, and U.S. Treasury notes. Although the value of a share is nominally fixed, usually, at one dollar, the total number of shares owned by an investor (abstracting from reinvested dividends) fluctuates according to market conditions affecting the overall value of the fund's portfolio.For a similar characterization of MMMFs, see Meyer, Monetary Economics, p. 29; and White, "Definition and Indentification of Money," p. 310. Under extreme circumstances, such as a stratospheric rise in shore-term interest races or the bankruptcy of a corporation whose paper the fund has heavily invested in, the fund's investors may well suffer a capital loss in the form of an actual reduction of the number of fixed-value shares they own. Unlike a check drawn on a demand deposit or MMDA, therefore, an MMMF draft does not simply represent a direct transfer of current claims to currency, but a dual order to the fund's manager to sell a specified portion of the shareowner's asset holdings and then to transfer the monetary proceeds to a third party named on the check.Typically, the funds establish a central clearning account at a bank. When checks, really drafts, written by individuals are presented to the bank, it notifies the mutual fund of the number of fund shares that must be liquidated to cover the check." (Monica Langley, "Holds on Checks Annoy Investors in Money Funds," The Wall Street Journal (November 11, 1986), p. 39. Note that the payment process is not finally completed until the payee receives money, typically in the form of a credit to his demand deposit.As White points out, "... the item that the check-writing MMMF customer relinquishes (ownership of shares in a portfolia of assets) is not what the payee accepts (ownership of an inside-money claim to bank reserves). Because the actual MMMF shres are not what the second part accepts (or intends to accept), MMMF shares cannot be considered a generally accepted medium of exchange; hence, they are not money." (White, "Definition and Identification of Money," p. 310.)
Another feature that distinguishes checkable MMMF shares from demand deposits and MMDAs is the fact that the former cannot be permanently expanded beyond the limit set by the public's willingness to hold such assets. If an excess supply of fund shares happens to emerge, the consequence would not be the general rise in prices occasioned by people's attempts to rid themselves of surplus dollars through increased spending.See above, pp. 2–3, for the description of this process. Unwanted MMMF shares simply go out of existence, as fund investors directly redeem them for money or use MMMF drafts to purchase alternative investment assets or consumers' goods. In the extreme case, if the public suddenly preferred to invest directly in the short-term credit market, without the intermediation of managed mutual funds, checkable MMMF shares would simply disappear from existence.
It is important to realize that the existence of MMMFs does have an effect on overall prices in the economy, but not because checkable fund shares constitute an addition to the money supply. Rather, the liquidity and checkability features of these assets permit their holders to reduce the amount of money they need to keep on hand to meet anticipated payments and to insure against future contingencies. This is also true, as we saw, of credit cards, which similarly provide their holders with access to an alternative payments system that economizes on money. By thus reducing the overall demand for money, MMMFs and credit cards encourage a higher rate of aggregate spending in the economy that results in a general rise in prices. However, the price increase associated with a given expansion of MMMFs is a "one-shot" phenomenon, whose magnitude is strictly governed by the corresponding reduction in the aggregate desired money balances of market participants. This sharply contrasts with inflation, which typically refers to a money-supply phenomenon involving a persistent decline in the purchasing power of the monetary unit that results from the creation of additional quantities of government fiat money, which, in theory, is limited only by the onset of a hyperinflationary currency breakdown.
Small-denomination time deposits refer mainly to federally-insured certificates of deposit (CDs) in denominations of less than $100,000 and are excluded from the TMS because they involve loans by the public to banks and thrifts.For details on institutional features of CDs, see Lester V. Chandler and Stephen M. Goldfeld, The Economics of Money and Banking, 7th ed. (New York: Harper & Row, 1977), pp. 148–49; also see Meyer, Monetary Economics, p. 88. As time deposits, CDs nominally are not cashable on demand, but are payable in dollars only after a contractually fixed period of time ranging from thirty days to a number of years. However, the fact that issuing institutions stand ready to redeem these liabilities in current dollars at any time prior to maturity does constitute a theoretical argument for their inclusion in the TMS at their current redemption value. On the other hand, depositors do have a strong incentive to abstain from cashing small CDs before their maturity dates, because issuing institutions typically assess heavy penalties—varying from forfeiture of accrued interest to loss of the original principal—in the event of premature redemption. The ultimate decision to exclude this item was also heavily influenced by the practical problem of obtaining the data necessary to permit a reasonable estimate of its value in current dollars, i.e., net of penalty assessments.
Components of M3 Not Included in M2Large-denomination time deposits, such as CDs issued in denominations of at least $100,000, are bona fide time liabilities, because they are not payable by the issuing institution before maturity.Chandler and Goldfeld, Money and Banking, pp. 148–49. Since they are not par value claims to immediately available dollars, they are excluded from the TMS. The same reasoning applies to the exclusion of term RPs and term eurodollars from the TMS. The shares of "institution-only" MMMFs are excluded from the TMS for the same reasons as the shares of the "general purpose & broker/dealer" MMMFs included in M2.
Components of L Not Included in M3U.S. Savings Bonds are instantly cashable at the U.S. Treasury (or at banks and thrifts acting in its behalf) at a fixed discount from their face value.Meyer, Monetary Economics, p. 152. As U.S. Treasury liabilities, moreover, their redeemability is "insured" by the full faith and credit of the Federal government. U.S. Savings Bonds are therefore included in the TMS at their redemption value, because they represent secure and current claims against the Treasury for contractually fixed quantities of the general medium of exchange.In 1946, Fetter recognized savings bonds as "immediate purchasing power," and, as part of a comprehensive anti-inflation package, recommended the absorption of savings bonds "redeemable on demand" by exchanging them for long-term bonds and life annunities. (Frank A. Fetter, "Inflation's Basic Causes: Too Much Money," Saturday Evening Post [July 13, 1946], p. 124.) Palyi adopts a definition of the U.S. money supply that includes U.S. Savings Bonds at redemption value. However, from our medium-of-exchange perspective, Palyi goes too far afield by including in the money supply "highly liquid" assets such as Treasury securities of less than one year's maturity, commercial paper and bankers' acceptances. On the other hand, we sympathize with Palyi's apparent support for the inclusion of the cash surrender value of life insurance policies in money-supply figures. See Melchior Paly, The Twilight of Gold, 1914–1936: Myths and Realities (Chicago: Henry Regnery, 1972), pp. 301–15. Albert G. Hart and Peter B. Kenen present a statistical definition of "liquid assets of the nonbank public," including U.S. Savings Bonds and the "net cash values of life insurance," which comes very close to the TMS. There are no significant omissioins, and the only clearly objectionalbe item is short-term government securities. See Albert G. Hart and Peter B. Kenen, Money, Debt and Economic Activity, 3rd ed. (Englewood Cliffs, NJ: Prentice-Hall, 1948), pp.3–6. In fact, U.S. Savings Bonds may usefully be treated as specific claims against "Treasury Cash," since this provides a rationale for the conventional omission of the latter item from money-supply statistics.Actually, "Treasury cash" refers to the small amount of Treasury-held gold which has not been monetized by the issue of gold certificates to the Fed in exchange for Treasure deposits. Nonetheless, since this "nonmonetized" gold stock may be converted into a stock of dollars at any time, via the issue of gold certificates to the Fed, it may be considered a monetary reserve for the redemption of savings bonds. On Treasury cash, see John G. Ranlett, Money and Banking: An Introduction to Analysis and Policy, 3rd, ed. (New York: John Wiley, 1977), pp. 60–67/
In contrast to savings bonds, shore-term Treasury securities are not payable before maturity and are therefore excluded from the TMS.
Memorandum ItemsThree items which are not included in any Fed measure of the money supply (Ml, M2, M3) or even of overall "liquidity" (L) find a place in the TMS. These are the demand and other deposits held by the U.S. government, foreign official institutions, and foreign commercial banks at U.S. commercial and Fed banks.
The somewhat mysterious exclusion of these items from money-supply measures is typically justified by one recent writer who claims that the deposits of these institutions "... serve an entirely different purpose than the holdings of the general public" or are "... viewed as being held for 'peculiar' reasons."Meyer, Monetary Economics, pp. 26–27. This overemphasis on the particular "motives" for holding money, as opposed to the importance of the quantity of money itself, is one of the modern legacies of the Keynesian revolution.In analyzing the Keynesian motives for holding money, Hart and Kenen cogently argue that "We cannot divide the cash balance of a given holder into definite parts representing each of these motives.... If, for example, he also has accumulated cash for speculative pruposes, he also has a margin of safety, so that he needs under the [precautionary] motive are swallowed up in those under the [speculative motive]. Besides, the different motives shad into one another. In analyzing them, it is less important to keep them distinct than to keep track of the common element that binds them all together—the adaption of business dealings to uncertainty." (Hart and Kenen, Money, Debt and Economic Activity, pp. 223–34.)
Moreover, there is nothing at all "peculiar" about the reasons for which such deposits are held. As one modern advocate of their inclusion in money-supply statistics points out:
The Treasury's deposits are not part of its reserve against money that it has issued, but are rather part of the general fund of the Treasury available for meeting general expenditures. Output is purchased and taxes are collected with the help of these deposits, and they would seem to be as much a part of the money stock with which the economy operates as are the deposits of state and local governments, which are included in adjusted demand deposits. Much the same may be said of Treasury deposits at Federal Reserve Banks. Also foreign-owned deposits at commercial banks are included, so why not foreign-owned deposits at the Federal Reserve?Barger, Money, Banking and Public Policy, p. 53.
Finally, pre-Keynesian monetary theorists routinely and properly counted "U.S. Government Deposits" in the "Total Deposits" component of the money supply. See, for example: Edwin Walter Kemmerer, High Prices and Deflation (Princeton, NJ: Princeton University Press, 1920), p. 27; Benjamin M. Anderson, Economics and the Public Welfare: A Financial and Economic History of the United States, 1914–1946, 2nd ed. (Indianapolis: Liberty Press, 1979), pp. 98, 183, 265; and Palyi, The Twilight of Gold, p. 36. This was and is the proper procedure, because it is variations of the total stock of money owned by all economic agents that are of vital importance in analyzing and attempting to forecast inflation and business-cycle phenomena.
No matter the historical era, governments have excelled at one thing: debasing their own currency. Rome was no exception, as Roman government excesses required inflation—lots of inflation.
Original Article: "Rome's Runaway Inflation: Currency Devaluation in the Fourth and Fifth Centuries"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The fiat monetary system is slowly breaking down, taking the economy with it.
Original Article: "The Present Fiat Monetary System Is Breaking Down"
This Audio Mises Wire is generously sponsored by Christopher Condon.
Jeff and Bob discuss whether the FTX scandal will be used to justify new "crypto" regulations or even the creation of a central bank digital currency.
Caitlin Long and Sam Bankman-Fried debating leveraging Bitcoin: Mises.org/HAP370A
Mises on circulation credit vs. commodity credit: Mises.org/HAP370B
President of the Minneapolis Fed Neel Kashkari on CBDCs: Mises.org/HAP370C
Download the slides from this lecture at Mises.org/MU22_PPT_06.
Recorded at the Mises Institute in Auburn, Alabama, on 25 July 2022.
This book provides the intelligent layperson with a concise yet comprehensive overview of the theory, history, and practice of money and banking, with a focus on the United States. Although the author considers himself an Austrian school economist, most of the material in this book is a neutral presentation of historical facts and an objective description of the mechanics of money creation in today's world.
The book is intended to be a reference for all readers, whether "Austrian" or not, and to bridge the gap by providing a crash course in the necessary theory and history while keeping the discussion tethered to current events.
— From the Introduction
Jeff Deist: You recently completed a series of articles for the Mises Institute, which we will publish in book form, on how money works today. Why is it important for average people to understand the mechanics of the plumbing of central and commercial banks?
Bob Murphy: There’s two main reasons. First, it’s intrinsically interesting. That’s why I went into economics. Just like the average person should know the basics about physics and chemistry and Darwin’s theory of evolution, likewise, the average person needs to know: How does money work, how do banks work? Just the raw basics of it because it’s an important part of modern society, even premodern society, in terms of money. But beyond that, because central banks certainly since 2008 and even more so in the wake of the pandemic in 2020 have done lots of things that I believe are setting the world up for a series of major financial crises, and the average person needs to know about this.
JD: Considering the monetary and fiscal machinations engaged in by governments since the pandemic, it’s as though we lost any sense of what money is. It seems unlimited. People on Twitter tell us money is just information, or energy in a system.
BM: I do know what you’re saying. On the one hand, I can’t bristle too much when outsiders, people like Eric Weinstein, come forward and they say the economists have just botched it. I get why they’re saying it, because the economists have done such a poor job. It’s hard for me to say hey, stay in your lane, leave money to the economists. But, on the other hand, you’re right. We shouldn’t jump to the conclusion that the older-school economists and the ones in the Austrian tradition don’t know anything and that there’s no point in reading them. There are lots of fallacies that intelligent people who are not conversant with the economics literature might fall prey to, just like if you go into philosophy, there are lots of detours, and you would do well to take a basic course in philosophy to avoid fallacies that plagued people centuries ago. Likewise with money, there are lots of ways you can go down the wrong path, and some of these bright people who are spouting off on Twitter are just going over stuff that was demolished by Mises in 1912. They’re just repeating those fallacies and it’s because they never heard of it before.
JD: To be fair, the average Joe or Jane might well say money is just this made-up thing government tells us to use.
BM: Exactly, and it’s interesting because there is this sense in which money is a social convention, but it’s not merely a social convention. Just like spoken language is a social convention in a sense but that doesn’t mean words can just mean whatever you want. Money is a complex topic and it is easy to think of money incorrectly and certainly to then endorse government policies that would be disastrous because you don’t really understand exactly what money is or how it functions.
JD: We’ve heard two words ad nauseam over the past sixteen months: stimulus and liquidity. One is fiscal, one is monetary. Executives, Treasury officials, legislatures, and central bankers all throwing everything but the kitchen sink at the problem. Are fiscal and monetary policy effectively merging?
BM: I think you’re right that part of what’s been happening is the traditional divide between fiscal and monetary actions has been blurred. For example, during the Obama administration (this is back when this was shocking) there were four years in a row in which the federal deficit was higher than a trillion dollars. And that was also roughly when the Federal Reserve, implementing its independent monetary policy, with no concern about the budget needs of the government, was engaged in these rounds of QE (quantitative easing). And at the time, I didn’t think that was a coincidence, just like now I don’t think it’s a coincidence that the federal government is running massive deficits right when the Fed keeps adding to its balance sheet and buying Treasurys. I don’t think that’s a coincidence.
So yes, there is this merging. Then you’ve got MMT (modern monetary theory), for example, which quite explicitly just consolidates everything. They say that when the federal government runs a deficit and buys fighter jets, the Treasury instructs the Fed to mark up the checking account balances of Northrop Grumman or Lockheed Martin, or whoever makes them. I think that’s wrong. There are still some legal issues involved, and technically the Treasury can’t just spend whatever it wants and tell the Fed, “Mark up the checking account.” Legally speaking, that’s not how it works. But you’re right, conceptually that’s the way a lot of people, even with PhDs in economics, are starting to talk about it, so it is blending together.
There are some senses in which that approach is probably correct: like I said, it was naïve for mainstream economists to act as if what the Bernanke Fed did during the Obama years was purely because they were targeting CPI (Consumer Price Index) and doing it not because they knew, the feds are issuing this much debt; if we don’t want interest rates going up on Treasurys, we have to buy a bunch of them. So, it is merging, but still, conceptually, the old-school distinctions are important if people want to understand that, for example, a government that’s in a regime of hard money can still borrow money, just like corporations or households can go borrow money and that’s not per se inflationary, whereas in the modern system, yes, if the Fed or the central bank in general is monetizing the debt, that is inflationary. It’s important to get cause and effect distinct.
JD: Give us your quintessentially fair and objective description of MMT, along with your critique.
BM: What’s funny is I’ve actually formally debated Warren Mosler. If you jump into YouTube and look at the comments, they’ll say, “Oh, Murphy agrees MMT is correct, he just doesn’t like it.” It’s a very seductive approach they have where they’re casting themselves as saying, “Look, we’re not passing judgment, we’re just saying this is modern monetary, this is the way the modern financial banking system, government money system, works, take it or leave it, and you need to know this.” But at the same time, I don’t know of any MMT proponents who want the US government to return to its constitutional duties. It seems that the MMT sort of neutral, positive as opposed to normative description of how the world works almost always goes hand in hand with prescriptions for a massive expansion in government entitlements and other types of spending programs, intervention and healthcare, because they think they’ve shown we don’t need to worry about debt.
And, just to circle back, what do they do? They’re saying, unlike private sector individuals or corporations who have to use the money but are not sovereign issuers, the monetary authorities, the US government or the Japanese government, they have monetary sovereignty. They can issue their own currency. They don’t have to pledge to redeem it in some other currency. It’s not tied to anything.
After 1971, the US dollar is not redeemable in anything. It just is what it is, it’s its own commodity unto itself, there’s no actual constraint on the US government spending more money. And so they say, if we’re talking about if we should have Medicare for all, stop saying, “How are we going to pay for it?” I think that’s the fundamental point of the MMT crowd and I’m not putting words in their mouths. Stephanie Kelton, one of the major proponents right now, that’s how she talks. And so then you say, “Okay, there’s a sense in which that’s correct, but there’s also a sense in which that’s extremely dangerous and misleading.”
So yes, it is true, if the federal government wants to fund another moon shot, wants to put a base on Mars, wants to guarantee everybody’s healthcare and that’s going to cost $20 trillion in current prices, they could go ahead and just create that money. There’s nothing legally stopping them. But to me that’s a very dangerous thing to tell the public, because it leads them to believe they can do it without any bad consequences, when in fact, I would argue, doing that’s going to raise the dollar prices of goods and services. You’re not creating extra real resources just by creating dollars. Under a gold standard, for example, everybody would agree, it’s too expensive, it’s not worth it to try to build a Mars base any time soon. By freeing the Federal Reserve from the fetters of gold, you don’t all of a sudden give us better technology. You don’t all of a sudden make more spaceships available or bases that are half built on Mars. It’s the same use of scarce resources to achieve that outcome regardless of the financing mechanism. That’s what I would say, and the MMT people will give a nod occasionally too and say, “We know prices could rise. We’re just saying that’s the constraint.” But still, that’s very misleading.
The analogy I’ve used often is to say: Imagine a couple, they’re over the kitchen table and they’re scratching their heads and say, man, these finances. We want to pay for the kids’ college, but my job only pays this, and we just can’t afford that vacation next month. And then, what if somebody gave them the insight and said, “No, stop thinking like that. You could put on a ski mask and go hold up a 7-Eleven.” And then the couple says, “Wouldn’t we go to jail or be shot by the store?” The third party would then say, “Yes, that’s true, we’re not denying that, but let’s stop talking about it in terms of we can’t afford things. Instead, the issue is do we want to go on the vacation more than we want to risk going to prison?” That’s really the tradeoff you face, and there’s a sense in which that third party giving the advice to the couple is correct, but they haven’t really helped the conversation any by making the correction that financing the vacation’s not the issue here. It’s do you want to risk going to prison if you hold up the convenience store?
That’s what the MMT people bring to the table when they say, “Let’s stop saying we can’t afford Medicare or is the public willing to tolerate higher taxes, because we can just print the money.” You’re not helping anything and in fact, you’re just dangerously leading people to believe this is some financing mechanism that actually you would never want to endorse.
JD: In the MMT conception, when Uncle Sam creates debt—public debt—that debt is private wealth.
BM: Great point and you’re right, that’s another pillar of MMT, at least about how they talk to the public and flip around your thinking about everything you’ve heard about government finance.
JD: Like deficits.
BM: Yes. That’s another sacred cow they’ll tackle. And let me be clear, I understand why so many people have become enamored with MMT, and especially Stephanie Kelton’s latest book, The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy, is provocative as well. She’s a funny writer, and I can see how someone who’s willing to go down that path can read her book and say, “This is great.” Specifically what they’ll say is, “Don’t listen to these budget hawks, who say let’s stop passing the buck to our grandkids. If you think about it from an accounting perspective, the only way the private sector can accumulate net financial assets is if the government goes deeper into debt.”
The way they’re thinking about it is: if my pension fund accumulates corporate bonds, my pension fund might have more assets, but then that means the corporation that issues those bonds now has that extra liability, so on net, those members of the private sector just cancel out. They’re saying the only way the private sector as a whole can have claims on some entity that doesn’t internally cancel out is if the entity is a non–private sector group like, oh, the US federal government. If the private sector accumulates Treasurys, stop looking at it as, Uncle Sam’s deeper in debt, how are we going to pay for this as taxpayers? Instead, look at it as, we now have many more assets, look at all these extra Treasurys we have. That’s the argument they use and I think there’s a sense in which it’s correct in terms of the accounting.
I actually think it’s not right because you could have equity. If someone starts a corporation and then people have shares of that and it’s a productive enterprise, your share price doesn’t correspond to somebody’s debit somewhere. Even on its own terms, that’s actually not correct. But even if it were correct, it still is misleading because you could just as well say, “The way that the world minus the Mises Institute gains net financial assets is the Mises Institute goes deeper into debt.” That’s also true in terms of the accounting. It’s misleading, especially when it comes to government bonds: the way we as a private sector get paid what we’re owed on those “net financial assets” is the government points guns at us, takes money, and then hands it right back to us and says, “Here’s the payment on your Treasurys, thank you.” There’s no sense in which we should view that as some asset that’s exogenous that makes the private sector wealthy.
JD: I’ll play devil’s advocate. To be fair to MMTers, in 2020 the US federal government borrowed about half of what it spent and the sky didn’t fall. And Professor Stephanie Kelton, the current face of MMT, is not nearly as odious as Krugman or some of our Keynesian friends.
BM: Right.
JD: If MMTers tend to hold left-wing political views and support big government, their retort would be that Austrians tend toward libertarian views—so our theory is just as “political.” And the idea that a sovereign issuer of currency can spend unlimited money, well you can see the enormous seductive appeal.
BM: Yes, Austrian economists stress that Austrian economics is positive, it’s not normative, and yet, in practice, very few people study Austrian economics and say, “Yes, now that I know how the business cycle works...” that’s possible. So, point well taken there. I also agree with you that Warren Mosler is a charming guy. When I debated him years ago, we were chatting before the debate and he was so charming and friendly that I realized I needed to step away, otherwise I was going to be a softie in this debate. The MMTers can say, “But regarding the issue of you right-wingers, not just the Austrians, but the Glenn Beck and Bill O’Reilly types of the world were warning since 2008, look what the Federal Reserve is doing and the dollar is going to crash. Some people were even using terms like hyperinflation, talking about the Weimar Republic and wheelbarrows. None of that happened, so how long are you guys going to continue to be wrong, talking like that?” I would say, on the one hand, yes, that’s a reason people should be careful and not throw out wild predictions, and I myself have made some predictions that turned out wrong and then I have to bear the brunt of that.
But, beyond that, if we are in an environment where the demand to hold money goes up, prices would have come down. Part of the problem is that people who had savings, they would have seen those savings having much more purchasing power than they do today. It’s really an issue of it’s a counterfactual relative to what otherwise would have happened. It still is true that by the Fed creating such and such more dollars, the purchasing power of the dollar is lower than it otherwise would have been, even though yes, measured in absolute terms, gasoline is not $20 a gallon right now. It’s also true too that by the Fed creating this money, it’s redirecting resources in the political channels.
Let’s use an analogy. If you found out your neighbor down the street was using his color printer to print out authentic-looking $100 bills, he’s been doing it for years, and that’s how he has nice cars. That’s how he goes on these vacations he’s telling you about. That’s how he can afford to dress impeccably. It would be silly for him to exonerate himself and say, “Did the economy crash, is gasoline $20? No, so stop blaming me; you can see nothing bad happened.” That wouldn’t be the issue, right? Can you understand why in that context, it’s the same thing economically? Just as I wouldn’t want my neighbor to have that ability, I don’t want Federal Reserve officials to have that ability either.
JD: Let’s talk about interest rates. Since 2008 and this period of extraordinary monetary policy, really since the Greenspan era, interest rates have been driven relentlessly lower. We’re now in a bizarro world where maybe a third of European sovereign debt is nominally negative. Nobody can make any money on a CD or simple savings account. What the hell is going on with interest rates?
BM: This is an area too where the economists have egg on their faces and I don’t just mean Austrian or conservative ones. Even Paul Krugman. They were matter- of-factly explaining: Nominal interest rates can’t go below zero because people would just switch to holding cash and that’s why once the Fed’s policy rate gets close to zero, we need to switch to other unconventional things or have deficit spending. The negative nominal interest rates shocked a lot of economists across the spectrum, because they had been teaching their students for years that it was literally impossible and then once it happened, the economists had to scratch around and say. That’s because in large institutions, to actually hold that much cash, you’d have to insure it and what are you going to do, put it in a safe deposit box? Once the impossible happens, economists are good at after the fact explaining why it happened and criticizing people who have, in their view, silly explanations.
But, it’s not that I saw negative nominal interest rates coming. I certainly think central banks have a lot to do with it, so to the people who argue to the contrary and say, “No, the Fed and ECB (European Central Bank) are just following the market down,” well, in one sense I want to say: then you should have no objection to the Fed and the ECB just liquidating their holdings and selling their assets, right? Because according to you, that’s not going to make interest rates go up. And usually they say, “No, that would make interest rates go up and that would crash everything. That would be a crazy policy to have such a restriction.” Usually when you push that they will admit yes, central banks and their policies have had something to do with lower interest rates. One of the points of QE was to lower long-term rates, because they were saying short-term rates went down to zero. Basically, that wasn’t enough, so now the Fed needs to intervene and try to push down long-term rates in order to stimulate spending, from a Keynesian perspective. Even the people pushing these things do admit, either explicitly or implicitly, the low nominal interest rates at least have something to do with massive central bank action.
Partly why it’s happened is people are so panicked. That right now, there’s such uncertainty and desire for perceived safety that people are willing to just sit on earning basically nothing with government debt. Especially if it’s from the US or the Japanese government, that’s perceived as being very safe in terms of they’re not going to default on the bond, even if they’re earning nothing or even if they’re earning slightly negative— even in nominal terms. But that’s not a natural evolution of capital. That’s not because the Chinese are saving so much. That’s because there have been these crazy business cycle swings, which, in the Austrian perspective, is because of massive central bank intervention. Ultimately, I would say it’s the central banks and their policies that have led us to this position, directly because they’re monetizing debt and pushing down interest rates and indirectly because they’ve caused the massive uncertainty that’s causing people to be so fearful that they want to have huge holdings in ostensibly safe assets.
JD: You mentioned some economists who say “Central banks don’t much matter; this trend was happening anyway.” But people like former Fed chair (now Treasury secretary) Janet Yellen also warn there are limits to monetary policy. The term is pushing on a string. There’s only so much monetary policy can do. What have these ultralow interest rates done for us?
BM: I agree that the ultralow interest rates have not done anything benign or good for us, that they present a problem. Somebody from a Yellen perspective or a Paul Krugman, what they mean when they talk like that is to say, “We can go ahead and push down interest rates, like I say, down to basically 0 percent and then we can engage in QE, even, and try to raise inflationary expectations in the future.” And the reason for doing that is to lower the real interest rate. So they’re saying once nominal rates get to zero (and yeah, they actually could go slightly negative, but they couldn’t go to –10 percent in nominal terms; even money market funds would switch to hold cash), how do you lower the real interest rate? You’ve got to raise expectations of future price inflation so that in real terms even a 0 percent nominal rate translates into –10 percent.
But, they’re coming from a Keynesian perspective when they talk like that. They think what you want to do is make people want to consume or invest now and the way you do that is you lower real interest rates. That’s the framework that they’re in and as an Austrian, I would say that that’s wrong, that interest rates have a job to do. They communicate information, if you want to use that language, and it means something. If the interest rate in the market would be 4 percent and instead it’s been pushed to zero, that’s going to screw things up. It causes the boom-bust cycle. As far as Yellen, especially now that she’s Treasury secretary, what they’re trying to get at is, there’s only so much the central bank can do. Once we’ve done all that and we’ve run out of ammo, it’s up to the fiscal policy to go ahead and run big budget deficits. So again, I think that’s totally wrong, what they’re saying, but that’s what they mean, because in their framework, what you do is you lower interest rates to stimulate spending, to fill aggregate demand. They’ve lowered interest rates, all right, and we’re still in a bad economy, so you can see how from their perspective, let’s try something else, then.
JD: Maybe it’s a political deflection on her part. But conceptually, axiomatically, we know nobody would loan you $100,000 today in exchange for a payment of $90,000 two years from now. Interest rates are supposed to be positive.
BM: Right. One way of putting it is look at the extraordinary circumstances that had to exist to explain why the Bank of Japan and maybe the ECB were considering this scenario. If you keep money on deposit with us and then you pull it out, they’re going to then charge you interest retroactively. I’m making these numbers up, but if they wanted to have a –10 percent rate and you pull out half your money, then they would actually ding the remainder that you left on deposit double that, so that you’re not gaining by pulling money out of the system. I’ve seen plans in place, I think it was in Japan, to avoid precisely that. That, if we wanted, if our policy rate were to be excessively negative in nominal terms, such that everybody would switch to holding physical currency, we’re going to set things up to ding you for that, to look at what your historical balance has been over the last five years to make it so that you don’t have the incentive to do that. They are setting that up so that they can get away with doing that, and that’s partly why there’s this push to get rid of cash, because that’s ultimately the way to protect yourself. I can hold a currency and earn zero percent in nominal terms in a safe in my house and so if they can get rid of currency so it’s all electronic, then you can’t even do that. You’re right, thinking through the logic of it in normal circumstances, why wouldn’t you just hold actual money if the banking system’s paying you negative nominal rates? There is a sense of that’s crazy and it can’t be a normal outcome.
JD: As an aside, it’s pretty remarkable how Mises’s Theory of Money and Credit from 1912 has held up. If you want to understand interest rates, go read that book.
BM: As you know, a few years ago the Mises Institute commissioned me to produce a study guide for that book. I had to reread it and sort of the old joke about when I was younger my dad was an idiot and then I grew up and I realized how much smarter he had become or wise. It was the same sort of thing—I had read it in grad school, and then having read it years later to do the study guide, I realized, Mises just has offhand remarks about all sorts of things like forex speculation and derivatives markets, and things like that, calls and puts, I think. It is interesting to see how much he really was a great financial economist. He understood modern money and banking and financial markets of his day and handled them as a brilliant theorist.
JD: There’s a lot of mainstream talk today about inflation. I wonder if that’s another concept, another term, where we have lost any agreed-upon definition.
BM: Right. Mises, famously, complained about— this was like the midcentury in terms of the US—he complained to an American audience saying how it used to be in the early 1900s, that everybody knew what inflation meant, it was an expansion of the quantity of money stock and/or the credit that the banks made available. And so, inflation had the inevitable consequence that prices quoted would go up, but inflation meant—just picture inflating something—a quantity of money would be inflated. That’s where the term came from, and he said, but now, over the decades, it has been changed—and again, he’s speaking in the 1950s— what the public thinks inflation means is rising prices. And that’s unfortunate, he said, because it’s now mistaking the symptom for the cause, and you can’t fight it if what you think the thing is is actually just a symptom. He said we have this perverse situation where the people causing the inflation are posing as the people protecting the public from inflation, which is crazy.
Since 2008, with all the massive monetary inflation that we’ve seen and with the rise of the internet and financial commentary by people outside the accepted gatekeepers, there’s been a resurgence and interest in that definition. Nowadays more people understand this huge expansion of the monetary base and look at the Fed’s balance sheet, look at all this inflation, and yes, it hasn’t shown up yet in prices at the grocery store necessarily, but look at all this inflation that’s now been pumped into the system. A lot of “regular people” who are not ideological and not steeped in the Austrian school understand that sort of language, and so we’re seeing a return to that.
But you’re right, there’s not an agreement on what does inflation mean and even in terms of looking at prices, the standard definition, it’s a very narrow basket of consumer goods. What if stock prices triple? Why isn’t that considered inflation, especially if the reason they went up is because the Fed created a bunch of money? What if real estate prices go up? People have to buy houses. It’s weird distinctions that they’re making: whereas the rental price, how much you have to pay to rent an apartment, can go into the cost of living index but if the price of a regular house goes from $200,000 to $400,000, that’s not considered that the cost of living has gone up, or at least it’s not that per se. You’d have to do implicit rental prices and whatnot. It is right that there is some disagreement, but I think it’s a healthy thing. At least, because the old consensus of two decades ago was wrong, or was harmful, at least now the fact that there’s some confusion is a sign of improvement.
JD: Just the other day Jerome Powell said that there is effectively no link between M2 and inflation. It feels like the Fed is going to do this forever. They’re going to do whatever is required to maintain at least the nominal price of equity markets. They’re going to keep interest rates low forever. They’re going to have “easy” monetary policy forever. But surely this can’t last forever?
BM: To elaborate a little bit on what you were saying with Powell, the Fed, they’ve been very slippery and so, it was true, like in 2008–09, when people like me, for example, or Peter Schiff, were warning about, look at this QE program, this is crazy. This monetary inflation will lead to price inflation. And the critics would say, “No, go look at CPI. Come on, you guys are crazy.” CPI’s just doing its thing, and then CPI starts rising and they say, “The Fed’s preferred measure is the Personal Consumption Expenditure Index, or, of course, CPI, let’s strip out the volatile food and energy price,” and they keep doing these redefinitions of things. Whether you’re looking at headlines, CPI, or even core CPI or personal, depending on each one, it’s going back ten, twenty years, and it’s the highest it’s been in thirty years. And it’s way above the Fed’s own stated target—and it’s funny, the headlines say things like, “Powell Sticks to the Script on Inflation,” like they’re not saying it as a conspiracy. I’m not saying Zero Hedge, I’m saying CNBC. The way they describe it is Powell’s got his script and he knows: Right now our position is inflation’s not a big deal. And so even though, according to their own metrics, it’s finally bouncing above what they’re saying the target is, we’re not going to tighten, because we think it’s transitory.
You’re right, they’re going to keep doing this until it’s so calamitous that even they can’t pretend that this is just a temporary blip. We’ve seen used car prices up over 50 percent year over year. They’re going to be able to blame it on the pandemic and just say, “No, that’s because of supply chains.” But eventually, you keep seeing numbers like this, they’re going to have to deal with them and at least make it look like they’re tightening. But they’ve painted themselves into a corner, like you say, now, financial markets are utterly dependent on the Fed being willing to come in and buy $50 billion plus of assets per month. The Fed needs to stop doing that because even they can’t ignore the warning signs in terms of standard prices that households face, then you’re going to have another major financial crisis.
JD: It is not just banks who are dependent on low rates, but also Congress itself. If average Treasury rates rose to historical averages, say 5 to 8 percent, debt service quickly becomes the single biggest federal budget item every year.
BM: Right, exactly. At Mises University, I had a chart in my talk recently just showing the metrics of the CBO (Congressional Budget Office)—as they describe it, the nonpartisan CBO. And they’re pretty good.
JD: Yes.
BM: I said that as if it was ironic, but no, even some of them would email me about things, areas like climate change and economics, when they were doing carbon taxes. So, yes, they want to at least be fair, or at least the people who were running it the last ten years that I’ve interacted with. But they’ll have charts of the US debt as a fraction of GDP. In the forecast, I’ll show it just going up and up and up, and that’s because, number one, you have demographic shifts, in terms of Medicare and Medicaid. You also have interest rates rising just a few percentage points, back to not even historic levels, but 1980s levels, even 2005 levels—then debt would be devastating in terms of the annual cost of servicing it, because there’s so much more outstanding nominal Treasury debt now compared to ten years ago. The reason it doesn’t feel so painful is because the yields on those Treasurys have been close to zero. And, that’s why you can get away with issuing trillions more in debt. But if those numbers go up, you’re right. If the Fed were in a position to maintain sanity in terms of purchasing power and to stop the runaway spiral in price inflation they were supposed to jack interest rates up to 8 percent; that would cripple the financial integrity of the US government. They are painting themselves into a corner where my guess is they’re going to do a little bit of both—let the dollar lose a lot of its value vis-à-vis other currencies and have the federal government’s finances get really hammered where we can pay for some of the entitlements and servicing the debt and that’s about it.
JD: We worry a lot about what Congress is doing and spending. We worry a lot about what the Fed’s doing. We worry about commercial banks responding to what the Fed’s doing. But in your forthcoming book you have an entire chapter devoted to shadow banking— carried out by nonbank lenders. What is shadow banking and should we be concerned about it?
BM: The term, as it suggests, is transactions happening in the shadows. These transactions, they serve the same economic function as traditional bank lending, but don’t operate through formal banks. If there’s any kind of private entity that raises capital and then goes around and funds ventures and things like that, that’s a way of ultimately linking savers and borrowers in a nexus that falls outside the traditional banking sector. Broadly speaking, that’s what shadow banking refers to.
The conventional reason, by the standard establishment types, they’re saying, After the 2008 crisis, we had Dodd-Frank (Dodd-Frank Wall Street Reform and Consumer Protection Act) and we can beef up the SEC (Securities and Exchange Commission). The Federal Reserve can go ahead and beef up regulations all they want, but that’s really clamping down on traditional banks. They look at investment banks, but that just pushes more people into the shadow banking sector, where we can’t regulate. So they use it as calls to have broader regulation and whatnot.
From my perspective, it is concerning because by its very nature, it’s hard to quantify this because it’s all kinds of things that don’t get reported on by the main government statisticians, and it’s hard to get data on this, but certainly those types of financing mechanisms have become more prevalent. The problem is, for example, that an institution, they owe people a bunch of money, but they’re saying, These other people owe us money. And so, those webs get pyramided on top of each other. That shows how if there’s a crisis in one area, they can all of a sudden have this domino effect elsewhere. You partly saw that in the 2008 crisis, that it wasn’t the fall in mortgages per se that caused the problem, it was the people that had put out things that would make you whole if your mortgages went down and that was even just a margin call. So, these were the chain reactions that made the mortgage-backed securities markets seize up.
That’s the concern that I have: there’s a sense in which the financial sector globally is intertwined and people are engaged in a lot more leverage, and even conventional metrics might miss some of this, and if a crisis breaks out even in one localized area, that could quickly spread, because people don’t fully realize how vulnerable the whole system is.
JD: How much off-balance-sheet debt is out there? Maybe there are trillions of dollars in exposures which don’t show up in our traditional measures of sovereign, corporate, household, or individual debt.
BM: I think that’s true. When I was doing research for the chapter you’re talking about in the book, it was surprisingly hard to pin down. I can see studies that look at this chart, but the problem was that they each had their idiosyncratic definitions as to what are we including in this metric.
JD: How much debt is in the world?
BM: If I have a $200 tab at my local bar, does that get counted? There’s lots of things like that that are more formalized, of course, but it’s ultimately how much do people think other people owe them, and there are different degrees of legality. Then who are you reporting that to? It’s not as easy to measure as how much outstanding Treasury debt is there.
What about what the federal government implicitly has promised current workers? When you retire, we owe you these benefits of social security. Well, that’s not a legally enforceable claim, but yet usually that gets counted in terms of the federal government’s liabilities, broadly considered. You’re right that there’s these different levels. Or if privately held companies have understandings with others, they could be formal contracts, but if nobody has access to that because they want to keep this secret, there could be all sorts of debt claims people hold against each other that aren’t showing up in our statistics.
And to the extent that there’s more regulation reporting requirements and there’s less privacy in the official channels, that’s made people go more underground, and especially with crypto, it’s becoming easier and easier for people to deal with each other financially in ways that do not show up in the public ledger. It’s true that these claims have grown, but by their very nature, it’s hard to quantify that. So how much? I don’t know because that’s kind of what we’re talking about; it’s in the shadows.
JD: It’s not always shadowy. Maybe the biggest nonbank lender in the United States is Quicken Loans, but we don’t think of them as nefarious. And they might seek out a political bailout from Congress if housing markets go south, but unlike commercial banks they can’t go to the Fed and get dollar reserves for their junk assets.
BM: Right.
JD: So maybe we should champion them.
BM: I use the term shadow banks just because that’s the term that’s thrown around, but you’re right. Like I said, a lot of times when you hear people discuss this, it’s from the perspective of people who don’t trust it. Unless the SEC and the Fed are involved, we can’t trust this. So, you’re right, it’s in the shadows should not be taken to mean there’s something illicit about it. I am in favor of financial transactions that are more just person to person and entity to entity and the government’s not involved. Unfortunately, though, like you said, the Fed has expanded the sorts of activities that it can dabble in, and that does mean that the bigger the sector, the more that people could argue these groups are too big to fail. Until the point at which the dollar starts really crashing, why wouldn’t the Fed come in and buy that up and rehabilitate that market?
JD: I want to finish by talking about bitcoin. You wrote Understanding Bitcoin: The Liberty Lover’s Guide to the Mechanics and Economics of Crypto-currencies in 2015. What prompted you to write that book, and have your thoughts on bitcoin changed or evolved?
BM: I want to mention my coauthor, Silas Barta. He was a person who had an early mining rig before I even understood what that term meant. He was into bitcoin and he helped in terms of the math.
JD: He’s currently filthy rich on a private island somewhere?
BM: I don’t know. I know he can pick and choose when he works, but I don’t know how much he actually held. Why I wrote the book, to answer your question, when bitcoin first came out, people were telling me about it, and I looked into it and did a lot of research. It’s a cool thing. I wasn’t into it so much at the beginning. As I got more and more into it I could see there was a group of people who knew about economic theory, monetary theory, and there was a group of people who understood public and private key encryption and Satoshi’s white paper, and there was very little overlap between those two groups. The monetary economists were talking about bitcoin in ways that were not right because the bitcoin community was saying, “No, you’re making false statements about how bitcoin works.” But then at the same time, the people who knew how bitcoin worked in terms of the mechanics of it would then say, “It’s the money right now and it’s the best currency,” and the economists would say, “No, that’s not how money works. You’re talking about money improperly.” That was the rationale for the book I wrote with Silas Barta, to give a framework. This is how bitcoin works mechanically and then in terms of how you would place this inside standard monetary theory in the Austrian tradition. This is how you would do it. I was just trying to clarify the terminology so those two groups could talk to each other and not make the other think they were idiots because they were making a basic mistake in nomenclature.
JD: Do you view bitcoin differently today? Seven years in bitcoin time is like seven hundred.
BM: Exactly. We were very careful in that book to say over and over we’re not telling you to invest and this isn’t saying it’s a good speculative asset. We are not talking about whether, measured in dollars or some other currency, bitcoin’s going to go up or down. We’re just explaining to you the mechanics of it. That was partly to make sure it wasn’t construed as investment advice, but also it was because I was more agnostic at the time.
Having seen it continue to grow, having seen massive price dips and people numerous times go, “Bitcoin’s dead, told you so,” and then it comes back and hits new highs. I now am comfortable saying in the year 2100, for example, people will still be checking the bitcoin blockchain. Some of it will be lost—people lose their private keys—and people will still know who holds it. I don’t necessarily think it will be a huge player in international commerce. It might be something akin to having big bars of gold right now, in that people know who owns them, but it’s not that those gold bars right now are the centerpiece of global transactions.
I’m not saying bitcoin is going to still be the primary cryptocurrency, but I do think people will hold it, whereas probably back when we wrote that guide I would not have been so comfortable saying that. I’ve seen enough now with the explosion of market caps and various types of cryptos to think that it is here to stay. It’s not that crypto’s going to disappear in ten years and people are going to look at that as a fad. That’s my view at the moment, and probably I’m more comfortable saying that now than I would have been back in 2015.
JD: Final question. What is the endgame? Does the US dollar get unseated in our lifetimes? How does all of this debt and monetization come to an end?
BM: I think it was Jim Rogers who said that the nineteenth century was the British century, the twentieth was the American, and the twenty-first is going to be the Chinese century, and I think that’s true. Given what they’re doing with the dollar, the only thing that’s going to make Federal Reserve officials pull back on how many dollars they’re creating is a massive crisis. Once that happens, they will be chastened, and maybe they’ll save some face, but I don’t think the dollar is going to reemerge as the global world’s reserve currency, with the prestige it had circa 1965. I don’t think that’s going to happen partly because the US’s prestige on the world stage is shrinking in many metrics and what the Fed’s been doing has been very irresponsible. It’s been coasting on its reputation.
If a South American government’s central bank had done the things the Fed has been doing, their currency would have crashed long ago. Speculators would have dumped it, saying this is reckless. The Fed gets away with it because people think, Come on, this is the Americans. They can’t be that foolish. Surely, if things start to get out of hand, they would quickly reverse course, and with what they’ve done now, that’s not going to be possible. That’s a long way of answering your question. Thirty years from now, I think the US in general is going to be a much smaller player in global affairs. There might be a basket of currencies that the IMF (International Monetary Fund) discusses, with SDRs (special drawing rights), or the World Bank, and the dollar still might be a big component of that. But in terms of is the dollar going to be viewed as the world’s reserve currency, no. In thirty years, I don’t think people will talk like that at all.
JD: Thanks very much, Bob Murphy.
BM: Thanks, Jeff.
The gold standard supposed a limit to the fiscal voracity of governments, and suspending it unleashed the perverse proclivity of the states toward indebtedness and to pass the current imbalances on to future generations.
Original Article: "The End of the Gold Standard. Fifty Years of Monetary Insanity"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Abstract: Recent debates in monetary theory have centered on so-called free banking and the role of banks in providing money in the form of fiduciary media in a pure market economy. This paper examines how and to what extent fiduciary media can emerge in a pure market economy. Based on the theory of value, it is argued that those economists are mistaken who claim that money substitutes must in all cases be interpreted as being money titles. Those economists too are mistaken, however, who claim a large role for the circulation of fiduciary media in a pure market economy. It is argued that holding fiduciary media in one’s cash balance is an entrepreneurial error, as fiduciary media by their nature do not have the qualities people demand in holding money. Money is the comparatively most certain good and the present good par excellence, qualities that fiduciary media do not have. Holding fiduciary media instead of money is therefore an entrepreneurial error, and like all errors in the free market, it will tend to be eliminated in the process of entrepreneurial profit and loss, leading to the virtual disappearance of all fiduciary media from the market economy.
JEL Classification: B53, E22, E51, G21
Kristoffer J. Mousten Hansen (kristoffer.mousten_hansen@uni-leipzig.de) is research assistant at the Institute for Economic Policy at the University of Leipzig.
The author would like to thank Mr. Karras Lambert, Dr. Tate Fegley and Dr. Karl-Friedrich Israel for comments on an earlier draft of this paper, as well as Dr. Salerno, Dr. Thornton, Dr. Newman and the other participants in the 2020 Mises Institute Summer Fellows’ Seminar, where an earlier version of the paper was presented, and the participants in the session on institutional analysis of the 2020 Southern Economic Association meeting. Two anonymous reviewers also provided helpful comments that significantly improved the paper. The final version was completed during a stay as visiting fellow at the American Institute for Economic Research, whose support is gratefully acknowledged.
There has in recent decades been a fierce debate among economists and monetary theorists following in the footsteps of Ludwig von Mises between the so-called free banking school, which admits a large role for fractional reserve banking in the monetary system, versus what we here will call the full-reserve school, which denies any social benefit from fractional reserve banking and the issuance of fiduciary media. A lot of the controversy has centered on whether fiduciary media—money substitutes not covered by reserves—are fraudulent or not, and therefore whether they are at all legitimate in a pure free market based on complete respect for property rights and freedom of contract.
In this article the issue of fraud will be sidestepped and the focus will be on the question of the emergence of fiduciary media in a pure market economy, where all men and institutions, and specifically all banks, are subject to “the rule of common law and the commercial codes that oblige everybody to perform contracts in full faithfulness to the pledged word” (Mises 1953, 440). In particular, there would be no legal tender laws, no deposit insurance, and no central bank acting as lender of last resort. In such a free market order, a bank that failed to honor its contractual obligations would be treated no differently from any other company or person that failed to do this.
If fiduciary media would naturally emerge in such an order, this would prima facie be evidence that they are compatible with it. Mises, despite his hostility to inflation and credit expansion of all kinds, nevertheless suggested that the use of fiduciary media would be a part of a free banking system absent government interventions (Mises 1998, 440; my italics):
Free banking [i.e., banking subject to the commercial codes etc.] is the only method for the prevention of the dangers inherent in credit expansion. It would, it is true, not hinder a slow credit expansion, kept within very narrow limits, on the part of cautious banks which provide the public with all information required about their financial status.
The free bankers have gone further than this and argue that the use of fiduciary media is beneficial to the economy; while the full-reserve school, pursuing the economic analysis of Mises critical of inflation and credit expansion, have often assumed the position, following the example of Murray N. Rothbard, that fractional reserve banking is a harmful institution and must be outlawed wherever it appears in the free market, since money substitutes are interpreted as titles to money and fiduciary media are by this definition necessarily fraudulent (Rothbard 2009, 2008; Huerta de Soto 2009; Hoppe 2006a, 2006b; and Bagus, Howden, and Gabriel 2015).
It is this article’s contention that the full-reserve theorists are mistaken when they insist that money substitutes must be interpreted as always being money titles, as this is at odds with the theory of value. A callable loan, for instance, could become a fiduciary medium if it is judged to be just as certain and serviceable as money proper by acting individuals. The free bankers too, however, are mistaken when they claim a large role for the circulation of fiduciary media in a pure market economy. It will be shown how it is fundamentally erroneous to consider a mere unbacked claim on a person or an institution as equivalent to money. The error consists in mistaking a future good, or a claim to a future good, for a present good, and in mistaking an unsafe asset for the comparatively safest good, viz., money. As all other errors in the free market, the error of mistaking fiduciary media for fully backed money certificates will tend to be corrected in the process of entrepreneurial profit and loss, leading to the virtual elimination of all fiduciary media from the market economy.
Thus, it will be argued that the full-reserve theorists are correct in asserting that fractional reserve banking has no role to play in the free market, since only by an error of judgment would anyone accept fiduciary media as money. Rather than encouraging the use of fiduciary media, the free market and free banking would correct such errors, leading to the virtual suppression of fiduciary media.
A Note on Definitions In this paper we will take the approach to monetary theory developed by Ludwig von Mises for granted. As already noted, Mises’s influence on both free-banking and full reserve theorists is apparent, but his monetary theory is also the one that best elucidates the economic facts. Specifically, the classification of money in the narrow and the broader sense that Mises (1953, 50–59; cf. Hülsmann 2012, 33–34) pioneered in 1912 helps distinguish between fiduciary media, other money substitutes, and money in the narrow sense.
Money, taken simply, is a common medium of exchange, valued for its purchasing power. If two commodities are commonly used as money, they are valued separately according to the laws that govern the value of money; they are not somehow aggregated to form one total money supply.
Money in the narrower sense, or money properly speaking, is simply the commodity used as money. Under the gold standard, physical gold was money in the narrow sense. In the modern economy, physical cash is money in the narrow sense.Reserves with the central bank might also be considered money in the narrow sense, despite their character as claims on the central bank, because there is no doubt that the central bank, empowered with the ability to create physical cash at will, will always be able to honor these claims. I thank an anonymous reviewer for pointing out the special case of central bank reserves.
Money in the broader sense is perfectly secure and instantly redeemable claims to money in the narrow sense. They can be used in commerce in exactly the same way as money is. “A claim to money may be transferred over and over again in an indefinite number of indirect exchanges without the person by whom it is payable ever being called upon to settle it.” (Mises 1953, 50). The reason for this is that money is not consumed or “used up” in the way that other goods are. Simply by possessing money, the individual gains all the services that money can render, and hence fully secure and present claims to money will be deemed equivalent to money in the narrow sense. Money in the broader sense is more usually referred to as money substitutes and can be further subdivided into money certificates and fiduciary media.
Money certificates are claims to money that are fully backed by money in the narrow sense. E.g., a bank that held physical cash for the full amount of its outstanding demand deposits would only issue money certificates. This would clearly only be a change of the form, not the substance, of money, and issuing money certificates would have no influence on the money supply.
Fiduciary media are claims to money that are not fully backed by money. Commercial demand deposits are nowadays the prime example of this, but historically private banknotes too were fiduciary media. These claims are used as if they could be instantly redeemed, but in reality the issuing bank only ever keeps reserves on hand to be able to redeem a fraction of its issue of money substitutes. Fiduciary media can take the legal form of warehouse receipts, titles to money, and callable loans, that is, instantly redeemable claims on a person or bank such as demand deposits.
Since an issue of titles to money or warehouse receipts in excess of what is kept on reserve is clearly fraudulent, this case will not be considered. This article will deal exclusively with fiduciary media in the form of callable loans. Every time the terms fiduciary media and claims to money are used, they will refer only to callable loans.
It is important to note that the individual holding a money substitute cannot tell whether it is a money certificate or fiduciary medium. This distinction can only be made on a systemic level, as an outsider looking at the economy. To the individual person holding money, the money substitute must have the status of a money certificate, he must be certain of the issuer’s ability to redeem it on demand, since, as Jeffrey Herbener has noted (2002, 83), “people only demand money-substitutes, not fiduciary media, and their demand exists only when they have confidence in full redemption.”
The reader will excuse this brief outline of the basic definitions in the Misesian system. Most of it should be familiar to monetary theorists, but since the argument made here hinges on a clear understanding of the relation between money and fiduciary media, it was thought expedient to include this brief synopsis.
THE FREE BANKING SCHOOL AND THE FULL RESERVE SCHOOL There are two fundamental positions in the debate on the status of fiduciary media: the free banking school and the full reserve school.The full reserve school could also, following Salerno (2012b, 100), be called the neocurrency school. The free bankers believe that fiduciary media are a useful part of the money supply, and that no fraud is necessarily involved in issuing them. What is here termed the full reserve school is of the opposite view: fractional reserve banking is necessarily fraudulent, and not only is it not beneficial, but the use of fiduciary media is positively harmful, as it causes inflation, Cantillon effects, and the business cycle. While these controversies have a long history reaching back into the nineteenth century and the great British monetary debates (cf. Smith 1936), the current debate among modern Austrian and Austrian-inspired economists began in the wake of the contributions of Ludwig von Mises.
Murray N. Rothbard can be considered the founder of the full reserve school. He first clearly advanced the position that all fiduciary media are necessarily fraudulent, as he saw all money substitutes as titles to a sum of money (Rothbard 2008; 2005). He also categorically denied any economic advantage to society as a whole from the use of fiduciary media, and considered their use the basic cause of the business cycle as well as the problems of inflation (Rothbard 1963, 34–36). Other full reserve theorists follow this basic framework. Jesús Huerta de Soto has argued with a foundation in Roman law that money substitutes are a type of irregular deposit and therefore cannot be increased beyond the amount of money on reserve (Huerta de Soto 2009, 1–36, 119–24) and he too considers the elasticity introduced in the money supply by their use as central to understanding the problems of the business cycle. Hans-Hermann Hoppe (2006a, 2006b) clearly enunciates the Rothbardian position, for instance when he writes (2006b, 200):
Freedom of contract does not imply that every mutually advantageous contract should be permitted. Clearly, if A and B contractually agree to rob C, this would not be in accordance with the principle. Freedom of contract means instead that A and B should be allowed to make any contract whatsoever regarding their own properties, yet fractional-reserve banking involves the making of contracts regarding the property of third parties.
While Robert P. Murphy too belongs to the full reserve school, he has avoided engaging the question of legality in his recent contribution (Murphy 2019) and has focused exclusively on the issue of distortions introduced by fiduciary media and fractional reserve banking. Philipp Bagus, David Howden, Walter E. Block, and Amadeus Gabriel (Bagus and Howden 2010; Bagus, Howden, and Block 2013; and Bagus, Howden, and Gabriel 2015) have entered the ranks of the full reserve school as well, arguing for the impermissibility of fractional reserve banking for involving a confusion between deposits and loans.
Joseph T. Salerno (2010) and Jörg Guido Hülsmann (1996, 2003a) are also here placed in the full reserve camp, although their positions differ slightly. On the one hand, Salerno is fully in agreement with Rothbard when he says that “the 100 percent reserve requirement is not arbitrarily imposed from outside the market, but is dictated by the very nature of the bank’s function as a money warehouse” (Salerno 2010, 362); on the other, he allows that in a fully denationalized system, the shares of banks or money funds that invest part of their “reserves” could become the predominant means of payment in the economy (Salerno 2010, 364). Hülsmann for his part allows for the possibility of “callable loans plus a redemption promise” (IOU + RP) circulating on par with money proper (Hülsmann 2003a). Both clearly, however, see no social benefit from stimulating the issue of fiduciary media and both think that it is a historical truth that the vast majority of actually circulating fiduciary media were and are fraudulent, which is why they are decidedly in the ranks of the full reserve school.
The free banking school takes its modern beginning from the works of Lawrence White and George Selgin (White 1995, 1999; Selgin 1988; and Selgin and White 1987, 1996) and also includes economists such as Kevin Dowd (1993), Larry Sechrest (1993), and Steven Horwitz (2000). The point at issue here, the possibility of fiduciary media in a free market, is a key component of free banking theory, and has been defended at length by the free bankers. Their basic claim is that the issue of fiduciary media can take the legal form of a loan or a note with an option clause. Historically, White (2003) has claimed that banknotes indeed took the form of a loan, not a title of ownership to underlying money. This is a strong argument against the full-reserve school’s insistence on interpreting all money substitutes as ownership titles.
The free bankers argue that a free banking system is based on freedom of contract, and therefore interfering with and redefining contracts between banks and their customers, changing loans into warehouse receipts, would be incompatible with the system (Salin 1998) and an unwarranted imposition of the economist’s own ethical judgments on other people (Rozeff 2010). Banks and their clients would be free to make whatever contracts they want, and fractional reserve banking would arise from their free agreement. Selgin (2012) and Evans and Horwitz (2012) have also answered the critiques raised by Bagus and Howden of the free banking position. Selgin in particular argues that the attempt to identify free banking theory with the real-bills doctrine is misguided and that full reserve theorists are wrong to claim that free bankers “confuse an increase in the demand for money with an increase in the overall extent of saving” (Selgin 2012, 139). Selgin here also makes the point, previously made by Hülsmann (1996, 34), that although aggregate demand for money is not the same as the public’s willingness to save and invest, demand for money to hold is a kind of saving. Selgin disagrees with Hülsmann, however, as Selgin (2012, 139) argues that demand for inside money—bank liabilities—is also a supply of savings for investment, whereas Hülsmann sees it as a form of plain saving.
MONEY AND FIDUCIARY MEDIA Clearly, the point at issue is whether callable loans can come to circulate as fiduciary media spontaneously in the free market. Issuing titles or warehouse receipts to more money than the issuer has in his reserves would be fraudulent and therefore ruled out by definition in a pure free banking system, where all must honor their contracts and banks benefit from no special privileges (Mises 1998, 437–41), but it is by no means clear that issuing callable loans would be. Although borrowing money at call and investing it in longer-term loans and securities might be seen as an extreme case of maturity mismatching, this practice is not in itself illicit (Bagus and Howden 2009). On the contrary, there seems to be nothing in this practice at odds with respect for property rights and freedom of contract. It might be a very risky kind of financial practice, and the investor in callable loans would probably expect a return commensurate with his assessment of the risk involved; however, that does not make it illegitimate. But does it mean that such loans can come to form part of the money supply?
In order to solve this question, we will adopt Hülsmann’s (2003a) idea of a callable loan plus redemption promise as our starting point.White’s (2003) criticism of Hülsmann, that banks don’t promise to pay but contractually obligate themselves to pay is, for our purposes, immaterial. What matters is how these claims are appraised by the acting individuals who possess them, not their legal nature. Hülsmann argues that the source of fractional reserve banking is to be found in a confusion between money titles and what he calls IOUs with a redemption promise. If this confusion did not exist, the IOUs could not circulate as part of the money supply, and the only money substitutes would be money titles. However, Hülsmann does not explain in depth why callable loans could not circulate as money substitutes absent this confusion. In order to do this, fiduciary media will have to be linked back to the laws of value governing money as well as all other economic goods.
Carl Menger first described the prerequisites for a thing to become an economic good (Menger 2007, 52ff.), a description that Mises later amended in order to emphasize the subjective nature of all value and, hence, of economic goods (Mises 1998, 120–21). All that is necessary for a thing to become an economic good is that the acting individual believe that control over it will help him attain his goals; it is his subjective judgment of the suitability of a thing for satisfying his wants that confers value on a good. Man’s judgment may be erroneous, and he may find from experience that he was wrong in judging a certain thing capable of helping him attain his ends, thus realizing that it was only what Menger termed an imaginary good (Menger 2007, 53–54), but until the actor in question revises his judgment, the thing in question will continue to be a good for him, no matter what the objective facts of the case may be.
Incorrect judgments are usually corrected when the actor is confronted with reality, as can easily be seen in the case of consumer goods and producer goods. For consumer goods, this happens when the individual realizes that he does not attain the end he thought he would by using it; e.g., when a man discovers that sea water is not good drinking water. For producer goods, an erroneous judgment concerning a good will be corrected when the production process in which the good, mistakenly thought to be suitable in this production process, was employed fails or at the very least does not return a product sufficient to warrant the previous valuation of the good. In both cases, what was previously considered a good immediately loses its goods character once its employment in action proves that the actor’s judgment was mistaken. Just as acting man profits from correct judgments, so he loses from incorrect ones. Entrepreneurial profit and loss is the basic mechanism that teaches man to conform his thinking and judgment to reality, as incorrect judgments and erroneous reasoning are punished and correct judgments rewarded.
The same holds true for money, although the consequences of incorrect judgments do not appear in exactly the same way. This is due to the special position of money among economic goods and the particular laws governing its value (Mises 1990). Whereas consumer goods are valued for the ends we expect to be able to achieve through their employment, and producer goods are valued for their contribution to the production of consumer goods, the medium of exchange is valued for its purchasing power. The value of money depends on the array of other goods that people expect to be able to trade each monetary unit for. It is the individual’s subjective judgment of the utility of having this purchasing power available to him.
Let us assume a society employing only gold as money, with no other media of exchange in use. In this society the acting individual will only accept pieces of gold in exchange and only consider gold pieces as part of his cash balance. Mistakes in this matter are usually quickly corrected, since it is comparatively easy to recognize and verify whether a given substance is indeed gold, and since all other people too will also only accept gold as money. A man may, for instance, think that lead is just as serviceable as gold, since it is similar to it in some respects. However, he will quickly be disabused of this notion once he tries to pay with it, since nobody else shares his peculiar evaluation of lead.
Because money is only ever exchanged, appraisals of a commodity in its role as money are never confronted with reality in the same way as evaluations of producer and consumer goods are. Whether a given commodity (or claim) is considered part of the money supply depends on how it is judged by people in the community. To continue with the example of a man who thinks lead and gold are interchangeable, if his trading partners disagree with this judgment, he will quickly realize that he was in error and that lead is not in fact gold. However, if other people accept lead as gold, lead becomes part of the money supply for as long as this mistaken judgment is not corrected. For as long as no one notices the difference between lead and gold, the money supply is increased by the addition of a quantity of lead. Widespread entrepreneurial error has led to a mistaken expansion of the money supply. Since money, titles, and claims to money are only ever exchanged and never consumed, the holders of money are never confronted with the same kind of test as owners of producer and consumer goods are. Erroneous judgments may therefore persist for longer here than in other areas of economic life. There are, however, powerful incentives at play to verify and certify the money commodity one accepts in exchange and holds in one’s cash balance. Nobody has an interest in receiving false coins or bad checks in exchange for their goods, since that would mean a heavy loss of purchasing power once the mistake is discovered. The precious metals gold and silver were selected as money to a large extent because it is comparatively easy to distinguish them from other materials (Menger 2009; and Selgin and White 1987, 440–42).
Claims to money obey the same laws of value: if they are perfectly secure and safe, they will be valued as money. In the normal course of affairs, we would expect a loan to be valued according to its maturity and its safety. Both of these factors would impose a discount, as individuals would tend to judge a loan, even if instantly redeemable, as less valuable than actual possession of the amount of money in question. This is so, since, objectively, such loans can never be as secure as money proper or fully secured money certificates—there is always some uncertainty attached to them.The only exception would be the case where the debtor kept on hand full reserves at all times. However, as just argued, the primary factor in establishing a thing as a good is the subjective judgment of individuals, and there is nothing to stop people from subjectively deeming callable loans on a par with money certificates. Therefore, they may gain the status of fiduciary media and constitute part of the money supply without any fraud or other violation of property rights having been committed. So long as claims to money are considered perfectly secure and instantly redeemable, they can perform all the functions of money in the narrow sense. Says Mises (1953, 267):
The fact that is peculiar to money alone is not that mature and secure claims to money are as highly valued in commerce as the sums of money to which they refer, but rather that such claims are complete substitutes for money, and, as such, are able to fulfil all the functions of money in those markets in which their essential characteristics of maturity and security are recognized.
There is thus no logical barrier to the acceptance of callable loans as money substitutes, since this depends on the judgment of the people receiving and holding money—on their recognizing “their essential characteristics of maturity and security,” whether those characteristics truly exist or not.
That said, this does not mean that such loans will constitute money substitutes for any length of time. First of all, the community as a whole has to accept the claim in question as a money substitute. One individual may have no doubts on the matter, as he trusts the issuing bank implicitly; but he cannot force other people to accept the claims at par value, and until they are widely considered money substitutes, they will continue to trade at a discount to money in the narrow sense. Although the clients of the same bank may treat their claims on it as equivalent to cash in their mutual exchanges, those outside the bank’s orbit may have no interest in holding claims on it as part of their cash balance.
Secondly, a claim’s character as a money substitute depends on there never being any doubt as to its safety and to the ability of the issuing institution to redeem it in full without delay. What the issuer requires to maintain his credit is a special kind of goodwill, without which the fiduciary media he has issued will immediately lose their character as money. Mises explained this very lucidly (1998, 442):
What makes a banknote a money-substitute is the special kind of good will of the issuing bank. The slightest doubt concerning the bank’s ability or willingness to redeem every banknote without any delay at any time and with no expense to the bearer impairs this special good will and removes the banknotes’ character as a money-substitute. We may assume that everybody not only is prepared to get such questionable banknotes as a loan but also prefers to receive them as payment instead of waiting longer. But if any doubts exist concerning their prime character, people will hurry to get rid of them as soon as possible. They will keep in their cash holdings money and such money-substitutes as they consider perfectly safe and will dispose of the suspect banknotes. These banknotes will be traded at a discount, and this fact will carry them back to the issuing bank which alone is bound to redeem them at their full face value.
Only if the public thinks the bank’s money substitutes are fully secure will they accept them at par with money, and only thus can they gain any circulation at all. Yet since fiduciary media in the form of loans are inherently less certain than money or true money titles, accepting them on par with money constitutes an entrepreneurial error no less than in the other cases of mistaken identity detailed above. The status of any claim as a fiduciary medium is therefore inherently perilous on the free market. As soon as the slightest doubt arises as to the issuer’s ability to redeem them in full and without delay—as soon as he loses the goodwill of the public—all his circulating notes will lose the character of money substitutes, trade at a discount to money, and return to the issuer. This process will continue until the issue of fiduciary media has been eliminated and the claims to money issued are again deemed to be fully backed.
UNCERTAINTY AND MONEY In order to understand more fully the error involved in holding fiduciary media, it must be asked exactly why people choose to hold some of their wealth in the form of money. Here the role of uncertainty is crucial. Uncertainty is here used in the sense of Mises (1998, 105–18) and Knight (1921) and distinguished from calculable risk. It is concerned with what Mises (1998, 110, 111) called case probability:
Case probability means: We know, with regard to a particular event, some of the factors which determine its outcome; but there are other determining factors about which we know nothing … Case probability is a particular feature of our dealing with problems of human action. Here any reference to frequency is inappropriate, as our statements always deal with unique events which as such—i.e., with regard to the problem in question—are not members of any class.
When dealing with uncertainty, acting man does not have recourse to the methods of actuarial science and numerical evaluation of risks. Rather, like the historian, he must use his specific understanding of what is unique and relevant in each event or class of event he is considering (Mises 1998, 58; cf. 2007):
Understanding is not a privilege of the historians. It is everybody’s business. In observing the conditions of his environment everybody is a historian. Everybody uses understanding in dealing with the uncertainty of future events to which he must adjust his own actions. The distinctive reasoning of the speculator is an understanding of the relevance of the various factors determining future events…. Acting man looks, as it were, with the eyes of a historian into the future.
Since there is always some uncertainty about the future, acting man cannot plan his actions completely and allocate all his income to purchases of consumer and producer goods. By keeping some cash on hand, acting man is better able to provide for unforeseen contingencies in the future. His degree of felt uncertainty is therefore at the root of his demand for money.
Free bankers seem to downplay the importance of uncertainty in explaining the demand for money. White (1999, 15–16, 54ff.) does not mention it in his discussion of par acceptance of bank money, and Selgin (1993, 354, 362) impatiently dismisses the idea that uncertainty could have any role in evaluating money and money substitutes, claiming that the historical record contradicts that idea. When Selgin discusses the role of trust in driving demand for money, he is exclusively talking about demand for banknotes relative to demand deposits, not demand for money proper versus money substitutes (Selgin 1988, 109). This is in clear contradiction to Mises’s basic insight that we would only hold money under conditions of uncertainty (Mises 1998, 414, 415):
Where there is no uncertainty concerning the future, there is no need for any cash holding. As money must necessarily be kept by people in their cash holdings, there cannot be any money…. On the market there is always change and movement. Only because there are fluctuations is there money. Money is an element of change not because it “circulates,” but because it is kept in cash holdings. Only because people expect changes about the kind and extent of which they have no certain knowledge whatsoever, do they keep money.
The fundamental reason for demanding and holding any money at all is that money is the most certain good. By holding money we avoid all the uncertainties affecting particular consumption goods and investment opportunities. Consumer goods are either immediately consumed or, in the case of durable consumer goods, can only be used for a few specific purposes. Durable goods are not as readily exchangeable as money and are furthermore subject to specific price risks concerning their specific market. Investment in producer goods has the same disadvantages, while investment in financial assets—shares, bonds, etc.—might be more liquid. Yet both of these are still subject to greater uncertainty and greater risk of loss than simply holding money. When people add to their cash balances instead of buying consumer or producer goods, they are thus essentially investing in reducing felt uncertainty, since money is the comparatively most certain good—its future purchasing power is less uncertain than the prices of consumer and producer goods.
This can be further elucidated by considering the quality of money (Bagus 2009, 2015): Money of high quality is such as can be expected to maintain a stable or increasing purchasing power in the future, while money of lower quality is that which is expected to lose purchasing power. On a gold standard, for instance, money production will be constrained by the same factors that constrain the production of other goods, namely the law of costs (H. F. Sennholz 1975, 47–48). Additional money will only be produced if there is a sufficient return, that is, a sufficient spread between the quantity produced (gold ounces) and expenditures (in gold ounces) (Hülsmann 2003b).
It is therefore possible to forecast with some accuracy the future evolution of gold’s purchasing power, and it is reasonable to expect it to be stable or even increase slightly, since gold production generally only increases in response to increases in the purchasing power of the monetary unit. Fiat paper money, on the other hand, is completely subject to the policies of the issuing institution, which may have to serve political interests at odds with sound monetary policy, and which may be guided according to erroneous economic principles. Even a relatively sound central bank is always at risk of being taken over by more inflationary leaders, which introduces an element of uncertainty that simply does not exist in the case of commodity money. Similarly, in the case of claims on banks there is an added element of uncertainty, since the holder of claims on the banks has to trust that the banks will always want to and be able to redeem the claims. Although this may be true under normal circumstances, it is precisely under unusual, unforeseen circumstances, when the holders of money might need their claims, that the banks are likely to default on their promises.
This is not to say that money is a certain good in some absolute sense. This would be patently false, since the purchasing power of money is always changing as conditions in the various goods markets change. Rather holding money is the comparatively most certain way of holding one’s wealth. Holding any money at all, then, is fundamentally a hedge against uncertainty (Rothbard 2009, 264–65), and adding to one’s cash balance is therefore best understood as an investment in reducing one’s felt uncertainty (Hoppe 2012; cf. Hicks 1935, 7–9), as money provides the service of immediately available purchasing power for whatever unforeseen purchases one will make in the immediate future (Hutt 1956).
Money, as the comparatively most certain good, can be seen as at one end of the spectrum of investment possibilities when considering their risk or uncertainty. Consequently, a man who, wanting to add to his cash balance, increases his holding of fiduciary media, is fundamentally in error: he wants to reduce the uncertainty of his investments by increasing his cash balance, but fiduciary media are precisely not the most certain investment option; they are claims on other people, whether individuals or institutions such as banks. As such, they are always liable to the risk of default and nonpayment. Wanting to increase his certainty by increasing his holding of fiduciary media, the individual in fact renders himself liable to lose all if the issuing institution suspends redemption.
THE CONFUSION OF DEMAND FOR MONEY WITH SUPPLY OF CREDIT Money, in addition to being the comparatively most certain good, is also a present good. In fact, according to Rothbard it is the present good par excellence (2009, 375). People demand money in order to be able to spend it immediately on other goods. However, one of the main claims of the free bankers is that issues of fiduciary media are an efficient way to regulate the money supply in order to compensate for changes in the demand for money and thereby avoid monetary disequilibrium (Yeager 1997, 93–94). Not only are they more flexible than production of commodity money, but an increase of fiduciary media is an increase in the supply of loanable funds, and this means that there is more money available for investment when banks extend their issues of fiduciary media to meet an increased demand for money.
In the free banking system, an increased demand to hold money is met by an increased issue of fiduciary media in order to maintain monetary equilibrium. The substitution of fiduciary media for commodity money means that
every increase in real money demand becomes a source of loanable funds to be invested by banks, whereas under a pure commodity-money regime an increase in money demand either leads to further investments in the production of commodity money, or, if the supply of commodity money is inelastic, to a permanent, general reduction in prices…. Thus, fiduciary issues made in response to demands for increased money balances allow Ruritania to enjoy greater capitalistic production than it could under a pure commodity-money regime. (Selgin 1988, 22)
This position is also common among economists outside the free banking school (e.g., Sanches 2016; and Mishkin 2019, chap. 9) and can seemingly be traced back to John Stuart Mill, who argued that banks of deposit make the “idle” capital of depositors to be employed through lending out the majority of their deposits (Mill 1909, bk. 3, chap. 11, § 2).
There are two problems with this view: first, the assumption that the supply of commodity money could not change fast enough to accommodate changes in the demand for money, or that, failing that, price changes could not adjust the stock of money to the new demand; and second, the idea that demand for money in the form of money substitutes is the same as supplying credit to banks is a fundamental error. The demand for money, no matter what form that demand may take, is very different from demanding financial assets. The demand for financial assets is always the supply of a present good in exchange for future goods, whereas the demand for money is always demand for a present good. Money and financial assets are two different things, and they serve different functions in the economy.
To briefly address the first problem, there is no reason to consider the supply of money fixed, but more fundamentally, there is no reason to assume that an increased demand for money has to be compensated in any way by an increase in supply. An increase in the demand for money necessarily implies a decreased demand schedule for nonmonetary goods and an increased supply schedule for nonmonetary goods and services (the inverse of an increased exchange demand for money).On exchange demand and reservation demand for money, see Rothbard (2009, 137–42, 756–62) and Salerno (2015). An increase in the demand for money would therefore naturally lead to lower prices as the change in the market data works itself out in a step-by-step process (cf. Hayek [1937] 1989, 19–25). In the short run there may be instability and a prolonged adjustment period caused by “sticky” prices, as entrepreneurs may at first be unwilling to adjust their prices downward. However, the process of entrepreneurial profit and loss will quickly overcome this as those entrepreneurs who make the necessary price adjustments profit at the expense of those who are reluctant to do so: the longer an entrepreneur refuses to sell his inventory at the market price, the greater his loss will be. Sticky prices are at most a problem of short-term adjustment.
In any event, should the demand for money increase, the purchasing power of money will increase through the process just described, and under a gold or other commodity standard this will stimulate the production of money (White 1999, chap. 1; and Herbener 2002). This may be a slower response to changes in demand for money than issuing fiduciary media, but that does not mean that the money supply could not adjust in the absence of fractional reserve banking. An increase in the demand for money might be caused by economic expansion, as savings, investment, and population growth increase productivity. As more goods are offered on the market (an increase in the exchange demand for money), money prices of goods fall and the purchasing power of the monetary unit increases. As the purchasing power of the monetary unit increases, entrepreneurs can afford to invest more in the production of commodity money, e.g., by mining gold where it was previously too expensive to do so or by prospecting for new gold mines. It might even be said that a pure commodity standard would mirror a “productivity norm” (Selgin 1997) in regulating the supply of money over the long term: economic expansion would stimulate money production, while economic contraction would shift the monetary commodity into nonmonetary employment. The way it has been presented here, however, this process is nothing but an implication of the traditional currency principle as articulated by Mises and his epigones. Monetary equilibrium thus does not depend on the issue of fiduciary media.
The second and more serious problem with free banking theory is the confusion of demand for money with a supply of savings that can be lent out. In the free banking system, the issuance of new money in response to an increase in demand for money takes the form of loans. As Selgin (1988, 22) puts it, “every increase in real money demand becomes a source of loanable funds to be invested by banks.” Increased demand for money is taken for an increase in the supply of credit. It is here immaterial that the new loans are of very short, i.e., instant, maturity (Hülsmann 1996, 20; and Machlup 1940); the new loans serve as a source of credit no matter their duration. The argument in favor of free banking is that holding money is a form of saving, and that it is therefore legitimate to transfer these savings from savers to investors by means of fiduciary media. It may be granted that increasing one’s cash balance can in certain circumstances be considered increasing savings, but it does not follow from this that more credit should be extended.
Holding any kind of asset instead of using it amounts to savings investment (Hülsmann 1996, 34), as it necessarily means that resources are allocated to an expected future need instead of being consumed in the present. This is also true of money: if people reduce their consumption in order to increase their cash holdings, this is a form of saving. This does not, however, mean that additions to people’s cash balance are available to be invested; rather, they constitute a peculiar form of investment. Following Bagus and Howden (2010, 41), we may say that there is a continuum of investment projects of different duration. Investment in cash balances is peculiar in that money is the present good par excellence (Rothbard 2009, 375), and increasing one’s cash balance therefore does not liberate resources for more roundabout projects—quite to the contrary, as it is possible that increased demand for money reflects decreased demand for investments of longer duration. We may call it monetary or cash balance saving to distinguish it from both plain saving and capitalist saving.Cf. Mises (1998, 527–28) for the distinction between plain and capitalist saving.
It does not matter for our point whether the increased demand for money takes the form of increased demand for money substitutes. Money substitutes are just as much a present good as money proper. According to Mises (1953, 266),
The peculiar attitude of individuals towards transactions involving circulation credit is explained by the circumstance that the claims in which it is expressed can be used in every connexion instead of money. He who requires money, in order to lend it, or to buy something, or to liquidate debts, or to pay taxes, is not first obliged to convert the claims to money (notes or bank balances) into money; he can also use the claims themselves directly as a means of payment. For everybody they therefore are really money-substitutes; they perform the monetary function in the same way as money; they are “ready money” to him, i.e., present, not future, money.
Although it is true that legally and formally fiduciary media take the form of credit claims, the “lender,” the holder of the claim, has not surrendered control of any present good. He has engaged in what Mises calls a claim transaction, not a credit transaction; he has exchanged a present good (money) for a claim to a present good (a claim to money). Only because he considers the claim completely certain and instantly redeemable is it equivalent to him to money in the narrow sense. If the issuing bank does not keep full reserves, therefore, the holder of the bank’s notes makes an entrepreneurial error: he thinks he owns a certain, present good, when in fact he only has an uncertain claim to a partly present, partly future good. If such error becomes widespread and many people are willing to hold fiduciary claims in their cash balance, banks can engage in credit expansion leading to inflation and initiating a business cycle.Cf. Hüslmann (1998) on error as the root of economic cycles. Since the business cycle must result in a bust, the banks’ shaky position will inevitably become apparent. The more they expand their fiduciary issues, the less credible their promise to pay in full on demand becomes. The result is bank runs when the banks’ special goodwill evaporates and all the holders of fiduciary media try to exchange them for money in the narrow sense. The error that initiated the business cycle—mistaking a fiduciary claim to a future good for a present claim to money—is then realized, claims on the banks lose their status as money substitutes and the resulting deflation helps purge the economy of the malinvestments of the boom (Rothbard 2009, 1008–10; cf. Mises 1998, 565; and Salerno 2012a).
It follows from this insight that the doctrine that increased demand for money liberates resources for investment is fundamentally wrong. Contra Selgin and Mill, the demand for fiduciary media in no way constitutes a supply of loanable funds. What the acting individual wants in holding fiduciary media is control over present goods (Rothbard 2009, 800ff.), not future goods, and he therefore does not invest in a longer production structure when he increases his cash balanceThis is not meant to imply that increasing one’s cash balance necessarily shortens the production structure. If the cash balance is increased by reducing consumption, it may be that the production structure is actually lengthened. See on this point Mises (1998, 518–20). Demand for money is not the same as supply of loans, but by mistaking fiduciary media for money certificates, the individual unwittingly extends credit; he means to increase his holding of money, a present good, but he commits an error and in reality acquires a claim to a future good. As with all errors of judgment, it is liable to be corrected by the mechanism of profit and loss. Specifically, the individual may find one day that he cannot redeem his claims at par, or someone else has realized this already, and as the issuing institution has lost the good will of the market, the claims now circulate at a discount and are no longer part of the money supply. This is the mechanism of “brand extinction” identified by Salerno (2012b, 112–15; cf. Mises 1998, 431ff.) as the primary limitation on the issue of fiduciary media: long before a bank’s reserves are depleted through the principle of adverse clearing, holders of its notes and deposits will have lost confidence in it and no longer value its liabilities as part of their cash holding. These liabilities would therefore trade at a discount, and return to the issuing bank in the hope of an arbitrage profit. This would make a bank run inevitable, but only after the claims in question have already lost their status as money substitutes (Salerno 2012b, 113).
It is also possible for entrepreneurial error to take another form, as the acting individual may recognize that fiduciary media are not in reality secure claims to cash but may judge holding them a safe investment anyway, as other people are willing to accept them as money. Since he recognizes their defects, he may very well think himself able to profit from using fiduciary media, e.g., from interest payments on demand deposits or through access to easy credit, while still being able to realize his assets before they lose their money character thinking that he will always be able to get rid of them at par—or at least do so before the rest of the populace panics and a bank run develops. Fiduciary media and fractional reserve banking are fundamentally unstable institutions however, and always liable to collapse. Although individual entrepreneurs may benefit from fiduciary issues, just as individual investment projects may be completed in the boom phase of the business cycle, on a systemic level there is no escape from the result of error: depression and a purge of fiduciary media.
In the free market, where no special privileges protect banks and no legal tender laws can compel the public to accept claims on banks as money, the dangers inherent in issuing fiduciary media would be apparent to bankers as well as to the general public. Again, according to Mises (2006, 125): “[A]s soon as bankers recognized the dangers of expanding circulation credit, they would have done their utmost, in their own interests, to avoid the crisis. They would then have taken the only course leading to this goal: extreme restraint in the issue of fiduciary media.”
The nature of fiduciary media is simply incompatible with the aim people have in holding money: having access to a presently available, safe medium of exchange.That is not to say that people could not demand fiduciary media for other reasons, but then it would by definition not be demand for money. E.g., if a person holds a callable loan to earn interest, and if he does not consider it part of his cash balance, then this demand would not be demand for money but demand for a claim to a future good. In this case, the holder really is supplying savings for investment. The lines between demand for money and demand for investments are often blurred in modern financial practice, but conceptually the two kinds of demand are quite distinct.
A CRITIQUE OF THE THEORY OF “MONEYNESS” Part of the disagreement over the nature of money may stem from a basic error in the free bankers’ conception of what money is. Their conception of money can be termed the theory of “moneyness.” The origin of this theory seems to be F. A. Hayek’s remark that he would rather conceive of money as an adjective rather than a noun (Hayek 1990, 56; italics in original):
I have always found it useful to explain to students that it has been rather a misfortune that we describe money by a noun, and that it would be more helpful for the explanation of monetary phenomena if “money” were an adjective describing a property which different things could possess to varying degrees.
Hayek attributes the term to Fritz Machlup, although it is not clear that he meant by it exactly what Hayek and the free bankers do (Machlup 1970, 220, 225). Be that as it may, we cannot subscribe to the idea that “moneyness” is really a characteristic possessed by all goods to different degrees (Horwitz 1990, 462–63; cf. White 1989, 203–17). By this theory, “moneyness” is simply a characteristic of a good or a claim that may explain its value along with other characteristics. Thus, money in the sense of cash is high in “moneyness”—it may very easily be exchanged for other goods—but does not have an interest yield, while a bond may not be as high in “moneyness” but to compensate for this offers an interest yield. In this way, all financial assets may be placed on a “moneyness” continuum from cash to bonds.
There are several problems with this theory. It is not clear how “moneyness” can be conceived of if it is not already known what money is. In order to appraise a claim as worth one hundred dollars, for instance, it must already be known what a dollar is. When a good or claim’s moneyness is evaluated, what is really occurring is what Mises calls appraisement (1998, 328–30): evaluating what the good will sell for on the market. This estimate can either be in terms of money or in terms of other goods, but it is manifest that when discussing moneyness, the theorists in question discuss the value of claims in terms of money. They therefore assume the existence of money and simply assume that other claims share a degree of moneyness.
The core problem is a confusion of Mises’s distinction between money and money substitutes, on the one hand, and the concept of secondary media of exchange on the other (Mises 1998, 459–63). What is described as “moneyness” is really best understood in terms of Menger and Mises’s concept of marketability: the ease and speed with which a good can be sold without discounting its expected market price. Money proper is the marketable good par excellence, while some other goods and claims high in marketability may be more easily marketable than other goods, but their degree of marketability is still much less than that of money. As a consequence, such goods and claims’ price is expressed in and fluctuates in terms of money. This is why Mises says that these goods and claims have a high degree of secondary marketability—because their marketability is secondary to that of money, the existence of which is the condition sine qua non of the advanced exchange economy, where highly liquid claims can emerge.
The distinction between secondary media of exchange and money substitutes is crucial (Mises 1998, 459–63). The latter are complete substitutes for money in the narrow sense, as they can perform all the functions of money and each unit is evaluated on a par with the monetary unit—banknotes and transferable demand deposits are the best examples of this. The precise legal nature of such claims is not essential, however: the crucial consideration is that they are deemed to be always redeemable in money at par. Secondary media of exchange, on the other hand, are not money substitutes, as it is not certain that they can be transformed into money at par or at a set ratio. They are, however, always highly sought after and can therefore easily be sold at their expected market value. In other words, they are very liquid—they have a high degree of secondary marketability, in Mises’s terms—and may therefore supplement market actors’ cash holdings, as they help economize on the holding of money in the narrow sense. In the “moneyness” view, on the contrary, the distinction between secondary media of exchange and money substitutes is obliterated. All the goods and claims used in exchange are simply placed on a continuum, with cash at one end and very liquid claims such as government bonds at the other end, with no regard paid to the essential difference in the nature of these economic goods.
By holding secondary media of exchange, economic actors economize on the need to hold cash. Assuming that the secondary media are financial assets of some kind, the cost saving can be expressed as the interest payment received on the financial assets that substitute for money. Callable loans, bills of exchange, and other financial instruments and claims have been employed in this role, and this extra demand for these claims will tend to raise their price, lower their yield, and stimulate their issue by expanding the market for them. This, however, does not change their goods character into that of money substitutes, and it is unlikely that they will jump this divide. After all, the issuers of secondary media are in precisely the same difficulty as we detailed above in the case of callable loans: they will have to invest the borrowed funds in order to make a return and pay interest on the outstanding claims, leaving them unable to at all times “redeem” the claims at par.“Redemption” is here just a metaphor, as there is no legal obligation to redeem in the case of secondary media. The fact that these secondary media are heterogeneous, different products, and thus require a separate evaluation in each case, is also significant, as it imposes a cost on their use as secondary media of exchange. There is no such cost attached to holding money and money substitutes.Perhaps the main secondary medium used today is US Treasurys. The fact that these do not trade at par and are not considered part of the money supply indicates that even in the absence of the problem of heterogeneity, secondary media cannot jump the gap and become money substitutes.
CONCLUSION This article has examined the question of fiduciary media and their possible existence on the purely free market. Although this paper disagrees with Rothbard and the full reserve school when they claim that all money substitutes have to be interpreted as money titles, the conclusion reached agrees with their perspective. Fiduciary media will have virtually no role to play in a free market. Elaborating the suggestion first made by Hülsmann (2003a), it has been argued that fiduciary media can only come into existence due to entrepreneurial error: specifically, due to individuals erroneously judging an uncertain claim to future money as a certain claim to present money.
Like all errors on the market, this erroneous judgment and its consequences will tend to be temporary, ephemeral, and self-correcting as the reality of the situation asserts itself. Since there are no institutions on the free market that will systematically spread the errors leading to the rise of fiduciary media, these will tend to only circulate locally and for a short time, as people unfamiliar with the claims in question will not accept them in lieu of money. In the same way, the societal consequences of fractional reserve banking—malinvestment, inflation, and so on—will also be very limited in scope.
The confusion of loans for money is the root cause of dysfunction in the contemporary monetary system. This has been known for a long time – as the great English banker Thomson Hankey (1873, 29) wrote:
Ready money is a most valuable thing, and it cannot from its very essence bear interest; every one is therefore constantly endeavouring to make it profitable and at the same time to retain its use as ready money, which is simply impossible. Turn it into whatever shape you please, it can never be made into more real capital than is due to its own intrinsic value, and it is the constant attempt to perform this miracle which leads to all sorts of confusion with respect to credit.
Mises (1953, 409) wrote that “the development of the fiduciary medium must necessarily lead to its breakdown.” We hope here to have shown that on a free market, with no privileged banking system, this breakdown will come quickly, before the fiduciary medium has gained widespread currency.
Download the slides from this lecture at Mises.org/MU21_PPT_33. Recorded at the Mises Institute in Auburn, Alabama, on 22 July 2021.
Download the slides from this lecture at Mises.org/MU21_PPT_07.
Recorded at the Mises Institute in Auburn, Alabama, on 19 July 2021.
Unlike the ongoing price inflation that is typically caused by central-bank expansion of the money supply, the price inflation generated by diminished supplies of goods is a one-shot affair.
Original Article: "Is There Such a Thing as Good Inflation?"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Peter Schiff is a well-known critic of bitcoin, and while he is an excellent resource on many economic and political topics, he misses the mark on cryptocurrency.
Original Article: "3 Common Criticisms of Crypto—and Why They're Wrong"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
An unbanked population, an economy dependent on remittances, and dollarization. These combine to make El Salvador a perfect case study for bitcoinization.
Original Article: "El Salvador Blazes the Path to Bitcoinization"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Governments always justify printing more money with the excuse that there is no inflation. When inflation rises, they say it is transitory. And when inflation soars, governments blame businesses and shop owners, presenting themselves as the solution with “price controls.”
Original Article: "Investors Won't Buy the "Transitory" Inflation Line"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Seemingly endless amounts of fiscal and monetary stimulus will keep prices rising in the near term. But if the banking sector and other bubble industries weaken, we will eventually see deflation as new loan activity lessens.
Original Article: "Boom to Bust: How Inflation Turns into Deflation"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Medium of exchange and store of value are very different products.
Original Article: "No, Dogecoin Does Not Compete with Bitcoin"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
It could take several years. But “Fedcoin'' is on its way and soon will be our reality. The question is: Will Fedcoin make our lives easier or just the Fed’s?
Original Article: "Fedcoin to the Rescue?"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
As FDR’s gold crackdown showed, tyrants know the importance of controlling money in a time of crisis. It appears cryptocurrency could be central banks' next target.
Original Article: "88 Years Ago, FDR Banned Gold. Will a Bitcoin Ban Be Next?"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
"Because there's so much debt today relative to 10, 15 years ago, a small debt, a small move in yields, 50 basis points in yields today is equivalent to 2% 15 years ago."
Original Article: "Big Debt Plus Rising Interest Rates = Big Danger"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Bob helps to clarify the Bitcoin debate. On the one hand, the “no intrinsic value” skeptics are ignoring how Austrians deal with gold, while on the other hand, the “HODL forever” enthusiasts would never allow Bitcoin to become a money.
Mentioned in the Episode and Other Links of Interest: Bob (and Silas Barta’s) guide to BitcoinBob’s book Contra Krugman For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on Apple Podcasts, Stitcher, Spotify, and via RSS.
Rothbard recognized that money and exchange could not develop without first establishing private property. So Rothbard also recognized that it was important to develop theories of how private property might come about.
Original Article: "To Understand Economics, First Understand Private Property"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
If Europe wants to build wealth for its poorest members, it needs private entrepreneurship. But entrepreneurs need exactly the opposite of the Keynesian plan for building a European superstate.
Original Article: "Why Europe's Left Wants a European Financial Superstate"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
As soon as cash has been pushed back or stripped away entirely, monetary policymakers can implement an uninhibited negative interest rate policy to devalue debt. Customers can no longer get out of the “bank balance sheet”; the final escape door is then locked.
Original Article: "The Dangers Lurking behind a Digital Euro"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Mainstream economists claim China needs more consumption and a bigger welfare state. They think China's high savings rate is a bad thing. These economists are wrong.
Original Article: "China Needs More Economic Freedom—Not a Bigger Welfare State"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
More state lawmakers than ever are introducing sound money legislation in the opening days of the 2021 legislative session.
Original Article: "State Legislators Are Considering a Host of New Sound-Money Reforms"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
The Swiss state should end antigold regulations, end negative interest rates, and return to zero rates on bank reserves. These are small steps on their own, perhaps, but would be progress away from the brewing mess that is the eurozone.
Original Article: "Gold Could Offer a Way out of Switzerland's Failing Inflationist Experiment"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
The task at hand is the study of the problems of the determination of prices and interest rates. This task requires a sharp distinction between money-certificates and fiduciary media.
Original Article: "There Is Money and Then There Are Money Substitutes"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
The taxpayer is backstopping more credit risk than ever. The Post reported that nearly 30 percent of the loans Fannie Mae guaranteed were to borrowers whose house payment exceeded half of their monthly income, up from 14 percent in 2016.
Original Article: "Low Rates and Limited Liability Mean Hot Markets"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Thanks to politics, confirmation bias, and bad monetary economics, central banks have a lousy record when it comes to economic forecasts.
Original Article: "Why Mainstream Economic Forecasts Are So Often Wrong"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
We're told more government spending will get the economy back on track. But increasing government spending weaken the process of wealth creation.
Original Article: "Fiscal Stimulus vs. Economic Growth"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Corporate cost cutting sets the stage for future gains in profitability and productivity, and there is no resulting "paradox of thrift" requiring easy money policies to "fix" the problem.
Original Article: "Why the Corporate Paradox of Thrift Isn't Really a Problem"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
The 1920s featured political détente, debt liquidations by prior consumer price inflation, an introductory stalling of monetary inflation, a German economic miracle, and a broad-based technological revolution. The 2020s have none of these.
Original Article: "Why the 2020s Won't Be like the Roaring 20s"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Let us begin with what CBDCs definitely are not: they are not a new kind of cryptocurrency akin to bitcoin.
Original Article: "Central Bank Digital Currency: A Primer"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Six hundred dollars, two thousand, or how about one million per person? How much money should a government give its people to get the wheels of commerce turning again?
Original Article: "The Angel Gabriel and Monetary Inflation"
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Bob reads from an article recently tweeted out by the NEA, which calls for an end to schooling as we know it in order to promote anti-racism. He then discusses what the Fed has been up to since the coronavirus panic began.
Mentioned in the Episode and Other Links of Interest: The YouTube version of this episode (with lots of visuals).Karlyn Borysenko’s YouTube episode on the NEA tweet.Jamilah Pitts’ article on school transformation.Fed article talking about dividend payments to member banks.Total assets of the Federal Reserve System. For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Monetary economist George Selgin agrees with Bob on the flaws with MMT, but then the two continue their debate (started at the Soho Forum) on fractional reserve free banking. The episode also includes George’s background and thoughts on Bitcoin.
Mentioned in the Episode and Other Links of Interest: The YouTube version of this episodeGeorge’s monograph Praxeology and UnderstandingMises’ book Theory and HistoryBob’s review of MMTGeorge and Bob debate at the Soho ForumGeorge’s article (co-authored with Larry White) defending fractional reserve free banking. Bob’s recent QJAE contribution to the debate.George’s articles at Alt-M on Canadian free banking, and 3 devoted to Scotland: one, two, and three.George’s interview on crytopcurrency. For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Janet Yellen was concerned that low inflation could "paralyze the economy," especially during economic downturns.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "The Origins of the 2 Percent Inflation Target".
Bob explains some of the highlights of his newly released chapter for the Mises Institute book on “Understanding Money Mechanics.” He explains the operation of the classical gold standard, as well as some of the issues of US bimetallism during the 1800s.
Mentioned in the Episode and Other Links of Interest: Bob’s new essay on the gold standardBob’s book on capitalism #CommissionsEarned (as an Amazon Associate I earn from qualifying purchases)Bob on the 1920–21 Depression For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Economist Robert Murphy joins the show to cover Rothbard's excellent treatment of money in Chapter 11 of Man, Economy, and State. Dr. Murphy and Jeff cover why "hoarding" money is socially beneficial; why the velocity of money (and the famous MV=PT equation) is a useless concept, and how new money in society is never neutral. How and why does money maintain purchasing power, and does the interest rate really show the "price" of money? Why do we want "hard" money anyway? This is the show you need to better understand Rothbard's landmark exposition of money in an Austrian framework.
Read the book free of charge in searchable HTML format here.
Use the code HAPOD for a discount on Man, Economy, and State from our bookstore: Mises.org/BuyMES
Additional Resources Hans-Hermann Hoppe on Hutt's "The Yield from Money Held": Mises.org/HoppeHutt
Bob Murphy's study guide to Man, Economy, and State: Mises.org/StudyMES
Man, Economy, and State: Mises.org/MES
Fed bugs sound like real estate agents in reverse: there is never a good time to buy gold.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Why Fed Bugs Really, Really Hate Gold".
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Why Two Wealthy Senators Might Not Like Judy Shelton".
The value of a paper dollar originates from its historical link to commodity money—which happens to be gold—and not government decree or social convention.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "The Origins of the Dollar's Value".
The media wants Judy Shelton destroyed, because she once made some sensible comments about gold and fiat money.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Why the MSM Hates Judy Shelton".
Download the slides from this lecture at Mises.org/MU20_PPT_26.
Recorded at the Mises Institute in Auburn, Alabama, on 16 July 2020.
Download the slides from this lecture at Mises.org/MU20_PPT_18.
Recorded at the Mises Institute in Auburn, Alabama, on 19 July 2020.
Download the slides from this lecture at Mises.org/MU20_PPT_21.
Recorded at the Mises Institute in Auburn, Alabama, on 15 July 2020.
Download the slides from this lecture at Mises.org/MU20_PPT_06.
Recorded at the Mises Institute in Auburn, Alabama, on 13 July 2020.
It is possible to conceive of a world where fractional reserve banking is understood by both banker and depositor and involves no deception or fraud. But in that world, deposits cease to be money and become complex credit securities.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Are Fractional Reserve Bank Deposits Money?"
American Bonds: How Credit Markets Shaped a NationSarah L. QuinnPrinceton, N.J.: Princeton University Press, 2019289 pp.
Patrick Newman (patrick.newm1@gmail.com) is assistant professor of economics at Florida Southern College and a fellow of its Center for Free Enterprise. He is also a fellow of the Mises Institute.
This is a frustrating book. Quinn’s American Bonds shows that the federal government’s credit policies were important factors behind the particular evolution of securitization and credit markets in the United States. Quinn’s historical narrative, from the country’s founding to the present day, is intertwined with a brief overview of important business cycles and economic crises that affected credit markets, such as the Panic of 1819 and the 2008 financial crisis. Although Quinn investigates how federal legislation and institutions were important in facilitating the intermediation of credit in various markets, including in land, railroads, and mortgages, she completely omits an analysis of the policies’ efficiency. She also fails to contribute to our understanding of whether the government was necessary for the formation and development of these particular markets or if private actors could have provided similar financial specialization in the absence of government involvement. In the end, American Bonds merely provides a historical overview of credit markets without seriously investigating whether the government’s intervention was indispensable or weighing the costs and benefits of its involvement.
The main problem of the book is its theoretical framework. According to Quinn markets cannot function, let alone exist, without significant government assistance and intervention. Moreover, misguided government intervention does not promote inefficiency or economic recessions, because without government involvement the outcome would have been even worse. In fact, laissez-faire is “a utopian dream,” and “attempts to move into a laissez-faire world would mean deregulation, which inevitably causes instability, crisis, and human suffering, leading people to demand protection from the government” (p. 203). Although Quinn argues that free markets are an illusion, quite astonishingly this does not stop her from describing various financial markets as “laissez-faire” because they lack (or purportedly lack) direct government oversight. Quinn naturally leaves out the indirect oversight of those financial markets, such as the Federal Reserve’s regulation of the banking system and its ability to inject credit into financial markets. Although Quinn utilizes the theories of Hyman Minsky and recognizes that “all bubbles depend on credit expansion,” expansionary monetary policy is surprisingly absent from the list of potential culprits in the start a boom (p. 27). Whenever the government does clearly contribute to a financial crisis, the escape hatch is that the unfettered market would have been much worse, so that in reality the government did nothing wrong. Quinn succinctly states her view when she discusses the recent 2008 financial crisis and the government’s decades-long involvement in securitization of mortgages and cheap credit policies:
Does this all mean that the federal government is to blame for the crisis? After all…the government played a central role in keeping credit cheap, and cheap credit fueled the crisis. While it is a fair question, I nevertheless worry that it is a misleading one. It is obviously bad policy for a government to hit the accelerator on financial markets while also removing the brakes. Aside from the issue of whether this question deflects responsibility from Wall Street…it carries the unspoken assumption of a world where advanced capitalist markets somehow exist without extensive government participation….the real problem was not regulation but overzealous deregulation. (p. 210)
Quinn’s theory of markets and the indispensable nature of state assistance allows her to sidestep investigating the efficiency and possible adverse consequences of government policies. Thus, Quinn is able to write about the development of land sales on credit without questioning whether it was an important factor behind the land speculation that led to the Panic of 1819. More importantly, Quinn fails to discuss how the government’s suspension of specie payments from 1814 through the post–War of 1812 era (with only nominal resumption in 1817) and the newly created Second Bank of the United States (established in 1816) were important factors in facilitating an increase in the money supply and a postwar boom. A similar lack of analysis is shown in Quinn’s section on federal assistance to railroads in the post–Civil War era, because she does not link the generous loan and land assistance with the transportation companies’ inefficiency and corruption (pp. 23–36).
Most aggravating are her overviews of the development of credit markets in the early twentieth century. Quinn champions the Federal Farm Loan Act of 1916, which established a system of land banks to lend to farmers. She documents the Treasury’s subsequent assistance and describes how the banks had lent roughly $350 million by the end of 1920. However, she does not link these actions at all with the difficulties that farmers experienced in the post–World War I era (pp. 82, 86–87). Could the new legislation, in addition to the European demand for US agricultural products during the war, have encouraged an overexpansion of farming and then delayed recovery by subsidizing agriculture after it was no longer needed in such large amounts? Quinn provides no answer. Quinn also neglects how other misguided government regulation in the housing market around this time gave a superficial indispensability to federal assistance. She recognizes that during the Progressive Era housing reformers advocated new construction codes that were important factors in driving up building costs beyond the increase in consumer prices, as well as how the war increased the profitability of manufacturing relative to the real estate market and led to rent controls and prohibitions on the construction of houses. However, Quinn then documents the government’s subsidization of home construction through the Army’s Ordinance Department, the Emergency Fleet Corporation, and the United States Housing Corporation without ever raising the possibility that the government created the crisis that the public and intellectuals came to believe only it could solve (pp. 92–93, 99–103). Instead, “the defenders of laissez-faire had good reasons to be worried,” because there was a clear need for the government to step into the breach (p. 103).
Overall, although this book provides important empirical information on the development of credit markets and various related government programs, it lacks a serious theoretical and interpretative framework.
As the debt bombs in Italy and Spain and France get worse, it increasingly looks like the eurozone will have to bail out a huge portion of the European economy. Either that, or break up the EU, provoking a new crisis.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "The COVID-19 Crisis Is Driving the EU to the Brink"
When governments and central banks announce massive stimulus packages at the very beginning of a crisis, they bet on a speedy recovery and a return to normal as if nothing had happened. This is far from the case.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Central Banks and the Next Crisis: From Deflation to Stagflation"
Dr. Joe Salerno joins the show for a dynamic look at Human Action Part Four, arguably the meatiest part of the book.
Chapters 18, 19, and 20 are where Mises presents the idea of pure time preference, his expanded theory of interest, and the parameters of business cycle theory and malinvestment. Salerno and Jeff Deist consider how time relates to capital; gratitude for society's accumulated wealth; convertibility of capital thanks to stock markets; why holding cash can be productive; originary interest as a ratio, the fallacious classical and Marxist notions of interest, and the boom/bust cycle created by politicians, voters, and bankers who see that inflation "works" for awhile. This is a great discussion of Mises at his best!
Use the code HAPOD for a discount on Human Action from our bookstore: Mises.org/BuyHA.
Additional Resources Human Action: Mises.org/HumanAction
Bob Murphy's Study Guide to Human Action: Mises.org/Study
We dive into Part Four of Human Action with Professor Jeffrey Herbener, Chair of the Economics Department at Grove City College.
This is a fantastic discussion of money and market exchange, with Mises proving timely as ever given the current financial meltdown and crazed response from Washington. Dr. Herbener and Jeff Deist cover catallactics and how imaginary constructs help us understand basic economics; markets as a system of social cooperation; how ordinal preferences find expression in money prices; the structure of production; consumer sovereignty; Mises's conception of monopoly; and the various media of exchange which complicate what ought to be the market's provision of commodity money.
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Abstract: I show evidence of Austrian boom-bust dynamics in historical data on the production structure of 28 developed economies. I employ an autoregressive distributed lag model to find that policy-induced deviations from the natural rate of interest increases roundaboutness. This could instigate an unsustainable boom. Additionally, I find that early-stage industries have higher cyclical sensitivity than late-stage industries, consistent with Austrian time-value dynamics in the structure of production.
Hayekian triangle roundaboutness monetary policy central bank business cycles JEL Classification: B53, C33, E23, E32, E43, E50 This paper is based on my MSc thesis. For valuable comments on earlier drafts of this paper including the thesis I thank Prof. Dirk J. Bezemer, Dr. Mark Skousen, Prof. Roger W. Garrison, and Prof. Lex H. Hoogduin. Last, I thank the editor and an anonymous referee for helpful suggestions that considerably improved this paper. All errors remain my own.
Mark Gertsen (markgertsen@gmail.com) is on the faculty of economics and business at the University of Groningen.
INTRODUCTION The influence of interest rates on the production structure of the economy is a key concept within the Austrian framework. In particular, interest-rate-setting central banks are deemed to be institutions distorting the market, often with a combination of artificially low interest rates and expansionary monetary policy. During the Great Moderation some economists claimed that the central banking puzzle was solved, but the 2008–09 global financial crises reignited the debate around this topic. A decade later, central banks are still dealing with the legacy of this crisis, for which the consequences are yet unclear. In this paper I provide an uncommon (to most policy-makers) though sensible view that could enrich the debate about the consequences of policy-induced monetary expansion inevitably followed by boom-bust episodes similar to the one in 2008–09. To substantiate, I attempt to quantify the difference between the natural rate of interest, defined by Wicksell ([1898] 1962) as the unobserved equilibrium price of savings and investments, and the market interest rate set by the central bank. Subsequently, I explore the effect of this interest rate gap on the production structure, or roundaboutness, of 28 OECD economies over the years 2000–14. Roundaboutness as originally pioneered by Menger (1871) and later expanded by Böhm-Bawerk (1891) explains the indirectness and lengthiness of the process in which consumption goods are created. To capture the roundaboutness of an economy, I make use of the Gross Output (GO) metric pioneered by Skousen (1990, 2015, 2018). GO measures the combined value of all stages of production in the economy.While Skousen has formalized and widely promoted the concept of GO, it is wholly based on Rothbard’s (2009, 396–403) distinction between the Keynesian “net expenditure / income approach” and the Austrian “gross expenditure / income approach”. By dividing GO by GDP, one obtains a measure which increases (decreases) with a lengthening (shortening) of the production process. Böhm-Bawerk (1891) argues that more indirect processes ceteris paribus are associated with more economic progress and increased productivity. However, expansionary monetary policy is prone to instigate an unsustainable growth path. A low-interest rate policy stimulates investments which are not profitable under the natural rate, leading to malinvestment and overconsumption, in turn leading to boom-bust dynamics (Mises [1912] 1953; Hayek 1932, 1933; Garrison 2002, 2004).
This paper contributes in three ways. First, I construct a unique data set on Gross Output for 28 OECD countries over the years 2000–14. Second, I develop a proxy measure for interest rate gaps combining the Taylor rate, the consumption-investment (CI) rate and the long-term interest (LTI) rate. Austrian theory suggests that a larger interest rate gap positively influences the roundaboutness of the economy.
Third, I explore this theoretical relation in autoregressive distributed lag (ARDL) models. There are a few studies which examine this relation for individual countries (e.g. Mulligan 2006; Carilli et al. 2008), but the present paper is the first to explore the average relation for a large number of developed economies.
The result are consistent with Austrian business cycle theory (ABCT). I find that larger interest rate gaps are indeed associated with greater roundaboutness of the economy. Additionally, I find that this effect is stronger in a subsample of the five most roundabout of 65 industries than on average (though only to prolonged gaps, of more than one year, and when using a Taylor-based proxy for the interest rate gap). In comparison, the association is three to five times weaker in a subsample of the five least roundabout industries. Also, these additional analyses are in line with Austrian business cycle theory, which implies that more roundabout, hence more capital intensive industries, should respond more to interest rate changes (Skousen, 2015, 273–304). An important qualifier of this analysis is that the results are based on average effects found in historical data—they are not forecasts, nor descriptions of individual countries. The findings do suggest that on average in 28 OECD countries during the years 2000–14, the association of empirical proxies for the interest rate gap and roundaboutness were just as suggested in Austrian business cycle theory.
Apart from the scientific contribution, the study has clear societal relevance. The effects of expansionary monetary policy are obviously of great and very topical concern. Monetary mismanagement is fundamental to macroeconomic dysfunctions in the intertemporal allocation of resources (Dobrescu et al. 2012). Policy makers as well as academics will benefit from an analysis that adds the Austrian perspective to what is primarily a mainstream debate on the direction of monetary policy.
This paper is further organized as follows. Section 2 provides a survey on the current knowledge about ABCT, both theoretical and empirical. Special attention is given to the theory and application of the Hayekian triangle. In section 3, I present an econometric model to estimate the responsiveness of (sectoral) roundaboutness to the interest rate gap and in section 4 I explain how the dataset is constructed. Section 5 provides results including model variations and a sensitivity analysis. Section 6 concludes the paper and offers some suggestions for future research.
- AUSTRIAN BUSINESS CYCLE THEORY TO DATE 1.1 Roundaboutness and Capital Theory
The conventional measure for the size of the economy is the gross domestic product (GDP). Skousen (2010, 2015, 178–85) lists the shortcomings. GDP is a net output measure of finished goods and services, which leaves out intermediate production activity and business spending in the supply chain. Each of these expenditures is the result of entrepreneurial decision making, which in turn influences the rest of the economy. Entrepreneurs do not start or expand activities based only on value added. If we are to construct an empirical proxy for ‘how the economy is doing,’ it should capture the totality of spending decisions. A gross measure, not a net measure, satisfies this criterion. Note that because of this theoretical motivation, there is no double counting problem, a common objection to the GO concept. In a system of accounts, intermediate business to business transactions are just as relevant and real as economic activity linked to final goods and services (Jorgenson et al. 2006). As Skousen (2015) puts it, “GO is the top line and GDP is the bottom line of national accounting, ….. [and both] are of equal importance” (p. xix). I will operationalize this below by using both GO and GDP in an empirical proxy of roundaboutness.
The degree of roundaboutness in an economy, a concept of central theoretical importance in Austrian theory, can be proxied by the value of GO relative to GDP. With increasing roundaboutness, increasing amounts of savings-induced capital are employed to sustainably increase the capital intensity and efficiency of the intertemporal production process. The aggregate of all these processes, with varying degrees of efficiency, forms the time structure of production of the economy. Hayek (1932) further developed the time structure of production into a schematic triangular construct, known as the Hayekian triangle. The improved version of this triangle as designed by Garrison (2002) is nowadays used to describe the successive processes of capital (goods) accruing value from the original means of production, through the resource phase, up to the final stage where they are transformed into consumption goods. Capital is heterogeneous: it moves up along the hypotenuse as working capital, which, at the final stage, is consumed (in)directly or put into use as fixed capital, aiding future working capital forward in the production process.
The concept of time is of crucial importance to capital heterogeneity and its impact on economic booms and busts. Garrison (1990) shows that the neoclassical stock-flow approach, which claims production and consumption are simultaneous, is unrealistic. The theory assumes all subjective factors in the production process as fixed through time and view the capital stock as a ‘permanent fund.’ This process may appear simultaneous, but when one refrains from the temptation to generalize capital as an attempt to formalize it, one notes that a fundamentally uncertain future by definition means the production process is subjective and not fixed through time. The subjective factors in this process are typically entrepreneurs who make decisions about how and what capital formation takes place (Mises [1949] 1998). These decisions are based on the interpretation of the economic outlook and are by no means based on clairvoyant expectations. Inherently, a fraction of the entrepreneurs always either misjudges the economic climate or is downright unfortunate, and the macroeconomic impact of these events is relatively small. However, when there is a broad central-bank-induced misconception about future demand due to misaligned—investor vs. consumer—(time) preferences, the fraction of bad decision-making significantly increases, which causes a consumption boom and a severe capital misallocation at the same time. Were it for neoclassicals, capital could easily be moved elsewhere at no cost. In reality, however, the liquidation, the adjustment and the redirection of wrongly allocated capital is a painful process.
1.2 Interest Rate Effects and Financial Sector Dominance
The main culprit for capital misallocation is the distortive effect of monetary expansion on the natural rate of interest. An excessive increase of the money supply sends conflicting signals to investors and consumers creating a wedge between the savings and investment equilibrium on the loanable funds market. The expansion lowers the interest rate and creates two virtual equilibria: (1) consumers see the lower rate as an incentive to spend more now, while (2) investors are led to believe that consumers will spend more later. This illusion of a surplus of available savings for early-stage investment purposes has been called ‘forced savings’ by Hayek (1932) and is wholly equivalent to Mises’s ([1949] 1998) malinvestment. Garrison (2004) shows graphically how these forced savings affect the structure of production leading to a ‘dueling’ production structure (Cochran 2001).
The rational expectations hypothesis is often brought up as a refutation of this theory (e.g. Wagner 1999, Cowen 1997). Evans and Baxendale (2008) nullify this argument introducing entrepreneurial heterogeneity in a prisoner’s dilemma setting based on an article by Carilli and Dempster (2001). This use of the prisoner’s dilemma illustrates the limits of rationality. Many investors may well be aware of the fact that a policy-induced credit expansion increases nominal rather than real savings. Some may even be aware of the boom-bust consequence. However, since central authorities have the sole right of issuing legal tender, investors (but even more so, banks) can externalize the cost of recessions towards (other banks and) the taxpayer (Hayek 1933). In fact, profit-maximizing investors must increase their lending or their competition will (King 2016). The incentive for the individual makes the collective system worse off. Even though investors might thus be aware of unsustainable lending practices, they are competitively forced into this behavior. In the words of Carilli and Dempster (2001), ‘banks need not be fooled or tricked into increasing lending’ (p. 324) but their customers will be fooled. The majority of customers is ignorant and just seeks the lowest price forcing banks to compete while unaware of the unsustainable system. Even the educated customer is ‘bribed’ into foolish behavior—in a macroeconomic sense—because he will otherwise get outcompeted by the ignorant ones (Garrison 1989, Block 2001). The result is that economic agents (no matter their background) are ‘pushed up’ the boom phase of the cycle towards margin lending because strategic behavior induces them to. This imposes clear restraints on the impact of rationality. The ‘search for yield’ systematically moves lenders towards riskier investments. Bloomberg (2016) writes: “Credit fund managers who, having largely sat out on the recent rally in junk-rated debts, now find themselves forced to re-enter the fray after underperforming the wider market” (emphasis mine). Additionally, Hendrickson (2017) finds that investment by firms at lower interest rates is increasingly more prone to coordination failures, adding to risk and uncertainty.
Mulligan (2013) argues that the ABCT shows resemblance with Minsky’s (1992) Financial Instability Hypothesis (FIH) in which a first mover advantage is present for lenders (borrowers) extending (taking on) more credit (debt). This means that the prisoner’s dilemma works over both the extensive and intensive margin: who is in/out, and who is first? Thus not only does excessive credit expansion lead to moral hazard, it also allows an adverse selection problem to materialize since margin lending (borrowing) lures ‘bad’ entrepreneurs and non-creditworthy borrowers into the market (Evans and Baxendale 2008). Moreover, informational cascades (or Cantillon effects) increase investor-consumer inequality due to a knowledge gap which in turn is amplified through the adhesive power of the financial sector (Howden 2010). Resource misallocation along the structure of production shifts focus and resources away from the real sector. Entrepreneurial knowledge is extracted by the financial sector leaving the real sector at a serious knowledge disadvantage on how to align consumer demands along the structure of production.
1.3 Empirical Approaches to the Structure of Production
According to Lewis and Wagner (2016) Austrian macro theory suffers from an underdevelopment in the use of empirics to support theory. Expanding on those, or developing new ways to empirically support theory would, according to the authors, make Austrian macro theory able to compete with mainstream dominance. Examples of empirical Austrian research are Mulligan (2006), Fillieule (2007), Young (2012) and Cachanosky and Lewin (2014) amongst others. Not surprisingly, they all relate to the Hayekian triangle in one way or another.
Mulligan (2006) for instance finds that lowering the interest rate below sustainable market rates provides a short-term boost to consumption and investment, but has a decreasing effect in the long run. This is in line with the ABCT. Fillieule (2007) mainly analyzes the goods-in-process structure of production and finds that a lower time preference is followed by a lengthening of the production structure in which the profitability of earlier stages relatively increases. While this provides some concrete results, he uses a formalized form of the average production structure concept of Böhm-Bawerk (1891) to counter the infinite-stages problem. Economists like Garrison (1981) argue this to be a futile attempt to quantify a series of subjective numbers into one value. An alternative approach by Cachanosky and Lewin (2014), though also based on an average production period, uses the economic value-added (EVA®) literature which allows them to ‘reframe roundaboutness and interest rate sensitivity into financial terminology’.EVA® is a registered trademark of Stern Stewart and Co. (Cachanosky and Lewin 2014). In their review of the triangle, they effectively determine that, due to its nature, empirical research is prone to subjective judgment because of the very structure of the triangular concept. The authors do endorse the approach taken by Young (2012) who qualitatively examines the impact of interest rate deviations on the aggregate roundaboutness of the Hayekian triangle rather than on specific stages. Young’s analysis of the 2002–09 US structure of production is relatively simple but elegant. He develops a ‘total industry output requirement’ (TIOR) as an indicator for roundaboutness. I will expand on his work by taking this indicator to a country level. The breadth of my dataset allows me to assess the economy-wide roundaboutness of 28 countries. This generalization, however, comes at the cost of not being able to assess individual country characteristics. Based on regression analysis, I expect similar results to match with ABCT in the sense that the production structure of an economy will expand with a larger interest rate gap.
- METHODOLOGY I use cross-country regression analysis to examine whether there are generalizable effects of a larger interest rate gap on the roundaboutness of economies. I approach roundaboutness by creating a similar metric to Young’s (2012) TIOR which I call TEOR, or, the ‘total economy’s output requirement’. The TEOR of a specific country reflects the amount of gross output required from its domestic industries both directly and indirectly to deliver a currency unit of final output.
Figure 1. A Simplified Hayekian Triangle
The TEOR is defined as the ratio of gross output to final output (excluding foreign inputs for simplicity). To illustrate, in Figure 1 I present the Hayekian triangle with intermediate and final outputs. The TEOR value is the surface of the triangle (total gross output) divided by the shaded part (final output). Formally, consider that the economy consists of an array of industries indexed by . Industries process intermediate (capital) goods yielding value added, denoted by , equal to final output (Garrison 2002). According to the Bureau of Economic Analysis, value added equals the difference between an economy’s gross output and the cost of its intermediate inputs.See https://www.bea.gov/faq/index.cfm?faq_id=1034. Industry gross output is denoted by .
Total gross output is then given by
from which the TEOR can be derived as,
By definition, a relative increase in the production of intermediate goods increases TEOR. Assuming no monetary intervention, such a situation occurs when the average relative time preference of consumers decreases. Conversely, a relative increase of final output decreases TEOR which occurs when the average relative time preference of consumers increases. This allows TEOR to function as an interpretation of roundaboutness which is an important step in the empirical analysis of ABCT.
To measure the interest rate gap, I take the difference between a country’s market interest rate (i.e. the short-term interest rate) and the natural interest rate. I proxy the latter following the original equation of Taylor (1993):
To simplify, I follow Taylor’s (1993) rule of thumb to attach 0.5 weights to and . I specify as the output gap which then yields,
where is the market interest rate that should be targeted, is the current core CPI inflation rate, is the desired inflation rate and is the estimated value of the equilibrium real interest rate. The latter’s estimations differ (Yellen, 2015) but I will follow Young (2012) and Taylor (1993) by setting it to 2 percent. A desired inflation rate of (close to) 2 percent is commonly accepted in OECD countries hence I equally standardize that rate. Natural rate estimation then follows:
(5)
Combining this with the actual market rate, the interest rate gap is calculated as:
(6)
The baseline regression then estimates the relation between the interest rate gap and roundaboutness:
(7)
where and respectively denote country and year. To recognize country heterogeneity, I control for time-invariant country characteristics in the intercept. Absolute differences between the two interest rates are useful because it allows for assessing the impact of sustained gaps. A production structure might not instantly adjust to a one-off deviation. Negative gaps ( ) pose no problems to the expected outcome since its reverse equally holds true (Rosen and Ravier, 2014).
Given the likelihood of a dynamic relationship and potential autocorrelation, I include lags of both variables and assume (trending) stationarity. Additionally, interest rates changes—often piecemeal—are subject to the Cantillon mechanism resembling distributive effects. Similarly, TEOR is also dependent on its previous values since economic growth is equally gradual. The possibility to detect the movements of both variables could be improved using quarterly or monthly data which I unfortunately do not have.
A consequence of using the ARDL model is the violation of the assumption that the dependent variable is uncorrelated with the error term—ARDL implies autocorrelation. To eliminate this, I include sufficient lags of both variables such that lagged errors can be excluded. The optimal lag amount minimizes the Akaike and Bayes information criteria. I further control for demographics since this is known to push down interest rates (Rachel and Smith, 2015; Carvalho et al., 2016). The ratio of old population (age > 65) to total population captures this effect.
To assess the elasticity of specific production stages to interest rate gaps, I follow Young (2012) and average respectively the five most roundabout (MR) and least roundabout (LR) industries into two ‘TIOR’ rates. The goal of creating these two averages is to examine the difference in cyclical sensitivity between early and late stages. Last, the CI and LTI proxy function as alternative to the Taylor proxy. Interest rate gaps are:
(8)
(9)
The CI proxy is inspired by Carilli et al. (2008) but modified following Rothbard (2009) who points out that the proportion between consumption and investment (rather than saving) reflects individual time preferences.
- DATA One of the main contributions of this paper is to construct a unique data set on Gross Output for 28 OECD countries over the years 2000–14.See Appendix A for a country overview. Underlying data has been retrieved from the World Input-Output Database (WIOD) 2016 release (Timmer et al. 2015, 2016). Specifically, I extracted annual data from 28 different National Supply and Use Tables (SUTs) corresponding to the OECD countries. The database is classified according to the ISIC Rev. 4 and its tables are based on SNA 2008. To retrieve GO per country, I use ‘total intermediate consumption’ (column labeled ‘INTC’) for GO—at basic prices—from the Use tables. This includes value added (at basic prices) plus intermediate inputs adjusted for taxes less subsidies. I calculate GDP as total value added of all industries using the same source (taxes and subsidies excluded).
Necessary data for the Taylor-rate equation are collected from several sources. The realized market interest rates per annum are retrieved from the OECD database on short term interest rates, with the exception of rates for Hungary, Japan and Slovenia which were collected from AMECO. Core CPI rates and output gaps are respectively from the OECD and AMECO database. Data on the old population ratio is from the World Bank Development Indicators (WDI). I calculated the consumption-investment interest rate proxy using data from the WDI. Specifically, I use Gross Capital Formation (as percent of GDP) and Final consumption expenditure (as percent of GDP). The long-term interest rate is proxied by OECD government bond data except for Estonia, Slovak Republic, and Slovenia, which are from the AMECO database. Some years are missing: Czech Republic (2000), Estonia (2011–14), Korea (2000), Mexico (2000, 2001), Poland (2000), Slovenia (2000, 2001).
Table 1. Descriptive Statistics Including Variable Definitions
MR and LR are calculated using underlying data from the national SUTs of the WIOD. One exception is made for Japan, where one of the five least roundabout industries, household activities, was calculated in a seemingly inconsistent way—I used the sixth least roundabout industry instead. According to Rosen and Ravier (2014), a new business cycle began around December 2000, hence I use 2001 as the base year to determine MR and LR.
The panel data are strongly balanced (N = 420). For further descriptives, see Table 1. Most variables are complete except for the LTI proxy. TEOR is relatively normally peaked but slightly skewed rightwards. MR has a few large outliers which might bias the estimators—normalizing solves some of the skewness. LR is more normally distributed but somewhat skewed to the right. The MR–LR distributional difference makes sense from a theoretical perspective. The included 65 industries roughly follow a Pareto-like distribution where MR industries are relatively more dispersed and further from the mean than LR industries. Taking the average from a sample of 10 industries to mitigate this difference barely affects LR but greatly affects MR potentially risking diluting its elasticity to the interest rate gap.
- ANALYSIS 4.1 Baseline results
I use a panel fixed effects baseline ARDL regression with clustered robust standard errors to counter heteroskedasticity in the error variance. A unit root test rejects non-stationarity. To determine the optimal lag amount for TEOR and the interest rate gap I add to both variables up to 5 lags and subject each specification to an AIC/BIC test. This suggests an ARDL(1,0) process to be optimal for modeling the relationship. A manually performed RESET test confirms that the model does not suffer from omitted variable bias. To check whether serial correlation has been eliminated, I compare the ARDL(1,0) process to eight other variations and again subject them to an information criteria test. To visualize the variations:
The model comparison shows that the ARDL(1,0) process remains to be the best fit. BIC results correcting for observation loss—due to added lags—points in the same direction. Note that it is not a certainty that autocorrelation in the error term is completely eliminated, but it is as much as possible.
Table 2. Comparison of the relationship between TEOR and the interest rate gap based on three different proxies. The dependent variable is logTEOR.
Robust standard errors in brackets * p<0.01, p<0.05, * p<0.10 To compare the Taylor-based ARDL process to the other two proxies, I run through the exact same process to determine the most optimal amount of lags for both specifications. Results suggest an ARDL(1,1) and ARDL(1,0) process for respectively the CI and LTI proxy. A comparison of the TEOR responding to all three proxies is provided in Table 2. Column 1 shows that a Taylor-based interest rate gap of 1 percent significantly results in a 0.11 percent more roundabout economy, ceteris paribus. Thus, GO increases with 0.11 percent as compared to final output, a difference in difference effect. The second column displays contradicting results and with a zero net effect does not support ABCT, whereas results in column 3 are insignificant alltogether. I want to make two additional remarks. First, I left out the control variable for the LTI proxy because demographic effects are already captured by the long term government bond interest rate (Rachel and Smith, 2015). Second, note that I included a test whether the adjusted R-squared in fact increases upon adding r_gap (and its lags) to the specification, indicating its relevance.
4.2 Cyclical Sensitivity and Country Conditions
I now substitute TEOR with MR and TR and run through the same procedure for lag and model optimization. Significant outcomes are for MR combined with the Taylor proxy and for LR combined with the CI and LTI proxy. Other variations return insignificant results. I provide the significant results in Table 3. Interestingly, the MR response to the interest rate gap is negative for the contemporaneous year but positive for its first lag. A prolonged (t>1) interest rate gap of 1 percent results in a net positive effect on roundaboutness of around 0.65 percent.
Table 3. Comparison of the average TEOR to stage-specific TIORs. DEPVAR refers to the relevant dependent variable specified below the column number.
Robust standard errors in brackets * p<0.01, p<0.05, * p<0.10 The responsiveness to an interest rate gap of the most roundabout industries is 5 times larger than that of the least roundabout industries (0.14–0.21 percent), providing the gap persists during at least two successive years. This suggests that more remote industries are as expected more elastic to interest rate changes. The CI and LTI proxy are inherently less volatile and might therefore explain the non-significant responses of MR. Conversely, the same reasoning might apply to LR estimations.
Finally, I check whether the baseline Taylor-based TEOR results are robust to specific country conditions (table not reported). In particular, I include three additional control variables on their own, and as interaction with the interest rate gap. First, I look at the growth rate of financial depth and proxy this with the growth rate of liquid liabilities as a percentage of GDP (King and Levine 1993). Second, I use R&D expenditures growth (as percent of GDP) to proxy capital intensity. Third, I use stock market capitalization growth (as percent of GDP) to determine the impact of financial sector development. A developed financial sector is generally associated with economic growth and better resource and capital allocation (Allen and Gale 2000, Levine 2002). For every addition, I re-run the lag and model optimization process to determine the most optimal ARDL specification. None of the three added control variables, nor their interactions with the interest rate gap, significantly changes the earlier results from Table 2.
- DISCUSSION AND CONCLUSION 5.1 Discussion of the Results
A positive relationship is found between TEOR and the Taylor-based interest rate gap. The outcome is both significant and economically relevant. Over the observation period, GO shows a relative growth rate of 0.11 percent to GDP for every percent increase in the interest rate gap. This translates approximately into a 0.22–0.33 percent change in GDP terms (i.e. TEOR rate* ∆GO). For a small (big) country like Belgium (United States) this means hypothetical capital misallocation of EUR 920 million (USD 34 billion) in 2014. In the upswing of a business cycle, capital misallocation accumulates over the years and pushes the economy beyond its maximally attainable production possibilities frontier until the inevitable correction sets in (Garrison 2004). A back-of-the-envelope calculation provides further color to this scenario by suggesting more capital misplacement results in deeper downturns (see Appendix B).I note two caveats here. The amounts mentioned for capital misallocation are hypothetical in the sense that it is impossible to know what share of capital is easily redirected during economic recovery and what part is plainly wasted. It is thus equally impossible to accurately determine the accumulated stock of misallocated capital the moment before a boom turns into a bust. The amounts are merely provided to give an impression of the magnitudes potentially affecting the production structure of an economy.
Figure 2. The Dueling Hayekian Triangle
Source: Garrison (2004). Policy-induced interest rates suggest an unsustainable increase in the capital-intensity of the economy potentially initiating an Austrian boom-bust cycle. Artificially low rates provide a short-term boost to both final output and gross output. ABCT predicts the latter effect to be dominant and this is indeed observable in the results. Early stage industries respond up to 5 times stronger to (prolonged) interest rate gaps than late stage industries. Early stage—more roundabout—industries act more pro-cyclical and more volatile due to time-value of money effects (Skousen 2015). Interestingly, MR industries also require a multi-lagged model suggesting they are also more sensitive to delayed interest rate effects. The fact that the average TEOR response is smaller than the lower-bound LR response may seem odd. A possible explanation for this behavior is that the average response is likely similar to a response from middle stages. In a ‘dueling’ Hayekian triangle setting, middle stages are relatively negatively affected due to misallocated capital (Cochran 2001, Garrison 2004). This results in a kink in the hypotenuse (see Figure 2). The potential relatively negative effect of the middle stages might have pulled down the economy wide average industrial response to an interest rate gap.
ABCT is particularly consistent with Minsky’s (1992) FIH which describes that extended periods of economic prosperity lead to under-evaluation of market risk inducing firms and other market participants to increase investment (Mulligan, 2013). While this process of progressive overleveraging is endogenous, the Austrian monetary expansion is exogenous. However, both mechanisms are prone to the influence that expansionary monetary pressure exerts on inflating the boom. Increasing roundaboutness due to interest rate gaps closely resembles a Minsky-like period of euphoria. Quite literally, due to misperception of risk variability and adjustment costs (i.e. price signals), entrepreneurs increasingly engage in plan revisions to further expand their business (Mulligan, 2013). This decreases productivity and leads to wasteful spending (Dobrescu et al., 2012).
5.2 Limitations and Suggestions for Future Research
Based on the constructed dataset, I put forward some suggestions I chose not to pursue in the current paper. First, different natural rate proxies could be used to calculate the interest rate gap. Labauch and Williams (2003) provide such an alternative, albeit technical, as well as Keeler (2001) who uses a term spread technique, which however should be slightly adjusted to meet the critique of Carilli et al. (2008). Second, the Taylor rate could equally be established differently. Here, both the proposition of Yellen (2015) to modify the real equilibrium interest rate or a non-generalized inflation rate to match specific countries’ past and present inflation targets could be followed.
Others interested in this topic but rather on a country level could combine the methodology of Young (2012) and the dataset of the present paper. This could yield 27 additional qualitative country-specific studies on production structures and would greatly expand the knowledge of Austrian business cycles in each of those countries. Additionally, these studies could be extended with an empirical VAR analysis including a Granger-causality check á la Carilli et al. (2008), which is quite laborious for panel data. If employing VAR, longer time series would then be desirable (e.g. by adding more years or finding quarterly or even monthly data).
Furthermore, the methodology of this paper could be used for within country panel analysis on the industrial level—each industry has its own TIOR. Data for this can be retrieved from the national SUTs of the WIOD (Timmer et al., 2015). In fact, the Young analysis could even be applied to a singly industry within or cross-country.
5.3. Conclusion
The empirical analysis of this paper confirms that Austrian boom-bust dynamics are economically relevant and do not just remain ABCT artifacts. I have employed an autoregressive distributed lag model to analyze historical data related to the production structure of 28 developed economies. I found that policy-induced deviations from the natural rate of interest increases roundaboutness and could instigate an unsustainable boom. Additionally, I found that early stage industries have higher cyclical sensitivity than late stage industries confirming the importance of time-value dynamics in the structure of production (Skousen 2015). I used three natural rate proxies the significance of which varied across the different dependent variables. The Taylor proxy applies best to average economic as well as early stage roundaboutness, while the alternative proxies are a better fit for late stage roundaboutness. Even though these differences can be explained to a certain extent, further research on these causes is warmly welcomed.
Appendix A. Overview of Countries Included in the Dataset
Source: Timmer et al. (2015). Note: I use GO/GDP ratios hence currencies play no role. Appendix B. Cross-Country Boom-Bust Statistics
Note: Capital misallocation is the cumulative sum over the years 2001 until the year before a downturn. For some countries this exceeded 1 year of negative growth in which case I also included the next year in Δ GDP during downturn. As the scatterplot shows, some countries did not experience a clear boom-bust scenario. Excluding these from the results does not change the significance of the correlation coefficient.
The Understanding Money Mechanics series by Robert P. Murphy, is a comprehensive overview of the theory, history, and practice of money and banking, with a focus on the United States.
The full book is available at the Mises Store, and free on mises.org in html and pdf versions. Also available on Amazon.
[The table of contents below is from an earlier serialized version of the book]:
TABLE OF CONTENTS Chapter 1: Introduction
Lays out the scope and purpose of the booklet, and the schedule for release.
PART I: THEORY AND HISTORY
Chapter 2: The Theory and Brief History of Money and Banking
Covers Menger’s theory of the origin of money, and briefly mentions the anthropological critique (David Graeber). Explains the attributes of a desirable commodity money. Gives a standard history of the origin and development of modern banking, including some important court rulings. Mentions the history of private mints.
Chapter 3: A Brief History of the Gold Standard, with a Focus on the United States
Explains the US dollar’s tie to the precious metals over time, and some of the major controversies such as William Jennings Bryan’s “Cross of Gold” speech. Explains the operation of the classical gold standard and how it evolved during the World Wars, Bretton Woods, and, finally, the Nixon Shock.
Chapter 4: The History and Structure of the Federal Reserve System
Explains the unusual circumstances of the Fed’s origin, and mentions “conspiracy theory” treatments. Explains how power was consolidated in DC and away from Reserve Banks under FDR, and how the Fed’s mandate again altered in 1977. Concludes with an overview of the modern organization of the Fed, including the number of member banks, how the Federal Open Market Committee (FOMC) is selected, how the chairman is picked, etc.
PART II: THE MECHANICS
Chapter 5: Standard Open Market Operations: How the Fed and Commercial Banks “Create Money”
Explains the “textbook” mechanics of the Fed buying assets to create new reserves, and then how commercial banks create new loans on top. Defines the various monetary aggregates (base, M1, M2, “Austrian true money supply,” etc.).
Chapter 6: Beyond the Fed: “Shadow Banking” and the Global Market for Dollars
Defines the concept of shadow banking and gives a brief history, plus some stats for context. Defines things like “eurodollar,” LIBOR, etc. Explains the Bank of International Settlements (BIS) and the Basel Accords. Explain the basics of the repo market and the difference between capital requirements and reserve requirements.
Chapter 7: Central Banking since the 2008 Financial Crisis
Explains the “emergency” measures that the Fed adopted (Term Auction Facility, QE rounds, interest on reserves) and negative interest rates abroad. Mentions the moves to suppress cash (tied up with negative interest rates, at least rhetorically). Explains how Maiden Lane programs are arguably illegal.
Chapter 8: The Fed’s Policies since the 2020 Coronavirus Panic
Explains some of the major changes implemented in the wake of the pandemic, such as the abolition of reserve requirements, unprecedented asset purchases, and a redefinition of M1.
PART III: APPLICATIONS
Chapter 9: Ludwig von Mises’s "Circulation Credit" Theory of the Trade Cycle
Lays out the basics of Austrian boom-bust theory. Explains that Mises developed it in The Theory of Money and Credit, in which he also said that fiat money was a theoretical possibility (!); this means that Mises clearly didn’t think that boom-bust was restricted to fiat money regimes. Using Mises’s analogy of a master builder running out of bricks, illustrates the difference between “overinvestment” and “malinvestment” theories, and also why continued pump-priming a bad idea.
Chapter 10: Monetary Inflation and Price Inflation
Starts with Friedman’s measures of money stock and (consumer price) inflation, and summarizes cases of hyperinflation (Civil War, Weimar Republic, Zimbabwe, Venezuela). Documents change in how the word “inflation” is used, and explains how “currency boards” are used by some countries to limit the ravages of inflation. Explains the famous equation of exchange (MV = PQ) and why Mises and Rothbard didn’t like it.
Chapter 11: The Inverted Yield Curve and Recession
Documents this surprisingly good forecasting tool, and then shows that it fits quite nicely within the Austrian framework.
Chapter 12: The Fed and the Housing Bubble/Bust
Shows that the textbook Austrian story fits the empirical facts of the housing boom/bust.
PART IV: CHALLENGES
Chapter 13: Does Textbook Explanation Get Money and Banking Backwards?
Is the “textbook” description (covered in chapter 5 above) actually wrong? Deals with the (relatively) recent claims—coming not just from internet critics but also a major UK institution—that bank lending is not reserve constrained. Also addresses that idea that “lending creates deposits” rather than vice versa, as the orthodox economists claim.
Chapter 14: Crying Wolf on (Hyper)Inflation?
Explains that some (including the present author) made erroneous warnings about (consumer price) inflation when QE was first implemented, and asks whether this invalidates the textbook treatment. Is it true that QE was “just an asset swap” and “wasn’t money printing”?
Chapter 15: The Keynesians on the Cause of, and Cure for, Depression
Explains the Keynesian perspective. Contrasts Austrians and Keynesians on the Great Depression. Explains the “liquidity trap” and why Keynesians think Say’s law works in the special case of “full employment” but that we need a general theory of employment, etc.
Chapter 16: The “Market Monetarists” and NGDP Targeting
Gives a brief history of the historical battles between original monetarists and Keynesians (Friedman/Phelps on the Phillips curve, the Robert Lucas critique, and rational expectations framework). Then explains how people like Scott Sumner updated Friedman’s monetarism and now offer the goal of “level targeting” of stable NGDP growth, which some Austrians argue is similar to Hayek’s approach.
Chapter 17: Bitcoin and the Theory of Money
Applies the earlier theoretical framework to Bitcoin, to answer questions such as “Is it money?” Addresses the challenge that Bitcoin violates Mises’s regression theorem.
Chapter 18: An Austrian Reaction to Modern Monetary Theory (MMT)
Reprints Murphy’s 2020 QJAE review of Stephanie Kelton’s popular book explaining MMT, The Deficit Myth.
Abstract: This paper aims to propose a non-distortionary monetary policy objective consistent with the Austrian business cycle theory. Since the price level should fall in the growing economy in the Hayekian framework, introduction of a negative inflation target combined with the Taylor rule is suggested as a non-distortionary monetary policy. To keep the money stream stable, the optimal inflation target would be equal to the opposite of the growth rate of the economy. Such policy should lead to the smoothing of the business cycle path since monetary policy could be less activist compared to the current state of the positive inflation target. Possible criticisms of this suggestion are anticipated and addressed in this paper.
central bank inflation targeting negative inflation taylor rule monetary policy business cycle JEL Classification: B53, E31, E32, E52, E58 Tomáš Frömmel (tomas.frommel@vse.cz) is a Ph.D. student in the economics department at the University of Economics, Prague.
INTRODUCTION Some economists from the Austrian school tend to criticize the existence of the central banks and suggest their abolition and transition towards a free banking system. Nonetheless, the existence of the central banks is a state that apparently cannot be changed, at least in the near future. For this reason, suggestions of the central banks’ abolition cannot be taken seriously, since they are far away from current reality. Although it may be true that the economy would develop better without the central banking system, Austrian economists might come up with some more realistic suggestions of rules for central bank policy.
The aim of this paper is, therefore, to develop a non-distortionary monetary policy objective consistent with the Austrian business cycle theory. The central bank committed to such an objective should not lower permanently the market rate of interest below the natural level, and would not distort free-market system of relative prices and trigger artificial boom-bust cycles.
The introduction of a negative inflation target combined with the Taylor rule is suggested as a satisfactory policy objective, complying with requirements presented above. Since, in the Hayekian framework, the price level should fall as the natural output of the economy grows, monetary policy could be less activist compared to the current state of positive inflation rate targeting; relative prices would not be distorted by permanent injections of new money into the economy and the course of economic development could be smoothed under the proposed rule.
There have already been some suggestions that the price level should be allowed to fall in the growing economy (e.g. Hayek 1935, Friedman 1984, Selgin 1997, or Potužák 2016). Unlike these papers, this essay respects the fact that current central banks do not target money supply and rather use interest rates as their policy instrument. Therefore, we aim to propose a non-distortionary rule prescribing how the central bank might set its interest rates. For this reason, our suggestion might be more realistic compared to the other suggestions.
The structure of the paper is as follows. The first section briefly presents monetary policy rules and especially the inflation targeting regime and the Taylor rule. The second section presents criticism of the inflation targeting from the Austrian perspective. The next section suggests the introduction of a negative inflation target and explains advantages of this policy. The last section aims to anticipate possible criticisms of the suggested policy and tries to disprove them.
- INFLATION TARGETING AND THE TAYLOR RULE Monetary policy rules are commonly seen as more convenient than discretionary policy (Sargent and Wallace 1975, Barro and Gordon 1983, or Svensson 1999). The main argument in favor of policy rules is the problem of time inconsistency of the central bank policy. A central bank committing itself to some policy rule should not adopt any policy that has not been declared in advance. Policy rules may thereby reduce entrepreneurs’ uncertainty concerning future monetary policy conditions, and the central bank becomes more predictable.
Furthermore, if arguments of the Austrian business cycle theory critics (e.g. Tullock 1988, Cowen 1997, or Wagner 1999) were right, monetary policy rules should lead to gradual smoothing of the cyclical development of the economy. If the central bank adopted and publicly communicated some policy rule, monetary policy would become more transparent and entrepreneurs would be able to understand the consequences of central bank policies more easily. Then, they would not be fooled by the monetary authority and an artificial boomThe Austrian business cycle theory (Mises 1953, Hayek 1933 and 1935, or Garrison 2001) predicts that lowering the market rate of interest below its natural level and subsequent non-uniform inflow of new money into the economy leads to investment into more roundabout production processes. Since increased investments are not accompanied by increased voluntary savings, newly created structures cannot be finished in the future. The economic boom is not sustainable for this reason, and the recession is an unavoidable result that allows re-equalization between real savings and investments. would not be triggered. To adopt a policy rule seems to be a suitable action since it limits the central bank’s ability to increase the amount of money in the economy and hereby initiates artificial boom-bust cycles.
One of the most common monetary policy rules or regimes is inflation targeting, defined by Bernanke and Mishkin (1997, 97) as “the announcement of official target ranges for the inflation rate at one or more horizons and… explicit acknowledgement that low and stable inflation is the overriding goal of monetary policy.” This regime of monetary policy is defended mostly for its high transparency and comprehensibility. A credible central bank may, by setting and publicly communicating its inflation target, simply control inflation expectations of agents in the economy and hereby control the inflation rate (Bernanke and Mishkin 1997). Furthermore, Svensson (1999) states that the inflation targeting regime helps to maintain low and stable inflation rate in the long run.
Taylor (1993) suggests a policy rule that allows the central bank to respond to the output gap and to the difference between the actual inflation rate and target for the inflation rate. The rule may be expressed by the following equation according to Mankiw’s (2009) macroeconomics textbook:Taylor (1993) assumed specific values of parameters ρ, πT, θπ and θY. Mankiw’s (2009) equation is written without any assumptions for parameters and variables.
(1)
where i denotes the central bank’s nominal rate of interest, π stands for the rate of inflation, πT is the central bank’s target for the inflation rate (set as a positive number), (yt – y*) expresses the percentage difference between current real output of the economy and its natural level, ρ is the natural rate of interest, and parameters θπ and θY express responsiveness of the central bank to changes in the inflation rate and to the deviations of real output from its natural level. Parameters πT, θπ and θY are set by the central bank. Money supply is endogenous under this rule.
The Taylor rule implies that if the rate of inflation is on the target and output does not deviate from its natural level, the central bank should set its nominal rate of interest equal to the nominal equilibrium rate of interest ρ + πt. If the rate of inflation decreases below the inflation target, the central bank should decrease its nominal rate of interest and vice versa.A sufficiently strong decrease in the central bank’s rate of interest pushes the real rate of interest downwards, below the natural level. This stimulates investments and consumption and increases the rate of inflation, which is hereby stabilized at its target.
Despite its several critics (e.g. Orphanides 2001, or Orphanides and Williams 2002), some version of the Taylor rule is used in models of new Keynesian economists (e.g. Clarida, Galí and Gertler 1998, or Svensson 2000a).
- INFLATION TARGETING: AN AUSTRIAN PERSPECTIVE Let us now assess the policy of inflation targeting from an Austrian perspective. The first problem may arise with the definition of inflation. While Austrian economists usually define inflation as an increase in the quantity of money in the circulation, mainstream economists usually speak of an increase in the aggregate price level (Bagus 2003). For purposes of this paper, let us accept the mainstream definition; inflation means a rising price level and may be measured by the consumer price index or by the GDP deflator.
Another, more serious, problem arises with targeting the positive inflation rate in the growing or stationary economy. While all central banks targeting inflation have positive inflation targets, Hayek (1928) suggests that if the quantity of money is held constant, prices must fall if the output rises and vice versa.
Hayek (1935) further argues that in the growing economy, the equality of the natural rate of interest and the market rate of interest is feasible only in case of the falling price level; price level should not be stabilized in the growing economy.Wicksell (1936) argues that the market rate of interest is equal to its natural level in case of stabilized price level. Hayek (1935) objects that this holds only in the stationary economy. Further discussion on this issue may be found in Potužák (2018).,White (1999) points out that Hayek (1976) not criticizing price level stabilization is not consistent with his previous works. Komrska and Hudík (2016) reject this alleged inconsistency. If prices are intended to rise or remain stable in such an economy, the central bank must permanently increase the amount of money in circulation, and it thereby creates permanent pressure for the reduction of the market rate of interest below its natural level.This holds regardless whether the central banks control interest rates or the money supply. An attempt to stabilize the price level in the growing economy leads to an increase in the money supply and to a decrease in the rate of interest below its natural level.
This may be simply shown using the quantity theory of money and the equation of exchange:
(2)
where M expresses the money supply, V velocity of circulation of money, P aggregate price level and Y real output. The expression MV on the right side of the equation 2 may be called nominal income of the economy.
Equation 2 implies that in case of a stable velocity of money and a stable money supply, nominal income is stable as well; then, if real output rises, the price level must fall. A permanent increase in the price level in an economy with growing natural output unambiguously implies the necessity of a permanent increase in the money supply or velocity. Targeting a positive inflation rate in the economy with growing or stationary natural output necessarily implies permanent pressure for the reduction of the market rate of interest below its natural level, which according to the Austrian business cycle theory, distorts the free market system of relative prices and triggers an artificial boom. Potužák (2018), therefore, shows that inflation targeting (or price level stabilization) is not a suitable policy in the economy with growing natural output; price level may be stabilized only in a stationary economy.
Furthermore, inflation targeting leads to the distortions in the free market system of relative prices (Cochran 2004). An increase in the price level due to an increase in the amount of money in circulation is never uniform; some prices rise and some may even fall when the central bank injects new money into the economy (Mises 1953). Selgin (1997) describes a case of a decrease in only one individual price due to a positive shift in technology while all the other prices remain unchanged. In such case, aggregate price level slightly decreases, and the central bank needs to increase the money supply to stabilize it. Thus, after a decrease in only one individual price, the central bank aiming to stabilize the price level changes all the prices in the economy. Selgin (1999) states that even Hayek realized that attempts to stabilize the price level if real output rises lead to serious dislocations of relative prices.
The last objection deals with the central bank’s alleged ability to simply control inflation expectations in the economy. This might be true; nevertheless, Murphy (2005) proposes that entrepreneurs need not care about all prices in the economy or about the aggregate price level. What matters in entrepreneurs’ decision-making are expectations about only a small set of market prices; entrepreneurs need to know only prices of their inputs and outputs. Since an increase in prices after monetary expansion is never uniform (Mises 1953), inflation expectations are different from expectations of individual price movements. All individual prices may change even in case of price level stability; hence, entrepreneurs may expect a change in a small set of prices even in case of a stabilized price level. Furthermore, some individual prices may decrease even in the case of an increasing price level. The presumed advantage of the inflation targeting regime might be hereby partly disproved from an Austrian perspective since the central bank does not possess the ability to control individual-price expectations, but only price-level expectations or inflation expectations.Inflation targeting might be probably problematic from some parts of mainstream economics (i.e. Lucas 1972) as well since it targets something that no single agent in the economy uses as his benchmark.
To sum up this section, it seems that inflation targeting suffers from several serious objections and, from an Austrian point of view, should not be evaluated as a suitable regime of the central bank policy in the growing economy. In the next section, we will introduce a rule that might be more convenient from the Austrian perspective.
- SUGGESTION OF THE NEGATIVE INFLATION TARGET There have already been some attempts to suggest a monetary policy rule that would not initiate boom-bust cycles in the growing economy. Hayek (1935) proposes that the central bank should not stabilize the price level, but rather money stream defined by the total nominal spending in the economy. Potužák (2016) explains that only keeping the money stream MV constant protects the economy against adverse effects of shocks to the velocity of money circulation that are similar to the effect of shocks to the money supply. Under Hayek’s (1935) rule,Potužák (2016) uses the term ‘Hayek MV-rule.’ money supply changes only in case of velocity changes; the central bank compensates changes in velocity of money circulation by opposite changes in the amount of money in the economy. Under such a rule, the price level would fall in the economy with growing natural output, which is consistent with the Austrian view presented in the previous section.
Nevertheless, currently central banks usually do not control the money supply but set nominal interest rates to keep the money growth within a certain interval and to fulfill their objectives. For this reason, Hayek’s proposal is not further considered as a suitable rule, but the suggestion of stabilizing money stream MV will be preserved. Some economists (e.g. Bean 1983, Hall and Mankiw 1994, West 1994, or McCallum and Nelson 1999) suggest nominal income targeting as an optimal monetary policy regime. Nominal gross domestic product would grow at a constant rate equal to the sum of the long-run average rate of growth of real output and targeted inflation rate. Nonetheless, such a policy is not significantly different from the inflation targeting. If nominal income growth is targeted, the right side of equation 2 is targeted to rise permanently. Then, the left side must grow at a stable growth rate as well, which means a permanent injection of new money into circulation. For this reason, nominal income targeting cannot be recommended as a suitable policy, since it suffers from the same problems as the inflation targeting.
As was already explained in the previous section, the Hayekian framework predicts that the aggregate price level must fall in the economy with growing natural output. Hence, introduction of the negative inflation target is suggested. The quantity theory of money and the equation of exchange is used to derive this negative inflation target. Equation 2 may be rewritten using the growth rates of all variables, obtaining the following equation:
(3)
A constant money stream MV is desired for the reasons explained above. Equality of the growth rate of the economy with the growth rate of potential output is assumed in the long run:
(4)
Hence, conclusions of Hayek (1928, 1935) combined with equations 3 and 4 imply the following formula for the optimal inflation target:
(5)
implying that in the Hayekian framework, the growth rate of the price level should be equal to the opposite to the growth rate of the potential output of the economy. The central bank could still use the Taylor rule and only use the equation 5 to set its optimal inflation target. Since the growth rate of the economy is roughly constant in the long run on the balanced-growth path (Barro and Sala-i-Martin 2004), target for inflation should be constant over time as well in such an economy.Campbell and Mankiw (1987) argue that an economic development has a stochastic trend and, thus, a growth rate of the economy is not constant over time. If this were true, the inflation target should be set as a long-term average growth rate of the economy and should be held constant for a longer time period. It would mean that monetary policy would not be completely neutral, since changes in the growth rate of the economy could cause deviations of the central bank’s inflation target from the optimal inflation target prescribed by the equation (4), but the central bank could simply control inflation expectations. Such a monetary policy regime could be acceptable for advocates of the inflation targeting (Bernanke and Mishkin 1997, or Svensson 1999) since their arguments in favor of the regime of inflation targeting might hold regardless whether the target is positive or negative. The suggestion of a negative inflation target incorporates a desired high level of transparency, trustworthiness and predictability of the central bank policy; by publicly announcing its negative inflation target, the central bank might reduce uncertainty concerning future monetary policy conditions and hereby control inflation expectations of entrepreneurs. Thus, from this perspective, inflation targeting with the positive target might not be more advantageous compared to the suggested negative inflation target policy.Nonetheless, inflation targeting proponents (Bernanke and Mishkin 1997, or Svensson 1999) broadly defend positive inflation targets. Our suggestion of negative inflation target policy would probably be criticized by them, even though the central bank would remain transparent and predictable. This objection will be discussed in the fourth section.
Nonetheless, negative inflation target policy could be more suitable than the inflation targeting with the positive target. Since, according to Hayek, the aggregate price level should gradually decrease in the economy that is going through technology-induced growth, monetary authority need not be so activist when targeting the negative inflation rate. Positive inflation rate in the economy with growing natural output must always be induced by the central bank injecting new money into the economy; on the contrary, negative inflation may be achieved per se, without any monetary authority actions.
If the central bank accepted negative inflation target policy, adjustments of the interest rate and money supply would not be needed so often and the free-market system of relative prices should be distorted less compared to targeting the positive inflation rate. Since the central bank would not permanently lower the money rate of interest below its natural level, monetary policy would not be excessively expansionary and would not initiate artificial boom and bust cycles so often. Output of the economy would be stabilized around its potential level and the course of the economic development would be smoothed.
Furthermore, since the central bank would not intervene permanently in the money markets, a free market system of relative prices would not be artificially distorted. Entrepreneurs might be able to form expectations and predictions of their prices more easily and more accurately than in case of the positive inflation target since prices would be affected only by market forces and fundamentals and not by monetary authorities (Murphy 2005).
Finally, introduction of a negative inflation target might not mean a large change in current central bank policies. Central banks setting a negative inflation target could still use some kind of the Taylor rule; the suggestion of a negative inflation target means only a change in one parameter of the monetary policy rule determined by the central bank.
- POSSIBLE CRITICISMS OF A NEGATIVE INFLATION TARGET POLICY Besides previously discussed advantages of the negative inflation target, there might be some criticisms of the suggested policy rule. This section aims to anticipate and partly disprove them.
Firstly, the suggested policy with a negative inflation target could not ensure absolute soundness of money. The central bank would have to intervene in credit markets in case of changes in the velocity of money circulation. A decrease in velocity should be accommodated by an increase in the money supply that would keep the money stream MV constant (Hayek 1935). Nevertheless, since injections of new money into the economy are not uniform and it is not ensured that new money enter exactly to the sectors with decreased velocity, free-market system of relative prices may be distorted by an inflow of new money. This monetary accommodation is, however, desirable since otherwise the economy would suffer from stronger deflation than implied by equation 5.
Moreover, the central bank would have to intervene during the business cycle since real output of the economy equals to the potential output only in the long run, and the same holds for the inflation rate and inflation target. In the short run, since the economy is hit by supply and demand shock and goes through cyclical fluctuations, the central bank committed to the negative inflation target policy would have to intervene by adjusting the rate of interest (and hence the money supply) to stabilize the inflation rate at its target and the output at its potential. If the economy is hit by a positive supply shock (i.e. due to a drop in commodity prices) and deflation deepens, the central bank, to comply with its negative inflation target, needs to lower its rate of interest to increase the amount of money in the economy. Such policy leads to a smaller decrease in the aggregate price level and the desired negative inflation rate target is met.The other possible way to conduct monetary policy in such a situation would be not to react at all and to let prices freely adjust. We treat such policy as less suitable since the rate of inflation would not be stabilized at the target and the central bank would lose control over inflation expectations. Nonetheless, the increase in prices after a monetary expansion is not uniform and the free market system of relative prices is distorted by such an attempt to override a supply-driven price development. The Austrian business cycle theory predicts that an artificial boom might be triggered by such policy. Hence, the suggested policy might not work optimally during the recessions when the inflation rate decreases below its target, which is attainable only after monetary expansion. Hence, the suggested policy might not be called non-distortionary, but rather less distortionary.
This criticism of inflation targeting, however, holds regardless of whether the inflation target is positive or negative. Nonetheless, Mises (1953) and Hayek (1933, 1935) claim that cyclical fluctuations of the economy are induced by overly expansionary policy of the monetary authority. The previous section concluded that a negative inflation target policy restricts interventions of the central bank in the credit markets and might lead to the business cycle smoothing. Then, the inflation rate should not deviate frequently from its targeted value and the frequency of central bank interventions should be lower compared to the positive inflation-target policy. From this perspective, the negative inflation target seems to be more appropriate than the positive target, although absolute neutrality of money would not be ensured.
Secondly, negative inflation target might be criticized by New Keynesians since they commonly prefer a positive inflation rate and there occurs a widespread fear from deflation (e.g. Akerlof, Dickens and Perry 1996, or Bernanke and Carey 1996). However, Borio and Filardo (2004a) distinguish three types of deflation: the good, the bad, and the ugly. Deflation implied by the proposed negative inflation target policy corresponds to the good one, caused by an increase in labor productivity and economic growth. Hence, there might be no reason for fear from this harmless deflation. Furthermore, Sargent and Wallace (1975) suggest that fully anticipated price changes should have no effect on the economic development. If the central bank with the negative inflation target were credible enough, there would be no unexpected deflation and no harmful effects on the economy.Any differences between the actual and expected rate of inflation might be avoided to prevent the deflation spiral and potentially other adverse effects of deflation. For this reason, if the central bank decided to implement the suggested negative inflation target policy, it should be implemented by gradually decreasing the inflation target accompanied by transparent communication of the central bank, so that all people may build the decreased inflation target into their inflation expectations.,Atkeson and Kehoe (2004) and Ryska (2017) showed empirically that there is no link between deflation and depression, except for the period of Great Depression. This may be another argument against fear from deflation.
Another argument in favor of the positive inflation rate claims that even fully anticipated deflation may be harmful since it leads to a reduction in consumer spending; consumers expect further decrease in prices and postpone their purchases in order to buy cheaper in the future (Krugman 1998). Potužák (2015) rejects this argument since the optimal flow of consumption over time does not depend on a ratio of present and future prices of consumption goods. The intertemporal allocation of consumption is determined by the real rate of interest. If expected deflation leads to a decrease in nominal rate of interest, real interest rate remains unaffected and optimal flow of consumption remains unaffected as well. Hence, there is no reason to be afraid of spending postponement in case of fully expected deflation.Further discussion on this issue may be found in Kovanda and Komrska (2017).
Thirdly, the proposed policy might be criticized for the problem of the zero-lower bound on nominal interest rates. Many economists (e.g. Summers 1991, McCallum 2000, Reifschneider and Williams 2000, Svensson 2000b, or Eggersson and Woodford 2003) point out that nominal interest rates cannot fall below zero. In case of the inflation rate below the target, the Taylor rule implies the necessity of lowering the central bank’s rate of interest. Because of the zero-lower bound, nominal interest rate could not be decreased below zero, which would increase real interest rate and the central bank would not be able to meet its inflation target. One might expect that the probability of the lower zero bound attainment would be increased in case of negative inflation target since equilibrium nominal interest rates would be closer to zero, compared with targeting the positive inflation rate.
Let us solve this issue. The Fisher equation expresses the following relation between the nominal and real rate of interest:
(6)
where i denotes the nominal interest rate, r stands for the real interest rate and π expresses the inflation rate. It is obvious that the negative inflation rate decreases the nominal interest rate compared to the positive target. Assuming that the inflation rate equals its target and real output is stabilized around its potential in the long run, plugging equation 5 into equation 6 implies that under the negative inflation target policy, the nominal interest rate would be given (in the long run) by the difference between the real interest rate and the growth rate of potential output of the economy:
(7)
It may be shown that the real rate of interest is higher than the growth rate of the real output if the economy is dynamically efficient (Romer 2006), hence, if the economy does not over-accumulate capital. In such an economy, the nominal interest rate is positive in the long run (Potužák 2016). Hence, even if the central bank targeted negative inflation rate, nominal interest rate would remain positive in the long run.Nominal interest rate would definitely be closer to zero than in the case of positive inflation target.
A zero lower bound might be hit in the short run since the inflation rate may fall below the target and a negative output gap may occur during the business cycle. In such a case, the Taylor rule prescribes that the central bank should lower the nominal interest rate. Since the nominal interest rate would be close to zero in the long run, there would be only limited scope for lowering the interest rates and the zero lower bound might be hit. Nonetheless, we have shown that the course of the business cycle might be smoothed under the negative inflation target policy, hence, the zero bound on nominal interest rates should not represent a serious threat under the proposed policy rule. Furthermore, since the path of economic development should be smoothed under the proposed policy, the probability of the zero-lower bound hit should be even lower than in the case of positive inflation target. The proposed negative inflation target policy might be superior to the current policies with positive inflation targets.Furthermore, Borio and Filardo (2004b) examining 14 economies in the 19th century conclude that the zero bound was never hit when the economy experienced sound deflation driven by technological progress and economic growth. This empirical result might support our theoretical conclusions, although there were no central banks in most of countries in the 19th century, while our suggestion of negative inflation target still counts with a central bank that actively sets interest rates.
Finally, New Keynesian economists (e.g. Summers 1991, Akerlof, Dickens and Perry 1996, or DeLong and Sims 1999) claim that a moderate positive inflation rate permits maximum employment and output growth in the long run because of the downward nominal-wage rigidities. For this reason, Ball (2013) even argues for an increase in inflation targets. Deflation might lead to higher than natural growth in real wages, which would increase involuntary unemployment. Nevertheless, the question is whether a decreasing profile of nominal wages would be necessary under the suggested policy. As the economy goes through the technology-induced growth, real wages grow because of the growing productivity of labor. Nominal wages might be kept constant and decreasing price level would lead to desired increase in real wages.
Let us examine this issue mathematically. Nominal wage wN is defined as a product of the real wage wR and the price level P:
(8)
Then, the growth rate of the nominal wage may be expressed by the following equation:
(9)
Neoclassical growth modelsNeoclassical growth models are explained in Barro and Sala-i-Martin (2004) or Romer (2006). predict that in the economy on the balanced growth path (steady state), the growth rate of the real wage is given by the technology growth g. Furthermore, equation 5 expresses the idea that the growth rate of the price level under the suggested negative inflation target policy equals the opposite of the growth rate of the potential output. Neoclassical growth models predict that this growth rate is given by the sum of the population growth n and the technology growth g. By plugging these growth rates into equation 9, we obtain the following formula for the growth rate of the nominal wage under the suggested policy:
(10)
We have expressed that the nominal wage growth rate would be given by the opposite of the population growth rate.Potužák (2015) comes to the same conclusion. Hence, downward rigidity of nominal wages constitutes a serious objection against the suggested negative inflation target policy if this policy were used in countries with positive population growth. In such countries with downward rigidities of nominal wages, our suggestion would lead to higher than natural growth in real wages, which would increase involuntary unemployment.
Nevertheless, Hayek (1976), Selgin (1997) and de Soto (2012) state that rigidities in nominal wages may be strengthened by the inflationary monetary policy. If real wages are rising due to technological progress and the central bank targets positive inflation rate, nominal wages must rise by a higher growth rate than the price level. This creates an environment that limits downward flexibility of nominal wages. In an environment of a stable and expected decrease in the price level, rigidities in nominal wages could be at least partly eliminated since employees could be even willing to accept a moderate decrease in their nominal wages implied by equation 10 and a falling price level would lead to an increase in their real wages.
CONCLUDING REMARKS This paper aimed to propose an objective for the central bank policy consistent with the Austrian business cycle theory. The research was motivated by the fact that many Austrian economists suggest a banking system without the central bank. Nevertheless, the existence of the central banks probably cannot be changed. Hence, Austrian economists might aim to find a non-distortionary rule for the monetary policy.
Since the price level should fall in the economy with growing natural output in the Hayekian framework, a positive inflation target is achievable only if the central bank regularly increases the amount of money in circulation. This policy is criticized from an Austrian perspective since increasing money supply pushes the money rate of interest below its natural level hereby initiates an artificial boom-bust cycle.
Introduction of a negative inflation target was suggested in this paper. Since a constant money stream is desired from the Austrian perspective, we proposed inflation targeting with the target set as the opposite number to the growth rate of the economy.
Such a policy should be superior to the positive inflation rate target since it reduces activism of the monetary authority and smooths economic development. Furthermore, all advantages of the positive inflation targeting might be kept. Possible criticisms of the suggested policy rule were anticipated and aimed to disprove, although it is not a completely non-distortionary policy.
In our view, the main challenge for future research lies in integrating the Austrian theory of capital and business cycle into the DSGE models that are one of the building blocks of modern macroeconomics. Development of the economy under the suggested negative inflation target policy could be simulated in such framework, which could help to further disprove possible criticisms of our suggestion.
Saifedean Ammous explains why Austrian economics helps us understand Bitcoin, and how Bitcoin can help us understand Austrian economics.
Presented at the Libertarian Scholars Conference on 28 September 2019, at The King's College in New York City. Includes an introduction by Jeff Deist.
Translated from the Italian Della Moneta (1751) by Peter R. Toscano (1977).
From Wikipedia:
Summary Della Moneta is divided into five sections, covering what are still seen today as the standard aspects of monetary theory. These include the origin of money, its value (including inflation and deflation), interest, and monetary policy.
The Origin of Money The author, only 23 years old at the time, started with the history of Italian coinage, going back to the Greeks and Romans. Discarding the contemporary view of the origin of money through centrally planned contracts, Galiani proposes that money tends to arise spontaneously, through the need for trade, anticipating the Austrian school of economics by well over a century. He describes a sort of thought experiment, in which a government would attempt to trade or confiscate through taxes a portion of all goods in the kingdom, until it finds that the plunder is too diverse and complex to manage, and would then turn to demanding only the trade equivalent in some simple commodities that happen to have the traits seen as useful for money at the time, like compactness, ease of distribution and ease of storage.[1]
The Value of Money Interwoven into the other themes throughout the book is a second premise, that money, and material goods in general, have value based on their utility to people: a premise that was only rediscovered with examination of marginal utility 120 years later.[2] He even touches upon a modern idea that would not be deeply examined again until the mid 20th century: that the value of money and goods may reach an equilibrium in price, based on supply and demand. This may also be the first modern examination of supply and demand as an economic driver.
Methodology In Della Moneta, Galiani attempts to use philosophical methodology in the presentation and organization of his book. He also criticizes other early economic texts as failing to do so. For example, he mentions Montesquieu, whose book he argues was harmful to France, because it commits the is-ought fallacy, contains wishful thinking, and lacks scientific rigour.[3]
Influences: Galiani appears to have been well-versed in the complex debates about how and why money had such an impact on Europe in the previous two centuries, brought on by incidents like the price revolution in Spain in the 16th century, where an influx of gold plundered from the New World caused dramatic inflation in first Spain, then all of Europe, a crisis that continued to varying degrees until around the time of Galiani's book.
He makes mention, in the book, of previous thoughts on topics of political economy by others, including John Locke and Ludovico Antonio Muratori.
Impact This book has widely cited by economists from different schools of economic thought from Adam Smith's time on, from Karl Marx through Joseph Schumpeter.
Bob Murphy explains some of the most important points in his new QJAE article on the fractional reserve banking debate. Bob shows why Mises thought any issuance of fiduciary media caused the boom-bust cycle, and he points out a major flaw in George Selgin’s defense of fractional reserve banking.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
Endorsed by F. A Hayek, it is one of the most important works on 100 percent banking ever written. Perhaps today's economists at the Fed should take a look.
From the preface to the first edition:
The revival now of this ancient 100% system, with the readjustments demanded by modern conditions, would effectually restrain the monetary inflation and deflation incident to our present system; that is, would actually stop the irresponsible creation and destruction of circulating medium by our thousands of commercial banks which now act like so many private mints. For these and other reasons, the 100% system would be a great boon, even to bankers.
That this is true is recognized by a few bankers who have studied the economic effects of the system under which they now operate and who see that the 100% system would largely save them from great depressions.
A private graduate seminar, recorded at the Mises Institute in Auburn, Alabama, on 16 July 2019.
Dr. Mark Thornton, our in-house Cantillon expert, joins the Human Action Podcast to discuss the contributions of this important proto-Austrian thinker. Cantillon may well have written the first true economic treatise, one which lays out a comprehensive theory of production, money, interest, value, method, and trade—almost 150 years before Menger's Principles. And along with the other French physiocrats, Cantillon gave us the concept of lassez-faire that later influenced Adam's Smith's invisible hand. If you want to understand economics today, and the precursors to the Austrian school, you need to know Cantillon and his work.
Cantillon's An Essay on Economic Theory, edited by Mark Thornton. Free PDF available.
A biography of Cantillon by Mark Thornton.
"More on Cantillon as A Proto-Austrian" by Guido Hülsmann.
Subscribe and listen to the Human Action Podcast on iTunes, YouTube, Stitcher, Soundcloud, Google Play, Spotify, or via RSS.
ABSTRACT: The extensive debate over fractional reserve free banking (FRFB) has spanned decades and includes volleys from many contributors. Consequently, relative newcomers to the controversy often wish to extend the conversation on several fronts. In this spirit, Bagus and Howden (2010) is a 27-page paper detailing numerous objections to FRFB, which they modestly entitled, “Fractional Reserve Free Banking: Some Quibbles.” The present paper continues in this tradition, elaborating on some of the key critiques of FRFB raised by others earlier in the debate. In particular, I critically explore two key claims of the FRFB camp: that holders of banknotes implicitly lend funds to the issuing bank, and that the historical periods of relatively free banking illustrate the stability of the system.
JEL Classification: B53, E32, E42, E58, G21 Robert P. Murphy (Robert.P.Murphy@ttu.edu) is a Research Assistant Professor with the Free Market Institute (FMI) at Texas Tech University.
I thank Vincent Geloso for references on early Canadian economic data. I also thank an anonymous referee for helpful suggestions on including more of the debate in my discussion.
Quarterly Journal of Austrian Economics 22, no. 1 (Spring 2019) full issue, click here.
I. INTRODUCTION The debate over fractional reserve banking predates the Austrian School. David Hume favorably cites the bank of Amsterdam (Hume 1987 [1742], II.III.4), while Adam Smith explains this famous case of 100 percent reserve banking in The Wealth of Nations.“The bank of Amsterdam professes to lend out no part of what is deposited with it, but, for every guilder for which it gives credit in its books, to keep in its repositories the value of a guilder either in money or bullion. That it keeps in its repositories all the money or bullion for which there are receipts in force, for which it is at all times liable to be called upon, and which, in reality, is continually going from it and returning to it again, cannot well be doubted…. At Amsterdam… no point of faith is better established than that for every guilder, circulated as bank money, there is a correspondent guilder in gold or silver to be found in the treasure of the bank” (Smith [1776] 1904, IV.3.27). In fairness to proponents of fractional reserve free banking, I concede that some later writers have described the bank of Amsterdam as a forerunner of modern central banks. The early 19th century British Currency School was so influential that it achieved a legislative insistence on 100 percent reserves in the issuance of banknotes (though not demand deposits) in the famous Peel’s Act of 1844. (Salerno 2012, p. 98)
Besides some economists in the Austrian tradition, the Chicago School is also known for a streak favoring 100 percent reserves (e.g. Fisher 1935), and in the wake of the financial crisis some prominent Real Business Cycle economists are reconsidering the proposal (Prescott and Wessel 2016). Yet the present paper falls squarely within the Austrian School, critiquing the practice of fractional reserve banking from the perspective of Mises-Hayek business cycle theory. Some representative works in this vein include Mises ([1912] 2009), Hayek ([1925] 1984), Rothbard ([1962] 2001), and Huerta de Soto (2006).
The foil for this paper’s perspective is the framework of “fractional reserve free banking” (FRFB) advanced for example in Selgin (1988), Selgin and White (1996), and Horwitz (2001). The free bankers endorse the Mises-Hayek theory of business cycles, but they deny that fractional reserve banking per se is the problem. Instead, the advocates of FRFB blame various types of government interference with money and banking.
As with Bagus and Howden (2010), the present paper joins this long-standing yet vigorous debate, seeking to address several of the key controversies. Although Bagus and Howden modestly label their contribution as a collection of “quibbles,” in fact their discussion of money demand and credit expansion highlights a devastating flaw in the FRFB position. In this paper, I elaborate on this problem,Selgin himself responded to Bagus and Howden (Selgin 2012), and then they responded in turn (Bagus and Howden 2011 and 2012). I will note in the text when these subsequent exchanges touched on the issues I want to revisit, but in my opinion their further discussion did not flesh out the points I make in this paper. showing that the FRFB claims are demonstrably incompatible with the Misesian approach to money and banking. Beyond that, I show that Selgin’s two highlighted examples of the best historical cases of FRFB (namely, Scotland and Canada) are, if anything, poster children for the Rothbardian warnings against fractional reserve banking.
In Section II, this paper establishes that Mises and Hayek both believed that fractional reserve banking per se is instrumental to the business cycle. Section III extends the Bagus-Howden approach to demonstrating the problem with the FRFB claim that fiduciary media need not disrupt the loan market. Section IV critically analyzes the historical examples of FRFB nominated by Selgin. Section V concludes.
II. MISES (AND HAYEK) THOUGHT FRB PER SE WAS DISRUPTIVE Setting aside the potential legal and conceptual problems with fractional reserve banking in order to focus on the economics, one of the key areas of dispute is whether FRB necessarily leads to an unsustainable boom as described first by Mises ([1912] 2009) and elaborated by his disciple Hayek (e.g. [1931] 1967). It is significant that both of these developers of what is sometimes called “the Mises-Hayek theory of the business cycle” thought that FRB was a central element of the story. To be sure, Mises and Hayek may have been mistaken, but it is worth documenting their position because in the debate over FRB, one often hears (especially in informal venues) casual claims that only dogmatic Rothbardians could find fault with fractional reserve banking per se.
We find an unambiguous statement of Mises’s position in Human Action. Mises defines “fiduciary media” as bank-issued claims to money, payable upon demand, that are not covered by base money in the vault, and then declares:
The notion of “normal” credit expansion is absurd. Issuance of additional fiduciary media, no matter what its quantity may be, always sets in motion those changes in the price structure the description of which is the task of the theory of the trade cycle. Of course, if the additional amount issued is not large, neither are the inevitable effects of the expansion. (Mises [1949] 1998, 439, n. 17; bold added.)
Regarding Hayek, even the FRFB writers admit that his understanding of commercial bank behavior is inconsistent with their claims. For example, Larry White (1999, 761) writes that Hayek ([1925] 1984, 29) “suggested in one of his earliest writings a radical solution to the problem of swings in the volume of commercial bank credit: impose a 100 percent marginal reserve requirement on all bank liabilities….”
Mises too at some points in his career called for an explicit prohibition on additional issuance of fiduciary media,In the early 1950s Mises wrote an essay (included in later editions of his The Theory of Money and Credit [1912] 2009) titled, “The Return to Sound Money.” In the portion pertaining to the United States Mises explicitly says,No bank must be permitted to expand the total amount of its deposits subject to cheque or the balance of such deposits of any individual customer… otherwise than by receiving cash deposits in legal tender bank-notes from the public or by receiving a cheque payable by another domestic bank subject to the same limitations. This means a rigid 100 per cent reserve for all future deposits, i.e. all deposits not already in existence on the first day of reform. (448) though he also wrote (for example in Human Action) in favor of “free banking” as the best practical way to restrain the issuance of fiduciary media. (Salerno 2012, 96–97) Readers should therefore not misinterpret Mises’s praise for laissez-faire in banking as an endorsement of the modern “free banking” claim that fractional reserve banking, at least under certain conditions, promotes economic stability.
To appreciate the specific problem of fiduciary media in the eyes of Mises, it is very instructive to consider where he placed the business cycle discussion in Human Action. One might have classified the periodic boom-bust cycles plaguing market economies as a result of political intervention, which would mean placing the discussion (as Rothbard did in Man, Economy, and StateSpecifically, in his own treatise Rothbard ([1962] 2009) discusses the business cycle in Chapter 12, which is titled, “The Economics of Violent Intervention in the Market.” (The discussion of inflation and the business cycle is contained in section 11 of the chapter, starting on p. 989.)) in the same section of the book that handled minimum wage laws and taxation. Yet Mises rejects this plausible approach, and his explanation illuminates his broader views on fractional reserve banking:
It is beyond doubt that credit expansion is one of the primary issues of interventionism. Nevertheless the right place for the analysis of the problems involved is not in the theory of interventionism but in that of the pure market economy. For the problem we have to deal with is essentially the relation between the supply of money and the rate of interest, a problem of which the consequences of credit expansion are only a particular instance.
Everything that has been asserted with regard to credit expansion is equally valid with regard to the effects of any increase in the supply of money proper as far as this additional supply reaches the loan market at an early stage of its inflow into the market system. If the additional quantity of money increases the quantity of money offered for loans at a time when commodity prices and wage rates have not yet been completely adjusted to the change in the money relation, the effects are no different from those of a credit expansion. In analyzing the problem of credit expansion, catallactics completes the structure of the theory of money and of interest….
What differentiates credit expansion from an increase in the supply of money as it can appear in an economy employing only commodity money and no fiduciary media at all is conditioned by divergences in the quantity of the increase and in the temporal sequence of its effects on the various parts of the market. Even a rapid increase in the production of the precious metals can never have the range which credit expansion can attain. The gold standard was an efficacious check upon credit expansion, as it forced the banks not to exceed certain limits in their expansionist ventures. The gold standard’s own inflationary potentialities were kept within limits by the vicissitudes of gold mining. Moreover, only a part of the additional gold immediately increased the supply offered on the loan market. The greater part acted first upon commodity prices and wage rates and affected the loan market only at a later stage of the inflationary process. (Mises [1949] 1998, 571–72; bold added.)
The above excerpt from Mises is extraordinarily important in understanding what role he thought the commercial banks played in a typical boom-bust cycle. Yet to correctly parse it, we should first remind ourselves what Mises means precisely by the phrase “credit expansion” (since he is contrasting it with “an increase in the supply of money proper”). Earlier in the book, Mises does not yet explain the trade cycle but defines the terminology that he will later need. He explains:
The term credit expansion has often been misinterpreted. It is important to realize that commodity credit cannot be expanded. The only vehicle of credit expansion is circulation credit. But the granting of circulation credit does not always mean credit expansion. If the amount of fiduciary media previously issued has consummated all its effects upon the market, if prices, wage rates, and interest rates have been adjusted to the total supply of money proper plus fiduciary media (supply of money in the broader sense), granting of circulation credit without a further increase in the quantity of fiduciary media is no longer credit expansion. Credit expansion is present only if credit is granted by the issue of an additional amount of fiduciary media, not if banks lend anew fiduciary media paid back to them by the old debtors. (Mises [1949] 1998, 431; italics in original, bold added.)
Putting together all three of the block quotations from Human Action that we have provided above, we can summarize Mises’s position as follows: The unsustainable boom occurs when a newly created (or mined) quantity of money enters the loan market and distorts interest rates, before other prices in the economy have had time to adjust. In principle, this process could occur even in the case of commodity money with 100 percent reserve banking.
However, in practice Mises believes such a theoretical possibility can be safely neglected, because (a) the quantity of new gold (or other commodity money) entering the economy will likely be relatively small over any short period and (b) whatever the stock of new commodity money entering the economy as a whole, typically only a small fraction of it would be channeled into the loan market upfront.
Thus, even though in principle Mises’s theory of the boom-bust cycle is fundamentally about new quantities of money hitting the loan market early on, in practice the explanation revolves around newly-created fiduciary media being lent into the market. That is why Mises described his explanation as the “circulation credit theory of the trade cycle.” When we understand how Mises thought (in principle) newly mined gold could conceivably set in motion the boom-bust cycle, it becomes crystal clear that he thought any amount of newly-issued fiduciary media—i.e., a credit expansion—would do the same. (Remember, our earlier quotation shows Mises claiming that “[i]ssuance of additional fiduciary media, no matter what its quantity may be, always sets in motion” the processes that cause the unsustainable boom.) Thus there are no caveats or other conditions to consider, on this narrow question. Mises thought fractional reserve banking per se would set in motion the business cycle.
III. EXCHANGING MONEY PROPER FOR A MONEY SUBSTITUTE IS NOT LENDING FUNDS TO THE BANK In contrast to the view of Mises and Hayek, the modern free bankers deny that FRB per se causes a deviation of market and natural interest rates. In a free market with no central bank or government-provided deposit insurance, profit-maximizing commercial banks will—so the free bankers claim—only issue fiduciary media in the case when the public increases its demand to hold bank money, and this is precisely the scenario in which we should want them to do so. The free bankers argue that an insistence on 100 percent bank reserves in the face of a sudden increase in the public’s demand to hold bank-issued money will lead to a period of monetary disequilibrium (in the sense of Yeager 1997).
With this approach, the free bankers apparently turn the 100%-reserve critique on its head. Selgin and White (1996) argue:
We aspire to be consistent Wicksellians, and so regard both price inflation and deflation as regrettable processes insofar as they are brought about by arbitrary changes in the nominal quantity of money, or by uncompensated changes in its velocity, and not by changes in the real availability of final goods or the cost of production of money. It is therefore an attractive feature of free banking with fractional reserves that the nominal quantity of bank-issued money tends to adjust so as to offset changes in the velocity of money. Free banking thus works against short-run monetary disequilibrium and its business cycle consequences. (Selgin and White 1996, 101–02; italics in original.)
Selgin (1988) makes the point in greater detail. He first recognizes that the balance between money supply and demand is conceptually distinct from equality between the market and natural rates of interest, but he claims that under a regime of free banking the two will be synchronized:
As used here “monetary equilibrium” will mean the state of affairs that prevails when there is neither an excess demand for money nor an excess supply of it at the existing level of prices. When a change in the (nominal) supply of money is demand accommodating—that is, when it corrects what would otherwise be a short-run excess demand or excess supply—the change will be called “warranted” because it maintains monetary equilibrium.
This view of monetary equilibrium is appropriate so long as matters are considered from the perspective of the market for money balances. But it is also possible to define monetary equilibrium in terms of conditions in the market for bank credit or loanable funds. Though these two views of monetary equilibrium differ, they do not conflict. One defines equilibrium in terms of a stock, the other in terms of the flow from which the stock is derived. When a change in the demand for (inside) money warrants a change in its supply (in order to prevent excess demand or excess supply in the short run), the adjustment must occur by means of a change in the amount of funds lent by the banking system.
An important question, one particularly controversial among monetary economists in the middle of this century, arises at this point. Are adjustments in the supply of loanable funds, meant to preserve monetary equilibrium, also consistent with the equality of voluntary savings and investment? The answer is yes, they are. The aggregate demand to hold balances of inside money is a reflection of the public’s willingness to supply loanable funds through the banks whose liabilities are held. To hold inside money is to engage in voluntary saving.
As George Clayton notes, whoever elects to hold bank liabilities received in exchange for goods or services “is abstaining from the consumption of goods and services to which he is entitled. Such saving by holding money embraces not merely the hoarding of money for fairly long periods by particular individuals but also the collective effect of the holding of money for quite short periods by a succession of individuals.” (Selgin 1988, 54–55, bold added.)
Steve Horwitz echoes these sentiments, arguing that “demanding bank liabilities is an act of savings” (1996, 299, qtd. in Bagus and Howden 2010, 40). Horwitz explicitly combines the bank function of credit intermediary with fractional reserves when he writes:
Savers supply real loanable funds based on their endowments and intertemporal preferences. Banks serve as intermediaries to redirect savings to investors via money creation. Depositors give banks custody of their funds, and banks create loans based on these deposits. The creation (supply) of money corresponds to a supply of funds for investment use by firms. (Horwitz 1992, 135, qtd. in Bagus and Howden 2010, 39; bold added.)
More generally, the FRFB writers see nothing special about demand deposits, that would make them qualitatively different from other forms of credit instruments. The FRFB writers can ask rhetorically: If Rothbardians do not object to a man lending $1,000 to the bank by buying a 12-month CD, then why do they object to a man effectively lending $1,000 to the bank by keeping it in his checking account for a year? Yes, it is true that if the bank lends out some of the funds and then the man tries to withdraw his money, there could be a problem. But by the same token, there could be a problem if the bank lends out the $1,000 from the CD sale to fund a project that will not be repaid for (say) two years. According to the FRFB writers, all this shows is that commercial banks need to pay attention to maturity matching. It is not fraudulent and it does not cause the business cycle if banks sell (say) 12-month CDs and lend the funds out for 2-year projects (hoping to roll over the CDs when they mature).In the text above, I am paraphrasing a line of argument from the FRFB camp, which presupposes that the typical Rothbardian does not object to maturity mismatching per se. However, some Rothbardians do argue that maturity mismatching is the fundamental problem, of which fractional reserve banking on demand deposits is only the most prominent example. See Block and Barnett (2017) for such a claim, and see Bagus, Howden, and de Soto (2018) for a critical response, which contains citations to the volleys of the running debate. Of course, for those in the 100 percent reserve camp who agree with Block and Barnett, this particular line of argument from the FRFB would fall flat. So by the same token, there is nothing especially risky or distortionary if we look at one end of the spectrum, where savers lend their funds to the bank for a loan that matures in “zero” time even though the bank uses those funds to invest in longer maturity projects. According to the FRFB writers, that is one way to appreciate the benignity of demand deposits or checking accounts: consider them as buying CDs that mature instantly and that the saver continuously rolls over.
As we have seen, it is essential for the FRFB position that people adding “inside money” (i.e. bank-issued claims to money payable upon demand) to their cash balances are engaged in an act of saving and furthermore are lending their savings to the bank. There is much controversy on this point. Some critics of FRFB (e.g. Hoppe 1994, 72) have denied that the accumulation of cash balances is a form of saving. However, I agree with Hülsmann (1996, 34) that the accumulation of cash is a form of (gross) saving. What I deny is that this act of saving, if performed using the vehicle of a banknote or demand deposit, represents an implicit loan to the commercial bank. Thus my position is compatible with Selgin’s (2012) response to Bagus and Howden on money balances and saving (p. 139); savings can take the form of an accumulation of bank notes. But admitting this does not mean that accumulating bank notes is the same thing as lending funds to the bank that issued them. The following thought experiment will illustrate the distinction.
Imagine a young boy who receives a weekly allowance of $10 for his household chores. Each week his parents give the boy a crisp $10 bill, which he promptly stores under his mattress. After eight weeks, the boy buys an $80 video game. Does anyone want to deny that he “saved up for” the purchase? Both plain language and—I would argue—economic definitions must conclude that the boy consumed less than his income for the eight-week period, and engaged in saving. He invested in the accumulation of a very liquid financial asset, namely fiat money.
Things would not change if the boy (week after week) exchanged his fiat dollars for instantly demandable notes issued by a reputable bank. The accumulation of these banknotes would still represent saving and investment on the part of the boy. But they would not constitute a loan to the bank, any more than a man who checks his coat at a restaurant (and receives a claim-ticket) is lending his garment to the establishment. Even though a Martian observer might think the man was engaged in a credit transaction, our understanding of the true situation informs us that the coat-checking process is not a loan.
If our hypothetical boy converts actual money (“money in the narrower sense” in Mises’s terminology, or “outside money” in Selgin’s) into a banknote or demand deposit (“money in the broader sense” for Mises or “inside money” for Selgin), he has not altered his ability to command goods and services immediately in the market. Therefore there is no additional credit transaction, besides the accumulation of money per se. The boy’s saving translates into the “investment” of an accumulation of dollars in his cash balances. If he converts the fiat currency into banknotes, then his prior acts of saving “correspond to” the banknotes now in his possession. It was not his decision to convert the fiat dollars into banknotes that represents saving; that decision merely altered the form in which he holds his savings. There is no “excess saving” on the part of the boy that could accommodate the creation of additional banknotes that the commercial bank then lends out, with the boy’s $80 in fiat dollar deposits serving as the reserves.
Our analysis here exactly mirrors that of Mises. In The Theory of Money and Credit he begins a section titled “The Granting of Circulation Credit” in this way:
According to the prevailing opinion, a bank which grants a loan in its own notes plays the part of a credit negotiator between the borrowers and those in whose hands the notes happen to be at any time. Thus in the last resort bank credit is not granted by the banks but by the holders of the notes. (Mises [1912] 2009, 271)
Those familiar with Mises’s rhetorical style can guess that things do not bode well for the FRFB camp. After some historical references, Mises continues the above train of thought by declaring:
Now this view by no means describes the essence of the matter. A person who accepts and holds notes, grants no credit; he exchanges no present good for a future good. The immediately-convertible note of a solvent bank is employable everywhere as a fiduciary medium instead of money in commercial transactions, and nobody draws a distinction between the money and the notes which he holds as cash. The note is a present good just as much as the money. (Mises [1912] 2009, 272, bold added.)
Now to be sure, just because Ludwig von Mises rejected a particular view, does not suffice to demonstrate its error. Yet when it comes to arguments over FRFB within the camp of economists who all endorse the Mises-Hayek theory of business cycles, it is crucial to study Mises’s own view of fiduciary media and the connection to an unsustainable boom.
Contrary to the FRFB writers, Mises does not think that banknotes are simply a credit instrument with zero maturity. On the contrary, they are a form of quasi-money because of their special nature. Indeed a few pages earlier (p. 267) Mises explains that other types of claims are eventually redeemed; you cannot eat a claim on bread. And this is why a “person who has a thousand loaves of bread at his immediate disposal will not dare to issue more than a thousand tickets” entitling the holder to a loaf of bread. But things are different with instantly convertible claims to money, because these claims (so long as their redemption is not doubted) perform the services of money proper. That is why issuers of these claims can dare to create more tickets than they can redeem.
Early in The Theory of Money and Credit (pp. 50–54), Mises weighs the pros and cons of including fiduciary media in the category of “money” itself. After all, a perfectly secure and instantly redeemable claim to money is itself a commonly accepted medium of exchange. But Mises decides instead to use the term “money-substitute” since he thinks it necessary to distinguish between “money in the narrower sense” and “money in the broader sense” in order to explain his circulation credit theory of the trade cycle.
I have stressed these aspects of The Theory of Money and Credit—and earlier in the paper, I dwelled on the exposition in Human Action—to show that the thesis of Salerno (2012) has firm roots. It is true that Mises has kind things to say about free banking in Human Action, and his section on “The Case Against the Issue of Fiduciary Media” (pp. 322–25) in TMC is ambivalent. My modest point in this paper is that the entire Misesian framework of money and banking denies the alleged ability of fractional reserve banking to enhance equilibration in the loanable funds market.
However, in fairness Selgin could respondIt is awkward that Selgin had a chance to respond to Bagus and Howden on this point and chose not to; I am therefore reduced to suggesting what he could have said (but did not). Also, an anonymous referee disagrees with my attempt to speak on behalf of Selgin; the referee believes Bagus and Howden’s example works as is. In any event, my own thought experiment in the text above perhaps makes the point even more forcefully. that in this case, the commercial bank would not find it profitable to issue more notes than the ones that would be held by the man (who first deposited his gold coins). It is only when the community wants to increase its total money holdings broadly defined (at given prices), Selgin would argue, that the profit-maximizing fractional reserve banks would find it in their interest to issue new loans (or engage in credit expansion, in Mises’s terminology).
Bagus and Howden (2010, 43) proceed along similar lines as the present critique when they imagine an individual who originally holds some gold coins under his mattress, but then—perhaps because of crime—decides to deposit them with a bank in exchange for notes. Bagus and Howden argue that the individual’s newfound willingness to hold banknotes should not be a signal to the bank to issue more loans to the community, because there is no act of net saving here.
Yet we can tweak the thought experiment to shore up Bagus and Howden’s critique. Suppose we have a gold-using community that is at an initial monetary equilibrium (in Yeager’s 1997 sense) and a loanable funds market equilibrium where the market and natural interest rates coincide (in Wicksell’s [1898] 1962 sense). Now suppose every single person in the community becomes more fearful for the future, and desires to increase his or her real cash balances by 10 percent. Under 100 percent reserves, the only way this can happen is through additional mining and/or falling prices (quoted in gold). Yet with FRFB, this sluggish adjustment can be neatly sidestepped: Each individual goes to the bank and takes out a loan, in the form of newly printed banknotes (claims on gold), which he or she then adds to cash balances. The community achieves its desired increase in cash holdings without “wasting” real resources digging up more gold, and without the discoordination of disequilibrium sticky prices.
The only odd thing about this scenario is that when asked to explain how this maintenance of “monetary equilibrium” can avoid disrupting the loan market, Selgin et al. would have to say, “Each individual in the community lent himself the extra money he is now holding.”
IV. THE ALLEGED HISTORICAL SUCCESS OF FRFB Besides the theoretical arguments, the proponents of FRFB claim that history vindicates their position. For example, Selgin (2000) argues:
Episodes of systemwide bank failures and serious bank over- and underexpansion have been less common than is often supposed. The episodes that have occurred can generally be shown to have resulted not from any problem inherent in fractional reserve banking but from central bank misconduct or misguided government regulation or both…. Where fractional reserve banks have operated free of both significant legal restrictions and the disturbing influence of central banks, as in nineteenth-century Scotland, Canada, and Sweden (to name just a few cases that have been studied), serious banking and monetary crises have been rare or nonexistent. (Selgin 2000, 98; bold added.)
In blog posts, Selgin has held up Canada and Scotland as epitomizing the success of his vision of money and banking. For example in a 2018 post Selgin begins:
As all dedicated Alt-M readers know, I am a big fan of the Canadian banking and monetary system that flourished between Canada’s Confederation in 1867 and the outbreak of the First World War. Besides thinking it was a darn good system, I also regard it as the best example, together with Scottish banking during the first half of the 19th century, of a “free” (that is, largely unregulated) banking system. (Selgin 2018; bold added.)
In the above quotation, Selgin’s phrase “I am a big fan of the Canadian monetary and banking system” is hyperlinked to his earlier 2015 post praising the Canadian system, saying it was “famously sound and famously stable.” This claim is in turn linked to an endnote where Selgin informs the reader, “For a very good review of the features and performance of the Canadian system in its heyday, see” R.M. Breckenridge (1895), The Canadian Banking System: 1817–1890, which is a nearly 500-page book on the subject.
Thus we have Selgin himself singling out the two apparently best examples of his brand of FRFB in action: Scotland and Canada, during the appropriately defined years. And yet, as we will see, both examples hardly seem exemplary, and if anything confirm the warnings of the Austrian critics of fractional reserve banking.
Free to Refuse: Scotland During the Free Banking Period
We can quickly deal with the case of Scotland by quoting from Murray Rothbard’s (1988) review of Larry White’s (1984) book on free banking in Britain. Rothbard observes:
From the beginning, there is one embarrassing and evident fact that Professor White has to cope with: that “free” Scottish banks suspended specie payment when England did, in 1797, and, like England, maintained that suspension until 1821. Free banks are not supposed to be able to, or want to, suspend specie payment, thereby violating the property rights of their depositors and noteholders, while they themselves are permitted to continue in business… (Rothbard 1988, 230–31; bold added.)
The fact that the Scottish banks suspended specie redemption for more than two decades and were not forced to close their doors, proves that they were clearly not following the textbook exposition of a “free bank,” which is allowed to maintain fractional reserves but of course is still subject to standard legal rules concerning contract enforcement. As Rothbard goes on to note, the fact that Scottish specie reserves fell to “a range of less than 1 to 3 percent in the first half of the nineteenth century” hardly clinches the case for fractional reserve banking. It is not surprising that “free banks” in Scotland let their reserves dwindle so low, when they were “free” to turn their customers away who demanded specie redemption.
Don’t Blame Canada: Economic Volatility During the “Famously Stable” Era
As we established earlier, besides the celebrated case of Scotland, Selgin also held up Canada during the period 1867–1914 as the best example of FRFB in action, saying its banking system was “famously sound and famously stable.” In this subsection I will offer some evidence to the contrary, relying (in part) on Selgin’s own cited source.
First we can get a sense of Canadian stability by looking at a recent update (using a new method to calculate the GNP deflator) of estimates of GNP per capita. The following figure is taken from Hinton and Geloso (2018), contrasting the standard series by Urquhart (1993) with their slightly revised version:
Figure 1. GNP per capita using different deflators [[{"fid":"84064","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"GNP per capita using deflators","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"2":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"GNP per capita using deflators","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"GNP per capita using deflators","class":"media-element file-image-no-caption","data-delta":"2"}}]]
Note that the period covered in the figure (1870–1900) is a subset of the period Selgin identified. And yet, as the figure indicates, the Canadian economy exhibited nothing like smooth steady growth. Depending on which deflator we choose, per capita GNP had a sharp or modest boom-bust cycle from 1872–78, at which point it soared, rising some 30 percent in a mere four years (1880–84). Then in a single year (from 1884–85), real per capita output fell a little more than 6 percent. (To get some perspective, during the Great Recession—which of course is the worst economic calamity to hit the world since the Great Depression—the biggest year/year drop in U.S. real GDP per capita was 4.9 percent, which occurred in the second quarter of 2009.Data for U.S. real GDP per capita available at: https://fred.stlouisfed.org/series/A939RX0Q048SBEA#0.)
After the trough in 1886, there was another expansion through 1891, followed by another multiyear contraction. Then from 1896–1900 we see the beginnings of yet another massive boom, with real output per capita again rising about 30 percent in four years.
Now in fairness to Selgin, 19th century economic data are notoriously prone to exaggerate the volatility in real output during business cycles, because of imperfect adjustment of the relevant price deflators. (This is why I used a chart taken from a very recent paper, which itself quibbled with the standard reference in the literature.) Yet even if Selgin and other FRFB advocates want to claim that the wild swings in Canadian output were mostly nominal, that still contradicts their claim of stability. Under the classical gold standard, nominal prices rose during booms and crashed during busts, but that was (at least partly) due to fractional reserve banking, where the bankers fed the boom by inflating through credit expansion and then starved the bust by deflating through credit contraction. The figure above—whether we take it at face value or even if we generously suppose it is partially mistaking nominal swings for real ones—is exactly what Murray Rothbard would suppose a FRFB economy would look like. It is not how the FRFB writers describe their vision.
Ironically, even if we turn to the very source Selgin cited—namely, R.M. Breckenridge’s (1895) large book on the Canadian economy—we find decent support for the claim that FRFB fosters the standard Mises-Hayek business cycle.
For example, in the Table of Contents, this is how Breckenridge lays out the topics in Chapter VIII:
Figure 2. Excerpt from Table of Contents of Breckenridge (1895) [[{"fid":"84063","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"Banking under the Confederation 1867 to 89","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"1":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"Banking under the Confederation 1867 to 89","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Banking under the Confederation 1867 to 89","class":"media-element file-image-no-caption","data-delta":"1"}}]]
Notice that the material in Chapter VIII covers the Canadian banking system for the first 22 years after Confederation—all of this falls under the period that Selgin singled out as epitomizing a sound, stable, fractional reserve free banking system in operation.
Now surely one does not have to be a fuddy duddy Rothbardian to say that the subject headings for Chapter VIII are inauspicious at best for the FRFB camp. We see a six-year “expansion” followed by a five-year “depression,” and a section devoted to the bank losses during the depression. The 100 percent reservists can now add Selgin’s recommended text as further evidence that FRFB fosters the Mises-Hayek boom-bust cycle.
Now to be fair to Selgin, Breckenridge is a fan of the Canadian banking system that he is describing. For example, here is how Breckenridge concludes his discussion of bank failures through 1889:
Here ends, for the present, the account of bank failures in Canada. If any conclusion may be drawn from the study, it is that the disasters have been due to faults of practice, rather than defects in the system. It is clear that legislation, scientifically framed, has not prevented poor management, bad management, or fraud. No one, probably, ever expected it would. It is clear also that it has not saved shareholders from loss. A careful estimate shows that, by reductions of capital, liquidations, failures, and contributions on the double liability, shareholders have sunk at least $23,000,000 in Canadian banking since the first of July, 1867. This sum, more than 37 per cent. of the present paid-up banking capital, is independent of the losses provided for out of profits, or met by reduction of rests [sic]. The security of a group of banks, however, must be judged, not by the losses of their proprietors, but by those of their creditors. We may see now how well the Canadian system has minimized the creditors’ risks. Out of 56 chartered banks, some time in operation in Canada since the first of July, 1867, just 38 survive. Ten of those gone before have failed. But the total loss of principal inflicted during twenty-seven years on noteholder, depositor, government, or creditor whomsoever, has not exceeded $2,000,000, or less than one per cent. of the total liabilities of Canadian banks on the 30th day of last June. (Breckenridge 1895, 314; bold added.)
And so we can see the sense in which Selgin could think the Canadian free banking system was vindicated. After all, the restaurants on a busy downtown strip (say) might be characterized by a high turnover, yet so long as entrepreneurs enter the field with eyes wide open, this could be a healthy example of cutthroat competition and Schumpeterian innovation. A high percentage of restaurant failures in a certain area would not necessarily prove that the market was failing consumers.
However, there are serious problems with such an attempt to rehabilitate the Canadian experience. First of all, in our hypothetical restaurant analogy, we surely would not say, “The disasters have been the fault of the restaurants’ management, not the system.” When you have to use the word “disaster”—as Selgin’s own preferred authority on the Canadian experience did—it is hard to maintain the claimed badges of stability and soundness.
Furthermore, Selgin is moving the goalposts if he thinks loss of customer deposits is the criterion for a desirable banking system. The claim—from Mises and Hayek through Rothbard up to writers such as Salerno in the present day—has always been that credit expansion sets in motion an unsustainable boom. Breckenridge’s historical account confirms that claim beautifully. To put the matter another way: By Selgin’s criterion, we could just as well “prove” that the United States banking system from 2000–10 was perfectly stable and sound. After all, no bank customers lost any deposits in standard checking accounts, and there were no banking panics of the kind witnessed during the 1930s.
As a final note, Breckenridge’s figure of a mere $2,000,000 in creditor losses is misleading. As Breckenridge explains earlier in the book, troubled banks had suspended note redemption, and in the consolidation process some depositors had to sell their notes at a loss, even though those notes would eventually be redeemed at par. This affected the public’s mood—imagine that!—when the bank charters came up for renewal:
The expiry of all bank charters had been set for the 1st of July, 1881. In accord with the policy adopted a decade before, Ministry and Parliament took up… the question of what changes to make in the system at the time of the first decennial renewal of charters.
They were anticipated both by the public and the banks. Among the people, much dissatisfaction had been caused by the bank suspensions of the preceding year. The notes of only one of the failed banks were finally redeemed at less than their nominal value, but at that time liquidation in several cases was still incomplete. To change the notes of failed banks into convertible paper, the holder had to submit to a discount, and the brokers who took the risk exacted ample pay for it. Many of those holding notes at the times of suspension had only the option between this loss and physical want. They were forced to realize at the time when the credit of their debtors was at the lowest ebb. They could not even wait until the fears of the first week were quieted, much less till the day of final payment….
The bankers understood the popular discontent with the security of the currency. They saw their own interest, and the country’s interest, no doubt, in calming it. For them, their privilege of circulation provided an easy, convenient, and useful means of profit; to the country, it gave an elastic currency, increased sources of discount, and through the system of branches promoted by it, widespread and accessible banking faciliites. (Breckenridge 1895, 289–90; bold added.)
Whatever one might say about the block quotation above, it hardly sounds like a description of a smoothly operating free market, bereft of political favoritism, and where customer satisfaction is Job #1. On the contrary, it sounds exactly like the negative picture painted by a Rothbardian critic of fractional reserve banking.
Our brief sketches of Scotland and Canada have shown that the two examples held up by Selgin were plagued by decades-long specie suspension on the one hand, and depression coupled with bank failures on the other. It leads the critic of FRFB to doubt the accuracy of Selgin’s assurances that all major problems with banking in history were the fault of anything but fiduciary media.
V. CONCLUSION The intra-Austrian debate over fractional reserve banking is long and contentious. In the present paper, I have focused on the specific issue of whether fiduciary media per se set in motion the boom-bust cycle. I have shown that even the very definitions Mises chose in his monetary theory underscore this elemental fact. Furthermore, the FRFB attempts to reconcile credit expansion with loan market equilibrium fall apart when subjected to simple thought experiments. Finally, I have shown that Selgin’s two favorite examples of the alleged stability of FRFB—Scotland and Canada—are in fact textbook illustrations of the dangers of fractional reserve banking.
Bob finishes his three-part series by first reviewing the contributions of Böhm-Bawerk, Fetter, and Mises to the modern Austrian explanation of interest, namely the “pure time preference theory” (PTPT). Then Bob explains some of the problems for the PTPT, especially for Austrian economists. Instead, Murphy offers a much more straightforward—and Austrian!—approach, which explains interest as the premium placed on present versus future units of money.
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In this re-broadcast of a recent Lara-Murphy Show episode, Bob Murphy and co-host Carlos Lara discuss the yield curve from an Austrian perspective. Carlos explains why a business owner who practices the Infinite Banking Concept (IBC) would want to retain ownership of the life insurance policy in his or her own name (rather than the company owning it). Their discussion is part of a series, which is tied to the upcoming seminar in Nashville, Tennessee, on May 10, 2019.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
The Theory of Money and Credit—Mises's first major work—revolutionized economics by introducing a new theory of how and why money has value.
It deserves serious attention, and Dr. Jeffrey Herbener joins The Human Action Podcast for an extended discussion of this seminal work and the achievement it represented.
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Joe Salerno is Academic Vice President of the Mises Institute and one of the world’s leading economists in the Rothbardian tradition. He discusses his intellectual roots, as well as his scholarly work on money and banking. But Bob also asks Joe to recount some of his funny adventures with Murray Rothbard.
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Appendix On the Coinage Juan de Mariana
Translated by Hazzard Bagg
Hazzard Bagg (hbagg@lincolnschool.org) is an instructor of Latin and Greek at Lincoln School in Providence, Rhode Island. This translation constitutes pp. 268–278 of the Mainz edition of 1605 of De rege et regis institutione. Quarterly Journal of Austrian Economics 21, no. 2 (Summer 2018) full issue, click here. In order to fill a gap in the budget, which is never not a problem, especially in a sprawling empire, certain smart and clever men propose that it would be helpful in many difficult situations if something were to be pulled out of the weight of the coinage or from its quality, by debasing the metal while still retaining its original value. The prince gets to keep whatever is deducted from the quality or the weight of the currency. And what is more amazing, in the absence of harm or complaint on the part of the provincials. This wonderful technique is not a secret, but rather a useful method by which an incredible amount of gold and silver is redirected into the public treasury without the imposition of any new burden.
I have always typically thought of those men who promise to transform metals by some magical method—to make silver out of bronze and gold out of silver—as being the most untrustworthy sort, like itinerant snake oil salesmen. Now I see that metals are rendered more valuable without any effort; that they are doubled in value without any smelting, controlled merely by the edict of the prince, as if multiplied by some sacred touch or higher power; that the subjects are getting back from the economy what they had before at full value; that there is public utility in the fact that what is left over is handed over to the prince for his use. Who is so unreasonable, or, if you prefer, so insightful, that he would begrudge this happy state of affairs—especially when no innovations are being introduced?
Rather, we tread upon a road trampled by the feet of many, standing upon which great princes from every era have gotten through difficult times. Who will be able to deny that the Romans, under the pressure of the Punic War, reduced their copper coins, which were previously generous, first to two ounces of bronze, then to one ounce, and again to half an ounce... and that the government was freed from debt by this technique? That Drusus, as Tribune of the People, mixed bronze into the denarii that appeared to be made of pure silver? Plautus’s comparison of a new bawdy form of comedy to the new coinage is as wise as it is old.The reference is to Plautus’s Casina, lines 9–10: Nam nunc novae quae prodeunt cōmoediae multō sunt nequiōrēs quam nummī novī... “For the new comedies that are coming out now are much more worthless than the new coins....” Need I bring up the Jewish people, that superstitious race, who shun everyone else?Editor’s note: Mariana is not a blind supporter of the Inquisition and he defends conversos. This comment likely contains some degree of sarcasm, precisely because Mariana is using the Jews as an example of a people who are no longer fooled by monetary manipulation, unlike so many of the Christian population of Castile, who continue to be fooled by the alchemists at Court. I note that among them the temple shekel is worth twice as much as the common shekel for no other reason than that after a while it became clear to the people that half the value had been subtracted from the correct and original weight of the coinage, either all at once in a single stroke or gradually by means of all too frequent acts of deceit (which I suspect is the more likely explanation). There is no need to go on about other countries since it is common knowledge to anyone explaining the past that money has often been made worse by great kings through frequent devaluation.
Or do you suppose that it is for some other reason that solidi, which were first made of gold and then of silver, ultimately ended up as bronze for the most part, unless this was due to an assumed right to contaminate metals by adding some extraneous alloy? What should I say about our own maravedí, once gold, not so long ago silver, and now completely copper? Indeed, who is so confident that he dare criticize a practice employed by all nations at every point in time? Do we seek a higher form of praise in finding fault with institutions? Are we grasping at the empty favor of the masses?Note how Mariana says that a sound coinage is important to commoners. He is alluding to the argument that supporting such a policy is populist demagoguery. Indeed, I shall not deny (for how could I?) that the coinage has often been debased by our forebears and that the type of crisis can sometimes happen in which it is necessary to have recourse to this remedy. I will be the first to say that not everything that our forebears did was without fault.Note how Mariana says that a sound coinage is important to commoners. He is alluding to the argument that supporting such a policy is populist demagoguery. I would also maintain that deceit lies hidden behind the appearance of exceptional and accessible usefulness, that pure fakery exists, that considerable difficulties have arisen from this practice, both for governments and for individuals, and that one must not stoop to this point if we want a healthy situation.
First off, I assert that neither the portable possessions nor the land of subjects is under the legal control of the prince to the degree that he can take these things for himself at his own discretion or hand them over to someone else on a whim. Those who argue otherwise are blowhards and yes-men of the sort that are numerous in the halls of the powerful. Because of this, it is the case that he cannot order new taxes upon his nation without the consent of the people. For he should get his subjects to pay by asking openly, not by cheating them,Mariana distinguishes between lawful and unlawful taxation, contrasting a formal request for funds with the act of swindling. nor should he capriciously take a cut on a daily basis whereby they are reduced from a state of abundance and prosperity to a state of need. For that would be to behave like a tyrant who measures everything by his own desires, who takes possession of everything for himself, not a king who restrains the power that he has received from willing people with law and reason, and who does not extend his power all over the place. But I do not want to pursue any further a matter that is clearly understood and that has been discussed at greater length elsewhere.An explicit reference to the earlier, and quite controversial, commentary on tyrants and regicide found in Chapters V, VI, VII, and VIII of Book I of De rege et regis institutione. I shall only add that of the two it is the case that a king cannot debase the coinage arbitrarily and without the consent of the people. It, too, is a kind of tax by which an amount is extracted from the possessions of subjects. Who would agree to exchange gold for an equal weight of silver, or silver for an equal weight of iron? Generally speaking, why would anyone agree to accept a silver coin for a gold one or a copper coin for a silver one? This happens every time the money is debased. Indeed, it will only be permitted for the king to change the appearance of the coinage, since coinage is listed among the things that are held by royal right under imperial law, provided that the value remains inviolate in accordance with the quality of the money and pre-existing law.
The value of coinage is twofold. First, there is its natural value based upon the quality and quantity of the metal used, which can be called its “intrinsic” value. The second value is its legal and “extrinsic” one, which the prince sets by law, as he does the prices of other goods so that they are not sold for more than what the law without question has ordained. He is a fool who so separates these two values such that the subsequent legal value does not stick to its natural value. Unfair is he who commands that something that is commonly valued at five be generally sold for ten. No one should try to make this happen through effort or strictness.Elsewhere in this same chapter (most notably in the discussion of Henry VIII in the penultimate paragraph), Mariana rails against imposing a debased coinage by force. For people are influenced by a common valuation, which is based upon the quality of things and supply and demand; a prince would struggle in vain to tear up these foundations of commerce (which stand better unmoved), to deviate from the common opinion, and to bring a kind of force against their minds. What happens in the case of other commodities should also be extended to money. When assessing value by law, a prince ought to consider the actual price and weight of the metal and should not try to go beyond the small amount that can be added to the value of the metal to cover the cost of minting. For we are also not of the opinion which has hold of great scholars and famous legal experts that a prince must mint the coinage at his own expense, and that he consequently should not add anything to the true value of the metal.
As a general rule, however, if we do not want to fall into error and overturn the laws of nature, the legal value should not be discordant with the natural and intrinsic value. What a sleazy deal it would be if a prince were to keep the extra for himself—and all the more disgusting if anything is subtracted from the quality of the metal or the weight of the money! Or should he be allowed to break into the granaries of his citizens, take a portion for himself, and compensate citizens for their loss by granting the option to sell what is left for the value of the whole pile before his portion had been taken away? Who would not proclaim open robbery, the worst sort of embezzlement? The same scenario could be played out in the case of businesses, farming operations, and any moveable property, but you get the point.
In ancient times they used to exchange things without using money: a goat for a sheep, a cow for some grain. Then they figured out that it would be easier if merchandise and grain were exchanged for metals: gold, silver, and copper. Ultimately, so that it would not forever be necessary to weigh metals out for their dealings and transactions with one another (which is quite a pain), they decided that the various metals should be divided into units by public authority and that these units should be stamped according to the weight of each. This is the proper and natural way to use money that Aristotle tells us about in the first book of the Politics;Mariana draws on Aristotle’s famous discussion of money in Politics (1.9.1257a). those other ways of turning a trick to cheat the people were developed and discovered by men who could not care less about transparency and fairness. But even if the prince is not taxing the other commodities and is not laying claim to them, he often takes a cut of the currency; this does not mean that there is any less blame in doing this, nor is it any less of a subversion of, and stain upon, the laws of nature. But these mysterious, dolled-up schemes deceive most people with the result that the disease is felt less acutely.
“What harm is there,” they say, “if the prince takes a half or a quarter for himself, and if what is left over for individuals is spent at a value that is no less than the original one? Indeed, you buy clothing and food just like before. Where is the loss? For their money is used only to buy necessities.” So easily are the people tricked that they put up with the debasing of the coinage! Thus, the prince has more power over the coinage than he does over other commodities. The mints, mint officials, their operations, and the bureaucrats are completely in his power and control. Because of this, he is able to blend metals without anyone stopping him, he can introduce a new coinage in place of the old one stamped with a new mark, with no more honesty than if he were directing the other possessions of his citizens to himself with blatant force.
You might ask, what should be done when a confident enemy challenges in war? Add to that one who is aggressive because of a fresh victory and strong in troops and supplies, and when there is no money available with which a soldier might be recruited or a salary paid. Or will you suppose that he ought to surrender and that every type of misfortune should be endured so that the coinage can remain intact? I would think that every possible remedy should be tried before it should come to the extreme measure of debasing the currency. But if a major crisis is pressing and the safety of the people is in jeopardy and the affected citizens cannot be forced to enter into an agreement whereby the prince can commandeer the other possessions of his subjects to come to the aid of the country in its moment of need, only then will he be able to blend metals or snip off a portion of the weight, but with the proviso that the permission to debase should come to an end along with the war and that the blemish not be permanent, and then that the bad money that necessity forced upon them be straightaway turned in and retired, and that the proper old coinage be restored in place of that bad one for those who were holding it in good faith.
Frederick Augustus, the second of that name, was laying siege to Faenza in Flaminia during a very harsh winter. There was no money for soldiers’ pay, everywhere soldiers were slipping away, and units were being abandoned continuously. Lifting the siege was a disgraceful and serious thing, but continuing it was a difficult one. He marked money made of rawhide with the value of a gold coin, and with this conceit he got out of the tight spot. Once he had taken the city as victor, he exchanged the rawhide coins for as many gold ones as he had promised. The source is Collenutius in Book Four of his History of Naples. This example has been followed in similar crises certainly long ago but also in recent times, and coinage quite often made of hide but sometimes even out of paper has been marked without harm or rebuke. However, if a prince thinks that it is within his purview to debase the currency outside of one of these crises just to fill a deficit in his treasury, something that is more or less always a problem, I proclaim certain destruction—nor will the respite be long-lasting—as the following terrible afflictions demonstrate.
The first consequence will be the high cost of all commodities and food—doubtless not less than the amount that will have been subtracted from the quality of the currency. For people do not value a currency any more than the quality and amount of metal allows—not even if there are strict laws against doing this. Indeed, at that point the people will bemoan the fact that they have been tricked by an illusion, and they will sense that the new currency that has been substituted for the old one is not worth as much as the former currency when they need much greater resources than they used to in order to feed their families. Or are we serving up delusions rather than things that are plain to see from the accuracy of our chronicles? King Alfonso of Castile, known as “The Wise,” as soon as he gained control of the crown and possessions of the realm, substituted a bad currency, called the burgalesa, for the pepión, which was the coinage in use at the time. In order to relieve the high cost of things that immediately followed, he set the value of merchandise with a new law. This solution made matters worse since no one was willing to sell at the set price. And so, this scheme to set prices fell apart right from the start. The problem of high prices went on for a while. I conclude that damage to the coinage was the primary reason for the disaffection of the people and for his replacement by Sancho and his son before the end of his life. For since Alfonso was stubborn, in the seventh year of his reign he recalled the burgalesa and introduced a coinage that was called “black” because of the poor quality of the metal.The relative blackness of a coin indicates its poor quality by revealing its copper content. The more copper a coin contains, the blacker it will become via oxidation.
Alfonso XI, in no way chastened by the example of his great grandfather, also minted a coinage made from metal that was not of high quality that they called novenes and coronados. So that the prices of food and other items not increase, he took the sensible enough precaution that a mark—that is to say two-thirds of a pound—of silver not be worth more maravedís than it was worth previously (that is, 125). This ineffectual measure, however, turned out to be a useless precaution: inflation followed, the value of silver skyrocketed. Enrique the second, the son of this Alfonso, upon gaining the throne after the murder of his brother, King Pedro, had recourse to this solution in order to pay the salaries of his foreign provincial soldiers (to whom he owed his life and his throne) because his accounts were in a lot of trouble, since both the public and his personal treasuries had been exhausted. He struck two types of coinage, reales and cruzados, doubtless valued above the amount of metal in them. We have examined the reales of King Pedro and those of his brother Enrique; indeed, Pedro’s are of good silver of the kind that is struck in our own day in Castile; Enrique’s are blackish, evidently with a lot of copper added in. In order to alleviate the rise in the prices of things that followed (together with the dismay of people in the provinces), after a fresh appraisal, he was compelled to subtract two thirds from the value of both types of coinage. Thus, things that have been dreamed up so ingeniously to save us do frequently fall the other way. Oh, the short-sighted and blind minds of men!
That much the same thing befell Enrique’s son, King Juan, is evident from his laws. For, being out of money because of the wars that he waged, first against the Portuguese and then incessantly against the English, he struck a coinage that he called the blanca in order to send the money that he owed to the Duke of Lancaster, his rival for the throne, in accordance with the treaty that he had recently entered into with him. Presently the prices of food went up. To alleviate this problem, he soon reduced the value of the new currency by about a half. But the high prices did not let up, as he himself admitted at the Cortes at Burgos the following year in 1388. Why should I bring up the kings who followed? I find that the same collapse has developed from the same corrupt origin.
So much for high prices... Another problem flows from the first: Commercial activity that for the most part makes up both public and private wealth is slowed down by a debased coinage. The low quality of the currency clearly frightens shopkeepers and their customers; the high prices that follow on from this problem also frighten them. But if the prince were to set prices for things by fiat (as always seems to happen), instead of a cure, the problem will get much worse since there is no one who will agree to sell for that price, which is so clearly unfair and not squared with commonly recognized valuation. Once commercial activity has stopped, there is no category of problem which does not befall such a people.Mariana’s genius is his ability to synthesize and extend the ideas of his precursors. Notice how neatly he signals the greater, more global, threat to commerce that is posed by monetary manipulation. See his assertion above: “No one should try to make this happen through effort or strictness.” Certainly, the provincials will be of necessity stretched thin in two ways: first, due to the slowdown in buying and selling, the income from which the majority of the population lives will grind to a halt. These people are craftsmen for the most part and people whose hopes for a meal lie in their hands and in working every day—which is most people.Mariana emphasizes that inflation affects the poor more than it does the rich! Earlier in this same essay Mariana speculated that he could be accused of pandering to the people for criticizing debasing the coinage. Here he proudly embraces the accusation. Second, the prince will be forced either to completely withdraw the bad currency which is the cause of the problem or to issue a currency that is worse with its previous value reduced. So it happened that in the reign of King Enrique the second of Castile, in spite of this, he subtracted two thirds from the value of his new currency. Whoever found themselves holding that money suddenly discovered that, by the power of a word, what had been three hundred gold pieces had been reduced to no more than one hundred.
We seem to be kidding. Let us set aside the past. From the moment that he left the Church, Henry, the eighth king of England by that name, ran into many problems. Among these problems he debased the currency. For that which had an eleventh part of copper mixed in was gradually reduced to the point that it retained only a sixth part of silver. With a fresh decree he swept up the old money from the provincials and exchanged it for an equal number and weight of the new, debased currency. The people remained silent as long as they feared the savagery of that man, who thought of bleeding his citizens as a game. But after his death, his son Edward brought it about that the value of this coinage was decreased by half. Edward’s sister, Elizabeth, also subtracted another half from the remaining value once she gained the throne. So it was the case that those people who used to have four hundred gold pieces in that currency had it reduced to one hundred once three quarters of the value had been subtracted. And the damage did not stop there; that currency was thereupon taken out of circulation with no way to restore the loss, a scandalous mugging. Sanders, a scholar and at one time in the past a friend of mine, confirms this toward the end of Book One of his On the English Schism.
With commercial activity suspended and, as a consequence, with the provincials stretched thin, the pitiable disaster of royal taxes will come to the fore. The prince will be punished in proportion to how much he has enjoyed the profit from that currency. For it cannot be a good situation for a king to have a kingdom which is practically struggling physically; nor will the provincials be in a position to be stretched thin by paying taxes. Also, tax collectors will not bring in as much in royal taxes as they had before. I read that when King Alfonso XI of Castile was a child, royal officials were forced to submit to an audit; I have gleaned that all the royal taxes for the year came to 1,600,000 maravedíes. Those maravedíes were worth more than ours and each one was worth about as much as seventeen of ours, still an undeniably tiny and laughable amount. The writer of the history of that king describes how one of the two causes of this disastrous situation was the debasing of the coinage carried out by quite a few of the previous kings. Evidently, with commercial activity brought to a standstill, the subjects were reduced to a state of penury and were unable to bring into the treasury what they had typically brought in during normal times.
Who would not see that this is a tremendous handicap? Who would not admit this? Would you then prefer that there be a universal hatred on the part of the people that will inevitably overwhelm the prince? Is it not preferable to be loved than to be feared? In general, all public failures are blamed on the person in charge. Philip the Fair, King of France, confessed right before his death that he faced the hatred of the people for no reason other than that the coinage had been debased, and with his last words he commanded his son Louis “Hutin” to change it. The source is Robert Gaguin. I do not read anywhere about what Louis did, but it seems to be the case that the demonstrations and hatred on the part of the people did not settle down before Enguerrand de Marigny, the author of the foul scheme, was publicly executed, as the majority of the nobles urged during the proceedings and the entire population applauded. There is no need to mention the fact that the precedent set by this disaster did not discourage Hutin’s brother, Charles the Fair, nor their mutual cousin and successor, Philip of Valois, from treading on this same path of debasing the currency in France; nor need I mention the magnitude of the public reaction.Note how close these examples come to endorsing tyrannicide in response to currency debasement. Instead, let a limit be placed upon the discussion that has been begun here. I would like to give princes one last piece of advice: if you want your state to be a healthy one, do not touch the primary foundations of commerce—units of weight, measurement, and the coinage. A many-layered swindle lies hidden behind the appearance of a quick fix.
How Global Currencies Work: Past, Present, and FutureBarry Eichengreen, Arnaud Mehl, and Livia ChituPrinceton, N.J.: Princeton University Press, 2018, 250 pp.
Carmen Elena Dorobăț (c.dorobat@leedstrinity.ac.uk) is assistant professor of business and economics at Leeds Trinity University in the United Kingdom and a Fellow of the Mises Institute. Quarterly Journal of Austrian Economics 21, no. 2 (Summer 2018) full issue, click here. The present volume is an engaging and intriguing account of how global currencies, such as British sterling and the U.S. dollar, have risen to global dominance in the international monetary arena, and how currencies such as the Chinese renminbi, for example, could follow in their footsteps. Divided into twelve chapters, the work focuses primarily on the international monetary history of the 20th century, complemented by a comparatively brief account of the 19th and 21st centuries. The narrower focus of the discussion in these chapters—and most of the data supplied in each chapter’s appendices—concerns the composition of foreign reserves, i.e. the balance between holdings of pounds and dollars, and later of yen, euro, and renminbi.
From this, the authors propose to tease out a few new factual discoveries and some implications for the future of the international monetary system. More precisely, they disavow the traditional theoretical view which argues that international currency status resembles a natural monopoly that arises organically from the benefits of using the currency of the most economically (commercially and financially) powerful country in international economic transactions, i.e. a monopoly due to network returns (p. 4), and winner-takes-all and lock-in effects.
Because, argue the authors, this ‘old’ model is not supported by much of the data from the 20th century, they propose a ‘new’ view arguing that multiple currencies can be used concomitantly on an international scale, such as the pound sterling and the dollar during the 1920s. These currencies played “consequential international roles” (p. 11) demonstrating that inertia and persistence due to network effects in international transactions are not as strong as previously thought. Their updated theoretical framework is borrowed from the process of technological development, where new technologies are adopted gradually by users and grow exponentially, thus using an analogy between the workings of international currencies and those of computer operating systems.
Eichengreen, Mehl and Chitu’s discussion also seems to revolve around the interplay between the political sphere and national monetary policies on an international scale, but this insight remains latent throughout their analysis. The authors focus rather on the technical aspects of international currency status and deliberately treat political and monetary matters as separate—in parts dismissing political matters completely.
Chapters 2, 3, and 4 contain a factually rich historical narrative of the origin and development of the holding of foreign reserves, particularly before and after the First World War. Scattered throughout are little gems useful to any scholar of monetary theory, like the fact that “foreign exchange reserves had accounted for less than 10 percent of total reserves in 1880, [but] accounted for nearly 15 percent in 1913” (p. 17).
In Chapter 4 the authors provide evidence of the currency composition of foreign exchange reserves in the 1920s and 1930s that best underpin their ‘new’ view: they find that the dollar overtook sterling as the international reserve currency in the mid-1920s, and not in the 1930s to 1940s as previously thought by monetary scholars. This proves that the sterling and the dollar shared, at the same time, the status of international currency. Contrary to the traditional view, then, international currency status is not subject to a natural monopoly.
To further explain how this came about, the authors show in subsequent chapters the great intervention efforts of the U.S. Federal Reserve to ‘support the market between 1917 and 1937’ (p. 69). The Fed’s heavy-handed approach to trade credit (chapter 5) and international bond markets (chapter 6) propelled the dollar to international currency status over a short period before its collapse during the Great Depression. However—and again disproving the theoretical model—the dollar recovered its status around the time of the Second World War and completely surpassed the British sterling, showing that the status of international currency is, once lost, not lost forever. Rather, it can be regained through the coordinated efforts of a powerful central bank, which can heavily benefit from engineering this rise to global currency status. Moreover, the authors argue, other countries benefit as well from not relying on one global lender of last resort, but rather on a network of lenders. Chapters 9, 10, and 11 discuss along the very same lines the rise and fall of the yen and the euro (with the euro crisis), and the future prospects of the Chinese renminbi, respectively.
Despite the great amount of historical information contained in this book, and the ample new data available to the authors, the volume falls short of the promise in its title. The narrative does not actually show how global currencies work in a comprehensive manner, but only how the global ascension of a currency can be traced back to the behind-the-scenes machinations of a central bank. As such, the subject could have been—and was—satisfactorily treated in a half dozen journal articles published by the authors between 2009 and 2016 (p. xv).
Nevertheless, it is still interesting to note that the geopolitical history of the world can be read through the history of monetary policy, or perhaps, that the history of monetary policy is mirrored in the history of geopolitics. As the authors themselves explain, the dominance of one country’s currency in international exchanges can indicate the “singular leverage” (p. 3) of that country’s central bank over international financial relations and international politics. More importantly, the reverse is also true: the dominance of one country in international politics is a good indicator of the international status of its currency throughout history.
However, because the authors choose to separate the political causes and implications of monetary policies from their economic aspects, the book ultimately provides a rather hesitant and unassuming analysis that makes it feel lackluster. Two questions arise that remain unanswered: Why do central banks benefit from their currency becoming global, if not by preventing domestic inflation from reflecting in their exchange rate and foreign reserves? And why do other countries benefit from having multiple lenders of last resort (multiple reserve currencies), if not by accomplishing the same disguise? Without an answer to these questions, or even an acknowledgment of their existence, the book appears to be a collection of great insights whose potential remains unrealized.
Let me briefly illustrate this by contrasting Eichengreen, Mehl, and Chitu’s analysis of the momentous change in international monetary relations at the Genoa Conference in 1922 with the one put forward by Mises and Rothbard.
The authors discuss in chapter 3 (From Jekyll Island to Genoa) the leading countries’ efforts to restore the gold standard in the 1920s whilst avoiding the deflationary repercussions following the period of great inflation during the First World War. According to the report of the financial commission,
the Genoa resolutions called for negotiating a convention based on the gold-exchange standard with a view to “preventing undue fluctuations in the purchasing power of gold”… The idea was to create an environment in which ‘credit will be regulated… with a view to maintaining the currencies at par with one another (pp. 38–39).
Eichengreen, Mehl and Chitu view this solely as an open effort of Great Britain to recover the lost dominance of the pound sterling, and the otherwise innocent desire to renounce the golden fetters of the pre-WWI gold standard. While discussing monetary competition between London and New York, they fail to pinpoint the nature of this competition, and avoid answering the question whether the new reserve system was “badly designed or badly managed” (p. 41).
In the system’s design lurked a fateful goal: the continued inflation of money supplies. Coordination efforts among central monetary authorities in reaching this goal was a first step toward abandoning the commodity money system. While the authors only seem to skirt around the issue, Rothbard (2010, pp. 94–95) explicitly argued that Great Britain wanted to establish
a new international monetary order which would induce or coerce other governments into inflating or into going back to gold at overvalued pars for their own currencies, thus crippling their own exports and subsidizing imports from Britain. This is precisely what Britain did, as it led the way, at the Genoa Conference of 1922, in creating a new international monetary order, the gold-exchange standard.
Mises had explained this need for policy coordination in a similar way:
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 (2010a, p. 252).
If the various governments and central banks do not all act in the same way, if some banks or governments go a little farther than the others… those who expand [the money supply] more are forced to return to the market rate of interest in order to preserve their solvency through liquidity; they want to prevent funds from being withdrawn from their country; they do not want to see their reserves in… foreign money dwindling (Mises, 2010b, p. 77).
The crucial issue here, therefore, is not the prominence of one currency or another, but that this prominence was engineered to speed up the renunciation of the gold standard, and greatly enlarge the freedom of all central banks to inflate money supplies. The Genoa Conference had thus paved the way for the next steps: the Bretton-Woods conference of 1944 and the “closing of the gold window” in 1971. This process did not unfold without problems, but it created the auspicious environment for inter-governmental monetary agreements, and allowed the U.S. and other powerful nations to employ a “policy of benign neglect toward the international monetary consequences of [their] actions” (Rothbard, 2010, p. 101). This further removed many obstacles to creating “the ideal condition for unlimited inflation” (Rothbard, 2009, p. 1018)—a system mimicking a global fiat currency as closely as possible.
In this light, the desire to engineer global currency status for one nation’s currency is open to another, more somber interpretation, which highlights the pressing dangers of international fiat money. According to Mises (2010b, p. 254):
Under a system of world inflation or world credit expansion every nation will be eager to belong to the class of gainers and not to that of the losers. It will ask for as much as possible of the additional quantity of paper money or credit for its own country.
It is not usual in a book review to criticize the authors for failing to achieve something they did not explicitly set out to accomplish. And yet, How Global Currencies Work: Past, Present, and Future is wanting in both its depth and breadth of analysis. Nonetheless, the abundance of data on the composition of foreign exchange reserves the authors make available is impressive, and their accomplishment in this regard must be commended. The book is easy to read, even though largely technical in nature and much too narrow in its focus.
I remain hopeful that this project will be followed by another, more extensive investigation into the workings of global currencies. An alternative analysis of this data, focused on the differences in kind between commodity and paper money, would provide a much deeper and richer illustration of how global fiat currencies are made to work to serve the political purposes of one powerful nation or another. This would indeed illuminate much of the dark history of monetary policy over the last three centuries.
[Previously unpublished online; Faith and Freedom 1, no. 3 (February 1950).]
When the war of the American Colonies against the British Crown broke out in 1775, the money supply of the Colonies consisted of about ten million dollars in gold and silver coins — "specie." The taxation was difficult for the newly-formed Continental Congress and its credit was shaky. The new government turned eagerly to the printing press to finance its military expenditures, and issued two million dollars of paper to be redeemable, dollar for dollar, in specie. In need of money quickly at the start of the emergency, Congress intended to print only this initial amount. The idea was to collect taxes and redeem the credit money between 1779 and 1782.
But a clamor arose for more and more issues of paper money. The public's confidence in the currency remained strong, and the government had apparently financed its expenditures with no visibly harmful effects. The public seemed to enjoy the bonanza of new money.
As a result, the Continental Congress stepped up the paper money issues. The result was a steady depreciation of the paper dollar, the "continental." Prices rose rapidly, and continentals fell in value, as compared to the specie dollar.
The Congress issued six million dollars of continentals in 1775, and the issues increased each year. One hundred and forty millions were issued in 1779. As prices rose, the government found that it needed more and more dollars to finance its expenditures. More money was printed. This added supply of dollars led to further depreciation in the infamous spiral of inflation. At the outset, the continental had circulated at par with a dollar of specie. By 1780, over one hundred continental dollars were required to exchange for one specie dollar; Congress had printed continentals until they were worth almost nothing.
The Continental Congress and the state governments tried every coercive means available to prevent the persistent trend of rising prices. Stringent price-control laws were passed; other laws compelled creditors and merchants to accept continentals on par with specie. In 1775, the Continental Congress resolved: "That if any person shall hereafter be so lost to all virtue and regard for his country as to refuse [to accept the Continentals] ... such person shall be deemed an enemy of his country." But to no avail.
For the troubles, the Congress officially blamed the "monopolistic merchants," "inflamed with the lust for gain." The people were disposed to agree.
Hazardous Exchange General Putnam decreed that every one refusing to accept continentals at par would have his goods seized and be imprisoned. The Council of Safety of Pennsylvania, functioning as an executive and judicial body throughout the Revolution, was particularly zealous in trying to outlaw inflation. The Council decreed that any violator of these control laws was a dangerous member of society; that the penalty for first offense would be the seizure of the goods and a heavy fine, and for the second offense would be exile from the state. Yet, this too proved ineffectual in stopping the depreciation and price rise.
Price control, particularly in Pennsylvania and New England, led to acute shortages and widespread violations. Self-appointed committees of citizens in New England looted stores at will, selling the goods from the shelves at fixed prices. All the while, owners were accused of conspiracy to raise prices and charged with being secret Tories, speculators, and enemies of the country.
Informed that a cargo of salt had been "monopolized" and that its price had been increased as a result, the Council of Safety of Pennsylvania seized the salt and ordered it sold at a low price. From then until the end of the war, salt was almost unobtainable in Pennsylvania, because merchants were unwilling to ship salt to Pennsylvania where salt cargoes were in danger of arbitrary seizure. The Council also authorized the Justices of the Peace to seize property if they were informed that any person held more goods than he needed for his personal use.
The Rhode Island State government decreed that if some people were in want and others were deemed to have too much wealth, the Justices of the Peace might order the constables to break open the houses of the "haves" and supply the "have nots" with the goods at lawful prices. (The state was to pocket the proceeds.)
The price control laws could not stem the tide of rising prices. Statesman John Adams reasoned that the laws actually raised prices, since they created a scarcity of goods.
But this experience, instead of leading to repeal of the laws or the ending of the currency inflation, led to demands for even more stringent enforcement. Connecticut decreed a rationing scheme prohibiting any person from buying more than a stipulated amount of food and other necessities. Purchases could not be made without a license from the state. These licenses were to be granted only to "men of good character and friends of independence." All violators of the control laws were considered to be of bad character, and deprived of their licenses.
An influential citizen of Pennsylvania recommended that a "party of soldiers seize any person accused of depreciating or refusing the Congress currency, .. Let them, immediately after seizing such persons, take an inventory of the person's estate ... and let the person so seized be immediately sent to state prison, there to remain without bail till trial for treason, and let the punishment be equal to the crime." Such proposals evidence the extent of the reign of terror throughout Revolutionary America.
Despite such tyrannical measures adopted during a war for liberty, prices sky-rocketed and the continental became worthless.
Engines of Oppression Peletiah Webster, a discerning contemporary of the Revolution, summed up the effects of the American experiment with the continental. "Paper money," said Webster, "polluted the equity of our laws, turned them into engines of oppression, corrupted the justice of our public administration, destroyed the fortunes of thousands who had confidence in it, enervated the trade, husbandry, and manufactures of our country, and went far to destroy the morality of our people."
In 1780, Congress repudiated its solemn dollar-for-dollar promises and announced specie redemption at a rate of one specie dollar for forty dollars of continentals. The result of this ignominious end of the continental was a surprisingly quick return to a specie circulation, and a rapid fall of prices to a stable level.
Here Lies A courageous American contemporary wrote a fitting epitaph to the continentals:
It becomes rulers to learn from the catastrophe of our Continental Currency, that money is upon a footing with commerce or religion. They all refuse to be the subject of law. It becomes the rulers of free men to learn further that money is property, and that the least attempt to lessen its value in our pockets and chests is taxing us without our consent. It is the highest act of tyranny. We have tried every art and device to keep up the credit of paper money except one — we have never yet tried the effects of being honest.
The Bank of England apparently wants to incorporate blockchain technology and cryptocurrencies into the central bankers’ tool kit.
Original article: The Blockchain Is a Tempting Target for Central Banks
The Labour Party wants the Bank of England to actively promote certain industries over others, not realizing that the Bank has already been doing this indirectly for decades. Original article: British Left Unveils Plan to "Weaponize" the Bank of England.
In the wake of the financial crisis of 2008, the economics profession suffered a blow to what reputation it had. But unlike most of his colleagues, Mark Thornton was vindicated by 2008. Mark has been a voice of sanity at times when the wild interventions of the Federal Reserve have caused otherwise sensible people to lose their minds.
This collection serves the valuable purpose of defending the market economy against the conventional view that freedom has failed us and we need still more controls. We had plenty of rules and bureaucrats on the eve of the financial crisis. A lot of good that did us. Pretty much none of them saw any problems on the horizon.
Maybe we should consider a real free market, with sound money and market interest rates, and abolish the giant bubble machine once and for all. Read Mark Thornton and you’ll entertain this and other forbidden thoughts.
From the Foreword by Thomas E. Woods, Jr.
What this book has established is that the central bank causes a variety of economic problems and that Austrian business cycle theory (ABCT) shines a scientific light on what otherwise is a highly complex phenomenon. I have shown that the Skyscraper Index has predicted most of the important economic crises for over a century. I have also shown that Austrian economists have predicted those crises using ABCT.
Now the question arises: what are the problems and what can be done about them? The two most obvious problems with central banking and the monetary inflation that flow from them are the boom/bust business cycle and inevitable price inflation. Embedded in the process of monetary inflation and price inflation is a degenerative process of economic inequality that is so apparent today. This effect on economic inequality and the channels through which it flows are described in further detail by Hülsmann.Jörg Guido Hülsmann, “Fiat Money and the Distribution of Incomes and Wealth,” in The Fed at One Hundred: A Critical Review on the Federal Reserve System, edited by David Howden and Joseph T. Salerno, (New York: Springer, 2014), pp. 127–38.
Monetary inflation depends on who gets the money and credit first and who gets it last. As fiat money is created by central banks, private banks are in a position to expand the amount of loans they make. The wealthy have established relationships with the banks, and they have the real estate and assets to provide collateral for the loans. Large, established companies and wealthy individuals are in favorable positions relative to small businesses and people with low or average incomes. The loans allow big companies and wealthy individuals to invest in capital goods during the boom phase of the business cycle. Central banks thereby create artificial inequality and poverty. This is the primary Cantillon effect of redistributing wealth.
We have rarely had a true “free market” in money and banking. The American colonies were controlled by English mercantilist policies. The antebellum era experienced the business cycles created by the First and Second Banks of the United States, which were essentially primitive central banks. Between the end of the Second Bank of the United States and the National Banking System was the era of “free banking.” This period best approximates a free market in money and banking because gold and silver coins served as money, entry into the banking business was relatively easy, and bank reserves were kept relatively high compared to demand deposits. Government spending and government intervention were historically very low. This period experienced the highest rates of economic growth in US history, but it was not perfection, as many state free-banking laws contained poisonous provisions that undermined the stability of banking.
The National Bank Acts were passed during the Civil War and “regulated” money and banking until the Federal Reserve Act was passed in 1913. The Fed and WWI effectively ended the classical gold standard and replaced it with the gold exchange standard. In 1933 all privately held monetary gold was confiscated by the federal government, and the nominal book value of gold was changed from $20.67/ounce to $35/ounce. The post-WWII Bretton Woods gold standard allowed other central banks to convert $35 into an ounce of gold, but it also freed the Fed to essentially print gold. This arrangement eventually became untenable when other central banks began converting dollars into gold. President Nixon closed the “gold window” on August 15, 1971.
Since that time the world has been on a fiat monetary system where currencies are not convertible and exchange rates between currencies are “flexible.” The power and authority of central banks has continued to expand over time. The money supplies and central bank balance sheets have continued to expand, and the value of currencies has continued to decline. For example, in mid-2008 the total assets of the Federal Reserve were less than $900 billion. By mid-2014 their total assets were over $4,400 billion. The Fed acquired these additional assets of government bonds and mortgage-backed securities by printing electronic dollars. As a reference point, measured in gold, the dollar is currently worth less than two cents of the pre-Fed dollar. The Bank of Japan, the People’s Bank of China, the European Central Banks (ECB), and other central banks around the world are pursuing similar policies in an undeclared currency war.
MurphyRobert Murphy, “Ben Bernanke, the FDR of Central Bankers,” in The Fed at One Hundred, edited by Howden and Salerno, pp. 31–42. shows that the Fed’s responses to the financial crisis were overwhelming, unprecedented, and of dubious statutory authority. These responses were so egregious that Murphy labels Ben Bernanke the FDR of monetary policy. Despite the Fed’s efforts, Murphy concludes the policies have not worked. The ECB has also overstepped its statutory authority from the European Union in response to the European debt crisis, to no avail.
Have these policies worked well? There has been a constant debate since 2008 over whether the economy has recovered and is growing, or whether it is mired in a lingering recession. There are supporters of both views from across the political and economic spectrums. The real dividing line depends on the relationship the person has with the establishment. Supporters of the establishment contend that the economy survived and recovered, while opponents of the establishment generally consider the economy to be broken and regressing.
The battle between these two views is generally undertaken with contending sets of statistics regarding GDP, unemployment, and price inflation. Austrian economics settles the issue by looking at things such as the big increases in government spending, deficit-financed spending, and the questionable value of investments financed with artificially low interest rates since 2008. Austrians argue that the real market value of increased government spending and malinvestments is far less than the dollars expended. Thus the resulting GDP statistics are very dubious. This analysis suggests that the US economy is regressing on a long-term basis and that we are much deeper in debt as a result.
In fact, EngelhardtLucas Engelhardt, “Unholy Matrimony: Monetary Expansion and Deficit Spending,” in The Fed at One Hundred, edited by Howden and Salerno, pp. 139–48. and others have argued that a central bank facilitates the process of deficit financing and the accumulation of a large national debt. A central bank can always print money to pay for the national debt, or print money to buy up the national debt, as the Fed is doing today with its various quantitative-easing policies. The US government had a debt of around $370 billion to begin the 1970s. At the end of 2007 the national debt was $9.3 trillion, and it more than doubled before the end of 2015 to a debt of $18.9 trillion and it continues to grow. In 1970 the national debt was the equivalent of 34 percent of GDP. In 2015 the national debt as a percentage of GDP was more than 100 percent. A large national debt is a negative drag on the economy and can even result in hyperinflation. SalernoJoseph T. Salerno, “War and the Money Machine: Concealing the Costs of War beneath the Veil of Inflation,” Journal des Economistes et des Etudes Humaines 6 (March 1995): 153–73. Reprinted in Joseph T. Salerno, Money Sound and Unsound (Auburn, AL: Mises Institute, 2010). has shown that central banks also facilitate unnecessary and expensive wars because the central bank can conceal the true costs of war from the citizens.
However, as a best-case scenario, let us make the heroic assumption that all that government spending was really valuable — that is, a dollar of additional government spending produced a dollar of consumer value — and that all those investments made between 2008 and the present will turn out great. If we take the government’s measure of the economy (i.e., GDP) and adjust for the government’s measure of price increases (i.e., the GDP deflator) and then adjust that figure by the increase in population, we find that the US economy grew at less than 4 percent over the entire period from 2008 to mid-2016. Compare that to the years during the free-banking era (1837–62) when inflation-adjusted, per capita GDP growth was 3 percent or even higher per year. That is a stark contrast.
It is not a mystery as to what has caused economic malaise in the US economy. In this, we note three important factors. First, the amount of debt that has accumulated in the US economy is enormous. The amount of debt of government, businesses, and consumers has soared over the last forty-five years, and this is no doubt linked to suppressed–interest rate policy and a depreciating currency generated by the Fed. Traditionally, the total amount of debt in the United States was about 1.5 times GDP or less. Today it is about 3.5 times GDP. In other words the debt burden is too high. Second, the personal savings rate in the United States has fallen dramatically. Prior to 1971 the average personal saving rate, as measured by the government, was over 10 percent. Since 1971 the personal saving rate has declined to as low as 2 percent during the housing bubble, although it has recovered to an average of over 5 percent since the financial crisis. The Fed’s suppressed–interest rate policy and depreciating currency are the major, but not the only causes of the low personal savings rate. Third, the regulatory burden in the US economy has increased enormously over the last half century, and the amount of and burden of regulation has only accelerated since the financial crisis in the form of Dodd-Frank financial regulation and the Affordable Care Act.
The reduction in savings and the increase in regulatory burden have caused the reduction in productivity growth. A lack of productivity growth explains the stagnation in wages and the lack of high-wage job growth. Any remaining income growth has been absorbed by the increased cost of financing debt, higher taxes to finance government debt, and mandated job benefits, such as medical insurance. All of this comes on top of the fact that family incomes have been stagnant or declining for a decade and a half. Meanwhile, billionaires thrive.
With the Fed passing one hundred years of age in 2014, there have been many retrospectives on the general value of this institution. There have been some favorable and encouraging reviews from inside the Fed, but most outsiders have taken an entirely negative stance on the very existence of the Fed and the place of central banking in a healthy and free society.
White,Lawrence H. White, “The Federal Reserve System’s Influence on Research in Monetary Economics," Econ Journal Watch 2, no. 2 (August 2005): 325–54. for example, questions the influence and impartiality of the Fed. The Fed spends vast resources on economic policy research, particularly on money, banking, and macroeconomics. This funding, as both carrot and stick, has no doubt produced a status quo bias in academic research on subjects that are the concern of the institution of the Fed. According to White:
The Fed employed about 495 full-time staff economists in 2002. That year it engaged more than 120 leading academic economists as consultants and visiting scholars, and conducted some 30 conferences that brought 300-plus academics to the podium alongside its own staff economists. It published more than 230 articles in its own research periodicals. Judging by the abstracts compiled by the December 2002 issue of the e-JEL, some 74 percent of the articles on monetary policy published by US-based economists in US-edited journals appear in Fed-published journals or are co-authored by Fed staff economists.Ibid., p. 235.
White puts the size of the Fed’s research staff into perspective by noting that the Fed’s staff of economists in 2002 was 27 percent larger than the number of macroeconomists and experts in money and banking employed by the top fifty PhD-granting economics departments in the United States combined. The Fed has numerous research journals that publish an enormous number of articles, but the articles that are published are vetted by the staffs at both the regional Fed banks and the Board of Governors in Washington, DC. This no doubt creates a tremendous bias against criticism of the Fed itself.
White also found that the Fed dominates the editorial boards of the leading academic journals specializing in money, banking, and macroeconomics. At the time of his research, one of the two main editors of the Journal of Monetary Economics and eight of the nine associate editors (82 percent) had one or more affiliations with the Fed. At the Journal of Money, Credit, and Banking, all three of the main editors and thirty-seven of the forty-three associate editors (87 percent) had Fed affiliations. Therefore not only does the Fed dominate the profession in terms of carrot-and-stick resources, but it also nearly acts as a universal gatekeeper at both the Fed and non-Fed academic journals dealing with money, banking, and macroeconomics. Not only is the Fed political in defense of its institutional power, but DiLorenzoThomas DiLorenzo, “A Fraudulent Legend,” in The Fed at One Hundred edited by Howden and Salerno, pp. 65–74. has shown that the “independence” of the Fed from the political process is a complete myth.
Selgin, Lastrapes, and WhiteGeorge Selgin, William D. Lastrapes, and Lawrence H. White, “Has the Fed Been a Failure?” Journal of Macroeconomics 34, no. 3 (September 2012): 569–96. examined the Fed’s track record and found it lacking in comparison to the National Banking system. With the exception of the Fed’s role in regulating banks, they examined its roles in controlling inflation and deflation as well as volatility of output and employment; the role of the Fed in the Great Moderation; and the frequency and distribution of recessions, banking panics, and lender-of-last-resort lending. They then evaluated the results against prior monetary experience using standard empirical techniques and published research.
They showed that prior to the Fed, the purchasing power of the dollar had long-term stability. In comparison, the Fed has produced powerful bouts of both inflation and deflation and greatly degraded the value of the dollar over the long term. There has also been a trend of increased volatility and decreased predictability of the changes in purchasing power of the dollar, making long-term plans and contracts more difficult. They found that the declining rate of inflation that occurred during the Great Moderation should be attributable to other factors than the Fed’s monetary policy. Finally, they showed that the Fed has not reduced panics or improved on its function as lender of last resort. In other words, the Fed has failed to match or exceed the results of the previous monetary regime. Historian Thomas WoodsThomas E. Woods, “Does U.S. History Vindicate Central Banking?” in The Fed at One Hundred, edited by Howden and Salerno, pp. 23–30. confirms that the problems of the pre-Fed money-and-banking system were the result of various government interventions, but that it was still better than the Fed. KleinPeter G. Klein, “Information, Incentives, and Organization: The Microfoundations of Central Banking,” in The Fed at One Hundred, edited by Howden and Salerno, pp. 149–62. and IsraelIsrael, Karl-Friedrich. “The Costs and Benefits of Central Banking,” PhD dissertation, Department of Law, Economics, and Business Administration, University of Angers, France, 2017. show that the institutional features of a central bank are inherently destabilizing.
ThorntonMark Thornton, “Transparency or Deception: What the Fed Was Saying in 2007,” Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 65–84. investigated the role of transparency in the conduct of the Fed’s monetary policy. Transparency is the notion that central banks reveal information about the concerns, intentions, and policies to the general public and particularly to specialists in markets and other central banks so as to not unintentionally shock markets with negative news. Generally, transparency by central banks has expanded over the last twenty-five years. Research on transparency has shown that increased central bank transparency has produced either positive or negligible effects on things you can measure with numbers, such as stock markets and interest rates. Instead of a statistical examination, Thornton reviewed the public statements prominent Fed officials made to groups of market specialists during 2007, the year between the housing bubble and the beginning of the financial crisis. He found that in these prominent public addresses, Fed officials consistently made misleading statements that often verged on deception. Economist Shawn RitenourShawn Ritenour, “The Federal Reserve: Reality Trumps Rhetoric,” in The Fed at One Hundred, edited by Howden and Salerno, pp. 55–64. has confirmed that the Fed has consistently used its rhetoric to promote the incorrect view that the Fed solves economic problems, it does not create economic problems.
Given the current scenario and the above analysis, what changes have to be made in order to create an economic environment that produces a stable economy without artificial redistribution of wealth? It would seem that the economic mess might be a web of problems too large and too tangled to solve, but that is not the case.
Let us begin with what are the ultimate goals. It should be clear that given the economic and historical analysis in this book that the goal here is to reestablish genuine markets for money and banking without government regulations and privileges. Market forces alone should regulate money and banking, just like the markets for aspirin, shoes, and cell phones. The following recommendations, couched in this respect, should not be considered a matter of mere opinion.
This seems like a tall task, but the process can begin on day one. The first thing to do is to disband the Federal Open Market Committee (FOMC) and allow the interest rate in the federal-funds market — the federal funds rate, which banks charge other banks for short-term loans — to be determined by market forces. The FOMC consists of the seven members of the Board of Governors in Washington, DC (political appointees), the president of the New York Federal Reserve Bank, and four rotating Federal Reserve District Bank presidents from the remaining twelve Federal Reserve District Banks. Their job is superfluous at best. This central-planning committee is the source of all the problems described in this book. It should be disbanded and its interest-rate–setting authority abolished.
The entire Federal Reserve System should be shutdown. Its legitimate functions, like check clearing, should be privatized. Gold on its balance sheet should be used to redeem Federal Reserve Notes for “gold dollars” equal to some established weight of gold. The Fed’s holdings of US government bonds should be cancelled and other assets should be turned over to the US Treasury. Howden and SalernoDavid Howden, and Joseph T. Salerno, “A Stocktaking and Plan for a Fed-less Future,” in The Fed at One Hundred, edited by Howden and Salerno, pp. 163–69. offer a similar plan, and SalernoJoseph T. Salerno, “Will Gold Plating the Fed Provide a Sound Dollar?” in The Fed at One Hundred, edited by Howden and Salerno, pp. 75–90. finds that most of the other types of plans to return to a “gold standard” do not work and that a “gold plated standard” does not stabilize the dollar or the economy.
All taxes on capital gains on gold and silver should be eliminated along with taxes on anything else that might emerge as a new type of money — for example, Bitcoin and copper. Legal tender laws should also be repealed so that people are not forced to use any particular type of money. Currently it is possible to deposit dollars into gold banks and make payments using a variety of media, such as checks or debit cards, but you have to pay capital gains taxes if a payment generates a capital gain.
Federal insurance of demand deposits should be eliminated. This would be replaced with banks complying with laws regarding other deposit-taking institutions, such as grain warehouses. They would be forced to use their own capital or money raised by selling bonds to make loans. By charging fees on the use of demand deposits (i.e., checking accounts) and offering interest on bonds, banks would reduce the amount of demand deposits and increase their long-term bonds. This would help solve the perennial problem of banking — borrowing short term, but lending long term. Banks would effectively be 100 percent reserve institutions. Banks would probably receive a great deal of deposits and bond purchases from the now largely irrelevant investment demand for gold, as hoarders of gold would have no reason to hold gold and more reason to invest in gold bonds in order to earn interest, instead of hoarding gold. The personal saving rate would no doubt increase. See Askari (George Washington University) and Krichene (International Monetary Fund)Hossein Askari, and Noureddine Krichene, “100 Percent Reserve Banking and the Path to a Single-Country Gold Standard,” Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 29–64. for a full explanation of the nature and history of 100 percent–reserve gold standard reform and the impressive list of noteworthy economists who support it.
None of this would be easy or free of disturbance. The highly leveraged economy would likely face a painful deleveraging process, concentrated in industries that benefitted most from the fiat-money central bank regime. There would probably be a massive wave of bankruptcies, foreclosures, defaults, and other legal and entrepreneurial solutions. The national debt would be in precarious shape and would have to be openly repudiated rather than the current process of default by inflation. The national debt could be put under the control of a legal custodian who would make payments from sales of government assets. If Obamacare, Medicaid, Medicare, and Social Security were significantly reformed and replaced with market institutions, the federal government appears to have enough assets to pay off the national debt and to meet its obligations. The federal government would probably not be able to draw additional credit, but forcing future generations to pay for past mistakes is an abhorrent practice. Massive budget cuts would have to be passed in order to balance the budget and to reestablish a market economy free of government intervention. The more government intervention that can be removed, the better the process of economic adjustment and the faster the economy will adjust and grow.
This process would involve deflation or falling prices. Mainstream economists have an unwarranted phobia of deflation. They think that deflation causes economic crises from which an economy cannot ever escape. Austrians have shown that deflation is actually the corrective process by which asset prices and wages fall relative to consumer goods, thus creating profit opportunities for entrepreneurs to reorganize and employ such resources.
With the United States moving to a 100 percent reserve gold standard, the value of the gold dollar would be fixed as a weight of gold. The exchange value would increase relative to other world currencies, and Americans would be made richer by the fact that their incomes and savings would buy more. It would be increasingly difficult to import goods into the United States. This would put pressure on other countries to follow the United States’ lead in adopting the gold standard and other monetary reforms. With the United States also cutting back on military and regulatory spending and selling vast amounts of resources to the private sector, the standard of living would quickly recover and the economy would experience high rates of economic growth.
Most people would not want to take the risks imagined by these recommendations. Politicians know this and exploit it. They and mainstream economists have plenty of horror stories to scare everyone else. However, SalernoJoseph T. Salerno, “The 100 Percent Gold Standard: A Proposal for Monetary Reform,” in Salerno, Money Sound and Unsound (Auburn, AL: Mises Institute, 2014), pp. 333–63. has shown that the standard criticisms of the gold standard are baseless.
The truth is the alternative of not reforming the system is much, much worse. As the dollar status as a reserve currency for other central banks worsens, the likelihood that some other government embarks on such a reform process increases. The government is too big, the national debt is too large, savings are too low, the money supply has been expanded too much, and the extent of artificial inequality threatens the fabric of cooperative society. These problems will only get worse over time and will end in hyperinflation, where that fabric is finally set ablaze on a bonfire of worthless paper money and government bonds.
The events in Washington, DC, today in 2018, represent a stalemate between President Trump and the establishment. This stalemate sustains the status quo at a time when there is radical rumbling on both left and right. Despite marginal reforms in taxation and regulation and despite the Fed’s announced reversal of policy, nothing remotely has changed to address the calamity that lies ahead, and that I’ve discussed throughout this book.
To reiterate, the Austrian business cycle theory (ABCT) shows that artificially low interest rates produce systematic distortions in the economy. The most important of these distortions is the inducement to build longer structures of production and more roundabout production processes involving advanced or premature technologies. It is during the resulting boom when all the mistakes or malinvestments occur in a temporal cluster. The bust or economic crisis is when these errors are later revealed. While ABCT has been under critical internal review,See Jeffrey Rogers Hummel, “Problems with Austrian Business Cycle Theory,” Reason Papers 5 (Winter 1979): 41–53, and Jörg Guido Hülsmann, “Towards a General Theory of Error Cycles,” Quarterly Journal of Austrian Economics 1, no. 4 (1997): 1–23. more recent worksJoseph T. Salerno, “Comment on Gordon Tullock, ‘Why Austrians are Wrong About Depressions,’” Review of Austrian Economics 3 (1988): 141–45. Reprinted in Joseph T. Salerno, Money Sound and Unsound (Auburn, AL: Mises Institute, 2010), pp. 325–31; William Barnett and Walter Block, “On Hummel on Austrian Business Cycle Theory,” Reason Papers 30 (Fall 2008): 59–90; Mihai Macovei, “The Austrian Business Cycle Theory: A Defense of Its General Validity,” Quarterly Journal of Austrian Economics 18, no. 4 (2015): 409–35. have found that ABCT has a “general validity.”
Although it is very difficult to model ABCT empirically, several empirical investigations have taken place with supportive results.C. Wainhouse, “Empirical Evidence for Hayek’s Theory of Economic Fluctuations,” in Money in Crisis, edited by B. Siegel, (San Francisco: Pacific Institute for Public Policy Research, 1984), pp. 37–71; P. le Roux, and M. Levin, “The Capital Structure and the Business Cycle: Some Tests of the Validity of the Austrian Business Cycle in South Africa,” Journal for Studies in Economics and Econometrics 22, no. 3 (1998): 91–109; James P. Keeler, “Empirical Evidence on the Austrian Business Cycle Theory,” Review of Austrian Economics 14, no. 4 (2001): 331–51; Robert F. Mulligan, “A Hayekian Analysis of the Term Structure of Production,” Quarterly Journal of Austrian Economics 5, no. 2 (2002): 17–33, and “An Empirical Investigation of the Austrian Business Cycle Theory,” Quarterly Journal of Austrian Economics 9, no. 2 (2006): 69–93. ABCT has also been proven useful in analyzing historical business cycles.A.M. Hughes, “The Recession of 1990: An Austrian Explanation,” Review of Austrian Economics 10, no. 1 (1997): 107–23; Jeffrey M. Herbener, Herbener, “The Rise and Fall of the Japanese Miracle,” Mises Daily, September 20, 1999; Benjamin Powell, “Explaining Japan’s Recession,” Quarterly Journal of Austrian Economics 5, no. 2 (2002): 35–50; Gene Callahan, and Roger W. Garrison, “Does Austrian Business Cycle Theory Help Explain the Dot-Com Boom and Bust?” Quarterly Journal of Austrian Economics 6, no. 2 (Summer 2003): 67–98; Patrick Newman, “The Depression of 1873–1879: An Austrian Perspective,” Quarterly Journal of Austrian Economics 17, no. 4 (Winter 2014): 474–509, and “The Depression of 1920–1921: A Credit Induced Boom and a Market Based Recovery?” Review of Austrian Economics (January 2016): 1–28.
The Austrian answer for the economic crisis is similar to the RBCT’s (real business cycle theory) rejection of the effectiveness of stimulative fiscal policy and monetary policy. However, ABCT does have a “positive” side to it. In general, government should follow a philosophy of laissez-faire. First, stop the inflation, raise interest rates, and achieve market-determined interest rates. Second, do not enact any policy that attempts to reduce bankruptcy or unemployment. Third, do not attempt to interfere with prices, wages, consumption, and saving.
This would allow the market’s corrective process to proceed at a fast pace to end the economic crisis quickly. On the active positive side, government should cut its budget, its taxes, and all types of regulations and prohibitions in order for more resources to be used productively and efficiently in the private sector. Following these policy recommendations would result in an economic crisis that is painful, but short.
The opposite policy approach to laissez-faire, which employs bailouts and monetary and fiscal stimulus, results in economic crises that are much more painful and prolonged. Examples of this include the Great Depression, the stagflation of the 1970s, Japan’s lost decade(s), and the current financial crisis. The Austrian policy approach tends to hurt the wealthy relatively more than the middle and lower income classes, while mainstream policy approaches tend to hurt the middle- and lower-income classes and to help the rich.
When interest in ABCT by the general public increased significantly after the housing bubble burst, it was largely ignored by mainstream economists. Eventually some economists started to make criticisms that were more like witticisms, such as when Nobel Prize–winning economist Paul Krugman labeled ABCT the “hangover theory.” More recently ABCT has experienced multiple attacks by notable mainstream economists. This could be a good sign if you believe in an idea often attributed to Mahatma Gandhi: “First they ignore you, then they ridicule you, then they fight you, and then you win.”
Criticisms of the Hydraulic Version of ABCT The hydraulic version of ABCT is the one described by Gottfried Haberler.Gottfried Haberler, Prosperity and Depression: A Theoretical Analysis of Cyclical Movements (Lake Success, NY: United Nations, 1937). It could be described as a mainstream translation of ABCT as developed by Mises, Hayek, and Rothbard, with several critical divergences. Nevertheless, this version was surprisingly seized upon by economists in order to criticize ABCT.Tyler Cowen, “Paul Krugman on Austrian Trade Cycle Theory,” Marginal Revolution, October 14, 2008; Bradford DeLong, “I Accept Larry White’s Correction.…” Cato Unbound, December 11, 2008; John Quiggin, “Austrian Business Cycle Theory,” Commentary on Australian & World Events from a Social Democratic Perspective, May 3, 2009; Bryan Caplan, “What’s Wrong with Austrian Business Cycle Theory?” EconLog, January 2, 2008.
Their basic point is that if investment goes up in the boom, consumption should go down; and during the bust when investment goes down, consumption will ipso facto go up. They conclude consumption did not go up in the bust — it went down significantly — and therefore ABCT has been disproven by the facts.
Instead of ABCT, what the critics are arguing against is a simple mainstream two-sector overinvestment theory of the business cycle. However, Austrian economists do not embrace an overinvestment theory, but rather a malinvestment theory. During the boom consumption does not go down but goes up for two reasons. First, the lower interest rate discourages savings and encourages consumption, and second, and more importantly, the wealth effect or net-worth effect of higher wages, asset prices, stock prices, and real estate prices encourages people to consume more. Consumers draw down their illusionary wealth because on paper they can afford it.
With people drawing down their true wealth they will actually be consuming their savings and wealth, and this implies that there will likely be less overall investment, not more, during the boom. During the bust phase, consumption will be relatively strong compared to capital investment, but because of unemployment, lower wages, a negative wealth effect and a general malaise among entrepreneurs, there will hardly be a boom in consumption. The fact that some mainstream economists would base their criticisms on an obscure and flawed presentation of ABCT could be an indication of malicious intentions. Salerno gave an in-depth analysis of this criticism of ABCT.Joseph T. Salerno, “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Quarterly Journal of Austrian Economics 15, no. 1 (Spring 2012): 3–44.
The Rational-Expectations Critique — Why Can’t Entrepreneurs Learn? ABCT has been criticized on the basis of rational-expectations theory. The critics argue that rational entrepreneurs could not be continuously fooled by artificially low interest rates. Based on entrepreneurs’ past experience and analysis of current market conditions, the critics ask, why would they be systematically fooled by the central bank?This criticism has already been addressed by several economists, such as Lucas Engelhardt, “Expansionary Monetary Policy and Decreasing Entrepreneurial Quality,” Quarterly Journal of Austrian Economics 15 no. 2 (Summer 2012): 172–94; Anthony J. Evans and Toby Baxendale, “Austrian Business Cycle Theory in Light of Rational Expectations: The Role of Heterogeneity, the Monetary Footprint, and Adverse Selection in Monetary Expansion,” Quarterly Journal of Austrian Economics 11, no. 2: 81–93 (2008); William Barnett II, and Walter Block, “Professor Tullock on Austrian Business Cycle Theory,” Advances in Austrian Economics 8 (2005): 431–43; and Anthony M. Carilli, and Gregory M. Dempster, “Expectations in Austrian Business Cycle Theory: An Application of the Prisoner’s Dilemma,” Review of Austrian Economics 14, no. 4 (2001): 319–30. For a review of these arguments, see Nicolás Cachanosky, “Expectation in Austrian Business Cycle Theory: Market Share Matters,” Review of Austrian Economics 28, no. 2 (2015): 151–65.
As I have emphasized throughout this book, the distortions in credit markets from artificially low interest rates are not something that is obvious to the casual observer, and the amount of distortion between the market rate and the natural rate is not known definitively by anyone. What we do know is that when you leave your ivory tower and investigate the economy, you will find that some entrepreneurs, bankers, and market analysts have the experience to detect the possibilities of such market distortions.
These people could act more cautiously, withdraw from certain markets, or require greater risk premia in their dealings. The problem for these people is that their competitors are acting in a boom market where everyone is seemingly making large profits and capital gains. Either you join the party or you get replaced. I have seen this displacement effect in the construction industry, banking, and even on CNBC.
ABCT shows that as the amount of loanable funds expands, less creditworthy borrowers will enter the market. Several economists have explored this adverse-selection argument at length.Evans and Baxendale, “Austrian Business Cycle Theory in Light of Rational Expectations”; and Engelhardt, “Expansionary Monetary Policy and Decreasing Entrepreneurial Quality.” Austrians see entrepreneurs as rational, but they also realize that the success or failure of a venture is dependent on many factors that cannot be known in advance. Easy-credit policies let more entrepreneurs into the process, the results of which are known not instantaneously, but only as or shortly after these long-term capital projects near or reach completion.
What about Nineteenth-Century Panics? ABCT has also been criticized for blaming the business cycle on the Federal Reserve when in fact there were business cycles in the nineteenth century before the Fed existed. I have already addressed this criticism in chapter 2 on the history of the skyscraper curse. ABCT actually blames the central bank and the fractional-reserve banking system. Even mainstream economists agree that the panics from the time of the Civil War to the time of World War I were caused by the National Banking Acts. The acts’ requirements ensured that bank deposits were structured in an unstable manner. Many also agree that business cycles prior to the Civil War were caused by the First and Second Banks of the United States, which were pseudo central banks.
What about Robert Murphy’s Prediction of Double-Digit Inflation? Critics of the Austrian school of economics have been throwing barbs at Austrians such as Robert Murphy because there is very little inflation in the economy. Of course, these critics are speaking about the mainstream concept of the price level as measured by the Consumer Price Index (CPI).
Let us ignore the problems with the concept of the price level and all the technical problems with the CPI. Let us further ignore the fact that this has little to do with Austrian business cycle theory, despite what the critics would like to suggest. The basic notion that more money (i.e., inflation) causes higher prices (i.e., price inflation) is not a uniquely Austrian view. It is a very old and commonly held view by professional economists and is presented in nearly every textbook that I have examined.
This common view is often labeled the quantity theory of money. Only economists with a mercantilist or Keynesian ideology even challenge this view. However, only Austrians can explain the current puzzle: why hasn’t the massive money printing by the central banks of the world resulted in higher prices?
Austrian economists such as Ludwig von Mises, Benjamin Anderson, and F. A. Hayek saw that commodity prices were stable in the 1920s but that other prices in the structure of production indicated problems related to the monetary policy of the Federal Reserve. Mises, in particular, warned that Fisher’s “stable dollar” policy, employed at the Fed, was going to have severe ramifications. Absent the Fed’s easy-money policies of the Roaring Twenties, prices would have likely fallen throughout that decade.
So let’s look at the prices that most economists ignore and see what we find. There are some obvious prices to look at, such as the price of oil. Mainstream economists really do not like looking at oil prices: they want them taken out of the CPI along with food prices, and Ben Bernanke says that oil prices have nothing to do with monetary policy and that oil prices are governed by other factors.
As an Austrian economist, I speculate that in a free market economy, with no central bank, the price of oil would be stable. I further speculate that in the actual economy with a central bank, the price of oil would be unstable and oil prices would reflect monetary policy in a manner informed by ABCT.
That is, artificially low interest rates generated by the Fed would encourage entrepreneurs to start new investment projects. This in turn would stimulate the demand for oil (where supply is relatively inelastic in the short run), leading to higher oil prices. As these entrepreneurs would have to pay higher prices for oil, gasoline, and energy (and many other inputs) and as their customers would cut back on demand for the entrepreneurs’ goods (in order to pay higher gasoline prices), some of the entrepreneurs’ new investment projects would turn from profitable to unprofitable. Therefore, you should see oil prices rise in a boom and fall during a bust. That is pretty much how things work.
As you can see, the price of oil was very stable when we were on the pseudo gold standard. The data also show dramatic instability during the fiat paper-dollar standard (post-1971). Furthermore, in general, the price of oil moves roughly as Austrians would suggest, although monetary policy is not the sole determinant of oil prices and obviously there is no stable numerical relationship between the two variables.
Another commodity that is noteworthy for its high price is gold. The price of gold also rises in the boom, and falls during the bust. However, since the last recession officially ended in 2009, the price of gold actually doubled. The Fed’s zero interest rate policy has made the opportunity cost of gold extraordinarily low. The Fed’s massive monetary pumping created an enormous spike in the price of gold. No surprise here.
Actually, commodity prices increased across the board. The Producer Price Index for commodities shows a similar pattern to oil and gold. The PPI (Producer Price Index) commodity index was more stable during the pseudo gold standard, with more volatility during the post-1971 fiat-paper standard. The index tends to spike before a recession and then recede during and after the recession.
High prices seem to be the norm. The US stock and bond markets are at, or near, all-time highs. Agricultural land in the United States reached an all-time high. The contemporary-art market in New York is booming, with record sales and high prices. The real estate markets in Manhattan and Washington, DC, are both at all-time highs as the Austrians would predict. That is, after all, where the money is being created, and the place where much of it is injected into the economy.
This doesn’t even consider what prices would be like if the Fed and world central banks had not acted as they did. Housing prices would be lower, commodity prices would be lower, and the CPI and PPI would be running negative. Low-income families would have seen a surge in their standard of living. Savers would get a decent return on their savings.
Of course, the stock market and the bond market would have seen significantly lower prices. Bank stocks would have collapsed, and the bad banks would have closed. Finance, hedge funds, and investment banks would have collapsed. Manhattan real estate would be in the tank. The market for fund managers, hedge fund operators, and bankers would have evaporated.
In other words, what the Fed chose to do ended up making the rich richer and the poor poorer. If it had not embarked on the most extreme and unorthodox monetary policy in memory, the poor would have experienced a relative rise in their standard of living and the rich would have experienced a collective relative decrease in their standard of living.
There are other major reasons why consumer prices have not risen in tandem with the money supply in the dramatic fashion of oil, gold, stocks, and bonds. It would seem that the inflationary and Keynesian policies followed by the United States, Europe, China, and Japan resulted in an economic and financial environment where bankers were afraid to lend, entrepreneurs were afraid to invest, and everyone is afraid of the currencies they are forced to endure.
In other words, the reason why consumer price-inflation predictions failed to materialize is that Keynesian policy prescriptions such as bailouts, stimulus packages, and massive monetary inflation have failed to work and have indeed helped wreck the economy.
Section 1 of this book has been about the Skyscraper Index, which was created by Andrew Lawrence in 1999. The index chronicles the puzzling connection between the building of record-breaking skyscrapers and the onset of severe economic crises. The resulting crises are dubbed skyscraper curses.
The skyscraper curse refers to the major economic crises that follow in the wake of record-breaking skyscrapers. In retrospect, curse is a poor choice of words. One use of curse indicates an irritation or annoyance, like psoriasis or a trouble-making daughter, distinct to the individual. A second use refers to being afflicted, at a much higher level of negativity, by a mystical being or worldly but religious person, such as a voodoo doctor. The third use refers to the use of swear words by one individual who is complaining about someone or something. The central contribution of section 1 has been to explain that the skyscraper curse is neither self-inflicted nor related to the use of curse words. It is also not about mystical beings or religious figures. The modern curse is about the imposition of severe economic harm imposed by the worldly beings at the Federal Reserve.
The Skyscraper Index has a remarkable record of showing a very close correlation between world-record-breaking skyscrapers and the onset of major economic crises. This section has extended that history back into the nineteenth century and forward in time since the index’s creation in 1999. It has also shown that the original exception to this historical record, the Woolworth Building, was not an exception at all, but simply an accident of history. We also can see that the index can be used to analyze this phenomenon at lower levels of aggregation, such as the state level and the urban level (the problem of urban sprawl).
Of course, if you had not read this section, you might have doubted the reliability of the index. As I have reiterated several times, the use of the Skyscraper Index as a forecasting tool is not highly recommended. Just as canals are no longer a central component of the economy’s transportation network, skyscrapers could easily lose their key position in the economy in the future. Another reason for caution is that major economic crises can be initiated by other causes than central banks, such as wars and pandemics. Plus, there is no precise mechanism to employ for forecasting, so there remain good reasons to be doubtful or at least skeptical in this regard.
Most promising indicators eventually fail, especially those that seem whimsical and have no fundamental basis, while others are of little use to guide long-term capital-investment expenditures. This section has provided the grounding or fundamental basis for the Skyscraper Index in economic theory and Austrian business cycle theory (ABCT). An artificially low-interest rate monetary policy pursued by central banks distorts capital-investment plans of entrepreneurs. This monetary policy follows the path from the interest rate setting policies of the central bank to open-market operations between the New York Fed and big banks. This eventually hits Main Street and results in more debt and misguided investments. We compared the natural process of economic growth and development driven by real savings with the disastrous results when apparent growth and development is driven artificially by central banks.
Most mainstream economists do not have an economic theory of business cycles. They see the economy as a simple machine that works just fine at the macro level as long as there are no technological or psychological shocks. These shocks are random and cannot be known in advance. Therefore they cannot be predicted or prevented. ABCT incorporates both technical and psychological change. Plus, ABCT theorists expect those changes to happen and can form expectations about when and where those changes will take place in the presence of artificially low-interest rate monetary policy.
By embracing the complexity of the economy with the aid of concepts such as the structure of production and the roundabout production process, ABCT can even provide insight into where the crisis will most likely be the most severe. The analysis of Cantillon effects is also helpful here because this is where the distortion causes malinvestment in product-specific capital goods. Austrian economists have disdain for magic wands in their economic analysis, whereas such wands play a crucial role in mainstream economic analysis.
We now turn our attention to the forecasting ability of Austrian economists regarding economic crises and compare that with the forecasting ability of mainstream economists. Hint: it has nothing to do with skyscrapers.
The Skyscraper Index expresses the strange relationship between the building of the world’s tallest skyscraper and the onset of a major economic crisis. This relationship only came to light in 1999 when research analyst Andrew Lawrence published a report noting the odd connection between record-height buildings and noteworthy economic crises — that is, the skyscraper curse, a relationship that dated back nearly a century. Without a theory to support it, journalists largely dismissed Lawrence’s report as the fun story of the day.
However, from the vantage point of Austrian business cycle theory, or ABCT, Lawrence’s report was important for understanding the business cycle: booms and busts. ABCT is the business cycle theory developed by the economists of the Austrian school during the early twentieth century.
In the 1860s, Austrian financial journalist Carl Menger (1840–1921) began to ponder economic activity that he was reporting on in light of the economics of the classical school — that is, Adam Smith (1723–90), David Ricardo (1772–1823), John Stuart Mill (1806–73), and so on. He found huge gaps in the explanation of many basic concepts, such as supply and demand. To close those gaps he developed some fundamental elements of modern economics, such as marginal analysis and the rudiments of opportunity cost, marginal utility, and subjective value.
His students at the University of Vienna learned from him and built on his insights. For example, Eugen von Böhm-Bawerk (1851–1914), who served as finance minister of the Austro-Hungarian Empire, built on Menger’s work to show that production can be less or more time consuming, or roundabout. From this perspective, we can see that laborers get paid very quickly, while capitalists are paid interest for delaying their rewards until the product is actually sold. Böhm-Bawerk showed that interest was based on the time preferences of workers and capitalists, savers and borrowers. The interest rate is a critical economic factor because it helps determine the size and complexity of an economy’s capital structure. The capital structure is simply the non-natural world around us: all the business assets related to mines, farms, factories, utilities, transportation, warehouses, wholesale and retail businesses, and so on. Austrian economics has been described by Peter Klein as mundane economics.Peter G. Klein, “The Mundane Economics of the Austrian School,” Quarterly Journal of Austrian Economics 11, nos. 3–4 (2008): 165–87.
For example, a market economy populated with individuals with low time preferences and interest rates would, over a long period, be characterized by a large accumulation of savings that is turned into large amounts of “brick and mortar” capital and advanced-technology production processes. The division of labor would be highly specialized. People would be wealthy and have a high standard of living.
Ludwig von Mises (1881–1973) was a student of Böhm-Bawerk who extended Austrian analysis into the area of money, solving the classical school’s problem of how to connect the workings of the real economy with monetary economics. He accomplished this with his regression theorem, which was based in part on Menger’s explanation for the origin of money. Mises also formulated a theory of the business cycle based on the interaction of the interest rate and capital allocation. His approach is based on distortions of the market rate of interest. His student, Friedrich August von Hayek (1899–1992), further elaborated and extended Mises’s theory, a contribution for which he was awarded the Nobel Prize for economics in 1974. Their theory is now known as Austrian business cycle theory. (See Roger Garrison for a technical explanation of Austrian macroeconomics.Roger W. Garrison, “The Austrian School: Capital-Based Macroeconomics,” in Modern Macroeconomics: Its Origins, Development and Current State, edited by Brian Snowden and Howard R. Vane (Aldershot: Edward Elgar, 2005).)
Inspired by ABCT, my reflections about skyscrapers eventually resulted in an academic working paper, “Skyscrapers and Business Cycles.” The manuscript was summarily rejected by several mainstream economic journals. The replies from the journal editors would often include a short or cryptic explanation such as “This paper does not have a testable hypothesis.” The articleMark Thornton, “Skyscrapers and Business Cycles,” Quarterly Journal of Austrian Economics 8, no. 1 (2005): 51–74. was eventually published in the Quarterly Journal of Austrian Economics in 2005. It uses ABCT to explain how record-breaking skyscrapers are linked to business cycles and economic crises. In particular I drew on the economic theories of Richard Cantillon (1680s–1734?), the first economic theorist and a proto-Austrian economist, in order to establish causal links between skyscrapers and business cycles.
Cantillon showed how the interest rate and the money supply can create changes and distortions in the economy, a phenomenon now referred to as Cantillon effects. The paper describes three such effects: (1) the relationship between the interest rate, land prices, and building height; (2) the relationship between the interest rate, the size of firms, and the demand for office space; and (3) the relationship between building height and the enhanced incentive for advanced — or premature — technological innovations in both design and construction.
The time period of my research on skyscrapers and business cycles was crucial for my early identification of the housing bubble. In my February 2004 article “ ‘Bull’ Market?” I used a trend-channel technique to define the initial stage of the bubble. Then in June 2004 I wrote “Housing: Too Good to Be True,” a full explanation of how the Federal Reserve’s monetary policy had caused a massive housing bubble. I also began giving presentations on this subject to the general public.
As a result of this publicity, I was invited in 2005 to contribute a chapter to a book, Housing America: Building Out of a Crisis, edited by Randall G. Holcombe and Benjamin Powell. I submitted the resulting chapter, “The Economics of Housing Bubbles,” to the editors the first week of June 2006.
The publisher of the book asked me to remove some text they considered too gloomy and ominous regarding what might happen in the aftermath of the housing bust. I agreed to the changes because the book was to be marketed to people interested in zoning laws, building codes, and urban planning, not economic Armageddon. However, the editors later allowed me to include that removed text, when, after a long publishing delay, the book was finally published in 2009. At that time my gloomy predictions seemed more appropriate. The removed text was placed in a Postscript in the original publication. Indeed the editors were so kind as to mention my chapter prominently at the beginning of their preface:
The timing is noteworthy because most of the chapters were completed in 2006 when the housing boom across much of the country was reaching its peak. One chapter in particular that deserves mention in this regard is Mark Thornton’s, because he was discussing the inevitable collapse of the housing market bubble at a time when many observers were arguing that house prices could continue rising indefinitely. Thornton’s chapter does a good job of explaining the collapse of housing prices in hindsight, and it is worth noting that Thornton’s hindsight was actually foresight: he was talking about the collapse before it actually occurred.Randall G. Holcombe, and Benjamin Powell, eds., Housing America: Building Out of a Crisis (New Brunswick, N.J.: Transactions Publishers, 2009), p. vii.
Between 2004 and 2007 audiences and readers generally scoffed at my analysis. This was a time when the accepted wisdom in mainstream economics and the real estate industry was that “housing prices never go down” and “you can never lose money in real estate.” Mainstream economics refers to what is widely taught at well-known universities and associated with the neoclassical synthesis, which combines neoclassical microeconomics and Keynesian approaches to macroeconomics.
One of my particularly provocative public lectures, circa 2006, “Luxury Game Day Condominiums,” was given to students at Auburn University. As it turned out local building contractors and bankers were also in attendance. The empirical evidence I presented was based on interviews of people who had purchased these game day condos during the housing bubble. The condos had been marketed to football fans of Auburn University who come to Auburn, Alabama, for the six or seven home football games per year. When I did the calculations I discovered that the condo buyers could have stayed at the best hotel in town and eaten all their meals at gourmet restaurants and saved money. I then asked the buyers, “Why buy the condo?” To this the answer would invariably be “I can always sell it for more money later.”
The complete bust in housing had not been recognized yet, but everyone in the audience knew that condo prices were falling and that some local projects had been cancelled. The students in the audience roared with laughter at those responses, but the builders and bankers were none too pleased. Of course it was not just local builders and bankers that wanted to keep the bubble going. By now Federal Reserve officials were publically cheerleading for the housing bubble and denying that it existed.Mark Thornton, “Transparency or Deception: What the Fed Was Saying in 2007,” Quarterly Journal of Austrian Economics 19, no. 1 (2016): 65–84.
They should have known better, or at least reexamined their models. After all, the housing industry as measured by the Philadelphia Stock Exchange Housing Sector Index peaked on June 30, 2005. On August 8, 2005, my short article “Is the Housing Bubble Popping?” was published.Mark Thornton, “Is the Housing Bubble Popping?” LewRockwell.com, August 8, (2005). In the article I presented charts that indicated that home-builder stock prices could be headed much lower and that short-term and long-term interest rates could be heading higher. Both trends, which did continue, were harbingers that the housing bubble would eventually pop.
In 2007, the skyscraper curse struck again, the second occurrence since Lawrence’s 1999 report. This time it happened in the Middle East in the city-state of Dubai. Located in the United Arab Emirates, between Saudi Arabia and Oman and across the Persian Gulf from Iran, Dubai is a fantasy city. Its ruler has transformed his oil wealth into a highly dynamic city with very tall and ornate buildings, hotels, the world’s largest shopping mall, and even man-made islands in the Persian Gulf designed to resemble a map of the world.
It was in Dubai that construction of the Burj Dubai tower began in 2004. It was designed to be a world-record setting skyscraper in terms of all metrics such as height, highest livable floor, the most floors, and so on. The next “skyscraper signal” occurred when construction reached a new record height in late July 2007. In August I reported:
There is a new record setting skyscraper in the making in the United Arab Emirates. The Skyscraper Index predicts economic depression and/or stock market collapses to occur prior to the completion of the skyscraper.Mark Thornton, “New Record Skyscraper (and Depression?) in the Making,” mises.org blog, August 7, 2007.
The tower was renamed the Burj Khalifa and opened in early January 2010. The building was renamed for the ruler of Abu Dhabi who had arranged for billions of dollars in emergency loans to bail out his cousin in Dubai. Clearly the skyscraper curse had hit once again. The media began to take it more seriously. On January 8, 2010, CNN.com’s Kevin Voigt reported:
When the Burj Khalifa officially opened in Dubai on Monday, much of the world press noted the irony of the world’s tallest building unveiled just weeks after the emirate’s debt crash.
But a look at the history of record-breaking skyscrapers and business cycles suggests otherwise — the opening of every single “world’s tallest” building in the past century has coincided with an economic downturn.
One person who wasn’t surprised by the economic woes greeting the dedication of the Burj Khalifa (renamed Monday from Burj Dubai in honor of the sheikh of Abu Dhabi, which recently threw Dubai a $10 billion lifeline) was Auburn University economist Mark Thornton.
He predicted tough times for the emirate two years ago in a blog entitled “New Record Skyscraper (and depression?) in the making.” He noted that economic depression or stock market collapse usually occurs prior to completion of such skyscrapers.Kevin Voigt, “As skyscrapers rise, markets fall,” CNN.com.
So the Skyscraper Index’s “curse” has correctly forecast all major economic crises for over a century. The skyscraper curse has also experienced a good deal of mainstream media coverage; and so it would seem that the Skyscraper Index theory is accurate and alive and well.
That was until March 28, 2015, when the Economist declared the skyscraper curse was dead. In reviewing the current “skyscraper boom” they noted in their unsigned “Towers of Babel” editorial the following:
Does this frenzy of building augur badly for the world economy? Various academics and pundits, many of them cited by The Economist, have long argued as much, but new research casts doubt on it.
As a side note, the majority of major media who write about my work and this phenomenon fail to cite me as a source, although they have clearly been drawing from my publications. Of the “various academics and pundits” most draw from Andrew Lawrence.Andrew Lawrence, “The Skyscraper Index: Faulty Towers!” Property Report, January 15, 1999 and “The Curse Bites: Skyscraper Index Strikes,” Property Report, March 3, 1999. The Economist’s article did not include me explicitly in the text, but at least they did reference my 2005 journal article at the end as a source.Thornton, “Skyscrapers and Business Cycles.” Thank you.
The Economist based its view on a new academic article, “Skyscraper Height and the Business Cycle: Separating Myth from Reality.” The article was written by three Rutgers University economists: Jason Barr, Bruce Mizrach, and Kusam Mundra. It was published in the academic journal Applied Economics in 2015.
Their article demonstrates that skyscrapers do not cause (in a technical economic sense) business cycles as measured by changes in overall economic activity — that is, GDP. Their statistical analysis shows that skyscraper construction and overall economic activity move together, having a common cause or trend. They also found it difficult to find a correlation between the skyscraper announcement and completion dates and changes in GDP.
Let’s be perfectly clear here. Skyscraper construction does not cause business cycles. The statistical evidence presented in Applied Economics actually supports the Skyscraper Index theory.
It should be clear from my “Skyscrapers and Business Cycles” article that there is a third factor at work. Skyscrapers are essentially part of the boom phase of the cycle. The cause of both is artificially very low interest rates and artificially very easy credit conditions. This cause results in new record-breaking skyscrapers, a boom in the economy, and eventually a substantial economic crisis — the skyscraper curse.
Immediately, I wrote a letter to the editor of The Economist to inform them of the error in the 2015 article and to ask them to change the date they printed for my journal article from 2004 to 2005. The letter was never published and the date of my paper was never corrected. I did receive an email three months later that said the magazine had misplaced my letter. I also submitted a comment (with Lucas Engelhardt) on the article published in Applied Economics. Surprisingly, the editors of Applied Economics rejected the comment. Accordingly, this book is dedicated, in part, to the editors of Applied Economics and The Economist.
The main point of the Skyscraper Index and the resulting curse is to give people a tangible, concrete example of what is happening to the economy during a business cycle. ABCT is necessarily vague on some issues and silent on others. For example, it refers to capital, the structure of production, and goods of higher and lower orders without being specific. The theory presents issues, such as interest rates being artificially low relative to market-determined rates, without providing readers with a mechanism to calculate whether and when they in fact apply.
That does not mean ABCT is unrealistic, hard to understand, or difficult to apply. Austrian economists have always striven to be realistic about the economy and the limits of economic theory, but that necessarily puts limitations on the analysis and forces us to introduce significant caveats to our conclusions. For example, Austrian economists cannot “predict” in the strictest scientific sense. We speculate about the future, given the caveat of ceteris paribus — that is, all things being equal — and without illusions that economic theory can help us determine the timing and magnitude of future events. However, we can make “pattern predictions” based on economic theory and an appraisal of the facts.
In contrast, when mainstream economists are faced with the complexities of real economies or with scarcity of data, they resort to unrealistic assumptions, questionable simplifications, and inappropriate data. For most mainstream economists, their sine qua non is predicting the future. However, mainstream theories of the business cycle, such as real business cycle theory and various Keynesian theories, cannot predict anything about the future because in their view, the cycle is generated by economic shocks that cannot be anticipated. They can only predict in the sense that they use historical data in their models, like “back testing” stock market strategies. They practice retrodiction, rarely prediction.
The grand benefit of this book then is to show what Austrian economists see with the aid of the business cycle theory. ABCT shows what causes the business cycle, what happens during the business cycle, and that the boom must inevitably end in a bust or economic crisis. The value of resources is squandered in the process and people are harmed. Austrian theory can also show how to best deal with the bust, what to avoid, and how to permanently fix the problem by ending the business cycle, or at least minimizing its impact.
In section 2, I present evidence that demonstrates the real-world usefulness of ABCT by showing that Austrian economists have correctly forecast almost every major economic crisis for over a century. I also present evidence that mainstream economists have a poor record of predicting business cycles and have made some very bad predictions.
To be fair, there have been some mainstream economists who have made correct forecasts of economic crises, but their numbers are few compared to the Austrian economists, especially considering that Vedder and GallawayRichard Vedder, and Lowell Gallaway, “The Austrian Market Share in the Marketplace for Ideas, 1871–2025,” Quarterly Journal of Austrian Economics 3, no. 1 (Spring 2000): 33–42. have estimated that there are about a hundred mainstream economists for every Austrian-school economist. Obviously, not all predictions by Austrian economists have come true or in a timely manner, including those of this author.
Before leaving section 2, let me be perfectly clear on one key point. Austrian economists have used ABCT to make their predictions about booms and busts since Böhm-Bawerk’s time over a century ago. But since the concept of the Skyscraper Index is a relatively new concept, it has not been a part of the Austrian economists’ toolkit. The idea of the Skyscraper Index was only discovered in 1999, and the theoretical justification for connecting it to ABCT has only been around since 2005.Before ending this introduction, a question arises: what are Austrian economists saying about the current economy and government policy? Austrian economists have spoken out against current fiscal and monetary policy, and many have argued that policy has been unconventional, unorthodox, and extreme even by mainstream standards. Austrian economists have recommended drastic changes to current policies, and they have speculated that the economic consequences of the next crisis will be truly horrible. There are obviously differences of opinion, but the Austrian school is united against the current policy regime.
A skyscraper alert has already been issued, in that a groundbreaking ceremony has taken place and construction has begun on the Jeddah Tower in Saudi Arabia, a prospectively record-setting skyscraper. If a skyscraper signal is issued, it will mean that that project’s height exceeds the current world record.
In conclusion, the book provides a remedy of how to best deal with the next economic crisis.
The author would like to acknowledge the assistance and support of many people and to apologize for no doubt forgetting the assistance of many others over the long course of this project.
First and foremost I would like to acknowledge the support of the officers, members, and donors of the Mises Institute who made this book possible. I would also like to thank Paul Cwik, Harry David, David Gordon, Lucas Engelhardt, Jörg Guido Hülsmann, Roger Garrison, Karl-Friedrich Israel, Floy Lilly, Greg Kaza, Jonathan Newman, Patrick Newman, Shawn Ritenour, Louis Rouanet, Joseph Salerno, Susan Schroeder, Judy Thommesen, Paul Wicks, all the economics teachers I’ve had throughout the years. I would most especially like to thank Robert B. Ekelund, Jr.
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Foreword by Thomas E. Woods, Jr.
Introduction
Section 1: The Skyscraper Curse
Chapter 1: What Is the Skyscraper Curse?
Chapter 2: The History of the Skyscraper Curse Reexamined
Chapter 3: Do You Have a Theory?
Chapter 4: How to Get Milk
Chapter 5: Cantillon Effects
Chapter 6: Cantillon Effects in Skyscrapers
Chapter 7: The Curse Misses New York. Is Auburn, Alabama, Next?
Chapter 8: When Will the Next Skyscraper Curse Come?
Chapter 9: It Is Not the Skyscraper’s Fault
Chapter 10: Should I Stay, or Should I Go?
Chapter 11: Razorbacks and Wolverines
Chapter 12: The Curse of the Federal Reserve
Section 2: And How Austrian Economists Predicted Every Major Economic Crisis of the Last 100 Years
Chapter 13: Who Predicted the Great Depression?
Chapter 14: The “New Economists” and the Depression of the 1970s
Chapter 15: The Return of the Austrians
Chapter 16: Bubble-Bust in Japan
Chapter 17: Who Predicted the Bubble? Who Predicted the Crash? Bubble Predictions Conclusions Appendix: Some Other Predictions
Chapter 18: “Bull” Market?
Chapter 19: Housing: Too Good To Be True More Greenspan The Housing Bubble Price Inflation Follows Monetary Inflation The Dirty Secret Do Housing Bubbles Burst?
Chapter 20: The Economics of Housing Bubbles What Causes Housing Bubbles? What Goes Up ... ... Must Come Down Summary and Conclusions Postscript — August 8, 2009
Chapter 21: Is the Housing Bubble Popping?
Chapter 22: Making Depressions Great Again
Chapter 23: String Theories
Chapter 24: What Is Wrong with ABCT? Criticisms of the Hydraulic Version of ABCT The Rational-Expectations Critique — Why Can’t Entrepreneurs Learn? What about Nineteenth-Century Panics? What about Robert Murphy’s Prediction of Double-Digit Inflation?
Chapter 25: Summary and Conclusion: End the Fed
Bibliography
Index
[The original version of this chapter was published as “Housing: Too Good to Be True,” Mises Daily, June 4, 2004.]
Signs of a “new era” in housing are everywhere in 2004. Housing construction is taking place at record rates. New records for real estate prices are being set across the country, especially on the East and West Coasts. Booming home prices and record-low interest rates are allowing homeowners to refinance their mortgages, “extract equity” to increase their spending, and lower their monthly payment! As one loan officer recently explained to me: “It’s almost too good to be true.”
In fact, it is too good to be true. What the prophets of the new housing paradigm don’t discuss is that real estate markets have experienced similar cycles in the past and that periods described as new paradigms or new eras are often followed by periods of distress in real estate markets, including foreclosure sales, bankruptcy, and bank failures.
The case of Japan’s real estate bubble is instructive. Japan had a stock market bubble in the 1980s that was very similar to the US stock market bubble in the 1990s. As the Japanese stock market started to bust, Japan’s real estate market continued to bubble. One general index of Japanese real estate shows that prices rose for almost two years after the stock market crashed, with prices staying above pre-crash levels for more than five years. The boom in home construction continued for nearly six years after the stock market crash. Prices for commercial, industrial, and residential real estate in Japan continues to fall and are now below the levels measured in 1985 when these statistics were first collected.
It has now been three years since the US stock market crash. Chairman Greenspan has indicated that interest rates could soon reverse their course, while longer-term interest rates have already moved higher. Higher interest rates should trigger a reversal in the housing market and expose the fallacies of the new paradigm, including how the housing boom has helped cover up increases in price inflation. Unfortunately, this exposure will hurt homeowners, and the larger problem could hit the American taxpayer, who could be forced to bail out the banks and government-sponsored mortgage guarantors who have encouraged irresponsible lending practices.
More Greenspan Once again, Fed chairman Alan Greenspan“Testimony of Chairman Alan Greenspan.” Federal Reserve Board’s Semiannual Monetary Policy Report to the Committee on Banking, Housing, and Urban Affairs, US Senate, February 12, 2003. has created a new-age economic panacea, and earlier this year he applauded his contribution to the economic recovery: “Very low interest rates and reduced taxes, have permitted relatively robust advances in residential construction and household expenditures. Indeed, residential construction activity moved up steadily over the year.”
The key to this panacea is the process of equity extraction that occurs when people refinance their homes; they take equity out and spend it to increase their standard of living. However, because variable-rate mortgages are so low, their payments actually go down, so they have more of their monthly income to spend or they can upgrade to a more expensive house. As Greenspan explained:
Other consumer outlays, financed partly by the large extraction of built-up equity in homes, have continued to trend up. Most equity extraction — reflecting the realized capital gains on home sales — usually occurs as a consequence of house turnover. But during the past year, an almost equal amount reflected the debt-financed cash-outs associated with an unprecedented surge in mortgage refinancings.Ibid.
As is the norm, Greenspan hedged his statements. He also considered some of the potential drawbacks and pitfalls on the horizon for the new paradigm in housing, but in the end he concluded that we really have nothing to worry about. Low interest rates, rising home prices, and lower financing costs mean that we actually can have our cake (i.e., our homes) and eat it too (i.e., equity extraction for consumption):
To be sure, the mortgage debt of homeowners relative to their income is high by historical norms. But as a consequence of low interest rates, the servicing requirement for the mortgage debt of homeowners relative to the corresponding disposable income of that group is well below the high levels of the early 1990s. Moreover, owing to continued large gains in residential real estate values, equity in homes has continued to rise despite sizable debt-financed extractions. Adding in the fixed costs associated with other financial obligations, such as rental payments of tenants, consumer installment credit, and auto leases, the total servicing costs faced by households relative to their incomes are below previous peaks and do not appear to be a significant cause for concern at this time.Ibid.
The Housing Bubble I first reported on the housing bubble in the United States at the beginning of this year (2004) when the bubble was already well under way, if not in full bloom. As the chart “Real Private Residential Fixed Investment” in chapter 18 indicates, real residential investment has jumped far above both its historical trend and even its cyclical trend channel. This indicates to me that there is a bubble in residential real estate. The data for this chart originally stopped at the beginning of 2003. We now know that investment in housing increased by 8.8 percent last year. This is a historically high rate of construction, but far from a record rate increase. However, 2003 marks the ninth year in a row that housing investment was positive, the first time that has ever occurred since the statistic has been collected. Frank ShostakFrank Shostak, “Housing Bubble: Myth or Reality?” Mises Daily, March 4, 2003. and Christopher MayerChristopher Mayer, “The Housing Bubble,” Free Market 23, no. 8 (August 1, 2003). have also written very informative articles on the housing bubble.
Recently I came across a piece of anecdotal evidence of a housing bubble. Last Sunday afternoon, a friend of mine put a “For Sale by Owner” sign on the front lawn of a small rental house he owned on a side street. It wasn’t listed with a real estate agent or in the newspaper, but he nonetheless had a couple of calls that afternoon, with many more to follow, and within a couple of days he had multiple offers before he finally accepted a bid that was substantially over his original asking price.
Mainstream economists who discount the possibility of a housing bubble would dismiss such evidence. But they also ignore all the macro evidence of the current housing boom and see it as a positive development. For example, the number of new homes being constructed is at an all-time high, despite a “soft” labor market. The annualized rate of new home construction has surpassed the two surges of the 1970s when inflation was out of control.
The prices of houses are also up circa 2004, but mainstream economists have generally ignored this development as well; and as noted above, Greenspan sees this as a positive development. Some economists can even point to the Consumer Price Index, which shows that the housing component in the CPI is steady or falling. And yet reports are coming out nearly every day saying that housing prices are up dramatically and setting records all across the country. Record prices have been recently reported in the San Francisco Bay Area, Denver, Boston, Las Vegas, the State of Washington, and even Buffalo, New York.
Nationally, the price of a median family home was up 15 percent between 2001 and 2003, with regional increases of 30 percent in the Northeast, 8.5 percent in the Midwest, 14.4 percent in the Southeast, and 20.4 percent in the West. Over the last year, increases have been reported as 18.7 percent in the Northeast, 1.9 percent in the Midwest, 3.8 percent in the Southeast, and 10.7 percent in the West, or 6.5 percent for the nation as a whole. Interestingly, the median price has actually dropped 7.2 percent in the Midwest and 7.3 percent in the South since peaking in the third quarter of 2003, while prices have been generally flat in the West. Statistics from the last couple of quarters might therefore suggest that the housing bubble may have topped out, or at least temporarily cooled down, in much of the country.
Why have home prices been increasing? David Lereah, chief economist with the National Association of Realtors, explained to Inman News (2004): “It’s a simple matter of supply and demand. … We continue to have more home buyers than sellers in most of the country, which results in tight housing inventories and higher rates of home price appreciation.”David Lereah, “Real Estate Prices Post Double Digit Gains,” Ocala Star-Banner, May 22, 7, 2004. Of course the cause of higher home prices is that the Federal Reserve has kept interest rates, and thus mortgage rates, at historically low rates such that people find it easier to finance homes. In fact, despite an 18 percent increase in home prices since 2001, the median monthly payment remained the same at $789/month and the median payment as a percentage of income has actually fallen. This is the magic of monetary inflation, courtesy of Alan Greenspan.
Price Inflation Follows Monetary Inflation The price of just about everything I buy is going up these days. Gasoline is higher, dairy products are higher, paper products and just about everything else — higher. Mainstream economists have sounded surprised by the recent upturn in price inflation, and they have offered us every excuse to ignore signs of inflation: Ignore rising oil prices. Ignore rising food prices. Ignore rising health care costs. Ignore higher taxes and government fees. And then there is their dirty little secret about housing prices.
Higher price inflation should not have been a surprise given that the Fed has increased the money supply by 25 percent during the period 2001–3. In addition, the price of basic commodities has been rising for many months, and these higher commodity prices eventually turn up in the price of goods and services. One leading indicator of higher commodity prices is the Dow Jones Commodity Index, which represents the stock prices of major commodity producers. It has been rising since the fourth quarter of 2001 and has doubled in value since that time. This stock index is now higher than it has ever been, outside of the blip that occurred in mid-2002.
Only recently have commodity prices begun influencing government price indexes like the Producer Price Index and the Consumer Price Index. For the first four months of 2004 CPI inflation increased at an annual rate of 4 percent, which is a higher rate than we have experienced in the last few years. The Producer Price Index actually decreased in 2001, but has increased in 2002 and 2003. During the year ending June 2004, prices for finished producer goods increased 3.7 percent, while at earlier stages of production the prices for intermediate goods increased by 5.1 percent and the prices of crude materials surged 20.4 percent. This would suggest that there is potentially plenty of price inflation still in the pipeline. The experience of the 1970s would suggest that price inflation adds fuel to housing bubbles because tangible assets such as homes serve as a hedge against inflation.
The Dirty Secret While this price inflation did not surprise me, the delay in its arrival did — that is, until I came across the dirty little secret in the CPI. With prices increasing all around us, there is one thing in Auburn, Alabama, that seems to be in abundance with stable, if not declining, prices. This “good” is now being advertised on most streets throughout the town, whereas in the past it did not require much, if any, advertising over the twenty-plus years I have lived in this college town. This abundant good is housing.
It is a truly odd market when houses and apartments move in opposite directions. After all, houses and apartments are just different products in the same market for housing. In Auburn, it is nearly impossible to find the kind of house you want to buy despite frantic building by construction companies, and yet rental properties, which include many smaller houses, seem to be readily available in all shapes and sizes. Has the population changed? Have people become antirent? Or are we just in a “new housing paradigm”? Is this a “new era” of homes?
Greenspan’s low interest rates have driven renters to become homeowners and knocked the market out of equilibrium. Underneath this Fed-inspired distortion rests the dirty little secret of how the cost of housing has served to limit increases in measured inflation. The Consumer Price Index has underreported price inflation because the government uses the rental value of housing, rather the actual price of houses, in its index.
In the basket of goods used to calculate CPI, the goods that have increased slower than housing include food and beverages, recreation, and education, which add up to about 30 percent of the weight in the CPI basket of goods. Housing accounts for 42 percent of the basket, with housing prices representing almost 25 percent of the entire basket. However, housing prices are calculated with “owner’s equivalent rent,” which is an estimate of the rent that people would have to pay for their houses. With home prices rising and rental rates stagnant, the CPI underestimates the real rate of price inflation over the last year (circa 2004) by about 50 percent.
Do Housing Bubbles Burst? Housing prices never, or rarely, go down. That is the conventional wisdom, and the conventional wisdom is correct. Housing is always a good investment, isn’t it? It’s an inflation hedge and it’s an investment that you get to use every day, plus you get a great tax break. And the home, after all, is a big part of the American dream, right?
Government can screw up just about anything. Given enough power and time it will screw up everything. Housing and real estate in America is just the latest example. The Federal Reserve and the Mac-Mae family of government-sponsored enterprises that facilitate various kinds of debt (i.e., Freddie, Fannie, Sallie, etc.) have conspired to create a housing bubble in the United States, and as the old saying goes, “What goes up must come down.” It’s only a matter of time.
Housing bubbles typically do not pop like a balloon; they don’t even crash like stock markets. Rather, the air in housing bubbles tends to leak out slowly — painfully slowly — while in commercial real estate markets there is a more noticeable hiss. We really don’t know the current value of our homes until we sell them. They are not traded on a daily basis, like shares of stock in Walmart. Some never get exchanged in the market, but are passed on within a family from generation to generation. The market value of a home may drop 20 percent and the owner might never realize it.
Worse yet, when the market for real estate collapses, prices are less likely to collapse because when buyers fail to make offers houses simply don’t sell. Sellers often resist cutting their prices in favor of just leaving the house on the market or taking it off the market. Traditionally the market adjustment to a collapse in real estate markets has come from the quantity side, not the price side — fewer houses are sold — while price reductions tend to come gradually. This doesn’t mean that housing bubbles can’t exist or that the bust is any less painful, only that it doesn’t make the same noise as a crash.
It is difficult to predict how long bubbles will last and when they will go bust. The best indicator is interest rates, because when the Fed forces rates down it tends to create bubbles, and when rates are forced upward bubbles tend to pop. My guess is that Greenspan will raise rates after the election.
Prior to this spike, interest rates had been falling since the early 1980s. As mentioned above, lower rates have coaxed people into refinancing their homes and extracting equity from their homes to spend on other purchases, such as cars, boats, renovations, vacations, or even investments in the stock market. As a result, owner equity as a percentage of real estate value is now at an all-time low.
Here is the unmentioned problem with Greenspan’s panacea. What happens to all these “equity poor” homeowners if the return of monetary inflation establishes a new trend of higher prices and higher interest rates over the coming years?
An ever-increasing proportion of mortgage financing has come in the form of variable-rate mortgages, where the payment increases as interest rates increase. In my experience, variable-rate mortgages come with a “cap” that only allows the variable rate to increase by a certain amount. Even with the cap, however, your mortgage payment could increase by around 50 percent. I have recently learned that many variable-rate loans are now offered without a cap. If rates were to explode upward, mortgage payments for these folks could double or triple. And if this did happen, the housing market would collapse with sellers swamping buyers.
Given the government’s encouragement of lax lending practices, home prices could crash, bankruptcies would increase, and financial companies, including the government-sponsored mortgage companies, might require another taxpayer bailout.
Of course inflation might not materialize. Interest rates could stay low. I reported on a new book Deflation: What Happens When Prices FallChris Farrell, Deflation: What Happens When Prices Fall (New York, 2005). that even predicts that deflation will rein in our financial future. Greenspan has suggested that his economic panacea has given American homeowners greater economic “flexibility.” I would suggest that it is not flexibility he offers, but the shackles to an economic nightmare. Stick with the fixed-rate mortgages, keep the equity in your homes, or go get one of those cheap apartments.
Preface During the 1980s Japan was feared as an economic and technological powerhouse. Most observers attributed their stock market bubble and high growth rates to easy monetary policy, management style, and government managed technological development. Since 1990, the Japanese government has been fighting price deflation with monetary inflation and trying to increase growth by government deficit spending. By all accounts it has not worked. Their economy remains mired in low growth, they have by far the highest ratio of government debt to GDP in the world, and they face a dramatic demographic crisis as their population continues to age. This chapter is the lesson of what NOT to do and who not to listen to for advice.
Business cycles and bubbles differ from one another, but the technical similarities between the Japanese and US bubbles are striking. The Japanese bubble began in the early 1970s, the US bubble started in the early 1980s. Both stock markets grew rapidly for thirteen years and then went parabolic to form bubbles, which peaked in Japan at the end of 1989 and in the United States during early 2000. Both stock markets lost about a third of their value eighteen months after their peaks. The Nikkei Stock Index has since lost as much as three-quarters of its peak value, while the Dow Jones Industrial Average has been down 40 percent and the NASDAQ Composite down by 75 percent of its peak value. The real estate bubble continued in Japan for some time after the stock market began its meltdown, and likewise, real estate — particularly housing — experienced (two) bubbles since the initial breakdown of the US stock market in 2000.
The surprising thing is that in the United States the lessons of the Japanese bubble seem to have almost gone unnoticed. Japan experienced fourteen years (now more than twenty-five years) of economic stagnation since its bubble popped. Most troubling, the United States not only failed to heed the warnings of the Japanese bubble, it has thus far mimicked Japan’s failed attempts to stimulate its economy with extremely low interest rates and large government budget deficits. Both countries have opted for a slow, agonizing “recovery,” rather than a sharp correction of past errors that would quickly reallocate resources and return the economy to sustainable growth. Experts tell us that the Japanese and their economy are very different from the Americans and their economy and that the Japanese bubble and Japan’s policy response to its crash were likewise different, but while there certainly are many important differences between the US and Japanese bubbles, the technical features and new-age thinking are strikingly similar in both bubbles.
For example, there is no doubt that technology and new-era thinking played a major role in the Japanese bubble. During the bubble, Japan took over leadership of high technology in the areas of consumer electronics, the automobile industry, manufacturing, and even robotics, and was perceived as a major threat to dominate all technological development around the globe — just as the United States is today. The threat posed by Japan’s growing technological prowess can be seen in the titles of books published during the bubble era: Japan’s High Technology Industries, edited by Hugh Patrick and Larry Meissner (1986); The Technopolis Strategy: Japan, High Technology, and the Control of the Twenty-First Century, by Sheridan Tatsuno (1986); A High Technology Gap?: Europe, America, and Japan, edited by Andrew J. Pierre (1987); The Science and Technology Resources of Japan: A Comparison with the United States, by Maria Papadakis (1988); Created in Japan: From Imitators to World-Class Innovators, by Sheridan M. Tatsuno (1990); Japan as a Scientific and Technological Superpower, by Justin L. Bloom (1990); Japanese Technology Policy: What’s the Secret? by David W. Cheney and William W. Grimes (1991); and Japan’s Growing Technological Capability: Implications for the U.S. Economy, edited by Thomas S. Arrison et al. (1992).
Writing near the pinnacle of the bubble in the stock market, Fumio KodamaFumio Kodama, Analyzing Japanese High Technologies: The Techno-Paradigm Shift (London: Pinter Publisher, 1991), p. 171. explained that the Japanese takeover of technological progress was a result of a new Japanese paradigm that was ushering in a new era:
Japan is becoming one of the frontrunners in industrial technology, which means that prominent science and technology policy researchers all over the world now pay more attention to Japan. Considering this change more deeply, one can understand the reason for the researcher’s academic interest: the paradigm of technological innovation is shifting.
KodamaIbid., p. 172. found that in Japan the innovation of high technology “seems to be different from that for conventional technologies,” and therefore studies focused on Europe and the United States would not lead to a “new scientific framework for analyzing innovation of high technologies.” He suggested that we break away from the inadequate linear model of the past to the unlimited model experienced under the unique “social and cultural context” of Japan. KodamaIbid., pp. 173–74. even ended his book with the suggestion that it was the Japanese cassette-tape recorder, VCR, and fax machine that made the Iranian revolution, Philippine revolution, and Tiananmen uprising possible. This is classic new-era bubble thinking.
Another component of modern new-era thinking is the belief that the so-called scientific management of the economy creates perpetual prosperity. Here the Japanese experience epitomizes this phenomenon because the Japanese economy was said to represent a new “third way,” positioned between the free market economy and that of the centrally planned economy. In Japan, government and corporations act cooperatively in both their self-interest and the general interest of the nation. Bureaucracies help plan and coordinate the economy. They provide incentives, such as financing and tax breaks, in order to channel investment in profitable directions. Corporations, in turn, participate in joint research programs with their competitors, but share the results among participating firms, with each choosing what technological advances to employ in their firms. Production planning is facilitated by an overlap of ownership between final-good producers and their input suppliers. Japanese management, especially during the bubble, was said to spur innovation, enhance product quality and reliability, and create large market shares in export markets for Japanese industries. Alas, none of this could prevent a meltdown of the Japanese stock market and well more than a decade (now more than a quarter century) of stagnation in the Japanese economy.
New-era thinking about the scientific management of the economy was never more prominent and bold than during the Japanese bubble of the 1980s. It was often said that the Japanese system would lead to economic dominance and threaten the preeminence of the US economy. Laura D’Andrea Tyson, who would later become chairman of President Clinton’s Council of Economic Advisors, outlined (at the apex of the bubble) the “threat” of Japan’s technological superiority:
Certainly Japan continues to obtain technology wherever it is available and to translate it into commercial advance, as the United States itself did for so long. However, now talk has begun of a new, “technoeconomic” paradigm emerging in Japan, a new trajectory of technological development. That trajectory emerged from a pattern of industrial catch-up shaped by policies of import substitution and export promotion. As Japan reaches industrial maturity in a broad range of industries, its government is exerting substantial efforts to build a Japanese position in advancing technologies. Agencies such as the Ministry of Trade and Industries (MITI), which have become familiar names in policy discussions in the United States, are involved.Laura D’Andrea Tyson, John Zysman, and Giovanni Dosi, “Trade, Technologies, and Development: A Framework for Discussing Japan,” in Politics and Productivity: The Real Story of Why Japan Works, edited by Chalmers Johnson, Laura D’Andrea Tyson, and John Zysman (Cambridge, MA: Ballinger Publishing, 1989), p. xiv.
In Japan, the government channeled research and development efforts, directed financing, and protected markets for business. This new, third way of government management of the economy was thought to be Japan’s source of economic strength and was to inevitably place it in a position of economic preeminence. As Tyson and ZysmanLaura D’Andrea Tyson, and John Zysman, “Preface: The Argument Refined,” in ibid., p. xiv. confidently asserted:
A generation from now, Japan will almost certainly have created its own mechanism for advancing the technological frontiers in a range of domains. Now the continuing pace of productivity increase suggests that Japan may indeed be on a growth trajectory different from that of the United States. As Japan ascends, America frets about its decline.
Tyson and her coauthors, Dosi and Zysman,Ibid., pp. 4–5. questioned the validity of traditional economic thought, as all new-era thinkers must. They justified Japan’s “often flagrant and self-aware violations of the nostrums of traditional economic thinking” because when “technological change is a key determinant of market outcomes, standard economic models that treat such change as exogenous are a poor guide to understanding the dynamics of market competition and the effects of policy on such competition.” They argued that the “nostrum” of economic efficiency should be abandoned in favor of the less constraining and poorly defined notions of growth efficiency and technological efficiency.
Leaving the anchor of economic efficiency and traditional economic thinking behind, Tyson, Zysman, and DosiIbid., pp. 14–15. were able to justify a variety of noneconomic policies such as “beggar thy neighbor” protectionism. She heralded the concept of growth efficiency, which is essentially a Keynesian idea that rests on the assumption “that there are always unutilized resources that can be mobilized to meet growing demand. … It is exactly this kind of thinking that led the Japanese to target industries whose products were perceived to have high income elasticities as a foundation for rapid economic growth.” Ignoring the economic condition of scarcity and grasping at the concept of an economy of perpetually unutilized resources is a precondition for new-era thinking, as well as a quintessential mistake of freshman college students taking their first course in economics. If resources are perpetually available then an unlimited amount of all goods and services can be produced and there are no economic problems to solve. This would seem to be the most basic of economic errors and a particularly grievous one to make in analyzing resource- and land-poor Japan.
Naturally Tyson also had to offer a rationale for why markets do not work, and she concluded that entrepreneurs will pass up more profitable long-run investments in order to pursue short-run profits under certain conditions. Tyson, Zysman, and DosiIbid., p. 17. even admitted that their argument was simply a variation of the long-discredited infant-industry argument for protectionism:
Under conditions of nondecreasing returns there is simply no way that markets can relate the varying future growth efficiencies of various industries to relative profitability signals facing individual producers. Basically, this argument is a variant of the infant-industry argument. Because of increasing returns, current market signals can be misleading indicators of future profitability. Consequently, government policies to promote a domestic industry with high future growth potential can improve economic welfare in the long run.
It would seem from the perspective of Tyson, Zysman, and Dosi that modern-day entrepreneurs might invest in the production of black-and-white television sets or mechanical typewriters made out of jute if not for the prodding and oversight of government bureaucrats.
In their justification of Japan’s new-era thinking, Tyson, Zysman, and Dosi viewed technology from the historical rather than economic perspective. In an age of information and communication technology, their “path dependent” and “sticky” processes of technological development seem odd and not entirely appropriate for new-age theorists, who often view technology as “spontaneous,” perfectly flexible, and ever present. Nevertheless, they clearly are new-era philosophers of the Japanese bubble and its new technological paradigm:
The expression technological paradigm … involves a new set of best practice rules and customs, new approaches to how to relate technology to market problems, new solutions to established problems. The notion of a major industrial transition, of a second industrial divide, of a shift from “Fordist to flexible” manufacturing that has become a fad in some debates points to just such a shift in technological paradigm.Ibid., p. 31.
In retrospect, the new-era thinkers of the Japanese bubble economy seem conceited and hopelessly naïve, but that is the power of bubbles to deceive. One of the few observers to correctly identify and characterize the bubble was Christopher Wood,Christopher Wood, The Bubble Economy: Japan’s Extraordinary Speculative Boom of the ’80s and the Dramatic Bust of the ’90s (New York: Atlantic Monthly Press, 1992), p. 255. who wrote that Japan “became so arrogant in the late 1980s because it really believed it was immune from the natural laws of the marketplace. This really was one of the most astonishing acts of mass delusion ever, and future historians … will marvel at it.” The Japanese people might be particularly susceptible to the delusions of a stock market bubble because their culture has so long emphasized honesty and respect for authority, and the government has carefully maintained the isolation of its people, both of which could contribute to herd-like behavior and which make them ripe for what Charles Mackay famously called “the madness of crowds.” The Japanese also have characteristics in their social psychology, as well as their well-known emphasis on precision and details, that might make them more susceptible to new-era delusions. The truth is that all these psychological characteristics are unimportant in terms of the cause of bubbles.
In the wake of the bubble and bust, Japan experienced a long series of corruption scandals, a procession of failed prime ministers, the ousting of financial ministers, the conviction of bureaucrats for corruption, and the breakup of its one-party system. However, the Japanese have failed to truly recognize the cause of their bubble and to liquidate their economic mistakes. Instead they embarked on a post-bubble course of easy credit, public works, and deficit spending that has only served to condemn the Japanese economy to continuing economic doldrums.
Postscript The success of Japan after WWII was due entirely to the free market economy, small government, low taxes, an appreciating currency, and a very high personal savings rate. That all changed when the bubble was born in the late 1980s because of overly stimulating monetary policy. A quarter century after the stock market meltdown Japan is still mired in an economic slump. At the prodding of mainstream economists, such as Paul Krugman, Japan has embarked on massive amounts of public works projects, enormous amounts of government borrowing, and extreme levels of monetary stimulus and quantitative easing. None of this has worked. It has left the country with the largest national debt relative to GDP in the world. It has also diverted the attention of the Japanese people and thus prevented the country from addressing its demographic crisis. In fact, it might have made the demographic crisis worse. After all, why get married and have children when the children will have to bear the enormous burden of the national debt?
[This chapter originally appeared as “The Economics of Housing Bubbles,” in Housing America: Building Out of a Crisis, edited by Randall G. Holcombe and Benjamin Powell (New Brunswick, NJ: Transactions Publishers, 2009), pp. 237–62. Reprinted with permission from the publisher.]
Nothing better illustrates government failure and the housing crisis than the housing bubble. While the housing bubble is being created by government, homes become increasingly expensive and beyond the economic reach of first-time home buyers. Then as interest rates rise and housing prices fall, many home buyers find themselves with bad investments that they can no longer afford. What started as a grand federal-government effort to improve homeownership for all Americans through a policy of “easy money” will have unintended consequences that will leave many Americans economically scarred for the rest of their lives. An easy-money policy involves the central bank (the Fed) setting low interest rates and expanding the money supply so that it is easier to get credit (loans), and it also involves government-sponsored credit organizations such as Fannie Mae and Freddie Mac that make getting home mortgages easier.
When an economic bubble pops, many people are harmed economically. In the case of a housing bubble, this will be especially true of homeowners, particularly new homeowners who buy homes during the peak phase of the housing bubble. However, the harm also consists of unemployment of labor and a loss of value to owners of capital, particularly in housing-related industries. At the individual level many people are forced into bankruptcy. On the macroeconomic level the bursting of the housing bubble can send the overall economy into recession or depression. Housing bubbles concentrate their impact in the home-building, materials and furnishings, real estate sales, and mortgage businesses.
On top of all that, people suffer psychological consequences as well. The people most involved in the bubble are confident, jubilant, and self-assured due to their apparently successful decision making. When the bubble bursts they lose confidence, go into despair and lose confidence in their decision making. In fact, they lose confidence in “the system,” which means they lose confidence in capitalism, and become susceptible to new political “reforms” that offer structure and security in exchange for some of their autonomy and freedoms.
The reason economic crises create fear and concession of liberty is that people do not generally know what caused the bust or economic crisis and generally do not even know that there was even a bubble in the first place. In fact, as the bubble bursts many people deny that there is a problem and believe that the whole situation will quickly return to what they consider normal. The average citizen thinks very little about what makes the economy work, but simply accepts the system for what it is, and tries to make the most of it.
The purpose of this chapter is to show how “the system” works, how it generates bubbles, why they eventually burst, and the macroeconomic effects of bubbles. Here we apply the economic understanding of bubbles derived from Austrian business cycle theory, or ABCT, to the current 2006 case of the housing bubble and show that this aspect of the housing crisis is the result of government failure — the inevitable failure of a government bureaucracy (i.e., the Fed) to manage the money supply and interest rates in an economically rational manner. However, the same reasoning can be applied to historical bubbles, from the tulip mania in seventeenth-century Holland to the dot-com tech bubble of the late 1990s, as well as to future bubbles.
What Causes Housing Bubbles? There are three basic views of bubbles that are held by economists and the general public. The dominant view among the general public and modern mainstream economists, including the Chicago school and proponents of supply-side economics, is to deny the existence of bubbles and to declare that what are thought to be “bubbles” are really the result of “real” factors. The second view, which is espoused by Keynesians and by proponents of behavioral finance, is that bubbles exist because of psychological factors such as those captured by the phrase “irrational exuberance.” The third and final view is that of the Austrian school, which sees bubbles as consisting of real and psychological changes caused by manipulations of monetary policy. This view has the advantage of being forward looking and identifying an economic cause of bubbles. By identifying an economic cause it also directs us to policy choices that would prevent future bubbles.
Most people agree with the majority of economists that there is no such thing as a housing bubble — housing prices, they say, “never go down.” Supply siders and Chicago-school economists seem to view the declaration of a bubble as an affront to homo economicus — economically rational man — because they view it as an assertion of some psychological flaw in people that requires government intervention.Homo economicus is the model of the rational economic person that economists use to build their models and theories about the economy. This assumption asserts that people are rational and will always attempt to maximize their utility. This is a source of contention and misunderstanding among economists and between economists and other social scientists. They note that if there were a rational cause or causes of housing bubbles, or any type of bubble for that matter, then even if only some people believed it was a bubble, they could profit by selling homes at inflated prices and deflate the bubble long before it ever became overinflated and burst. Furthermore, if housing bubbles had irrational foundations, then certainly an economically rational man could profit enormously by shedding light on the erroneous psychological motivations that were causing the bubble.
Although there is much diversity in this camp, it is well illustrated by two economists from the Federal Reserve Bank of New York who examined concerns about the existence of a speculative bubble in the US housing market. While McCarty and Peach did find that a housing bubble could have a severe impact on the economy — if it existed and were to burst — they ultimately concluded that such fears were unfounded:
Our main conclusion is that the most widely cited evidence of a bubble is not persuasive because it fails to account for developments in the housing market over the past decade. In particular, significant declines in nominal mortgage interest rates and demographic forces have supported housing demand, home construction, and home values during this period.Jonathan McCarthy and Richard W. Peach, “Are Home Prices the Next ‘Bubble’?” FRBNY Economic Policy Review (December 2004): 2.
Furthermore they find “no basis for concern” for any severe drop in housing prices. They found that when the United States has gone into recession or experienced periods of high nominal interest rates, any price declines have been “moderate”; and they found that significant declines can only happen regionally such that they would not have “devastating effects on the national economy.”
This is essentially the view of Alan Greenspan and Ben Bernanke. In particular, Greenspan was aware of the possibility of a housing bubble, but he offered every possible reason why it did not exist, and how if one did exist it would not be a major problem. The chairman is usually difficult to interpret and at times so incomprehensible as to be almost misleading. His testimony before Congress has been labeled “Greenspam.”Mark Thornton, “Surviving GreenSpam,” LewRockwell.com, February 16, 2004. However, on the topic of the housing bubble he is clear and direct and worth quoting at length:
The ongoing strength in the housing market has raised concerns about the possible emergence of a bubble in home prices. However, the analogy often made to the building and bursting of a stock price bubble is imperfect. First, unlike in the stock market, sales in the real estate market incur substantial transactions costs and, when most homes are sold, the seller must physically move out. Doing so often entails significant financial and emotional costs and is an obvious impediment to stimulating a bubble through speculative trading in homes. Thus, while stock market turnover is more than 100 percent annually, the turnover of home ownership is less than 10 percent annually — scarcely tinder for speculative conflagration. Second, arbitrage opportunities are much more limited in housing markets than in securities markets. A home in Portland, Oregon is not a close substitute for a home in Portland, Maine, and the “national” housing market is better understood as a collection of small, local housing markets. Even if a bubble were to develop in a local market, it would not necessarily have implications for the nation as a whole.Alan Greenspan, “Monetary Policy and the Economic Outlook,” Testimony before the Joint Economic Committee of the US Congress, April 17, 2002.
As the bubble approached its peak, GreenspanAlan Greenspan, “Mortgage Banking.” Speech to the American Bankers Association Annual Convention, Palm Desert, CA, September 26, 2005. did admit that there was some “apparent froth” in some local housing markets, but overall he found that conditions in the housing market were “encouraging.” In his first speech after leaving office Greenspan said that the “extraordinary boom” in the housing market was over, but that there was no danger and that home prices would not decrease.Joe B. Bruno, “Former Fed Chair Says Housing Boom Over,” Associated Press, May 19, 2006. The new Fed chairman, Ben Bernanke,Ben Bernanke, “Reflections on the Yield Curve and Monetary Policy.” Remarks before the Economic Club of New York, March 20, 2006. admitted the possibility of “slower growth in house prices,” but confidently declared that if this did happen he would just lower interest rates. Bernanke also believed that the mortgage market is more stable than in the past. Bernanke noted in particular that “our examiners tell us that lending standards are generally sound and are not comparable to the standards that contributed to broad problems in the banking industry two decades ago. In particular, real estate appraisal practices have improved.”Ben Bernanke, Speech to the Independent Community Bankers of America National Convention and Techworld, Las Vegas, NV, March 8, 2006.
A second view of housing bubbles and bubbles in general is that they exist, but that they are fundamentally caused by psychological factors. Many people and many important economists subscribe to this view of bubbles, including Keynesian economists and proponents of behavioral finance, such as Robert Shiller. From this perspective the business cycle is seen as the ebb and flow of mass consciousness and emotions. Real factors may play a role, but the important causal factors for deviations in the business cycle are psychological. Booms develop because people become confident and then overconfident in the economy. Investors likewise are confident and increase their tolerance for taking risk. Rising profits and asset prices lead to “speculative” behavior where economic decisions are no longer based on old rules and procedures, but on the bravery instilled by a “new era.”All of our actions involve some speculation about the future. Here “speculative” behavior refers to actions that involve great risks which are unwarranted based on the normal or known fundamentals of the economy. For example, betting on a round of golf with your friend involves some speculation and uncertainty, but past experience provides some guidance to the risks you are taking. Here, betting on a round of golf with Tiger Woods would be “speculative.” As the investment mania sets in, the bubble expands. Then, for whatever reason, people begin to lose faith and new investments are exposed as disappointing. Economic reports and statistics turn sour, and stories of scandal begin to appear in the press.It is a common misconception that corporate scandal is the source of bubbles and that it was companies like Enron and WorldCom that tricked investors during the late 1990s to bid up the stock markets to such high levels. It is true that scandal is a common feature of bubbles, but scandal could never account for more than a small percentage of bubbles, and in reality scandal is caused by the same source as the bubble itself — the existence of cheap and abundant credit that must be allocated to increasingly risky and suspect investments. Many investors remain determined in thinking that this turn of events is only temporary, but results grow worse, prices continue to fall, and investment projects are postponed, halted, or cancelled. The mood of the market is one of gloom or even doom. The economy enters a depression.
Representing the behavioral-finance camp is Professor Robert Shiller of Yale University, who is the author of Irrational Exuberance, the first edition of which correctly predicted the stock market bubble; the second edition predicted the housing bubble, whose “ultimate causes are mostly psychological.” Like the Keynesians to follow, ShillerRobert Shiller, “Are Housing Prices a House of Cards?” Project-Syndicate.org. September 2004. does not deny the existence of real factors; he simply downplays them in order to emphasize psychological factors. With the case of the housing bubble he finds three important factors. First, the increased risk and chaos in the world since the technology bubble and the terrorist attacks of 9/11 have caused a flight of investment into quality and safety — your own home. Second, the explosive growth in global communications has increased the glamour appeal of living in one of the world’s leading cities such as Paris, London, New York, or San Francisco. The third psychological factor is “the speculative contagion that underlies any bubble.” Here one higher price begets another, and higher prices in one city lead to higher prices in another city, and the process of higher prices simply builds on itself. Shiller declared that the first two factors will remain in effect, but the third factor cannot last forever. Once prices begin to drop, the contagion works in the downward direction and can last for years before the process is reversed again.
Representing the Keynesian camp is Paul Krugman, who is an economics professor at Princeton University and a writer for the New York Times. Krugman did not predict a housing bubble, but he did finally realize that we were in one and that it presented a big problem for the US economy. Commenting on the hectic pace of housing construction and the “absurd” housing prices Krugman drew parallels to previous investment manias: “In parts of the country there’s a speculative fever among people who shouldn’t be speculators that seem all too familiar from past bubbles — the shoeshine boys with stock tips in the 1920’s, the beer-and-pizza joints showing CNBC, not ESPN, on the TV sets in the 1990s.”Paul Krugman, “Running Out of Bubbles,” New York Times, May 27, 2005.
It is also correct to connect the phenomenon of day traders of technology stocks in the late 1990s to the house flippers of the housing bubble. The real question is: what causes this irrational behavior? Krugman suggested that, with the housing bubble, the bubble builds on expectations of capital gains:
So when people become willing to spend more on houses, say because of a fall in mortgage rates, some houses get built, but the prices of existing houses also go up. And if people think prices will continue to rise, they become willing to spend even more, driving prices still higher, and so on. … [P]rices will keep rising rapidly, generating big capital gains. That’s pretty much the definition of a bubble.Paul Krugman, “That Hissing Sound,” Ocala Star-Banner, May 22, 7, 2004. New York Times, August 8, 2005.
Notice that Krugman placed his emphasis on a supposedly unfounded change in taste or demand (“when people become willing to spend more on houses”) but downplayed the actual cause of the change in the demand for housing (“say because of a fall in mortgage rates”), as if anything might have ignited the bubble. The more Krugman tried to provide an economic rationale for the bubble the more he sounded like the Austrian economists who dominate the third and final view of the housing bubble. Another possible example of this is Baker and Rosnick,Baker and David Rosnick, Will a Bursting Bubble Trouble Bernanke? Evidence for a Housing Bubble (Washington, DC: Center for Economic and Policy Research, November, 2005). who demonstrate the case for a housing bubble and do so in a manner similar to Austrian economists; and even though they date the beginning of the bubble to 1997 they ignore the real factor that tax-law changes in that year were a catalyst to housing and higher housing prices. In fact, KrugmanKrugman, “Running Out of Bubbles.” cites fellow Keynesian Paul McCulley, who did correctly predict the housing bubble and did so in the manner typical of Austrian economists, where interest rate cuts lead to higher home prices, a construction boom, and higher consumer spending all based on increased debt — and he explicitly placed the blame for the bubble on the Fed. The problem with Keynesians such as Krugman and McCulley is that their cures — discretionary monetary and fiscal policy — usually make matters worse. Even if they could be made to work perfectly it would create a conundrum for Keynesian economists because a highly stabilized economy desensitizes investors to risk and makes them “irrationally exuberant” and thus creates the prerequisite for bubbles. Even Alan GreenspanAlan Greenspan, “Reflections on Central Banking,” speech given at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, WY, August 26, 2005. has warned, in his own convoluted way, that “history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”
As you can see, the first view wishes to dismiss psychological reasons for bubbles to focus only on real factors, while the second view wishes to downplay real factors in order to emphasize psychological causes. The third view believes that there are changes in both real factors and market psychology during bubbles and that both are driven by the cause of the business cycle — policy manipulations by the Federal Reserve. This view of bubbles is based on Austrian business cycle theory. This is a minority view held by Austrian-school economists and some fellow travelers of the school.A fellow traveler is someone who sympathizes with or supports various tenets of the Austrian school without being an acknowledged member or embracing all aspects of Austrian economics.
According to ABCT, if the Fed does not pursue a loose monetary policy then bubbles like the technology stock bubble of the late 1990s or the one in housing that we are now experiencing would not develop. If the Fed does follow a loose monetary policy, then a bubble can develop somewhere in the economy, whether it be in tulip bulbs, stocks, or real estate. If the new money is directed toward housing, a bubble will develop in housing. Austrian economists further emphasize that the additional resources allocated to housing are resources that are not available elsewhere in an economy, so that while more resources than normal are allocated to housing construction, fewer resources are available to other areas of the economy such as manufacturing, which will experience higher costs for its inputs such as labor and materials and will produce a proportionately smaller output. It is this mismatching of resources across industries and sectors that has to be resolved — painfully — in the inevitable bust or correction.
In a real estate bubble the price of existing homes rises. The bubble also fuels the construction of new homes so that the wages of construction workers rise and labor reallocates itself into construction and related industries. The bubble also increases the price of construction materials and land. Construction and construction-related industries are also where the most unemployment occurs and where the biggest price and wage declines occur in the inevitable bust. Another unique feature of the Austrian approach is that they do not see a need for prices to increase uniformly across markets, or for prices to increase to extreme levels in all markets. Many doubters of the housing bubble point to the smaller price increases in the center of the country compared to coastal regions, but price is only one dimension of bubbles — quantity can also increase beyond sustainable levels. In fact, one could conceptualize a bubble where prices stayed the same and all the bubble adjustment occurred only in the quantity dimension. If we doubled the number of houses and prices barely budged, we would be left with too many houses for the population and all the labor and materials that went into the production of those goods (i.e., houses) would be tied up and unavailable to serve more urgent needs after the bursting of the bubble revealed that the superfluous houses were bad investments.
Among the Austrians who identified the housing bubble is economist Frank Shostak, who defined a bubble as any activity that “springs up” from loose monetary policies: “In other words, in the absence of monetary pumping these activities would not emerge.” As a result of this pumping, a misallocation of resources develops whereby nonproductive activities increase relative to productive activities — something that seems to clearly characterize the US economy since he wrote in early 2003: “The magnitude of the housing price bubble is depicted … in terms of the median price of new houses in relation to the historical trend between 1963 and 1979. In this regard the median price stood at 73 percent above the trend in December 2002.”Frank Shostak, “Housing Bubble: Myth or Reality?” Mises Daily, March 4, 2003.
The only “problem” with his warning is that it came too soon. A year later Shostak warned that there “is a strong likelihood that the US housing market bubble has already reached dangerous dimensions.”Frank Shostak, “Who Made the Fannie and Freddie Threat?” Mises Daily, March 5, 2004. While early warning maybe a problem for investors in home building stocks, the problems of predicting the timing and magnitude of bubbles and business cycles affects all forecasters, and Shostak’s warning was primarily for the purpose of judging public policy. In effect he was noting that policymakers have made a mistake that they should correct immediately and not make the situation in the housing market any worse.
Also from the Austrian camp is banker Christopher Meyer, who noted that there is always a bubble in the making in a world of fractional reserve banking and fiat currency, and that housing has often been impacted by bubble conditions in the United States and elsewhere. In the summer of 2003 he identified the current housing bubble:
The strong housing market has all the makings of being the next bubble — in particular high leverage and unsustainable price increases. While the larger economy seems to sputter along, the housing market continues to run a hot race. Low interest rates have propelled refinancing, freeing up $100 billion last year alone, according to the Wall Street Journal. Not surprisingly, the low interest rates have increased buying power and supported housing prices.Christopher Mayer, “The Housing Bubble,” Free Market 23, no. 8 (August 1, 2003).
In early 2004 I pointed investors to the on-going housing bubble and specifically that it might not be a good idea to increase your mortgage: “It might not be a good time for you to obtain a home equity loan to invest in hot tech stocks. We are going through a housing bubble.”Thornton, “Surviving GreenSpam.” I followed this up later that year with a more detailed examination of the housing bubble and found:
Signs of a “new era” in housing are everywhere. Housing construction is taking place at record rates. New records for real estate prices are being set across the country, especially on the east and west coasts. Booming home prices and record low interest rates are allowing homeowners to refinance their mortgages, “extract equity” to increase their spending, and lower their monthly payment! As one loan officer explained to me: “It’s almost too good to be true.” In fact, it is too good to be true.Thornton, “Housing: Too Good to Be True.”
The problem with the “new era” diagnosis is that it ignores the historical fact that the housing market, and the construction of structures in general, has experienced regular cycles of boom and bust, with prices rising and falling for residential, commercial, industrial, and agricultural real estate. Likewise occupancy and lease rates, new construction, and the fate of construction firms and land speculators point us to the history of real estate bubbles. In fact, statistically, housing starts are a leading indicator of the business cycle and home construction is procyclical (i.e., home construction is positively related to changes in the overall economy, but more volatile). The Skyscraper Indicator even shows that historically the building of a record-setting high skyscraper foreshadows severe negative changes in the economy.Mark Thornton, “Skyscrapers and Business Cycles,” Quarterly Journal of Austrian Economics 8, no. 1 (Spring 2005): 51–74.
What Goes Up… ABCT demonstrates that monetary inflation has different effects depending on who receives the new money first and how it is spent. Is the new money introduced into the economy in the areas of banking and investment, consumer loans, or directly to a group of consumers or producers? Do the people who receive the money want to save it or spend it? If they save it interest rates will go down, and if they spend it interest rates will go up as entrepreneurs borrow money in order to increase production. If the money is spent, it depends on who is spending it. The economy will experience different changes if the money is given to welfare recipients instead of military generals. If the money is saved the economy will experience different changes than if it is invested in stocks rather than housing. The point here is that monetary inflation can cause bubbles and booms in the areas of the economy where it is first introduced. This foundation of ABCT comes down to us from Richard Cantillon, the founder of economic theory, who wrote in the aftermath of the Mississippi Bubble circa 1720s. Tracking the flow of monetary inflation through the economy is very difficult, and most mainstream economists just assume away the problem and declare that money is neutral on the economy.
By the end of the eighteenth century the world had converted from free banking to central banking, with the United States being the last major nation to establish a central bank in 1913. In the first treatise on monetary theory in the modern era, Ludwig von Mises produced the foundations of ABCT.Ludwig von Mises, The Theory of Money and Credit (Indianapolis, IN: Liberty Classics [1908] 1981). With central banks established for the purpose of producing monetary inflation, Mises could now establish a general theory of business cycles rather than the case-by-case basis of Cantillon. By integrating the contributions of Carl Menger, Eugen von Böhm-Bawerk, and Knut Wicksell he was able to show that when the central bank — the Fed — increases the supply of money, it causes the market rate of interest to fall below the natural rate of interest that would have existed in the absence of Fed intervention. This would cause investors to borrow more money, to expand their investments, and to undertake riskier projects and more roundabout production processes. As these borrowers compete for assets, resources, and goods, price inflation inevitably occurs and the rate of interest will increase. This in turn will negatively affect the economy, and some of the riskier and more roundabout investment projects will be discovered to be bad investments. Bankruptcies can also impact previously existing investments and production processes that are caught in the wake of the bust. Mises student F. A. Hayek expanded ABCT to include capital theory and its integration into the structure of production.
According to ABCT, when a central bank makes loans or purchases government bonds from banks it is injecting bank reserves into the economy. Banks now have excess reserves that they can loan, but the existence of excess loanable funds means that banks must reduce the interest rate they charge, reduce the credit-quality requirements of borrowers, or both. The result is a greater quantity of borrowing and investing, particularly in projects that “pay off” over a long period of time. Lower interest rates also discourage savings because the return from savings is lower. In this manner the Federal Reserve drives the market rates of interest below the natural rate of interest that would have existed in the absence of Federal Reserve intervention.
Ever since the Depository Institutions Deregulation and Monetary Control Act of 1980 and Paul Volcker’s (chairman of the Fed from 1979 to 1987) war on inflation of the early 1980s, interest rates have been on a downward path. This culminated with the large reductions in the federal funds rate that followed in the aftermath of the 9/11 terrorist attack in 2001. Under Greenspan the rate was reduced from 6.5 percent in November 2000 to 1 percent in July 2003. The federal funds rate remained at 1 percent until June 2004, coinciding with the launching of the final phase of the housing bubble. The Philadelphia Housing Sector Index peaked at the end of August 2005. At this low level, interest rates were negative when price inflation is taken into account.
The federal funds rate, which is the rate that banks can borrow from other banks in order to meet their reserve requirements imposed by the Fed. The Fed “targets” this short-term rate and injects reserves into this market by purchasing government bonds from banks, thereby freeing up reserves in the banking system. This essentially is the engine of inflation because the Fed simply makes a bookkeeping entry in the bank’s account with the Federal Reserve — modern inflation is essentially an electronic bookkeeping entry. The low rates of the 1960s resulted in no recession and a booming economy, but those low rates also caused the stagflation of the 1970s, where both price inflation and unemployment were very high. This culminated in Volcker’s war on inflation of the early 1980s. By greatly reducing expectation of price inflation and deregulating the banking system, the Fed has been able to reduce interest rates and ignite a giant boom in financial and asset markets throughout the 1980s and 1990s, as well as the housing bubble of the early 2000s when rates were clearly pushed below their natural levels and when rates were negative, when adjusted for inflation.
When banks have access to bank reserves from the Fed at low rates they can offer their customers lower rates on loans. The impact of changes in the federal funds rate has a direct impact on mortgage rates: increasing during the 1970s and peaking during Volcker’s war on inflation at 18 percent, and then generally declining throughout the 1980s and 1990s and then reaching historical lows during the early 2000s. During the housing bubble interest rates on thirty-year conventional mortgages were at their lowest levels ever during the post–gold standard era. When interest rates fall, asset prices and real estate prices tend to rise, and vice versa.
Naturally, lower rates for home mortgages have stimulated borrowing for real estate purposes. Total real estate loans first exceed $1 trillion in early 1995, reached $2 trillion in late 2002 and reached $3 trillion in early 2006 (the maximum for the bubble occurred in mid-2009 at $3.8 trillion). In addition to the Fed, there were other factors that helped direct all this new credit money into real estate. First, in 1997 homeowners were given a $250,000 exemption ($500,000 for couples) for capital gains that resulted from the sale of their house, adding greatly to the tax benefits of homeownership. This tax break could be said to have lit the fuse of the housing bubble. Second, government-sponsored credit corporations such as Fannie Mae and Freddie Mac, which can acquire capital at a subsidized rate because of the implicit assumption that the federal government will bail them out, began to collateralize home mortgage debt on a grand scale so that lenders could quickly and easily resell the loans they make. These government-sponsored agencies have helped stimulate the flow of credit to riskier borrowers who might not otherwise have access to credit, and have therefore helped to lower the credit standards of lending institutions. The problem with these institutions is so large that even Alan Greenspan has publically scolded them.Kathleen Hays, “Greenspan Steps Up Criticism of Fannie: Fed Chief Says Company and Freddie Mac Have Exploited Their Relationship with the Treasury,” CNN.com, May 19, 2005. In truth, the original problem lies with Alan, not Fannie or Freddie.
The artificially low rates generated by the Fed also have the effect of discouraging people from saving money and encouraging them to borrow more for consumption and speculation. The impact of monetary pumping by the Fed has driven down the personal savings rate throughout the 1980s and 1990s, and during the early 2000s it has driven the rate to zero — and even below — which means people are spending more than they earn. Contributing to the problem of the low personal savings rate are the artificially inflated asset and real estate prices which naturally make people feel wealthier and allow them to “cash out” equity from their homes when they refinance their home mortgages. During the housing bubble many Americans used their homes as a kind of giant ATM to withdraw cash from the equity in their homes. Others used the “magic checkbook” from second mortgages to spend the equity they had in their homes.Carol Lloyd, “Home Sweet Cash Cow: How Our Houses Are Financing Our Lives.” SFGate.com, March 10, 2006.
At this point one should be wondering — how could borrowing be going up and savings going down? One answer to the question is that America was borrowing money from overseas in the form of the trade deficit, but the main answer is monetary pumping by the Fed. By artificially lowering rates via increases in the money supply the Fed created a giant gap between borrowing and saving. MZM (money of zero maturity) is a relatively new measure of the money supply and one that is close to the Austrian-school definition of money, which is that it is immediately redeemable at par. MZM includes currency, demand deposits — that is, checking accounts — traveler’s checks, savings deposits, and deposits in money market mutual funds. During the period from January 1959 to August 1971 (11.7 years), when Nixon took the United States off the gold standard, the money supply grew by 82.2 percent for an average annual growth rate of 5.26 percent. Between August 1971 and 1984, when complete decontrol was established from the Depository Institutions Deregulation and Monetary Control Act of 1980 (13 years), the money supply increased by 180.4 percent for an average annual growth rate of 8.25 percent. Ever since 1984 (16.6 years) the money supply as measured by MZM grew by 390.1 percent, or an average annual growth rate of 10 percent. It would seem that all this new money first went into the New York Stock Exchange, especially during the 1980s, then the NASDAQ stock market during the late 1990s, and finally into the housing market after the dot-com bust in 2000.
A large part of the increase in the money supply found its way into the market for home mortgages. Since the recession of 2001 the increase in mortgage debt was about equal to the increase in MZM. This one stylized fact probably best illustrates the housing bubble and its cause. Another measure of the housing bubble is the amount of real private residential fixed investment. Investment in housing was low during the Great Depression and WWII, but beginning in the mid-1940s investment in housing, adjusted for price inflation, has shown a positive trend, which is based on economic and population growth over that same period. The cycle in housing investment was less severe before we went off the gold standard, more severe on the fiat standard, and even more severe after monetary deregulation in 1980. Most noteworthy is that investment in housing hit a boom high during the dot-com bubble of the late 1990s and then “jumped higher off the historical trend” during the recession of 2001, when historically it would have retreated back toward recessionary trend levels. It therefore seems clear that in terms of investment value there has been a housing bubble since at least the recession of 2001.
ABCT does not rely on measuring the cycle or bubble, but empirical measures do often help illustrate the approach. The next such measure is the number of homes built (apartments and other multiunit structures are not included here). Typically there are sharp downturns in the number of housing starts often coincide with the beginnings of recessions and that the sharper the drop the longer the recession. For example, in the late 1970s the number of housing starts fell from an annual rate of over 1.5 million to a rate of barely 0.5 million in the early 1980s, which was a severe recession. Since the recession of 1991 the trend in new housing starts has been steeply upward, and there was no noticeable downturn in housing starts during the recession of 2001 — the only recession on record where that did not occur. Instead housing starts continued to increase and have set several new records over the last few years. In terms of this quantity dimension the United States has been in a housing bubble since the early 2000s.
The final dimension of the housing bubble presented here is the price of houses. Doubters of the housing bubble claim that housing prices are rising on the East and West Coasts, but are not rising by bubble proportions in much of the center of the country. Of course housing prices have increased faster in the West and Northeast compared to the Midwest and South, but ABCT theorists would be shocked if home prices were rising uniformly across the country — after all the whole theory is based on changing relative prices, not uniform increases or decreases in a price level. There are microeconomic and public policy reasons why home prices rise more dramatically and are always at a higher level in, for example, California than they are in Alabama. These issues are explored in many of the other contributions to Powell and Holcombe.Holcombe and Powell, Housing America: Building Out of a Crisis. However, the same could be said about stock prices during the technology bubble — rare stocks in tight supply (e.g., dot-coms) did much better than widely held stocks (e.g., stocks in the DJIA). The same was true of tulip bulbs during the tulip mania that happened in seventeenth-century Holland — rare species were affected more by monetary conditions than ordinary species, but they all went up in price.Douglas E. French, “The Dutch Monetary Environment during Tulipmania,” Quarterly Journal of Austrian Economics 9 (Spring 2006): 3–14.
ABCT expects prices in general to rise, but not to rise uniformly. The extent of the rise depends on both where the money is being injected and the flexibility of the supply side of the markets where the injections are taking place. However, if we look at the national price index for the typical 1996 one-family house between 1998 and 2005 we find that prices have increased by 45 percent, which is a 125 percent larger increase compared to the increase in the Consumer Price Index. According to the Bureau of the Census, the price of the average house, as opposed to the “typical” house, has been increasing even faster, which indicates that people are buying bigger, more expensive homes as well. The price dimension — while muted somewhat by the economy’s ability to produce greater quantities of housing — still indicates a large increase in the real price of housing. We should also remember that new housing is generally built on lower-priced land, that house-building technology has reduced building costs, and that the large influx of labor from Mexico has also helped hold down costs.
… Must Come Down ABCT shows that it is government failure that started the housing bubble in the first place. This is where resources are allocated in an incorrect and ultimately unsustainable fashion. In a housing bubble too many houses are built, houses of the wrong sort are built, and houses are built in the wrong locations based on the underlying fundamentals of the economy and people’s real desires for housing not artificially stimulated by monetary inflation by the Fed. While most people are very happy during boom times, the Austrian economists view the boom as the real problem because this is where resources are misallocated. This is also when people become financially overextended and engage in excessive luxury spending.Thomas Kostigen, “Skewed Views: If the Rich Are Doing So Well, How Much Worse Off Are the Rest of Us?” MarketWatch, May 23, 2006. Inflationary periods tend to be when the rich get richer and the poor get poorer.
The bubble must come to an end because it is based on an irrational allocation of resources caused by the Fed’s misleading interest rate policy. Money that is tied up in an asset bubble initially prevents monetary inflation from being revealed as price inflation as measured by the Consumer Price Index. However, if the monetary pumping is used to purchase assets like stocks, bonds, or real estate then the inflation is revealed in the price of those assets, which will rise even though the underlying earnings of the assets have not improved. When money begins to leak out of asset bubbles into consumption, then the price of goods that are used to determine price indexes will begin to rise. The asset bubble is popped or deflated when interest rates rise. This can occur when either the market raises rates due to rising inflation premiums on loans or when the Fed tries to curtail increases in the Consumer Price Index by preemptively raising rates.
The bursting of the bubble reveals the cluster of errors in the housing market and related industries and begins the process of reallocating resources to their best uses by changes in prices, buying and selling, relocation, bankruptcy, and unemployment. The macroeconomic effect of deflating the bubble is that it causes the economy to go into recession or depression. However, the effects of the bubble will also be concentrated as it deflates. Note that the bubble in employment in the construction industry began in 1997 when it rose above a trend level, which dates back to the end of WWII. Note too that the trend in construction employment has always been negative during recessionary periods — even the recession of 2001 — and that the negative trends often extend beyond the periods identified as recession. Given that the trends in construction employment have been so strong for so long during the housing bubble, it would not be surprising that the negative impact of the bubble would take on a similar but negative effect on construction employment and spending, and that these effects would spread beyond to the construction-materials industry, mortgage lending, real estate sales, furniture, appliances, and household-goods items.
Another natural concern about the bursting of the housing bubble is the indebtedness of the average American. As we previously have shown, the personal savings rate of Americans has been declining for many years, in part because Americans have felt wealthier due to the rising price of their real estate properties. This is then coupled with the rising debt of the average American household. Total household debt was less than $500 billion when the United States went off the gold standard in 1971. It first exceeded $5 trillion in 1996 and $10 trillion in 2004. In October 2005, the last reported period, total debt exceeded $11.5 trillion. Certainly these figures could be adjusted for inflation, population, and economic growth, but that does not negate the fact that Americans have taken on a large amount of debt, but have not set aside a similar amount of savings to offset this debt or to insulate themselves from periods of economic distress.
As the economy goes into recession and unemployment increases, homeowners with large mortgages will have a difficult time making their monthly payments and may face the possibility of bankruptcy. This “squeeze” will be compounded by the fact that many homeowners have taken equity out of their homes in recent years, increasing the size of their mortgage. Further difficulties are presented by the fact that a large percentage of borrowers have taken out variable-rate mortgages rather than fixed-rate mortgages, which means that their monthly payment will rise and will rise substantially when interest rates increase. There are variable-rate mortgages where the payment stays the same, but this entails the principal on the loan increases when rates rise, which could place these borrowers “upside down” or “underwater” on the homes, which means the mortgage would be much larger than the value of the home. Lenders have also been providing mortgage loans based on much smaller down payments, in percentage terms, with some lenders even providing loans that exceed 100 percent of the price of the house. All of this points to the likelihood of a large number of foreclosures and bankruptcies. This in turn points us to the stability of the banking and mortgage-lending industries and the likelihood of a taxpayer bailout of banks and government-sponsored institutions such as Freddie Mac that buy mortgage loans from lenders.
Summary and Conclusions There are three views of the housing bubble. The mainstream view does not believe in bubbles and attributes such changes in the economy to real factors such as technology shocks, and believes there is nothing the government can do to solve such real problems. The Keynesian view is that bubbles exist because of psychological instabilities in the economy, not real factors, and that countercyclical policies of the government should be used to tame the business cycle. ABCT incorporates real and psychological changes into a view where bubbles are caused by the policy manipulation of the Federal Reserve.
The housing bubble that began in the late 1990s is a classic example of government failure as applied to the housing crisis. Inflation of the money supply that accompanied the Fed’s cheap-credit policy led to a borrowing and building binge of an unprecedented scale. The number of new homes built, the price of new and existing homes, and the total amount of real estate investment all indicate that the Fed policy, combined with a favorable tax policy and taxpayer-subsidized lending practices, created the housing bubble.
The bubble is not just a bunch of hot air. Real resources are involved, which have been misdirected during the bubble and which will cause painful adjustments in the aftermath of the bubble. This will involve unemployment, foreclosure, and bankruptcy for many people, especially those in the construction and construction-related industries. The macroeconomy will be sent into a recession or depression, which could be of a lengthy duration because of the slowness of the housing market as compared to the stock market, which can process very large changes in value within the period of one market day.
The lesson of the housing bubble is that what at first appeared to be the government’s trying to help improve homeownership for Americans has been a giant government failure and will have the unintended effect of economically scaring many homeowners, particularly those who bought houses at the peak of the bubble. Others have been fooled into extracting equity from their homes, increasing their mortgages, and taking loans, such as variable-rate loans, that they believed were necessary to qualify to buy houses at inflated prices. Similar trends in housing have occurred in countries around the world as many of the world’s central banks have been engaged in monetary pumping that has been injected into their housing sectors.
The policy lesson of the housing bubble, as provided by ABCT, is that the Fed is responsible for the housing bubble as well as the normal booms and busts in the economy, that it must be relieved of its authority to set what are in effect price controls on interest rates, and also be relieved of its control over the money supply. Furthermore, all federal policy toward housing should be guided by the principles of neutrality, laissez-faire, and do no harm.
Postscript — August 8, 2009 The housing and financial crisis discussed in this chapter is now well underway and we may well have entered the worst global economic crisis of this generation. The question of how economic policy will address these problems has also been revealed in that the Federal Reserve and the US Treasury have initiated aggressive and unprecedented policy responses. Under the cover of preventing a financial market meltdown, these policy responses are really attempts to bailout the owners of large financial business. They will do little to help the housing market and will increase the overall economic harm of the housing bubble.
Will policy responses continue to be aggressive and unprecedented in the direction of greater government centralization and power as the economic crisis worsens? The importance of this question goes beyond any measure of economic harm because it can result in fundamental changes in society. It could of course result in correct economic reforms such as the abolition of the Federal Reserve, the restoration of the gold standard, and the abandonment of Federal government subsidies to housing, but as I wrote in the initial draft of this chapter in June of 2006, which the editors asked me to remove:
On top of all that, people suffer psychological consequences as well. The people most involved in the bubble are confident, jubilant, and self-assured by their apparently successful decision making. When the bubble bursts they lose confidence, go into despair and lose confidence in their decision making. In fact, they lose confidence in the “system,” which means they lose confidence in capitalism and become susceptible to new political “reforms” that offer structure and security in exchange for some of their autonomy and freedoms.
In this manner, great nations of people have given away their liberties in exchange for security. The Russians submitted to Communism and the Germans submitted to National Socialism because of economic chaos. In 20th century America, economic crises — and fear more generally — provided the justification for the adoption of “reforms” such as a central bank (i.e. the Federal Reserve), the New Deal, the Cold War, and even fiat money during the economic crisis of the early 1970s.Robert Higgs, Crisis and Leviathan: Critical Episodes in the Growth of American Government (New York: Oxford University Press, 1987) shows how crisis (such as war or depression) lead to large increases in the size of government that were only partially offset by cutbacks after the crisis was over. On the final page of the book Higgs correctly predicted that future crises would include terrorism in addition to war and depression.
Fear of terrorism after 9/11 resulted in a massive transfer of power to government at the expense of individual liberty.Robert Higgs, Resurgence of the Warfare State: The Crisis Since 9/11 (Oakland, CA: Independent Institute, 2005) correctly predicted (in the days immediately after 9/11) that among other things that government would greatly expand its power “particularly surveillance of ordinary citizens.” Submission of liberty and individual autonomy in exchange for security and the “greater good” is now often referred to as choosing the dark side.A crisis is a crossroad or turning point where the decision maker can make the correct or incorrect choice. The wrong, fear-driven choice is now often referred to as choosing the “dark side” à la Star Wars movies. See Mark Thornton, “What Is the ‘Dark Side’ and Why Do Some People Choose It?” Mises Daily. May 13, 2005.
The reason economic crises create fear and submission of liberty is that people do not generally know what caused the bust or economic crisis and generally do not even know that there was even a bubble in the first place. In fact, as the bubble is bursting many people will deny that there is a problem and believe that the whole situation will quickly return to what they consider normal. The average citizen thinks very little about what makes the economy work, but simply accepts the system for what it is, and tries to make the most of it.
Increased government intervention in housing markets and the virtual socialization of the Government-Sponsored Entities (GSEs such as Fannie Mae), and the risk of mortgage-backed securities indicates that this dangerous trend will continue.
It has often been claimed that Austrian economist Ludwig von Mises predicted the Great Depression, but that is not quite true. He did predict in 1924 that a large Austrian bank would eventually fail, and he turned down a prestigious job at another large Austrian bank in 1929 because he did not want his name associated with its failure. Mises was clearly expecting a severe economic crisis, but as Murray RothbardMurray N. Rothbard, America’s Great Depression, 5th ed. (1963; Auburn, AL: Mises Institute, 2000). has shown, what made the Great Depression “great,” in that it was both severe and long lasting, were the policies implemented in response to the original crisis. Austrian business cycle theory (ABCT) is generally silent with respect to the timing and magnitude of the economic crisis.
The most important consideration here is that Mises published a thorough theoretical critique of existing monetary policy in the United States and elsewhere in 1928. That book is Monetary Stabilization and Cyclical Policy. Now we will look at opposing views regarding the business cycle of the late 1920s, most notably contrasting the views of Ludwig von Mises and his American counterpart, Irving Fisher.
The first “new era” of the twentieth century took place during the 1920s. People started to believe that this period of extended economic growth was actually one of self-sustaining growth and perpetually increasing prosperity. World War I had ravaged the developed world, central banks had been established across the globe, and the United States had become a leading economic and military power. The Progressive Era had reinvented America largely through constitutional change. Women now had the right to vote, there was a new federal income tax, and alcohol was prohibited across the nation. America also had joined the rest of the developed world by establishing a central bank with the passage of the Federal Reserve Act in 1913. The world was at peace and with a series of federal tax cuts in place, the United States had a very prosperous, although unstable, economy during the 1920s.Robert B. Ekelund, Jr., and Mark Thornton, “Schumpeterian Analysis, Supply-Side Economics, and Macroeconomic Policy in the 1920s,” Review of Social Economy 44, no. 3 (December 1986): 221–37.
There was also a technological revolution as important as the world has ever experienced. This was the decade when the airplane and automobile went into mass production. In communication, it was the onset of mass availability of the telephone and radio. Motion pictures were invented, along with household appliances such as the dishwasher, electric toaster, and refrigerator. The use of petroleum products and electricity increased dramatically while the use of manual power decreased significantly. Assembly line production became ubiquitous and was seen as the key to industrial progress.
The period of economic boom and stock market bubble during the 1920s is often referred to as the “Roaring Twenties.” Few people seemed to think it was unusual that the world’s three tallest buildings were being built either on or close to Wall Street, in New York City. However, it was far from a utopian time given all the crime, corruption, and violence created by alcohol prohibition, and there were clearly imbalances and instability in the economy. None of this, however, could discourage or dissuade the optimists that this was indeed a “new era.”
Edward AnglyEdward Angly, Oh Yeah? (New York: Viking Press, 1931). compiled quotations from newspapers and public records to chronicle the “new era” thinking during the bubble and its aftermath. A prime example of this thinking came from Herbert Hoover in his speech accepting the Republican Party nomination for president, where he proclaimed on August 11, 1928:
Unemployment in the sense of distress is widely disappearing. … We in America today are nearer to the final triumph over poverty than ever before in the history of any land. The poor-house is vanishing from among us. We have not reached the goal, but given a chance to go forward with the policies of the last eight years, and we shall soon with the help of God be in sight of the day when poverty will be banished from this nation. There is no guarantee against poverty equal to a job for every man. That is the primary purpose of the economic policies we advocate.Ibid., p. 9.
Not surprisingly Hoover believed the prosperity of the 1920s owed itself to the economic policies of his Republican Party, but his future policies to save jobs would be responsible for turning the economic crisis into the Great Depression.
Industrialists also saw a new era. Magnus Alexander, the president of the National Industrial Conference Board, said in 1927: “There is no reason why there should be any more panics.” The president of the Pierce-Arrow Motor Car Company, Myron Forbes, claimed on New Year’s Day, 1928, that there “will be no interruption of our present prosperity,” while Irving Bush, the president of the Bush Terminal Company proclaimed in November that “we are at the beginning of a period that will go down in history as the golden age.”
Charles Schwab, the chairman of Bethlehem Steel, noted in March 1929 that “I do not feel there is any danger to the public in the present situation” and in an October speech to the American Iron and Steel Institute reassured members that “in my long association with the steel industry I have never known it to enjoy a greater stability or more promising outlook than it does today.” As is typical of new-era philosophy, in October 1931, he blamed the depression on psychological factors: “The overliquidated prices of many securities are a sign of too short perspective and too excitable temperament.”
The financial press was similarly intoxicated with the economic bubble, with the Wall Street Journal reporting on October 26, 1929, “Conditions do not seem to foreshadow anything more formidable than an arrest of stock activity and business prosperity like that in 1923. Suggestions that the wiping out of paper profits will reduce the country’s real purchasing power seem far-fetched.” Syndicated columnist Arthur Brisbane reported four days later that “those that foolishly talk about a national panic, will please remember that the income of this nation is one hundred billion dollars per year.” In November he reported that “business is good, money is cheap” and that “it ought to be a good year.”
Shortly thereafter he encouraged his readers by reporting that “all the really important millionaires are planning to continue prosperity” and that “if every man would learn to talk about the country’s progress and future as a young mother talks about her new baby, there would be no danger of hard times.” On New Year’s Day, 1930, he declared the economic crisis was over, noting: “Now that the ‘big wind’ that swept through Wall Street, blowing away paper profits, has died down, there are sad hearts, but no real losses.” And one week later he wrote, “It is safe to say that the peak of idleness has about been reached, with better conditions coming.” As the economy worsened and unemployment continued to mount, Brisbane’s assurances became increasingly bizarre and macabre. On January 2, 1931, he wrote: “Sometimes when things go wrong, it is a comfort to be reminded that nothing matters very much. If the earth fell toward the sun, it would melt like a flake of snow falling on a red-hot stove.”
Politicians were big promoters and defenders of new-era thinking. Secretary of the Treasury Andrew Mellon told the American people near the peak of the boom that there “is no cause for worry. The high tide of prosperity will continue.” After the stock market crashed and unemployment began to rise, he reassured Americans on New Year’s Day of 1930:
I see nothing, however, in the present situation that is either menacing or warrants pessimism. During the winter months there may be some slackness or unemployment, but hardly more than at this season each year. I have every confidence that there will be a revival of activity in the spring and that during the coming year the country will make steady progress.Ibid., p. 23.
Republican officials continued to report throughout 1930 that the economy was fine, that conditions were satisfactory, that the worst was already over, that things would improve in a couple of weeks, and that signs of recovery were everywhere. However, by the end of 1930 some panic and confusion had entered into Republican ranks. On October 15, 1930, Simeon Fess, the chairman of the Republican National Committee, complained:
Persons high in Republican circles are beginning to believe that there is some concerted effort on foot to utilize the stock market as a method of discrediting the administration. Every time an Administration official gives out an optimistic statement about business conditions, the market immediately drops.Ibid., p. 27.
This statement is a sign of both alarm and paranoia and, if true, indicates that the “market” had finally entered a phase of disbelief in the pronouncements from the White House because of a large number of past inaccuracies.
Irving Fisher was the most prominent American economist of the period and is still considered by mainstream economists to be one of the greatest economists of all time. He was an enthusiastic supporter of Herbert Hoover and believed that the great economic prosperity of the 1920s was attributable in part to alcohol prohibition, which he championed, but more importantly he felt the prosperity was based on his theory concerning the “scientific” stabilization of the dollar that had been undertaken by the Federal Reserve. Naturally, with both alcohol prohibition and dollar stabilization firmly in place, Fisher was completely blindsided by the Great Depression. On the eve of the great stock market crash of September 5, 1929, Fisher reassured investors that he foresaw no problem in the stock market:
There may be a recession in stock prices, but not anything in the nature of a crash. Dividend returns on stocks are moving higher. This is not due to receding prices for stocks, and will not be hastened by any anticipated crash, the possibility of which I fail to see. A few years ago people were as much afraid of common stocks as they were of a red-hot poker. In the popular mind there was a tremendous risk in common stocks. Why? Mainly because the average investor could afford to invest in only one common stock. Today he obtains wide and well managed diversification of stock holdings by purchasing shares in good investment trusts.Ibid., 37.
Unfortunately, while Fisher continued to preach that stocks had reached a “permanent high plateau” throughout October 1929, stocks lost one-third of their value. Diversification via investment trusts, which were like the mutual funds of today, might have encouraged people to invest in stocks, but it did little to protect their wealth. The market value of investment trusts fell 95 percent over the two years following his prediction, and the Dow Jones stock index lost nearly 90 percent of its peak value.
Well after the fact, Irving Fisher identified in his 1932 book Booms and Depressions: Some First Principles most precisely and perceptively what he meant by a new era. In trying to identify the cause of the stock market crash and depression he found most explanations lacking. What he did find was that new eras occurred when technology allowed for higher productivity, lower costs, more profits, and higher stock prices:
In such a period, the commodity market and the stock market are apt to diverge; commodity prices falling by reason of the lowered cost, and stock prices rising by reason of the increased profits. In a word, this was an exceptional period — really a “New Era.”Irving Fisher, Booms and Depressions: Some First Principles (New York: Adelphi Company, 1932), p. 75.
The key development of the 1920s that clouded Fisher’s perception was that monetary inflation did not show up in price inflation as measured by price indexes. As FisherIbid., p. 74. noted: “One warning, however, failed to put in an appearance — the commodity price level did not rise.” He suggested that price inflation would have normally kept economic excesses in check, but that price indexes have “theoretical imperfections”:
During and after the World War, it (wholesale commodity price level) responded very exactly to both inflation and deflation. If it did not do so during the inflationary period from 1923–29, this was partly because trade had grown with the inflation, and partly because technological improvements had reduced the cost, so that many producers were able to get higher profits without charging higher prices.Ibid., p. 75.
Fisher had stumbled to a near-correct understanding of the problem of new-era thinking. Technology can drive down costs and increase profits, creating periods of economic euphoria, where economic signals would otherwise inject greater caution and clearer thinking. In other words, the Fed had kept interest rates artificially low, stimulating investments in technology beyond normal levels and thereby creating deflationary pressures in commodity prices.
However, he never lost his faith in scientific management of the economy or his devotion to the idea of a stable dollar, despite the implication that his stable-dollar policy had caused the Great Depression. Fisher’s detailed analysis and painstaking investigations of the crash also did little to improve his economic forecasting:
As this book goes to press (September 1932) recovery seems to be in sight. In the course of about two months, stocks have nearly doubled in price and commodities have risen 5½. European stock prices were the first to rise, and European buyers were among the first to make themselves felt in the American market.Ibid., p. 157.
He attributed this “success” to reflationary measures by the Fed that were of deliberate “human effort more than a mere pendulum reaction.”Ibid., p. 158. Unfortunately, not only was his prediction wrong, the world was only at the end of the beginning of the Great Depression and the “human effort” that he thought was the tonic of recovery was actually the toxin of lingering depression. He scoffed at the “mere pendulum reaction” of the market economy that can correct for the excesses in the economy by liquidating capital and credit, a concept that he clearly opposed. However, James GrantGrant, James. 1996. The Trouble with Prosperity: The Loss of Fear, the Rise of Speculation, and the Risk to American Savings (New York: Random House). and Tom WoodsThomas E. Woods, “Warren Harding and the Forgotten Depression of 1920,” Intercollegiate Review (Fall 2009): 22–29. have shown that this type of “pendulum reaction” worked extremely well during the short depression of 1920–21.
Was the Great Depression predictable? Was it preventable? The failure of the market economy to “right itself” in the wake of the Great Crash is the most pivotal development in modern economic history, and its impact has continued to shape mass ideology and to determine public institutions and policy. Unfortunately, few saw the development of the stock market bubble, understood its cause, or predicted the bust and the resulting depression.
In Austria, economist Ludwig von Mises apparently saw the problem developing in its early stages because of his theoretical insight concerning institutional and ideological changes. The world economy was controlled by central banks instead of the classical gold standard, and artificially reduced interest rates were widely considered to be a good thing. Mises forecast to colleagues the crash of the large Austrian bank Credit Anstalt as early as 1924. In a eulogy for his teacher Eugen von Böhm-Bawerk, Mises wrote in August 1924:
And no citizen of this country [i.e., Austria] shall forget the minister of finance, the last Austrian minister of finance [i.e., Böhm-Bawerk], who, in spite of all obstacles, earnestly aimed at balancing the public budget and preventing the upcoming financial catastrophe. (emphasis added)Ludwig von Mises, “The Economist Eugen v. Böhm-Bawerk, on the Occasion of the Tenth Anniversary of His Death,” translated Karl Friedrich Israel, Quarterly Journal of Austrian Economics 19, no. 2 (Summer 2016): 170. Originally published in Neue Freie Presse, Vienna, August 27, 1924.
As mentioned at the beginning of this chapter, Mises published a book-length critique of Irving Fisher’s ideas on monetary policy in 1928, titled Monetary Stabilization and Cyclical Policy. There he targeted Fisher’s “stable dollar” policy and its reliance on the price index as a key vulnerability that would bring about the economic crisis, concluding: “Because of the imperfection of the index number, these calculations would necessarily lead in time to errors of very considerable proportions.”Ludwig von Mises, “Monetary Stabilization and Cyclical Policy [Geldwertstabilisierung und Konjunkturpolitik],” in The Causes of the Economic Crisis: And Other Essays before and after the Great Depression, edited by Percy L. Greaves (1928; Auburn, AL: Mises Institute, 2006), p. 82.
Mises found that Fisher’s attempt to stabilize purchasing power was riddled with inherent technical difficulties and was incapable of achieving its goals: “In regard to the role of money as a standard of deferred payments, the verdict must be that, for long-term contracts, Fisher’s scheme is inadequate. For short-term commitments, it is both inadequate and superfluous.”Ibid., p. 84. He then demonstrated how Fisher’s type of monetary reforms cause booms and that these booms inevitably result in crisis and stagnation. He attributes the popularity of Fisher’s scheme to political influence and bad ideology:
The fact that each crisis, with its unpleasant consequences, is followed once more by a new “boom,” which must eventually expend itself as another crisis, is due only to the circumstances that the ideology which dominates all influential groups — political economists, politicians, statesmen, the press and the business world — not only sanctions, but also demands, the expansion of circulation credit.Ibid., p. 128.
Mises had addressed the same problems in a 1923 work, but named Fisher and his scheme in 1928. In addition to demonstrating the inevitability of the crisis, he clearly identified its cause, where most others could not:
It is clear that the crisis must come sooner or later. It is also clear that the crisis must always be caused, primarily and directly, by the change in the conduct of the banks. If we speak of error on the part of the banks, however, we must point to the wrong they do in encouraging the upswing. The fault lies, not with the policy of raising the interest rate, but only with the fact that it was raised too late.Ibid., p. 131.
He showed that the central bank’s attempt to keep interest rates low and to maintain the boom only makes the crisis worse. Despite the tremendous odds against the adoption of Mises’s own solution — that is, the traditional gold standard — he ended his analysis with a prescription for preventing future cycles:
The only way to do away with, or even to alleviate, the periodic return of the trade cycle — with its denouement, the crisis — is to reject the fallacy that prosperity can be produced by using banking procedures to make credit cheap.Ibid., p. 153.
Mark SkousenMark Skousen, Economics on Trial: Lies, Myths, and Realities (Homewood, IL: Business One Irvin, 1991). notes that in addition to Ludwig von Mises, Mises’s student F. A. Hayek is said to have predicted the collapse of the American boom in early 1929 (but probably not in written form). Felix Somary, who like Mises was a student at the University of Vienna, issued several dire warnings in the late 1920s; and in America economist Benjamin Anderson also warned that the Federal Reserve’s policies would cause a crisis, but like Somary, they were largely ignored. Mises and followers of his business cycle theory clearly had the upper hand over Fisher and the proponents of his stable-dollar policy.
Members of the Austrian school of economics were uprooted by WWII, with Mises in New York and Hayek in London and others scattered in academic posts at other prestigious universities. Despite the Austrians winning the prediction game against Fisher, Keynesian economics would soon rise to control economic thought as the Austrian school went into a general decline. Politically this was tied to the rise of fascism, Nazism, and FDR’s New Deal.
Fortunately, in the wake of WWII, the world returned to a Bretton Woods–style gold standard, and free market economies were established in Germany and Japan. The world quickly recovered from the war and the fascist-style economics that dominated prior to WWII. It would be a quarter century before the next economic depression hit the United States.
The notion that a record-breaking skyscraper can cause economic crises sounds ridiculous, and it is very much absurd. There is no causal relations between skyscraper construction and the skyscraper curse.
The causality that does exist is between artificially low interest rates causing both record-breaking skyscrapers and economic crises. Artificially low rates also cause distortions throughout the economy. Very low rates over extended periods of time are what bring about the record skyscrapers and the economic crises. The skyscraper itself is merely an identifiable manifestation of what is happening throughout the economy.
There are distortions, also known as Cantillon effects, directly tied to the skyscraper, such as what happened with the new lightweight elevator cable. Resources had to be diverted to research and development of the new elevator cable from other investment possibilities. A new production facility and production process had to be designed to produce the cable in a profitable fashion. Distribution could probably take place with existing company facilities, but certainly the marketing aspect of the product would have to be built from scratch. When the economic crisis comes, all these resources could have very low value. What happened to the elevator cable company is taking place in all areas of the economy, although it is not universal.
This type of distortion is occurring throughout the economy as entrepreneurs succumb to the lure of artificially low interest rates and embark on investments in more roundabout and advanced production techniques. These investments will later be discovered to be malinvestments in what has been described as a cluster of entrepreneurial errors, a phrase first used by British economist Lionel RobbinsLionel Robbins, The Great Depression (London: Macmillan, 1934). in his description of the Great Depression of the 1930s.
Much of the interest in the Skyscraper Index can be linked to its ability to forecast the business cycle and to predict the business cycle. In my view, its primary and best use is not to be able to predict the future, but to be able to describe the types of real changes that occur in an economy exposed to artificially low interest rates. Those changes can then be linked to the troubles we experience in the economic crises that follow. Thus, it helps us to understand the business cycle. Unfortunately, many economists ignore the business cycle or do not believe in economic causes of the business cycle. I am afraid that if this situation is not rectified soon, Karl Marx might turn out to be right about business cycles. He argued that business cycles will intensify over time and bring about the demise of capitalism.
In what follows I review an editorial from The Economist“Towers of Babel: Is There Such a Thing as the Skyscraper Curse?” March 28, 2015. that was published March 28, 2015, under the title “Towers of Babel.” The editorial was based on an academic article published by three Rutgers University economists. Unfortunately, the editorial staff of The Economist accepted the wrong, naïve understanding of cause and effect when it comes to skyscrapers. They did not refer to me by name in the editorial, but they did reference my 2005 article as a reference for what, in their minds, is the wrong point of view.
The editorial begins by noting that the world is in a major skyscraper boom and that such booms have often been an ominous signal of tough economic times ahead — the skyscraper curse. The Economist had long reported on and agreed with the Skyscraper Index,Jason Barr, “Skyscrapers and the Skyline: Manhattan, 1865–2004,” Real Estate Economics 38, no. 3 (2010): 567–97. but they were no longer sure:
Does this frenzy of building augur badly for the world economy? Various academics and pundits, many of them cited by The Economist, have long argued as much, but new research casts doubt on it.Ibid.
They then explain the economics of skyscrapers, noting that taller buildings mean more potential revenues. However, they correctly note that the marginal costs of construction also increase with taller buildings. This part of the editorial is a great capsule summary of my 2005 paper, although the role of the interest rate is not introduced. They then mention Jason Barr’s 2010 article, which seems to provide some support for the Skyscraper Index.
Then they turn to the paper, “The Skyscraper Curse: Separating Myth from Reality.”Jason Barr, Bruce Mizrach, and Kusam Mundra, “Skyscraper Height and the Business Cycle: Separating Myth from Reality,” Applied Economics 47, no. 2 (January 2015): 148–60. Two sets of evidence from that paper are presented. The first set examined the question of why the biggest towers are built near the peak of the business cycle and whether that relationship could help you predict changes in Gross Domestic Product (GDP). They found that the time between announcement date of record setters and business cycle peaks is very long and that only half of the skyscraper opening dates occurred during a downward phase of the business cycle: “In other words, you cannot accurately forecast a recession or financial panic by looking at either the announcement date or the completion date of the world’s tallest building.”
The problem with this is that no one familiar with the Skyscraper Index would use the announcement dates and completion dates as a consistent forecasting tool. The World Trade Center towers were announced in the early 1960s, nearly a decade before the first tower opened. Also, many announced record-breaking buildings never get off the drawing board or off the ground, or are not built as planned. The better dating method for identifying the existence of a bubble and future trouble would be to look at groundbreaking ceremonies. Such ceremonies are an indication that plans have been approved, financing and permits have been obtained, land has been purchased, and any necessary testing has been started or completed.
When looking for signs of trouble — that is, the skyscraper curse — a better date would be when the project has actually beaten the old record, or is approaching that point. The Burj Khalifa tower broke the old record in the summer of 2007, when economic conditions seemed good, but it was two and half years before it was completed and opened to the public. As a word of caution, none of these dating processes are some kind of exact, precise, or magical process; they are just rules of thumb based on experience. However, by using announcement and completion dates, the Barr, Mizrach, and Mundra study exaggerated the amount of error that actually exists. Plus, as The Economist notes, it is based on a very small sample size of fourteen. The role of clusters or cycles of record-breaking skyscrapers should also not be ignored.
To rectify the small sample size, the study’s authors turned to a second set of data that includes the tallest building completed each year in four countries, which expanded the number of data points to 311. They compared data on tall but not necessarily record-breaking buildings to changes in local per capita GDP, not severe economic crises. As a result, they found that skyscraper construction and per capita GDP were cointegrated. When two time-series data sets are cointegrated it means that they move, in general, in the same direction and are thought to be the result of the same causal forces. For example, national income and national consumption will tend to move in the same direction, with small variations. You can think of a dog owner walking the dog on a leash as being cointegrated. The dog might be out front and then move behind the owner, but they are both following the same basic path. The fact that Barr, Mizrach, and Mundra found that skyscrapers and GDP are cointegrated means the two data sets move in the same general direction and implies, in other words, that skyscraper construction does not cause the business cycle, and that both statistics are caused by some other factor or factors.
One major problem with this data is that the Skyscraper Index is not based on general skyscraper construction, but instead on record-breaking skyscrapers. As we have seen before, because of the technology requirements and economic constraints, building two, hundred-story buildings is not the same thing as building one 200-story building. Another problem is that the skyscraper curse involves an economic crisis, not the ordinary ebbs and flows of the typical business cycle.
But let us ignore these fundamental problems with their evidence. The evidence that skyscraper construction and per capita GDP are cointegrated and move together with a common cause is exactly what is predicted by the Skyscraper Index! Both statistics move together and have the common cause of artificially low interest rates. The Skyscraper Index tells us that artificially low interest rates cause record-breaking skyscrapers, usually in clusters, as well as a bubble in the economy and eventually an economic crisis — the skyscraper curse. In other words, none of their evidence undermines the Skyscraper Index; it supports it.
Stunned by the editorial, I wrote The Economist a letter to the editor to try to clarify the meaning and status of the Skyscraper Index. That letter of March 30, 2015, is reprinted here verbatim:
Dear Editor of The Economist:
Thank you for discussing my research and referencing my journal article from the Quarterly Journal of Austrian Economics. (“Is there such a thing as a skyscraper curse?” March 28th) I would note that Mr. Barr, Bruce Mizrach and Kusum Mundra’s research actually supports my thesis that misaligned interest rates cause both record setting skyscrapers and economic crisis. The fact that skyscraper height and GDP are cointegrated is no surprise and actually supports the case for a skyscraper curse. Also, I claim no precision with respect to the exact timing of events, especially with respect to “announcements” and “completions.” Groundbreaking and record achieving dates are actually more relevant, yet are still imprecise. They say a picture is worth a 1000 words and I think you’re graphic of the timing of record setting skyscrapers and economic crisis says it all.
Mark Thornton, PhD.Senior Fellow (economist)Ludwig von Mises InstituteAuburn, AL 36830 (USA)
Unfortunately, they did not print my letter. I was contacted more than three months later and they explained that my letter had been misplaced.
Based on discussions with Lucas Engelhardt, we decided to go back to the original academic journal article and reexamine their findings. Based on that examination, we determined that a comment should be written on the article. Once a common practice, the comment is not nearly as common today, but it still exists at many academic economic journals, including Applied Economics, where the original Barr, Mizrach, and Mundra article was published. Originally, we thought the title of the comment should be “Skyscraper Height and the Business Cycle: Separating Data from Reality,” but we chose instead to go for the conventional approach. The comment is reproduced below.
Skyscraper Height and the Business Cycle: Separating Myth from Reality, a Comment In a recent paper in this journal (Applied Economics), Jason Barr, Bruce Mizrach and Kusum Mundra test for the existence of a Skyscraper Curse, which Lawrence (1999) states is the “eerie correlation” between the building of record-breaking skyscrapers and economic crisis. Thornton (2005) shows the theoretical connections between record-breaking skyscrapers and economic crisis. However, the evidence that Barr et al. (2015) presents brings into doubt the existence of the Skyscraper Curse. Based on their evidence the Economist declared: “you cannot accurately forecast a recession or financial panic by looking at either the announcement or the completion dates of the world’s tallest building.”
Here we reexamine Barr et al. (2015) and come to a completely different conclusion. Their evidence does not refute the Skyscraper Curse and most of the more rigorous evidence actually supports it. With the Skyscraper Curse, output and height should be cointegrated and output should Granger cause height. Their evidence here is not only strong, but is more broadly applicable beyond the more narrow issue of record-breaking skyscrapers and once-in-a-lifetime economic crises.
Barr et al. (2015) use Granger causality and cointegration tests to analyze the relationship between skyscraper height and output. They use annual time series data for the tallest building completed each year and real per capita GDP for the United States, Canada, China, and Hong Kong as their measure for output. Their evidence shows that both height and output have a common trend indicating a cointegrated relationship. Granger causality tests show that output causes height, but height does not cause output.
The evidence from Granger causality and cointegration tests actually supports the theory of the Skyscraper Curse. No one believes that simply building a record-breaking skyscraper actually causes an economic crisis. The record-breaking skyscraper is more of an illustration of the types of microeconomic and technical changes to the overall structures of production that take place throughout the economy in response to artificially low interest rates.
Thornton (2005) clearly describes the Skyscraper Curse theory in terms of a third causal factor, artificially low interest rates, that cause both record-setting skyscrapers and unsustainable economic booms and, eventually, economic crisis. There have been several studies such as Barr (2012) that have suggested that such a third factor is responsible for the building of record-setting skyscrapers, such as builder competition, social status, and ego. However, in contrast to these psychological factors, artificially low interest rates provide an economic explanation for 1. Record-breaking skyscrapers, 2. The boom-bust cycle, and 3. Changes in social psychology. Therefore the results of the Granger causality and cointegration tests are completely in line with the expectations of Thornton’s (2005) model.
In contrast to their Granger causality and cointegration test results, the evidence in Table 1 of Barr et al. (2015) does strongly bring into question the existence of the Skyscraper Curse. They use the dates that record-setting skyscrapers were publically announced and the dates that those buildings were opened to the public and find little correlation with either of these dates and the business cycle.
However, there are multiple problems with their evidence. First, neither of these dates would be expected to be well correlated with the business cycle and especially with major economic crises, except in one sense. Announcement dates should generally occur during the boom phase of the cycle. They did find that 10 of 14 announcements did occur correctly in an expansion and 1 occurred at the very peak of the cycle. The 3 remainders occur because the “nearest US peak” is arbitrarily used, placing the 3 announcement dates after a previous peak. Additionally, using NBER peak and trough dates is not a true test of the Skyscraper Curse which is restricted to major economic crises.
Thornton (2014) suggests that announcement dates should be ignored and that instead, ground-breaking dates should be considered “skyscraper alerts” indicating that bubble-related investment opportunities exist, but danger is ahead. Furthermore, the date of record-completion, in the sense that the record-breaking height has been achieved, is a “skyscraper signal” suggesting that economic danger is imminent. Opening dates may be many months or even years in the future from record-completion dates and record-breakers often open in the midst of an economic crisis.
Barr et al. (2015) also downplay the Skyscraper Curse by noting that “the range of months between the announcement and peak is tremendous, varying from 0 to 45 months.” However, this variation is the result of using the announcement date so that, for example, the World Trade Towers was announced in January 1964, but the ground-breaking date for construction began in August 1968. They also use US cycle dating for two foreign records, Petronas Towers and Taipei 101. These record-breakers are normally connected to the Asian Financial Crisis of 1997–98 and also to the Tech Bubble-Bust (1997–2001), but these events bear little relationship with either the announcement or opening dates.
There remain several anomalies in Table 1. The Woolworth Building was announced in July of 1910 and opened in April 1913, but there is no economic crisis of note connected to it. However, the economy did peak and began contracting in the first quarter of 1913 and continued to contract until the fourth quarter of 1914. This contraction included the third worst quarterly decline in real GNP between 1875 and 1918, and was worse than any quarterly performance between 1946 and 1983. The founding of the Federal Reserve System in 1913 and the coming of World War I in Europe in 1914 provided stabilization for the American economy as exports to Europe soared. These 2 exogenous factors prevented the Woolworth Building from being associated with the Skyscraper Curse because the intervention of World War I reversed the deepening economic slump and prevented a historical label (e.g., “Depression of 1913–15”) from being created.
Table 1 also lists the Pulitzer (1890) and Manhattan Life (1894) buildings, which along with the Masonic Temple in Chicago (1892) and Auditorium Building (1889) represent a wave of record-breaking skyscrapers that preceded the beginning of the largest contraction in US history, culminating in the largest quarterly decline in real GNP in US history, which was then followed by the Panic of 1893 and 6 years of double-digit unemployment.
With these clarifications, 13 of the 14 buildings listed by Barr et al. (2015) come into agreement with the Skyscraper Curse model. The Park Row Building, which was announced in 1896 and opened in 1899 does not seem to fit the model, but is in synch with the emergence of the then new steel frame construction technology. If you take skyscraper waves and historical context into account, record-breaking skyscrapers are indeed associated with major economic crises and the Skyscraper Curse does add to our ability to foresee macroeconomic risks, even if the complexities of history prevent predictions of timing from being precise. We agree with Barr et al. (2015) and the Economist that the Skyscraper Index and its Curse is of little value in forecasting the normal ebb and flow of the macroeconomy.
We were quite surprised to learn many weeks later that our comment had been rejected by Applied Economics. The editor sent us two referee reports. Neither of the reports dealt directly with our primary comment, and both were defensive of the Barr, Mizrach, and Mundra paper. We noticed that in one of the reports, the referee identifies himself as one of the authors of the Barr, Mizrach, and Mundra paper, writing, “It is hard to reject a comment that agrees with your paper.” However, he managed to fight that urge and did reject our comment. It is not unheard of to send an author of an article a comment on their paper to referee, but it does seem odd to give them veto rights without the editor having read the paper and comment, which seems obvious in this case.
It is no embarrassment for a journal to publish a flawed paper. It happens on a regular basis. It is part of the academic process. For example, new econometric techniques have brought into question many early empirical papers. Hundreds of papers have been written on the Phillips Curve, and no doubt many are mistaken and now irrelevant. In the case of Barr, Mizrach, and Mundra, their paper is actually not wrong per se; they just came to the wrong conclusions based on their evidence. Even their secondary evidence could be salvageable. This experience provides a clear window into the messy world of academic publishing.
We expanded the comment into a paper with additional empirical evidence, and this paper was accepted for publication at the Quarterly Journal of Austrian Economics. There are other important developing lines of research on the Skyscraper Index, two of which I will report on next. One study looks at the Skyscraper Curse at the state level, the other examines the microeconomics of the Curse at the city level and helps explain the old real estate adage that what matters is “location, location, location.”
It makes very little difference how new money is injected. — Scott Sumner, TheMoneyIllusion
In previous chapters, I described economic growth and development as a process whereby lowering time preferences leads to an accumulation of savings that are invested in more-roundabout production processes, which in turn increase future consumption possibilities, labor productivity, and wages and incomes.
We now turn our attention to what happens with an increase in the money supply, rather than an increase in savings. This is critically important. The mercantilist idea that increasing the money supply increases prosperity was exposed as an error centuries ago by Richard Cantillon.Richard Cantillon, Essai sur la Nature du Commerce en Général, translated and edited by Henry Higgs (1755; London: Cass, 1931), chap. 1. However, modern mainstream economists, including the monetarists, Keynesians of various sorts, and the now-fashionable market monetarists, fully embrace the idea that printing money is necessary for prosperity.
In fact, the major central banks of the world have embarked on an unprecedented policy of monetary expansion both before and after the financial crisis of 2008. These central banks are led by people with advanced degrees in “economics,” and they have large research staffs of people with PhDs in mainstream economics. The result is a world currency war whereby each currency is printed in an effort to implement an economic expansion by a beggar-thy-neighbor policy, another widely discredited idea.
The beggar-thy-neighbor policy involves printing money to reduce the value of your domestic currency vs. foreign currencies. Reducing the value of your currency reduces the relative price of your exports and makes foreign products relatively more expensive so that you increase exports and domestically produced goods and reduce imports. The problem is that you also increase the price of imports and decrease efficiency. Ultimately this policy does not work: in the end you are worse off.
What happens when the supply of money increases? One of the first to examine this question was Richard Cantillon, writing in the 1730s in the wake of the Mississippi and South Sea Bubbles. Murray Rothbard wrote that Cantillon should have the premier honor among economists:
The honor of being called the “father of modern economics” belongs, then, not to its usual recipient, Adam Smith, but to a gallicized Irish merchant, banker, and adventurer who wrote the first treatise on economics more than four decades before the publication of the Wealth of Nations. Richard Cantillon (c. early 1680s–1734) is one of the most fascinating characters in the history of social or economic thought.Murray N. Rothbard, Economic Thought before Adam Smith: An Austrian Perspective on the History of Economic Thought (Brookfield, VT: Edward Elgar, 1995), vol. 1, p. 345.
I have written elsewhere about looking at Cantillon’s contributions through a modern and contemporary lens.Mark Thornton, “Richard Cantillon and the Origins of Economic Theory,” Journal of Economics and Humane Studies 8, no. 1 (March 1998): 61–74.
The Essai sur la Nature du Commerce en Général was completed shortly before Cantillon was murdered in 1734. Due to French censorship laws it was not published until 1755, and under mysterious circumstances. The book was initially very influential. It is believed he wrote Essai to explain the Mississippi and South Sea Bubbles, but he ended up creating an entire theoretical apparatus and what we now call Cantillon effects.
Cantillon investigated several possible causes of an increase in the domestic money supply including money’s importation from foreign countries and the discovery of new gold and silver mines. His important insight was that the effect of this new money depended on who had control of this new money and where it was injected into the economy. New money has a disruptive impact on an economy and can cause what we now call the business cycle.
Mainstream economists typically limit the discussion of Cantillon effects to the redistribution of wealth that accompanies an increase in the money supply.Andreas Marquart, and Philipp Bagus, Blind Robbery! How the Fed, Banks, and Government Steal Our Money (Munich: FinanzBuch Verlag, 2016). The first recipients of the money experience an increase in wealth, while those who do not receive it experience a decrease in wealth.Mark Thornton, “Cantillon on the Cause of the Business Cycle,” Quarterly Journal of Austrian Economics 9, no. 3 (Fall 2006): 45–60. Rouanet provides extensive empirical evidence of the Cantillon effect in terms of changing the distribution of income.Louis Rouanet, “Monetary Policy, Asset Price Inflation and Inequality.” Master’s Thesis, School of Public Affairs, Institut d’Etudes Politiques de Paris, 2017. However, this redistribution of wealth is only the first step in Cantillon’s much deeper analysis of the effects of an increase in money.
For example, if the increased money came from new silver mines, then the money would be in the hands of the owners of the mines and the miners themselves. Cantillon speculated that these now-rich people would consume more meat and wine, instead of bread and beer. This would in turn increase the price of meat and wine and decrease the price of grain. As a result, these price changes would lead farmers to increase the land devoted to raising cattle and vineyards, rather than grain. These are structural changes to the economy, and obviously the mine owners and miners are better off. The peasants who lived on bread and beer would be worse off because the decreased production of grain would mean higher bread and beer prices. Cantillon further theorized that money flows, prices, and the structural changes that were built on them could be reversed and that various businesses would be ruined as a result.
Mainstream economists dismiss all of these real changes in an economy as first-round effects. They do not believe there are any important real-economy impacts from an increase in the money supply, and if minor alterations did occur, it would only lead to temporary, inconsequential changes in the structure of production and income distribution.
To emphasize the importance of where the new money is injected into an economy, Cantillon noted that if the new money came into the hands of entrepreneurs, the rate of interest would fall, but if the new money came into the hands of consumers, the rate of interest would rise. If entrepreneurs found themselves with twice the amount of money they previously had, then they would have less demand for loans to finance their purchases of raw materials and to pay their labor. Therefore the rate of interest would be lower. If instead the new money were to double the amount of money that consumers possessed, then they would increase their purchases of goods. This would cause entrepreneurs to borrow more in order to supply the increased demand for goods, which would result in a higher interest rate. Either channel of increased money would put upward pressures on prices. In both cases, the group that receives the money first benefits, while those who receive it later, or not at all, are harmed by the higher prices.
Furthermore, Cantillon was the first to develop the theory of the price-specie-flow mechanism. This theory shows that a country that receives a bounty of new money will eventually experience higher prices. Some types of goods can be produced either domestically or imported from other countries. As the new money causes domestic prices to rise, there is an increased tendency for people to buy imported goods, and therefore money is sent to other countries. In this way, Cantillon showed that domestic industries that benefit and expand because of the increased supply of money will eventually be ruined because their expanded capacity will no longer be profitable in the face of low-priced foreign competition.
The general form of a Cantillon effect is that there is increased money coming into an economy from somewhere. The first recipients benefit. They spend it according to their preferences, and this causes certain prices to go up. The sellers of those goods benefit from the new money, while others who only face higher prices are hurt. Entrepreneurs respond to the higher prices by increasing their capacity to produce those goods by acquiring specific capital goods, raw materials, and labor. As the economy moves toward monetary equilibrium, the industry-specific capital goods are exposed as unprofitable, and if it is difficult to repurpose them for alternative uses, the adjustment process threatens those entrepreneurs with bankruptcy. The main point of Cantillon’s broader analysis is that changes in money result in changes in relative prices, which will change production plans and result in a different pattern of fixed investment such that new money changes the real economy and results in winners and losers.
Cantillon’s analysis regarding injection of new money has been adopted and extended by Ludwig von Mises and F. A. Hayek as a foundation of Austrian business cycle theory (ABCT). In the modern theory the increase in the money supply is usually restricted to an expansion of bank reserves by the central bank and an expansion of bank loans. In ABCT, this reduces the interest rate below the natural rate and initiates a boom in the prices of capital goods as well as company stocks and real estate. This, in turn, leads to the production of fixed capital goods that will later be revealed as malinvestments, in turn leading to bankruptcies, if not a skyscraper curse.
The Skyscraper Curse: And How Austrian Economists Predicted Every Major Economic Crisis of the Last Century By Mark Thornton
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In 1993, Milton Friedman proposed his famous “plucking model”Milton Friedman, “The ‘Plucking Model’ of Business Cycle Fluctuations Revisited,” Economic Inquiry 31, no. 2 (1993): 171–77. of the business cycle. To understand this theory, imagine a string or straight rising line on a graph that represents the potential growth of the economy. Also on the graph is another string that represents actual economic growth and follows the potential growth line except for when the second string is “plucked” downward by policy mistakes or external forces. In Friedman’s model, after the economy has been plucked economic growth quickly returns to the potential growth string. For Friedman it is important to explain the pluck and economic bust, but not the boom because in his model the boom is normal.
Friedman would recommend no special polices regarding the business cycle other than avoiding policy errors. If monetary policy is too tight, loosen it. In particular, money mattered for Friedman and the monetarists, and Friedman argued that a mistakenly restrictive monetary policy and high real interest rates were responsible for the Great Depression. GarrisonRoger Garrison, “Friedman’s ‘Plucking Model’: Comment,” Economic Inquiry 34, no. 4 (1996): 799–802. provides an effective critique of the plucking model.
In the Friedman context, you could try to make an argument that policy makers made an error that brought on the financial crisis, but this would conflict with Friedman’sMilton Friedman, Interview on Charlie Rose, December 29, 2005. own vision. He appeared on the Charlie Rose show on December 29, 2005, the zenith of the housing bubble, and summarized his view of the US economy: “The stability of the economy is greater than it has ever been in our history. We really are in remarkably good shape. It’s amazing.”
He went on to praise Alan Greenspan and the work being done at the Federal Reserve. Not only did Friedman fail to see the housing bubble, but his recommended policy response of loosening the supply of money and credit did not solve the problem. In fact, a loose monetary policy of zero interest rate policy (i.e., ZIRP) and quantitative easing (i.e., QE), have all failed to get the economic-growth string back to the potential-economic-growth string thus far.Ryan Murphy, “The Plucking Model, the Great Recession, and Austrian Business Cycle Theory,” Quarterly Journal of Austrian Economics 18, no. 1 (Spring 2015): 40–44.
Another string theorist is Ben Bernanke. The former chairman of the Fed was a student of the Great Depression and Friedman’s work on that subject. More generally he is considered to be in the camp of the New Keynesian school, which assumes that people have rational expectations about the future but live in an economy with imperfections and market failures. Extending Friedman’s work, Bernanke found in his research that the collapse of the banking sector in 1933 was the main reason that the depression was “great.” The stock market crash and ensuing economic crisis weakened banks, and many of them failed. After FDR’s bank holiday in March 1933 the normal channels of credit turned into a market failure that held back the economy for many years to come. The bank failures were like a weight hung on the actual-economic-growth string preventing it from reconnecting to the potential-economic-growth string. Therefore Bernanke places a great deal of emphasis on protecting the large, systemically important banks and the credit-industry infrastructure. However, he also believes that loose monetary and fiscal policies are necessary for controlling the business cycle.
On the occasion of Milton Friedman’s ninetieth birthday, Bernanke delivered extensive remarks on Friedman and Schwartz’sMilton Friedman, and Anna J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963). work on the Great Depression, holding it in the very highest regard. Although some of his conclusions do differ from Friedman and Schwartz, BernankeBen S. Bernanke, “Remarks by Governor Ben S. Bernanke,” Speech at the Conference to Honor Milton Friedman, University of Chicago, November 8, 2002. closed his remarks on the Great Depression with the following apology and promise: “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression, you’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
Bernanke was working at the Fed as vice chairman and then chairman during the housing bubble. He repeatedly denied the existence of the housing bubble and often suggested that if a bubble did exist and did pop, he would just lower interest rates. When it became evident that there was trouble in the housing market Bernanke moved aggressively in terms of monetary policy. He used both policies along traditional lines, such as reducing the federal funds rate and the discount rate, and aggressive, untried nontraditional policies, such as quantitative easing and zero interest rate policy. The overall policy response included radical decreases in interest rates, radical increases of liquidity in banks, a bailout of the systemically important banks and industries, and an enormous fiscal stimulus from the federal government, including multiyear trillion-dollar deficit spending. Bernanke soon began speaking of his ability to see “green shoots” in the economy, but many years later the actual-economic-growth string continues to lag badly behind the potential-economic-growth string.
Paul Krugman will here represent the Keynesian school of economics. The Keynesian view of the business cycle is based on social psychology. In the Keynesian view, periods of investment euphoria give way to periods of panic, retrenchment, and depression. If the actual-economic-growth string veers even slightly down from the potential-economic-growth string, then this sets up a potential scenario of dashed expectations, cutbacks, and diminished investment that can lead to layoffs, high rates of unemployment, and a significant decline in aggregate demand. This scenario is caused by what Keynes himself referred to as “animal spirits,” which is the irrational fear associated with investment.
When aggregate demand does not keep up with aggregate supply, this leads to lower prices, or price deflation. This can plunge an economy into what Krugman describes as an economic “black hole” from which the economy will never recover. As such, Keynesian economists and mainstream economists more generally have a phobia of deflation, or “apoplithorismosphobia,” which is the irrational fear of price deflation. However, much has been written about why deflation is not to be feared.See Philipp Bagus, In Defense of Deflation (New York: Springer, 2015); Jörg Guido Hülsmann, Deflation and Liberty (Auburn, AL: Mises Institute, 2008); Greg Kaza, “Deflation and Economic Growth,” Quarterly Journal of Austrian Economics 9, no. 2 (Summer 2006): 95–97; Mark Thornton, “Apoplithorismosphobia,” Quarterly Journal of Austrian Economics 6, no. 4 (Winter 2003): 5–18; Joseph T. Salerno, “An Austrian Taxonomy of Deflation—with Applications to the U.S.” Quarterly Journal of Austrian Economics 6, no. 4 (Winter 2003): 81–109, and “Deflation and Depression: Where’s the Link?” Mises.org, August 6, 2004.
Krugman has been very vocal since the financial crisis, calling for aggressive fiscal stimulus — that is, for the government to borrow vast amounts of temporarily unused savings and spend it. What the government spends the money on is less important than how much it spends beyond its means. It is important that consumers get money in their pockets, that businesses are put back to work doing something, and that the spending has the biggest possible impact on increasing aggregate demand. Certain important industries should receive bailouts if necessary, and public works programs should be begun in hard-hit areas. In order to guard against the possibility of deflation Krugman also recommends a stimulative monetary policy. Krugman has even argued that a Martian invasion hoax would fix the economy:
If we discovered that space aliens were planning to attack and we needed a massive buildup to counter the space alien threat and really inflation and budget deficits (concerns) took secondary place to that, this slump would be over in 18 months. And then if we discovered, oops, we made a mistake, there aren’t any aliens, we’d be better off.Paul Krugman, “Krugman Calls for Space Aliens to Fix U.S. Economy?” Global Public Square, August 12. 2011.
Krugman even later congratulated Japan for adopting the “moral equivalent of space aliens” in the form of Abenomics (i.e., aggressive monetary and fiscal stimulus), and for rejecting the “austerian orthodoxy” (i.e., balanced budgets).
The problem for Krugman is that with the exception of the fake Martian invasion, all of these policies have been implemented in the United States at unprecedented levels since 2008. In Japan, they have been implemented at higher levels for a longer period of time, to no good effect. Of course Krugman might object that these policies were still not large enough or quick enough to solve the problem. However, that just means his approach is untenable: Keynesians cannot predict a crisis in advance, because their analysis of the economic crisis starts with an unpredictable shock to social psychology; similarly, in the case of RBCT (real business cycle theory), the analysis starts with an unpredictable technological shock, or some other exogenous change.
These theories of the business cycle start with stylized facts that describe business cycles. From this, economists develop a hypothesis concerning what causes the business cycle. From this hypothesis, they develop a policy recommendation that agrees with their ideological perspective. Conservative economists — for example, those of the Chicago school — typically recommend no or limited remedial policy actions when faced with an economic downturn, while liberal economists from Ivy League universities are much more likely to recommend significant government intervention when faced with the same crisis. The most general problem with these approaches is that all of these recommendations have been tried since the beginning of the financial crisis and they have all failed.
In 2010, I argued in “America’s Second Great Depression”Mark Thornton, “America’s Second Great Depression: A Symposium in Memory of Larry Sechrest,” Quarterly Journal of Austrian Economics 13, no. 3 (Fall 2010): 3–6. that the US economy was in an economic depression and that it would likely continue for some time until economic policy was reversed. This was one of six papers organized as a symposium in honor of the late Larry Sechrest at the Southern Economic Association’s 2009 convention. While this assessment is a matter of debate, there are plenty of important mainstream economists that agree that current conditions have much more in common with an economic depression than normal economic growth.
An economic depression is a multiyear contraction of economic activity noticeably below the economy’s potential. Great depressions are even longer and deeper and can be interspersed with periods of contraction and expansion. There is nothing in economic theory that can determine whether an economy is in a recession, depression, or great depression. These labels are a matter of assessment, opinion, and professional standards and are subject to change.
Instead of addressing how “great” current economic conditions are, this chapter examines theories of the business cycle and how well they appear to perform in light of economic policies that have been enacted since 2007 in the United States and the global economy.
The Great Depression was clearly a great depression in both its length and depth. In addition, it was a worldwide phenomenon. As Professor HiggsRobert Higgs, “Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s,” Journal of Economy History 52, no. 1 (March 1992): 41–60. has shown, the United States never really recovered from the Great Depression until after World War II in terms of inflation-adjusted per capita consumption.
I have also suggested that the stagflation of the 1970s (1970–82) was an economic depression. It was certainly long enough, and it was not confined to the United States. Statistically, it might not have been as bad as the Great Depression. There were economic expansions during the period, but the economy failed to keep up with its potential. However, in contrast with the past, it did inflict both high inflation and high unemployment — that is, stagflation — on the population, simultaneously, really for the first time.
It might surprise you to learn that great depressions are not purely monetary phenomena. Throughout this book great attention has been paid to the phenomenon of central banks’ artificially low interest rate monetary policy causing a business cycle. However, business cycle expansions and contractions are typically of a much shorter time span than a great depression.
Depressions begin with a considerable period of monetary expansion followed by an economic crisis. RothbardMurray Rothbard, America’s Great Depression, 5th ed. (Auburn, AL: Mises Institute [1963] 2000). shows that there was a considerable period of monetary expansion prior to the stock market crash in 1929. Rothbard’s calculation of the money supply in the 1920s has been challenged by Timberlake.Richard Timberlake, “Money in the 1920s and 1930s,” Freeman (April 1999): 37–42. However, SalernoJoseph Salerno, “Money and Gold in the 1920s and 1930s: An Austrian View,” Freeman (October 1999): 31–40. Reprinted in Joseph T. Salerno, Money Sound and Unsound (Auburn, AL: Mises Institute, 2010), pp. 431–49. has shown that even if you remove the “offending” categories from calculations of the money supply — for example, the cash value of life insurance policies — monetary policy in the 1920s was still highly expansionary.
Turning the crisis into a depression or great depression requires a significant and sustained effort on the part of the government to use various policies in an attempt to stop and reverse the corrective market process — that is, the economic crisis. In other words, the dominant ideology is some variation of Keynesianism, and the government’s response to the crisis involves, among other things, an expansionary monetary and fiscal policy. RothbardRothbard, America’s Great Depression. showed that President Hoover’s policies were intended to keep wages and prices high. This turned an ordinary economic crisis into the Great Depression. Hoover’s “New Deal-like” policies included maintaining high prices and incomes, stimulating the economy with public works projects, loans, bailouts, protectionism, and currency devaluation. HerbenerJeffrey Herbener, “Fed Policy Errors of the Great Depression,” in The Fed at One Hundred: A Critical Review on the Federal Reserve System, edited by David Howden and Joseph T. Salerno (Springer, 2014), pp. 43–45. shows that the Fed was interventionist, with a low interest rate monetary policy until 1937. Ohanian and ColeLee E. Ohanian and Harold Cole, “New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis,” Journal of Political Economy 112, no. 4 (August 2004): 779–816. and OhanianLee E. Ohanian, “What—or Who—Started the Great Depression?” Journal of Economic Theory 144 (October 2009): 2310–2335. empirically verified the Rothbard hypothesis. Hoover’s and later Roosevelt’s policies became the basis of what would become Keynesian economics.Arthur Okun, The Political Economy of Prosperity (Washington, DC: Brookings Institution, 1970). Keynesian ideology was also the dominant force during the stagflation of the 1970s and in the Japanese economy from 1989 to the present.
The alternative approach to business cycle contractions is espoused by the classical economists, the Austrian-school economists, and the real business cycle theorists. This “do nothing” approach involves shrinking government and balancing the budget, expanding resources in the private sector, and a nonexpansionary monetary policy. This was employed by Presidents Woodrow Wilson and Warren G. Harding during the fifteen-month-long depression of 1920–21. This period was one of the most severely deflationary in US history, and yet it is hardly mentioned in history textbooks.
James GrantJames Grant, The Forgotten Depression: 1921: The Crash That Cured Itself (New York: Simon & Schuster, 2014). found that the reason this depression was so short was because it largely cured itself before government meddling could begin. Thomas WoodsThomas E. Woods, “Warren Harding and the Forgotten Depression of 1920,” Intercollegiate Review (Fall 2009): 22–29. shows that Harding was really a “do something” liquidationist in the sense that he wanted to reduce the size of government and raise interest rates to actively stamp out the inflation from World War I. There has been some quibbling regarding the timing and effect of various policies and policy changes, but Patrick NewmanPatrick Newman, “The Depression of 1920–1921: A Credit Induced Boom and a Market Based Recovery?” Review of Austrian Economics (January 2016): 1–28. has decisively shown that a liquidationist policy was dominant before the recovery began.
In the chapter to follow, I will present a simplified version of business cycle theories and discuss what those theories would recommend as policy remedies for economic crises, and how well those remedies worked in the wake of the financial crisis. See BagusPhilipp Bagus, “Modern Business Cycle Theories in Light of ABCT,” in Theory of Money and Fiduciary Media: Essays in Celebration of the Centennial, edited by Jörg Guido Hülsmann (Auburn, AL: Mises Institute, 2012), pp. 229–46. for a more in-depth Austrian critique of modern mainstream business cycle theories.
In the wake of the financial crisis of 2008, the economics profession suffered a blow to what reputation it had. But unlike most of his colleagues, Mark Thornton was vindicated by 2008. Mark has been a voice of sanity at times when the wild interventions of the Federal Reserve have caused otherwise sensible people to lose their minds.
One rule of thumb I’ve adopted is: whenever the idea that the business cycle may have been tamed forever starts to become mainstream, the bust is around the corner.
After reading this book, you’ll see why. Mark discusses the very different records of Irving Fisher and Ludwig von Mises in the 1920s, with the former saying (in late 1929!) that stock prices had reached a “permanently high plateau” and Mises warning that all the artificial credit creation of the world’s central banks meant a reckoning was coming.
At the end of the 1960s, presidential economic adviser Arthur Okun announced that wise fiscal and monetary policy was making boom and bust a thing of the past. One month after his book on the subject was released, the United States was officially in recession.
The dot-com bubble of the 1990s continued the pattern. Federal Reserve chairman Alan Greenspan even speculated that we had entered an age in which booms no longer necessarily had to be followed by busts.
I trust you know what happened next.
The most recent financial crisis, which was connected to an especially destructive housing bubble, yielded the same kind of crazy commentary: why, real estate prices never fall!I trust you know what happened next.
In fact, Mark Thornton was one of a handful of economists to warn — as early as 2004 — of a housing bubble and its inevitable consequence. That was a lonely position to adopt in those days. Nobody wanted to hear the words “unsustainable” or “bubble” when buying multiple properties and sitting on them seemed to be a path to certain riches. Of course, Mark was the voice that would have done them the most good had they bothered to listen, because they might thereby have limited their exposure to the bust that was surely coming.
But when all so-called respectable voices are assuring everyone that all is well, it is the wise man who appears to be the crank.
Now had Mark been known for nothing more than being a conscientious historian of these earlier business cycles and an accurate prognosticator of the housing bust and financial crisis, that would be ample reason to respect him as a scholar worthy of our attention and respect.
But of course Mark has done much more than this. In this book, for instance, you will encounter Mark’s work on the so-called “skyscraper curse.” I shall not here disclose Mark’s thesis on the matter; the author of a foreword ought to know his place, and stealing the author’s thunder is rather unbecoming.
For now, I can say this: although a correlation between the setting of new skyscraper records on the one hand and plunges into recession on the other had been noted by certain writers, the connection had been generally dismissed as little more than a curious coincidence. Mark, on the other hand, has shown how the two phenomena are connected — not that tall skyscrapers cause the business cycle, of course, but rather that they embody numerous features of the boom period described by Austrian business cycle theory.
Austrian business cycle theory, in turn, is probably the most important piece of economic information and understanding for Americans and indeed the world to understand right now. Again I shall leave the full exposition to Mark. For now, what matters is that according to economists of the Austrian school, the familiar pattern of economic boom and bust is not an inherent feature of the market economy, but instead the product of intervention into the economy by the monetary authority. When the central bank lowers interest rates below what they would have reached on the market, it sets in motion a series of responses by investors and consumers that will prove to be incompatible. The result is the recession, which is the economy’s return to health: the economy’s unsustainable configuration is unwound, and resources (including labor) are reallocated to lines of production that make sense in terms of resource availability and consumer preferences.
In the pages that follow, Mark explains the theory, applies it to various historical (and present) cases, and rebuts the most common objections.
In short, this collection serves the valuable purpose of defending the market economy against the conventional view that freedom has failed us and we need still more controls. We had plenty of rules and bureaucrats on the eve of the financial crisis. A lot of good that did us. Pretty much none of them saw any problems on the horizon, and the sheafs of rules and regulations were aimed in the wrong direction: while the private sector operated in the equivalent of a Kafka novel, the Federal Reserve was able to carry out its mischief unimpeded.
Here’s a crazy thought: maybe this time we might consider a real free market, with sound money and market interest rates, and abolish the giant bubble machine once and for all. Read Mark Thornton and you’ll entertain this and other forbidden thoughts.
Thomas E. Woods, Jr.Harmony, Florida
You could probably go back in history and find examples of the skyscraper curse in structures such as the Egyptian pyramids and medieval cathedrals. Here the review is confined to modern buildings, but we will expand our time horizon to examine records prior to and after the original Skyscraper Index (1907–99). We will also reexamine the one record-setting building, the Woolworth Building, that Andrew Lawrence considered a failure of the index because no curse occurred. As a result of this reexamination, the Skyscraper Index appears more reliable than previously thought.
This reexamination will consider modern buildings with steel-frame construction. The primary criteria for record-breaking projects are the number of floors of livable space and building height, not counting features such as antennas and spires. Those types of adornments are not costly or technologically challenging, compared to difficulties of building taller buildings with more livable space, which have requirements for such things as elevators, plumbing, and temperature control.
The two important inventions that made skyscraper construction feasible were the elevator and the steel-frame construction technique. Prior to the introduction of elevators in the 1850s, construction was typically limited to four-story buildings. Before the introduction of elevators, the lower floors were more highly valued and the higher floors were less highly valued because of the added time and effort of climbing more stairs. This limited the demand to build higher. With elevators, the higher floors became more highly valued, with the exception of first-floor retail space. The introduction of steel-frame construction in the late nineteenth century made it much more cost effective to build taller structures. Steel-beam construction bears the load or weight of taller buildings, and construction can proceed at a faster pace. In contrast, masonry construction requires an ever-larger base to carry the load of taller buildings.
The Equitable Life Assurance Building in New York City is considered by many to be the first skyscraper. Construction was completed in early 1870 and the building opened on May 1. It served as the home of the Equitable Life Assurance Society and was the first office building to feature hydraulic passenger elevators. It had seven floors and set a new record height at 130 feet.
Prior to its opening and approximately when it set the record height, the first Black Friday occurred on September 24, 1869. Jay Gould and James Fisk were attempting to corner the gold market in New York City, but US Treasury officials broke up their plot by selling large amounts of gold. Nevertheless, the economy was adversely affected as the price of gold first skyrocketed and then collapsed. In the aftermath, stocks fell by 20 percent and agricultural exports, the key output of the US economy, declined by 50 percent. According to Robert Kennedy,Robert C. Kennedy, “Gold at 160, Gold at 130,” Harper’s Weekly, October 16, 1869. there were several bankruptcies of brokerage firms “and a severe disruption to the national economy for months.” The aftermath has been labeled both a panic and a depression, but not a significant one.
The Home Insurance Building was completed in 1884 in Chicago. It rose to a height of ten floors and 138 feet. Interestingly, two more floors were added in 1890. This building is connected to the panic of 1884 and the depression of 1882–85. While the financial panic was real, the depression that occurred was mostly about deflation and the railroad bubble. According to Victor Zarnowitz,Victor Zarnowitz, Business Cycles: Theory, History, Indicators, and Forecasting (Chicago: University of Chicago Press, 1992), pp. 221–16. his measure of economic activity indicates that the depression was less severe than the panics of 1873 and 1893 and the depression of 1920–21.
The Auditorium Building in Chicago set a new record of seventeen floors and 222 feet to the top floor in late 1889. Meanwhile the New York World Building, also known as the Pulitzer Building, was completed in 1890 with sixteen to twenty floors (depending on how it is measured) and was 309 feet high, setting a new height record.
This cluster of new-record skyscrapers can be linked to the panic of 1890. Also known as the Baring crisis, it involved the near insolvency of Barings Bank in London. The crisis was international in scope, but the most severe impact did not involve the US economy. It should be kept in mind that the United States was becoming the world economic powerhouse, transforming itself from a largely agricultural economy into a manufacturing and service economy. As farmers went to the cities they often took jobs not only in manufacturing, but also in service sectors, such as insurance and sewing machine salespersons. The service industries were a significant component of the demand for office space and hence skyscrapers.
The Manhattan Life Insurance Building was completed in 1894 with eighteen floors and 348 feet in height, setting a new record. Also completed at this time were the American Surety Building with twenty floors and 303 feet in 1895 and the Masonic Temple with nineteen floors and 302 feet in 1892, but they are not widely considered clear record-breaking skyscrapers. Nevertheless, this cluster of skyscraper construction coincided with the largest contraction in US history, culminating in the largest quarterly decline in real GNP in US history and included the panic of 1893, which is thought to have begun six years of double-digit unemployment, although those statistics are still open to debate among economic historians.
The Park Row Building was completed in 1899. It was twenty-six full floors and is at least 309 feet in height: if the three-story cupolas are included its height is 390 feet, which would make it the world’s then-tallest skyscraper. The opening of the building was preceded by the fourth-largest quarterly decline in real GNP over the period of 1875–1918.
The next skyscraper cluster took place between 1904 and 1909. This is the cycle where Lawrence begins his documentation of the Skyscraper Index. It included the Singer Building, which, at forty-seven floors and 612 total feet in height, became the world’s tallest skyscraper when completed in 1908. The Metropolitan Life Insurance Company Tower set another new record in 1909 with fifty floors and 700 total feet in height. Both projects were begun prior to the panic of 1907 and were reaching record heights when the panic occurred. The panic occurred at a time when seasonal factors relating to fall harvests coincided with cyclical factors in credit markets. It ignited in October when a bank regulated under the National Banking Act refused to clear funds for the Knickerbocker Trust Company, an unregulated bank. The result was widespread runs on banks and one of the sharpest downturns in US history. This episode is historically important and of continuing relevance because it is widely considered to be the key event that led to the passage of the Federal Reserve Act in 1913.
It is worth noting that the panic of 1907, like many nineteenth-century panics, is now widely considered to have been caused by the regulatory structure imposed by the National Banking Acts (1863 and 1864). According to Howden,David Howden, “A Pre-History of the Federal Reserve,” in The Fed at One Hundred: A Critical Review on the Federal Reserve System, edited by David Howden and Joseph T. Salerno (New York: Springer, 2014). the financial instability during this period was not the result of a lack of regulation or unfettered capitalism. According to Michael Bordo, Peter Rappoport, and Anna J. Schwartz,Michael D. Bordo, Peter Rappoport, and Anna J. Schwartz, “Money versus Credit Rationing: Evidence for the National Banking Era, 1880–1914,” in Strategic Factors in Nineteenth-Century American Economic Growth, edited by Claudia Goldin and Hugh Rockoff (Chicago: University of Chicago Press, 1992), p. 189. the National Banking Acts created a system that was “characterized by monetary and cyclical instability, four banking panics, frequent stock market crashes, and other financial disturbances.” The poor performance of the subsequently adopted Federal Reserve has led many economists to call into question the suitability of a central bank for solving the problems caused by the National Banking Acts.
The Woolworth Building was the world’s next record-breaking skyscraper in 1913. When completed, it stood fifty-seven floors and 792 feet tall. Lawrence saw the Woolworth Building as an exception to, or error in, his Skyscraper Index because there was no curse in the sense that there was no major economic crisis that coincided with the building. There is no famous panic or depression in the history textbooks. Therefore it seems like the Skyscraper Index failed in this case.
However, it would be wrong to consider the Woolworth Building as evidence against the Skyscraper Index. The Woolworth Building project was announced in March of 1910, but at first it was planned to be a modestly tall building. In November 1910 its projected height was increased, but it was still only slated to become the third-tallest building in the world. In January of 1911 the building was re-planned to become one of the tallest buildings in the world at 750 feet, but this figure was later raised still higher to more than 792 feet high.Sara Bradford Landau, and Carl W. Condit, Rise of the New York Skyscraper: 1865–1913 (New Haven, CT: Yale University Press, 1996), pp. 382–84. The opening ceremonies for the Woolworth Building were held on April 24, 1913, although it was not fully completed until later.Ibid., p. 390.
In fact, the US economy peaked and began to contract in the first quarter of 1913, ahead of opening ceremonies. The economy continued to contract until the fourth quarter of 1914. This contraction included the third-worst quarterly decline in real GNP between 1875 and 1918, and was worse than any quarterly performance between 1946 and 1983. KazaGreg Kaza, “Note: Wolverines, Razorbacks, and Skyscrapers,” Quarterly Journal of Austrian Economics 13, no. 4 (Winter 2010): 74–79. reports that the building’s opening ceremony occurred during a twenty-three-month-long contraction between January 1913 and December 1914. This would clearly qualify this period as a severe recession.
The only reason that American history textbooks do not refer to the depression of 1913 or something else was that World War I was already brewing in Europe and hostilities would break out in mid-1914. WWI was the largest conflagration in human history, resulting in over twenty million casualties of all types. However, in the United States the war created a tremendous increase in demand from Europe for US agricultural products, metal production, and armaments, as well as labor. This event singlehandedly provided stabilization for the American economy and pulled it into an expansion, not an ordinary recovery. While economic historians now know that World War II did not get America out of the Great Depression,Robert Higgs, “Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s,” Journal of Economy History 52, no. 1 (March 1992): 41–60. WWI appears to have prevented the United States from falling into one.
Therefore, it would seem that the Woolworth Building should not be viewed as an exception to or error in the Skyscraper Index. It was simply that World War I in Europe did not provide enough time for the economic slump in the United States to deepen and to justify a historical label such as the depression of 1913.
A reexamination pre-Index of the evidence suggests that the Skyscraper Index is an even better forecasting tool than first presented by Lawrence. First, we have shown that the skyscraper curse occurred several times in the late nineteenth century. Second, the only example of an error of the original Skyscraper Index, when the curse did not happen, has a simple explanation. Our examination of this early period also makes clear that the causes behind both skyscrapers reaching new heights and economic crises emerging are related to government intervention in credit markets.
The next cluster of the world’s tallest buildings occurred at the onset of the Great Depression. Three record-breaking skyscrapers were announced during the late 1920s, when the stock market boom was being matched by booms in residential and commercial construction, as well as in manufacturing. In May 1930, the skyscraper at 40 Wall Street (now the Trump Building) was completed at a height of seventy floors and 927 feet. This was followed by the Chrysler Building in 1930 at seventy-seven floors and a height of 899 feet (925 feet to the roof and 1,046 to the top of the spire). The Empire State Building was completed a year later in May 1931 at 102 floors and 1,224 feet. Clearly, there was a capital-oriented boom in the construction of ever-taller buildings before the Great Depression.
Economists have offered many different explanations for the Great Depression, and Robert LucasRobert E. Lucas, Jr., Models of Business Cycles (New York: Basil Blackwell, 1987). has even claimed that it defies explanation. What is clear is that there was a significant increase in the money stock between the founding of the Federal Reserve and the stock market crash, a significant restructuring in banking and bank regulation, a significant decline in the supply of money after the crash, despite the Fed’s best efforts to stop it,Joseph T. Salerno, “Money and Gold in the 1920s and 1930s: An Austrian View,” Freeman (October 1999): 31–40. Reprinted in Joseph T. Salerno, Money Sound and Unsound (Auburn, AL: Mises Institute, 2010), pp. 431–49. a significant number of bank failures, and a variety of other important factors that contributed to the initiation and duration of the depression, including the Smoot-Hawley tariff and President Hoover’s and President Roosevelt’s New Deal policies.Murray N. Rothbard, America’s Great Depression, 5th ed. (1963; Auburn, AL: Mises Institute, 2000).
It is also worth noting that Ben Bernanke,Ben S. Bernanke, Essays on the Great Depression (Princeton, NJ: Princeton University Press, 2004). Milton Friedman and Anna Schwartz,Milton Friedman, and Anna J. Schwartz, The Great Contraction, 1929–1933 (Princeton, NJ: Princeton University Press, 1965). and Murray RothbardRothbard, America’s Great Depression. all place the blame for the Great Depression on the Federal Reserve, but for different reasons. Bernanke believes the problem was that the Federal Reserve failed to bail out systemically important banks in the 1930s. Friedman and Schwartz believe the problem was that the Fed failed to prevent a drop in the stock of money in the 1930s. Rothbard, using ABCT, found the cause to be the Fed’s expansionary monetary policy in the 1920s. These three theories will be reexamined later in the book.
The next major cluster of skyscraper records occurred in the early 1970s. Once again the economy was coming off a strong and sustained boom in economic activity during the 1960s. At the peak of the 1960s boom, construction workers in New York and Chicago were busy building the next group of the world’s tallest buildings. They would break records set back in the early days of the Great Depression. The World Trade Center was completed in 1972 and opened in April 1973. Both of the Twin Towers were 110 floors, with 1 World Trade Center at 1,368 feet in height and 2 World Trade Center at 1,362 feet in height. Then in Chicago, the Sears Tower was completed in 1974, which also had 110 floors but reached a height of 1,450 feet.
The economic downturn of early 1970 marked the beginning of a slump more than a decade long with the then-rare confluences of high rates of both inflation and unemployment. The breakdown of the Bretton Woods monetary system, abandoning the last vestiges of the gold standard, wage and price controls, gasoline shortages, and several recessions occurred between 1970 and 1982. There were several straight months in the early 1980s where unemployment was double digits and interest rates exceeded 15 percent. The US stock market declined in value between 1970 and 1982 by an inflation-adjusted 50 percent. The skyscraper curse for this period is known as the stagflation of the 1970s. This indicates that there was a general depression in the US economy between 1970 and 1982. The experience thoroughly discredited the then-dominant Keynesian school of economics, at least temporarily.
The next skyscraper cycle ushered in the 1997 Asian financial crisis and the dot-com bubble. The Pacific Rim countries, such as Hong Kong, Malaysia, Singapore, Vietnam, and South Korea, experienced significant economic growth during the 1980s and 1990s. Japan was the region’s leading economy, but it was in recession for much of the 1990s. Observers named the smaller regional economies the Asian Tigers. They were considered miracle economies because they were strong and durable despite being small and volatile. The bubble in East Asia was rooted in technology and export manufacturing, but it was fueled by an expansion of money and credit, much of it foreign money seeking high returns for “investors without borders.” This influx of foreign-investment money led to large increases in domestic money supplies and bank lending.
The Petronas Towers were completed in Kuala Lumpur, the capital of Malaysia, setting a new record for the world’s tallest building. They are only eighty-eight floors, but 1,483 feet in height, which breaks the old record by 33 feet. The two Petronas Towers were completed just months before the skyscraper curse hit in mid-1997. It marked the beginning of the extreme drop in Malaysia’s stock market and those around the region, rapid depreciation of local currencies, and even widespread social unrest. Financial and economic problems spread to economies throughout the region, a phenomenon known as the Asian contagion or, more generally, the Asian financial crisis. The ensuing credit crunch increased bankruptcies and created panic-like conditions.
At the same time, with increased US interest rates and a stronger dollar, the United States became a more attractive investment environment relative to East Asia. Starting in early 1996 this began to hurt Asian exports into the United States. These events essentially transferred the tech bubble from Asia to the United States and to a lesser extent Singapore and Taiwan, which were initially insulated from the crisis.
The next record breaker’s planning began in 1997. Construction began in 1999 on Taipei 101 in Taiwan City, the capital of the Republic of China (a.k.a. Taiwan). The 101-floor building set a new world record if you go by the height of livable space of 1,671 feet. This height surpassed the Petronas Towers, and Taipei 101 became the first skyscraper to exceed one-half of a kilometer. The roof was completed in June 2003, but we are not sure when the new record was set. However, its construction closely paralleled the dot-com ∕ tech bubble’s bursting. This was the first skyscraper cycle to occur in the developing world and the first in which one record, the Petronas Towers, was broken at the beginning of a crisis and the other, Taipei 101, was completed at the end of the crisis — that is, the dot-com ∕ tech bubble. A wild card here is the tech bubble, which was essentially transferred from the Asian-contagion countries to the United States and non-Asian-contagion countries, such as Taiwan and Korea. Taipei 101 is the first addition to the Skyscraper Index after Lawrence.Andrew Lawrence, “The Skyscraper Index: Faulty Towers!” Property Report, January 15, 1999.
The next world-record-breaking skyscraper was the Burj Dubai tower, which began construction in 2004 in Dubai, in the United Arab Emirates. At this time, it was clear to me that in the United States there was what would come to be called the housing bubble. The tower set a new record in the summer of 2007 just as the housing bubble ended and a financial crisis started to become apparent. The building opened to the public in January 2010 in the depths of the financial crisis, with Dubai bankrupt and needing a multibillion-dollar bailout from a neighboring emirate. The bailout resulted in the name of the building being changed from the Burj Dubai to the Burj Khalifa tower. This is another addition to the Skyscraper Index after Lawrence.Ibid.
These skyscraper cycles reliably contain common features. A cycle begins with a long period of easy money and credit. This leads to an expansion of the economy and a boom in the stock market. In particular, the relatively easy availability of credit fuels a substantial increase in capital expenditures. Capital expenditures start to flow in the direction of new technologies, which in turn create new industries and transform existing industries. This is when the world’s tallest buildings are begun. At some point afterward there is a necessary reversal. Many things could initiate the reversal. The reversal often gives the appearance of panic and mass psychological disorder, but people are being scared by real things such as not meeting profit expectations and projections, increases in interest rates, and problems with meeting sales projections, controlling costs, and retrieving accounts receivable. Finally, unemployment increases, particularly in capital- and technology-intensive industries. While this analysis concentrates on the US economy, the impact of these crises often has international implications.
The skyscraper has many of the characteristic features that play critical roles in various business cycle theories. These features make skyscrapers an important marker of the twentieth century’s business cycles, that is, the recurring pattern of entrepreneurial errors in a boom phase that are later revealed during a bust phase to be malinvestments.
It would be very easy to dismiss the Skyscraper Index as a predictor of the business cycle, just as indicators and indexes of other major entrepreneurial advances like canals, railroads, and factories were. The twentieth century skyscraper replaced the factories and railroads, just as the information and service sectors have replaced heavy industry and manufacturing as the prominent sectors of the present US economy.
It should not be surprising that the skyscraper, an important manifestation of the twentieth-century business cycle and indicator of modern global capitalism and commerce, will itself be replaced in the same way by an unknown new capital and technologically intensive investment in the future.
This chapter has demonstrated that Lawrence’s Skyscraper Index can be extended backward and forward in time and that the one instance where the Skyscraper Index was thought to have failed because the skyscraper curse failed to materialize has a perfectly logical explanation. Next we turn our attention to the question of what makes the Skyscraper Index work.
In 2014, there should have been a skyscraper alert issued for China. Groundbreaking ceremonies took place on what was expected to be the world’s tallest skyscraper, called Sky City tower. This project was noteworthy not just as an attempt to build a record-breaking skyscraper of 2,749 feet in height, but also because of the remarkably short construction schedule due to the construction company’s prefabricated construction process. Initially, on-site construction was delayed until April 2014. Later, the government cancelled the project due to environmental concerns over nearby wetlands. That reversed the need to broadcast a skyscraper alert.
The confluence of regional skyscraper signals in Europe, North America, and China, along with a skyscraper alert clearly suggested the possibility of a burgeoning world-wide economic crisis. This pattern would be very much like previous episodes of skyscraper records including the panic of 1907, the Great Depression, the stagflation of the 1970s, the Asian contagion ∕ dot-com bubble, and the housing bubble. In line with these skyscraper-based predictions, a fundamental case can be built around the notion of a looming world economic crisis. Most of the world’s major economies are facing pressing economic difficulties, including the United States, Europe, Russia, Brazil, Japan, and China. Additionally, central banks have been engaged in a worldwide currency war since the housing bubble, on a scale that has never been experienced in human history. It should not be surprising that super tall buildings are being built at an astonishing rate.
Not only is the world teeming with real estate speculation and skyscraper-building from China, to New York, to London and the Middle East, there is a new world-record-setting skyscraper being constructed in Jeddah, Saudi Arabia. The Kingdom Tower is designed to be over one kilometer in height, or more than eleven football fields. It is scheduled to be completed in 2020. As designed, the Kingdom Tower will exceed the height of the Burj Khalifa by more than 500 feet, although only a few floors of inhabitable space. If events proceed as the skyscraper curse predicts, the beginning of construction of the Kingdom Tower signaled a crisis alert, as a new record-breaking skyscraper has had its groundbreaking ceremony. This will change to a skyscraper signal when a new record height has been achieved between now and 2020.
The skyscrapers can sometimes tell us about the geography of world economic bubbles. The last bubble occurred in the oil-rich Middle East, and the next one would also be in the Middle East. Both bubble projects were begun when oil prices exceeded $100 a barrel.
It is interesting to note that according to Television Post,Television Post, “Prince Alwaleed Sells 5.6% Stake in News Corp for $188 Million,” March 2, 2015. Prince Alwaleed, the owner of the Kingdom Tower project, recently and unexpectedly sold most of his large stake of stock in News Corp., Rupert Murdoch’s media conglomerate, to raise nearly $200 million. The move was said to have been part of an overall review and rebalancing of the prince’s $20 billion portfolio. This is probably a smart move given the collapse of oil prices and the hefty price tag of $1.2 billion for the prince’s Kingdom Tower.
With more financing in place, the next world’s tallest skyscraper project is moving forward. The final piece of financing that is necessary to bring the $1.2 billion Kingdom Tower project in Saudi Arabia to record heights has been obtained. Media reports also show that the structure has risen to more than seventy-five meters (246 feet), and construction is proceeding at an uninterrupted pace, although there remain many concerns about the project’s viability. (Subsequently, the project experienced more delays.)
For example, above-ground construction on the long-delayed Kingdom Tower, now called the Jeddah Tower, started in September 2014, but there was considerable doubt that the financing for the one-kilometer (3,280.84 feet) tower could be obtained, given the shaky financial conditions in Saudi Arabia.
But the Jeddah Tower is only the latest phase in an enormous boom that began setting new records in 2014. As I reported in February 2015:
Super tall buildings, or skyscrapers, are being built at an astonishing rate. Ninety-seven buildings that exceed 200 meters (656 feet) high were constructed in 2014, setting a new record. The previous record was eighty-one buildings completed in 2011. The total number of skyscrapers in existence now is 935, a whopping 350 percent increase since the year 2000.Mark Thornton, “Where Is the Skyscraper Curse Today,” Mises Daily, February 24, 2015.
If completed as planned, Jeddah Tower will be the tallest building in the world. Jackie Salo, in the International Business Times, reports:
Saudi Arabia’s Kingdom Tower in Jeddah is slated to become the world’s highest skyscraper when it is erected in 2020, knocking Dubai’s Burj Khalifa tower from its perch as tallest building at 2,716 feet. The new tower will claim the title if it reaches its planned height of 3,280 feet. …The 200-floor Kingdom Tower will be part of a reported $8.4 billion project to construct Jeddah City. Construction of the skyscraper will entail 5.7 million square feet of concrete and 80,000 tons of steel.Jackie Salo, “World’s Tallest Skyscraper Is Saudi Arabia’s Kingdom Tower? Jeddah Building Projected to Break Height Records,” International Business Times, December 1, 2015.
In other words, the Tower could be the next record-breaking skyscraper, which is just part of an even more massive project. That means it’s time for a new skyscraper alert (as of January 1, 2016).
Remember, a skyscraper alert is an indicator that suggests a significant economic crisis will occur in the near future, even though economic conditions currently appear good. This alert could have been issued earlier, because an alert is defined based on the groundbreaking ceremonies of a world-record-breaking skyscraper, not the initial announcement of the project, which in this case occurred in August 2011. At that time there was still considerable doubt the project would be completed as planned.
Skyscraper alerts indicate significant looming danger in the economy, but the danger is not necessarily imminent. The next pivotal date for the Jeddah Tower project is when it reaches the height to break the old record and a skyscraper signal is given. That date is difficult to estimate given the uncertainty of construction. Media reports indicate that the project will be completed in 2020 without indicating whether that date is the completion date or the opening ceremonies.
So, will this latest frenzy of new construction tip us off to the next bust? The Skyscraper Index is silent on the issue of timing, so the dating of when the skyscraper curse becomes apparent is just guesswork. It seems that the boom reaches its peak around the time the new record height is set, and this is when a skyscraper signal should be issued. The skyscraper signal means that economic danger is looming. In most episodes, record-breaking skyscrapers generally have their completion dates and opening ceremonies when the economic crisis is readily apparent.
The important thing to remember is that skyscrapers do not cause economic crises. Rather they are just very noticeable examples of the distortions taking place throughout the economy when interest rates are kept artificially low by the central bank. This point will be thoroughly reinforced in the next chapter.
Economists understand very little about how technological progress occurs. — Alan Greenspan, “Testimony of Chairman Alan Greenspan”
Before we leave the topic of the problems and blessings of roundaboutness of production and the structure of production, it will be very useful to see a natural, concrete example of it in action. It then will become easier to understand the unnatural cases involving malinvestments and the skyscraper curse.
Making production processes more roundabout results in greater production in terms of the quantity produced and a lower cost on a per-unit basis. Entrepreneurs would not want to make production processes more roundabout unless they thought they would create more profits as a result. More roundabout production takes more time, more steps, and a more extensive division of labor. It also uses new technology.
Entrepreneurs do make mistakes, of course, but the only systematic errors they make are when they are fooled into rearranging production because of artificially low interest rates and easy credit conditions. When the central bank lowers its target interest rates it also makes credit conditions easier in that banks will make a larger volume of loans, which means they weaken their lending standards in order to facilitate the larger volume of loans.
A good example of a very direct production process, in contrast to a more roundabout one, is a farmer who goes to the barn, milks a cow, and then returns to the house and feeds the milk to his family.
An example of a more roundabout, although still very direct, production process comes from my childhood. We lived on the edge of a small town. Just beyond our house were fields and barns. Dairy cattle would feed on the grass in the fields. Later they would return to the barns to be milked. The milk would then be transported a short distance — a couple miles — in a small tanker truck to one of three small dairies in my hometown. There the milk would be processed and packaged. Early the next morning a dairy man in a white suit would arrive at our house and place several quart-size glass bottles of milk in an insulated dairy box outside of our back door and pick up any empty bottles we had placed there. If we wanted an ice cream sundae, we had to go to the dairy during retail hours.
By the time I graduated from high school the entire system had changed. The small dairy farms had been largely replaced with larger farms. The small four-wheel tanker trucks had been replaced by large eighteen-wheel tankers. An eighteen-wheel tanker truck brought the raw milk from the farms to the dairy factory about thirty miles from our house, and a different eighteen-wheel refrigerated truck brought cartons of milk and ice cream as well as boxes of butter to the supermarket. All three of the small hometown dairies eventually went out of business. They were replaced by much larger, factory-size dairies many miles from our home. Instead of having the milk bottles delivered directly to our house, we now purchased dairy products at the local supermarket, an institution that was also a relatively new phenomenon.
The dairy factory system is a much more roundabout production process. It takes more time. The milk travels a round-trip journey of more than sixty miles instead of the less-than-four-mile journey in the old days. There is a greater amount of capital as well as advanced technology involved and there is also far less labor per unit of milk. The overall cost of milk is lower, and with competition between large dairy wholesalers and supermarkets, so is the price.
In order to attain a more roundabout production process there are several requirements. It requires entrepreneurs with a vision of the most profitable action among all possible actions. It requires investment in more capital goods and new technology. Of course, all of this rearranging of production is going to take a great deal of time and even more time for it to be profitable.
Therefore, the entrepreneurs need to have access to savings. They need to have either their own savings or someone else’s savings on a long-term basis in order to proceed. Hence there must be more overall savings in an economy in order to achieve more roundabout production and all the benefits it entails. Savers must have lower time preferences and be willing to delay some consumption in the present. Savers will be rewarded with interest income, with which they will be able to make a greater number of purchases in the future and at lower prices because of the increase in production of goods. The whole process is regulated by the rate of interest, the price system, and the system of profit and loss.
This process is sometimes referred to as creating economies of scale. But notice that while there are economies of scale in this example, everything about the production process changed. The most successful approach was not preordained or known in times past. The entire recipe or technology of production has changed. All the capital goods — including the milking machines, the trucks, and the machinery inside the dairies — are different. Notice further that the change in the dairy industry is going to induce changes in other industries, including technology and investment in the mechanical milking machines industry. All of this requires a careful synchronization process, which is obviously beyond the scope of central planning. The process is driven by the rate of interest. So we will now see what happens when the interest rate is misleading and results in an economic bust and, in severe cases, the skyscraper curse.
The 1960s and 70s were precarious times for the Austrian school. Ludwig von Mises was very old, retired, and would die in 1973 at the age of ninety-two. Friedrich Hayek was also retired and ensconced at the University of Salzburg in Austria from 1969 to 1977. He called his move to Salzburg a mistake. He had not worked on business cycles and monetary policy for many decades and his research interests at this time were very different. Henry Hazlitt retired from Newsweek in 1966 at the age of seventy-two. Murray Rothbard was a young man and was marginalized and isolated, with little institutional support. There were precious few other Austrian economists in the entire world, and the next generation of Austrian economists had not left graduate school or had not even entered graduate school.
Mises at the age of eighty-nine continued to lecture during the critical 1968–70 period, and make public appearances. Some of his more important lectures included: “The Problems of Inflation” (April 3, 1968); “On Money” (April 3, 1969); “The Balance of Payments” (May 1, 1969); “A Seminar on Money” (November 8, 1969); “The Free Market Society” (February 21, 1970), where he discussed the problems arising from increasing the supply of money; and “Monetary Problems” (June 23, 1970), where he discussed why the return to the true gold standard was so important and essential for economic growth and stability and why the Bretton Woods system was so problematic. Sampling these lectures makes it obvious that Mises in his elder years was completely attuned to the monetary-policy problems and their potential consequences and was doing his best to alert others of the looming dangerous outcomes.
Henry Hazlitt was hardly retired either. After leaving Newsweek in the fall of 1966 he began writing for the Los Angeles Times, and between the fall of 1966 and June 1969 Hazlitt published 177 articles in the Times.Jeffrey A. Tucker, Henry Hazlitt: A Giant of Liberty (Auburn, AL: Mises Institute, 1994). Almost all of the articles discussed the dangers looming because of current monetary and fiscal policy. He clearly saw that the Bretton Woods gold standard was the core problem because it led to too much government spending and a loose monetary policy. For example, he wrote articles such as “Budget Out of Control” (February 12, 1967), “People Want Gold” (February 22, 1967), and “Currency Crisis Ahead” (March 29, 1967) in early 1967. In 1968 he wrote “What a Gold Reserve Is For” (February 3, 1968), “The Most Irresponsible Budget” (February 11, 1968), and “The Dollar Crisis: A Way Out” (March 17, 1968). Hazlitt wrote in 1969 on topics like “The Coming Monetary Collapse” (March 23, 1969), “Pretending That Paper Is Gold” (May 4, 1969), and “Good-Bye to the ‘New Economics’” (June 8, 1969). Hazlitt clearly saw the critical fault in the Bretton Woods System: that the US government would overspend — for example, spending on the Vietnam War, the space mission to the moon, and the War on Poverty — and pay for it by printing dollars. He clearly saw early on that the Bretton Woods–style gold standard would collapse, which it did in 1971.
Murray Rothbard was also keenly aware of what was happening to the US economy in the late 1960s. He published a small pamphlet on the subject of business cycles in 1969 — Economic Depressions: Their Cause and Cure. This was just prior to the end of the longest expansion in US history and the beginning of thirteen years of stagflation and depression. It is very similar to Mises’s book The Causes of the Economic Crisis published the year before the stock market crashed in 1929. Rothbard would continue writing about the looming crisis and the role of the Austrian business cycle theory:
In the sphere of economics the Nixon Administration had been highly touted among conservatives. It was supposed to herald a return to the free-market and a check upon galloping inflation through monetary restriction. Again, nothing has happened. The much publicized monetary tightening has been half-hearted at best, and provides no real test of the effectiveness of monetary policy. For the Administration has been doing precisely what its spokesmen had been deriding the Democrats for doing: trying to “fine-tune” the economy, trying to cut back ever so gently on inflation so as not to precipitate any recession. But it can’t be done. If restrictionist measures were ever sharp enough to check the inflationary boom, they would also be strong enough to generate a temporary recession.Murray N. Rothbard, “Nixon’s Decisions,” Libertarian Forum 1, no. 8 (July 15, 1969): 1.
Rothbard continued his assault on Nixon’s economic policies:
The phenomenon of inflationary recession cannot be understood by Establishment economists, whether of the Keynesian or the Milton Friedman variety. Neither of these prominent groups has any tools to understand what is going on. Both Keynesians and Friedmanites see business cycles in a very simple-minded way; business fluctuations are basically considered inexplicable, causeless, due to arcane changes within the economy, although Friedman believes that these cycles can be aggravated by unwise monetary policies of government.Ibid., p. 4.
In contrast, Rothbard was keenly aware of this political dilemma, the “inflationary recession,” because he attended some lectures by his then thesis advisor Dr. Arthur F. BurnsDoug French, “Arthur Burns: The Ph.D. Standard Begins and the End of Independence,” in The Fed at One Hundred: A Critical Review on the Federal Reserve System, edited by David Howden and Joseph T. Salerno (Heidelberg, New York, London: Springer, 2014), pp. 91–102. at Columbia University in 1958. Rothbard recalled the incident with his professor and later chairman of the Federal Reserve:
I remember vividly a prophetic incident during the 1958 recession, when the phenomenon of inflation-during-recession hit the country for the first time. I attended a series of lectures by Dr. Arthur F. Burns, former head of the Council of Economic Advisers, now head of the Federal Reserve Board, and someone curiously beloved by many free-market adherents. I asked him what policies he would advocate if the inflationary recession continued. He assured me that it wouldn’t, that prices were soon leveling off, and the recession would soon be approaching an end; I conceded this, but pressed him to say what he would do in a future recession of this kind. “Then,” he said, “we would all have to resign.” It is high time that we all took Burns and his colleagues up on that promise.Murray N. Rothbard, “The Nixon Mess,” Libertarian Forum 2, no. 12 (June 15, 1970): 1–3.
Rothbard is directly confronting the “new economists” and their beloved Phillips Curve analysis with the phenomenon we now call stagflation, which Rothbard called an “inflationary recession.”
Rothbard also attacked the Nixon administration’s labor guidelines and income policy. He correctly predicted that such policies would likely lead to wage and price controls, which they did the following year:
While we can firmly predict accelerating inflation, and dislocations stemming from direct controls, we cannot so readily predict whether the Nixonite expansionism will lead to a prompt business recovery. That is problematic; surely, in any case we cannot expect any sort of rampant boom in the stock market, which will inevitably be held back by interest rates which, despite the Administration propaganda, must remain high so long as inflation continues.Murray N. Rothbard, “Nixonite Socialism,” Libertarian Forum 3, no. 1 (January 1971): 1–2.
Rothbard went on to show that Keynesian and Friedmanite economists cannot understand this phenomenon and have no way to address such problems. In contrast, he showed how Austrian economists can understand this phenomenon through price theory and capital theory and that they do have policy recommendations on how best to address the problems of stagflation. Interest rates must be raised in order to flush out malinvestments and price inflation from the economy.
F. A. Hayek was awarded the Nobel Prize in economics in 1974 for his work building on Mises’s writings on business cycle theory. Hayek had been working in isolation in Austria and concentrating on his research in entirely different directions for some years. However, when the crisis hit in the early 1970s he rushed back into action. Hayek’sF. A. Hayek, “The Outlook for the 1970s: Open or Repressed Inflation?” in Tiger by the Tail: The Keynesian Legacy of Inflation, edited by Sudha R. Shenoy (Washington, DC: Cato Institute, 1972). first publication on this issue was put together by Sudha R. Shenoy, the daughter of the great Indian economist B. R. Shenoy. She seamlessly strung together materials from Hayek’s early writings on money and business cycles into a coherent monograph. To this 1972 book, Hayek contributed the essay “The Outlook for the 1970s: Open or Repressed Inflation?” He also published three monographs — Choice in Currency: A Way to Stop Inflation (1976), Denationalization of Money: The Argument Refined (1977), and Unemployment and Monetary Policy: Government as Generator of the “Business Cycle” (1979) — that sought to address the problem of the monetary crisis and economic depression.
The Austrians of the time were few but they turned out to be very vocal and correct about the threat of economic crisis. In fact their emphasis on raising interest rates and stopping the money printing might have been very influential in the form of the interest rate policy adopted by Fed chairman Paul Volcker (1979–87). It did cause a severe contraction, but it did end the monetary and price inflation and set the stage for a robust recovery.
It should also be noted that Dr. Ron Paul, an advocate of Austrian economics, decided in 1971 to run for a seat in the House of Representatives because Nixon had taken the United States off the gold standard. He has helped build a worldwide movement for Austrian economics. Also, the Cato Institute was founded in 1974 by Ed Crane, Murray Rothbard, and Charles Koch. The Cato Institute in 1982 published the monographs by F. A. Hayek, as well as The Case for Gold: A Minority Report of the U.S. Gold Commission, by Ron Paul and Lewis Lehrman.Ron Paul and Lewis Lehrman, The Case for Gold: A Minority Report of the U.S. Gold Commission (Washington, DC: Cato Institute, 1982), which was based on the research of Murray Rothbard. Finally, the Ludwig von Mises Institute was founded in 1982 by Llewellyn H. Rockwell, Jr.; its premier mission is to educate people about the benefits of a true gold standard as described in the Gold Commission’s minority report. The monetarist-packed US Gold Commission won the battle to maintain fiat money, but Ron Paul, the Cato Institute, the Mises Institute, and the Austrian school have all grown enormously in influence since then.
[The original version of this chapter was published as “Is the Housing Bubble Popping?” LewRockwell.com, August 8, 2005.]
Friday, August 5, 2005, was a bad day for housing stocks and this could be a sign that the housing bubble may have sprung its first leak. This is what the Philadelphia Stock Exchange Housing Sector Index looked like this week — losing about 5 percent for the week.
Investors have made around 50 percent on their money since I first reported on the housing bubble,Mark Thornton, “Housing: Too Good to Be True,” Mises Daily, June 4, 2004. and there could very well be more bubblingto come. In this graph of high-flying Toll Brothers (TOL), one of the largest home-building companies. The stock has increased by over 50 percent in the last year. Optimists point to the company’s price-to-earnings ratio of “only” fifteen, which is below the market average.
The pessimist’s case for a bursting or deflating of the housing bubble is the issue of rising interest rates. As Greenspan increases short-term interest rates it causes problems for those who have variable-rate mortgages tied to short-term interest rates. Energy prices and a slowdown in the economy can also dampen enthusiasm in the housing sector.
The larger problem may be for long-term rates because they are the foundation for fixed mortgage rates. As Greenspan increases short-term rates the thinking goes that he is reducing inflation expectations and thus reducing the likelihood of increases in long-term rates. However, if long-term rates rise, this is an indication that short-term rates are not rising fast enough to dampen inflationary price pressures.
Long-term interest rates are rising and there was a big increase in the interest rate on ten-year Treasury bonds on Friday, August 5th that coincided with the fall in home-builder stocks. Over the last summer this interest rate made a “double bottom” at about 3.9% which is almost the lowest it has been in my lifetime. It is now 4.4% and probably headed higher. [Note: it was 5.25% a year later.]
A double bottom is a term from technical stock analysis that is a bullish indicator, which in this case predicts higher long-term interest rates. Higher rates spell trouble for the home builders and give some indication the housing bubble might be coming to an end.
Hopefully, Alan Greenspan will know the correct lever to pull next. He did in the 1960s.Ron Paul, “Ron Paul vs. Alan Greenspan.” Testimony before the House Financial Affairs Committee, July 20, 2005.
Postscript If you look at a long-term chart of the Philadelphia Stock Exchange Housing Sector Index (symbol HGX) you will see that this was indeed the exact turning point for home-builder stocks, which typically lead the actual housing market. The Taylor rule, a guide to monetary policy, can also be said to have predicted the housing bubble ∕ financial crisis. WoodsThomas E. Woods, Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse (Washington, DC: Regnery Publishing, 2009). is the best analysis of the housing bubble, financial crisis, and the policy response to it.
Science is prediction. — Motto of the Econometrics Society
Those who have knowledge, don’t predict. Those who predict, don’t have knowledge. — Lao Tzu
Predicting economic behavior is inherently difficult. As Niels Bohr joked, “Prediction is very difficult, especially if it’s about the future.”
Originally published “Who Predicted the Bubble and Who Predicted the Bust?” Independent Review 4, no. 1 (Summer 2004): 5–30. Excerpted here and reprinted with permission.
Quotation at http://www.brainyquote.com/quotes/quotes/n/q130288.html
People’s economic actions are subject to choice and change, unlike the subject matter of the physical sciences, which has fixed properties. Therefore, the future must remain uncertain. Predicting the economy as a whole is fraught with additional dangers and complications, and all leading indicators of economy-wide change either do not have or eventually lose the capacity to predict the future accurately. As Paul Samuelson once quipped, “Wall Street indices predicted nine out of the last five recessions.”Paul A. Samuelson, “Science and Stocks,” Newsweek, September 19, 1966, p. 92. In light of these difficulties, economists have taken widely divergent positions on prediction.
Many modern mainstream economists, like their colleagues in the physical sciences, view prediction as the essence of science. If you cannot predict with a high degree of accuracy, then you are not being scientific. You must put your science to the empirical test and pass that test. The dominance of positivism in economic methodology encourages economists to worry less about the logical consistency of their models and to concentrate more on the development of models that exploit historical data in making predictions. Government and business economists then use the models to forecast variables such as gross domestic product, interest rates, unemployment, company sales, stock prices, housing starts, and demographic changes.
There is also substantial support for the position that we cannot predict and that economists have a terrible forecasting record. With respect to the technology bust in 2001, Mike Norman put this view of economists in perspective:
I’m an economist. Big deal, right? Until last year, economists got even less respect than Wall Street analysts; now, we’re just a notch above. Admittedly, this reputation is well-deserved, because it comes from our less-than-stellar ability to get economic forecasts right. With all of that data and plenty of powerful computing ability, you’d think we could produce better forecasts. Heck, even the local weatherman puts us to shame.Mike Norman, “Dismal Science May Get a Little Sunnier,” Special to the Street, April 21, 2003.
“The Street,” having witnessed countless forecasts go wrong, is naturally suspect. As Lindley Clark once noted in the Wall Street Journal, “Economists have a great deal of trouble predicting the future, and it’s unlikely that this unhappy situation ever will change.”Lindley H. Clark, Jr., “Housing May Be in for a Long Dry Spell,” Wall Street Journal, January 19, 1990. Indeed, some economists think that forecasts are akin to “magic” and that such magic is contradicted by the very essence of economic science. Deirdre McCloskey has expounded on this view of economic forecasts:
Economics is the science of the postmagical age. Far from being unscientific hoobla-hoo, economics is deeply antimagical. It keeps telling us that we cannot do it, that magic will not help. Only the superstitious think that profitable forecasts about human action are easily obtainable. That is why economics, contrary to common sneer, is not mere magic and hooblahoo. Economics says that forecasts, like many other desirable things, are scarce. It cannot be easy to know what great empire will fall or when the market will turn. “Doctor Friedman, what’s going to happen to interest rates next year?” Hoobla-hoo. Some economists allow themselves to be paid cash money to answer such questions, but they know they cannot. Their very science says so.Donald McCloskey, “The Art of Forecasting: From Ancient to Modern Times,” Cato Journal 12 (Spring–Summer 1992): 40.
Though agreeing in the main that forecasting has questionable value, Michael BordoMichael Bordo, “The Limits of Economic Forecasting,” Cato Journal 12 (Spring–Summer 1992): 47. claims that forecasting has some scientific and practical value and is not all just snake oil and magic. He notes that not all economists have been such dismal failures as forecasters: Richard Cantillon made correct predictions about John Law’s Mississippi Bubble system based on economic theory, and he made a fortune as a result.
Others, following the famous Chinese philosopher Lao Tzu, are skeptical about the prospects for prediction but do not altogether reject the possibility of accurate prediction. They merely restrict themselves to hypothetical and qualitative prediction. Foremost among this group are the Austrian-school economists, who reject the notion of fixed relations between human-controlled variables and even the idea that data can be used to “test” an economic theory. Austrian economist Ludwig von Mises rejected the general notion of forecasting and claimed that economics can provide only qualitative predictions about particular policies:
Economics can predict the effects to be expected from resorting to definite measures of economic policies. It can answer the question whether a definite policy is able to attain the ends aimed at and, if the answer is in the negative, what its real effects will be. But, of course, this prediction can be only “qualitative.” It cannot be “quantitative” as there are no constant relations between the factors and effects concerned. The practical value of economics is to be seen in this neatly circumscribed power of predicting the outcome of definite measures.Ludwig von Mises, The Ultimate Foundations of Economic Science: An Essay on Method (Princeton, NJ: D. Van Nostrand, 1962), p. 67.
The problem of predicting (with the goal of preventing) stock market bubbles and crashes is especially important, not just because busts result in huge financial loses for some investors, but because many of these extreme financial cycles can disrupt the financial system and lead to real economic contractions.Frederic S. Mishkin, and Eugene N. White, “Stock Market Bubbles: When Does Intervention Work?” Milken Institute Review: A Journal of Economic Policy 5 (2nd quart. 2003). Unfortunately, economists have yet to develop a generally accepted view of bubbles and have little to offer in predicting them.
Bubble Predictions If you can look into the seeds of time, and say which grain will grow and which will not, speak then unto me.— William Shakespeare, Macbeth
Responsible economists and economic analysts should have been warning the public about the prospects of a market crash and its implications for both the economy as a whole and their personal fortunes. However, few economists were issuing such warnings.— Dean Baker, “Dangerous Minds? The Track Record of Economic and Financial Analysts”
One person who did issue warnings regarding the stock market bubble and the problems a stock market crash might generate was Dean Baker of the Center for Economic and Policy Research. In the aftermath of the technology bust in 2001, he made the following observations:
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It should have been very simple for any competent analyst to recognize the bubble as the ratio of stock prices to corporate earnings hit levels that clearly were not sustainable in the late nineties. … The failure to recognize the bubble and warn of its consequences stems in part from a misunderstanding of the stock market and its role in the economy. …
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While there were some economic analysts who did warn of the market bubble, their views were almost completely excluded from the media. …
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Due to their failure to recognize the stock market bubble, official forecasters, like the Congressional Budget Office (CBO) and the Social Security Administration (SSA), made projections that were implausible on their face. …
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Most managers of large investment funds, including public and private pensions, and university and foundation endowments, failed to see the bubble and its inevitable collapse. … While the failure to recognize and warn of the stock bubble amounted to an enormous professional lapse, few economic or financial analysts seem to have paid much of [a] price for their mistake.Dean Baker, Dangerous Minds? The Track Record of Economic and Financial Analysts (Washington, DC: Center for Economic and Policy Research, 2002), p. 3.
I myself presented such warnings and analysis in public lectures, radio broadcasts, and newspaper articles and on the internet, but with little or no effect. In a public lecture in Houston on July 15, 1999, I addressed an audience about Alan Greenspan’s “luck” in increasing the money stock without price inflation, and I warned that the Fed’s actions inevitably would have negative economic consequences, especially for stocks and the dollar. I appeared on the Financial Sense News Hour on April 3, 2000, and April 4, 2001, and on a radio show called Credit Bubble.See http://www.financialsense.com/Experts/Thornton.htm On the Barstool Economist list on January 5, 2001, and January 7, 2001, I issued warnings that the dollar (then near its peak) would probably weaken over time. I also wrote several letters to newspapers, such as Investor's Business Daily, during this period, none of which was printed.
The Wall Street Journal’s semiannual survey of economic predictions indicates that forecasters have had difficulties in understanding the stock market bubble. The survey released on January 4, 1999, found forecasters to be concerned about the economy and forecasting low rates of economic growth, the majority expecting higher inflation and a 30 percent chance of entering a bear market in stocks. The survey released July 2, 1999, found those same economists raising their forecasts of the GDP growth rate by 50 percent for the remainder of 1999 in response to higher-than-predicted growth rates in early 1999. Even though they remained personally bullish on the stock market, they expressed greater concern about a bear market beginning in 1999. After the Y2K crisis passed, the survey released on January 3, 2000, found economists to be euphoric about the prospects for 2000. “There is no end in sight to the expansion,” said Allen Sinai, an economist at Primark Corporation. The group remained bullish on stocks, and 95 percent of the forecasters attached a probability of less than 30 percent to the onset of a recession. Only longtime bear Gary Shilling forecast a recession based on the stock market’s crashing. After a decline of more than 30 percent in the NASDAQ index, the survey released on July 3, 2000, found economists confident that the Federal Reserve (the Fed) would engineer a “soft landing”; the optimists believed in the Fed’s perfect soft landing, whereas the pessimists foresaw a soft landing but worried that the Fed would not do enough to fight inflation. However, the group finally was starting to express more concern about the future of the economy and the stock market. These forecasters’ record seems extremely weak. Even as reported by the Wall Street Journal, their record is poor: they seemed to have no clue about changes in the economy’s short-term outlook, instead simply projecting the historical trends forward.
The record of government economists mirrors that of Wall Street analysts. I compare forecasts from the Congressional Budget Office (CBO) and the White House with those from Wall Street in table 1. Under each group’s heading, its annual forecasts for the period 1992–2002 are compared with actual economic growth rates. From 1992 through 1996, the forecasts were accurate as the economy followed the trend line. From 1996 through 2000, forecasters from all three groups underestimated economic growth rates as the economy and the stock market went into the bubble phase. Then, from 2000 to 2002, they all overestimated economic growth rates, following the trend and failing to anticipate the meltdown in the stock market and the economy. The mean absolute error for all three groups was approximately one percentage point, so their average forecast for growth rates was off by approximately 20 percent.
Two of the most famous predictions concerning the stock market came from James K. Glassman and Kevin A. Hassett in their 1999 book Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock MarketNew York: Random House. and from Robert J. Shiller’s Irrational ExuberancePrinceton, N.J.: Princeton University Press. in 2000.
Some traditional investment advisors were quick to warn against Glassman and Hassett’s recommendations. In particular, Charles Murray of the American Institute for Economic Research noted that such books are often a harbinger of disaster:
At the time (October 25, 1999), we said that books such as Dow 36,000 seem mainly to make their appearance at or near market tops. In fact, investors had their choice among Dow titles in the past year: David Elias explained why the Dow will reach 40,000 in Dow 40,000; whereas Charles W. Kadlec and Ralph J. Acampora predicted (although wouldn’t guarantee) that the Dow will eclipse 100,000 in — you guessed it — Dow 100,000.Charles Murray, “Bubble Trouble,” Research Reports 67, no. 11 (June 12, 2000): 63.
Murray’s traditional approach led to the conclusion that the market was in a bubble and to a prediction that a crash or bear market was imminent. Readers could have protected themselves against the crash by acting on Murray’s advice:
Readers of these Reports know that for some time we have noted that the market’s valuation of common stocks has been markedly high in relation to most measures used in security analysis — cash flow, book value, earnings, etc. However, the historical record does not tell us what the “right” valuation is, only that the current valuations are exceptional. We have also observed that the current bull market is of unprecedented duration and magnitude and that at some point a genuine bear market or even crash can be expected. Again, at what point this valuation becomes unsustainable is far from clear.Ibid., p. 64.
Murray noted that the traditional valuation methods have shortcomings and that for larger purposes, such as the prevention of bubbles, valuation techniques do not tell us what causes bubbles in the first place.
Another good foil to Glassman and Hassett is economics and financial writer Christopher Mayer,Christopher Mayer, “The Meaning of Over-valued,” Mises Daily, March 30, 2000. who investigated and wrote about their book during its heyday. He concentrated on the meaning of the term overvalued — not so much on how to determine when something is overvalued numerically, but on the cause, meaning, and effect of overvalued stocks. Specifically, he criticized the notion of perfectly rational and efficient markets and showed how markets can, in a sense, lose their rationality. First, Mayer introduced the general mindset of the new paradigm that dominated the view of the market during the bubble, and he linked Glassman and Hassett to this mindset:
Are stocks overvalued? One answer is that it depends on whom you ask. Those who are buying and holding apparently think that they will be able to sell them at higher prices. Maybe they believe in a new paradigm where the old yardsticks of value are useless. James Glassman and Kevin Hassett recently wrote a book called Dow 36,000 in which they maintain that the stock market is currently undervalued.Ibid.
Next, he made his own prediction, linking Glassman and Hassett with the hapless Irving Fisher. More important, he explained specifically why a bubble existed, rather than arguing simply that the market was overvalued by some historical yardstick:
Looking back, future financial historians will likely relate the Glassman/Hassett thesis to Irving Fisher’s famous proclamation in 1929 that “stock prices have reached a permanent and high plateau.” James Grant likes to say that there are three common features of a bubble: one part fundamental (i.e., a technological revolution), one part financial (i.e., a surge in money and credit) and one part psychological (i.e., a suspension of belief in traditional valuation measures). All the ingredients would appear to exist in the current bull market.
As is often said, only time will tell. Unfortunately, no theory of cycles or bubbles can tell us precisely when it will all end. Maybe twenty years from now, we will be able to definitively state whether these prices were reasonable or whether the boom time of the 1990s ended in a bust. From where I sit, heeding the teachings of the Austrians, I’ll place my bet on the latter.Ibid.
One of the earliest prognostications regarding the boom and bust was certainly the one mentioned by analyst James Grant, the editor of Grant’s Interest Rate Observer. Grant closed his book The Trouble with Prosperity, written in May 1996 “at what may or may not prove to be the ultimate peak of the speculative frenzy,” with the following conclusions:
Predictably, the risks to saving are the greatest just when they appear to be the smallest. By suppressing crises, the modern financial welfare state has inadvertently promoted speculation. Never before has a boom ended except in crisis. In anticipation of just such an outcome, a skeptical Seattle investor, William A. Fleckenstein, founded a hedge fund in 1995 to buy cheap stocks and to sell dear ones. He named it The RTM Fund, the initials signifying “reversion to the mean.” They may be the financial watchwords for the millennium.James Grant, The Trouble with Prosperity: The Loss of Fear, the Rise of Speculation, and the Risk to American Savings (New York: Random House, 1996), pp. 314–15.
Grant continued to warn investors about the stock market bubble in his investment newsletter, to provide detailed explanations of the cause of the bubble, and to chronicle the relevant statistics.
Another early analysis came from Tony Deden (1999) at Sage Capital Management, who identified the bubble and its causes and predicted a crash:
We fully expect a decline in securities prices and the almighty dollar over the next years. … There is no new paradigm. Economic sins have consequences. Hopefully, perhaps even economists will learn that inflation is measured by the growth in money and credit rather than in an idiotic index of consumer prices. They might even learn that growth achieved with smoke and mirrors ultimately leads to ruin.
Is the incredible rise in securities prices since 1995 a reflection of real value created or is it merely a bubble? Is this really a second Industrial Revolution that changes our very basic economic assumptions or is it not? Is it a “new paradigm”? A world of fast growth, record (low) unemployment and no apparent inflation? Have economic laws been suspended? And if not, how could so many people be so wrong?Anthony Deden, “Reflections on Prosperity,” Sage Chronicle, December 29, 1999.
Writing near the peak in the bubble, Deden declared with regard to the size and magnitude of the distortions:
Let there be no doubt, that what we are witnessing is, indeed, history’s greatest financial bubble. The indescribable financial excesses, the massive increase in debt, the monstrous use of leverage upon leverage, the collapse in private savings, the incredulous current account deficits, and the ballooning central bank assets all describe the very severe financial imbalances which no amount of statistical revision nor hype from CNBC can erase.Ibid.
He was equally clear and unequivocal about the cause of the bubble and related distortions in the economy:
Their cause is not the fault of capitalism as it has been suggested, but an excessive amount of money and credit created by central banks. Yet, this seems to escape the understanding of those who will, in one day, convene congressional hearings to determine what caused this destruction. The culprit is, as it always has been, the same organization, which professes interest in bringing about price stability and low inflation: The Federal Reserve Bank and its policies of money market intervention, credit creation and loose money.Ibid.
Economist Jörg G. Hülsmann, writing in August 1999, provided an analysis and prediction of the stock market bubble based on the post-1980 monetary regime in the United States. He concluded that the market boom had been created artificially and that it was doomed to fail:
You do not need a rocket scientist to predict the bitter end of this evolution. … Just as any other state of affairs that has been artificially created and maintained by inflation, the present system bears in itself the germs if its own destruction. It will experience a flat landing of which even the most recent crises in South-East Asia, Russia, and Latin-America only give a weak foretaste.Jörg Guido Hülsmann, Scöne neue Zeichengeldwelt (Brave New World of Fiat Monies). Postface to Murray Rothbard, Das Schein-Geld-System (Gräfelfing), p. 140.
Hülsmann discussed the alternative courses of action that the Fed might take to deal with the boom and bust in the stock market. The first is to continue inflating money and credit, the second to stop that inflation. However, he concluded: “In any case the crisis is therefore inevitable. It breaks out as soon as the price-enhancing effect of the inflation is no longer neutralized through currency exports or other factors. (And of course the crisis accelerates when the inflationary currency streams back from abroad).”Ibid., p. 147. From these arguments, he concluded that the system of boom and bust based on national fiat currencies must eventually come to an end and that either path of economic policy will entail extreme changes in our political economy:
It is but a question of time until North-America and Europe also reach the dead end of an economy built on fiat money. At that point, however, there will be nobody to extend the life span of this shallow game through further credits and further inflation. Either the western economies will then be under total government control, as it has already been the case in German National Socialism, or we are expecting a hyperinflation. It may take some more years or even decades until we reach this point of time. It can be further delayed through a currency union between Dollar and Euro (and Yen?). But it is and remains a dead end street, at the end of which there is either socialism or hyperinflation. Only radical free-market reforms — in Rothbard’s words: return to a commodity money such as gold on a free currency market and a complete ban of government from monetary affairs — lead us out of this.Ibid., p. 154.
If Hülsmann is correct, not just about the end of the bull market but about the economic and political consequences of the bust, then the issue of stock market bubbles, their cause, and their consequences takes on a critical importance for our understanding of the future course of the overall political economy.
Hülsmann is not the only economist who traced this business cycle back to the post-1980 monetary regime of deregulation. At the height of the bull market, allies of the Austrian school of economics held a conference at which most participants emphasized the role of the Fed in creating the boom. In particular, Frank Shostak highlighted the impact of the central bank’s policies:
Today’s prevailing view is that central banks and other policy makers are knowledgeable enough to pre-empt severe economic slump. … Notwithstanding the popular view, the US economy is severely out of balance. The reason for this is the prolonged loose monetary policies of the US central bank. The federal-funds rate which stood at 17.6% in April 1980 fell to the current level of 5%. At one stage in 1992 the rate stood at 3%. The money stock M3 climbed from $1824 billion in January 1980 to $6152 billion at the end of June 1999. In a time span of less than a decade it grew by over 200%. Another indicator of the magnitude of monetary pumping is the Federal debt held by the US central bank. It jumped to $465 billion in the first quarter of 1999 from $117 billion in the first quarter 1980, a 300% rise. Obviously the sheer dimension of the monetary pumping and the accompanied artificial lowering of interest rates has caused a massive misallocation of resources which ultimately will culminate in a severe economic slump.
The intensity of the misallocation of resources was further strengthened with the early 1980’s financial de-regulation. The idea of financial deregulation was to free the financial system from the excessive controls of the central bank. It is held that freeing financial markets will permit a more efficient allocation of economy’s scarce resources, thereby raising individual well being. It was argued that the overly controlled monetary system leads to more rather than less instability. Nonetheless, rather than producing more stability, the “liberated” system gave rise to more shocks.
The 1980’s financial de-regulation resulted in a reduction of the central bank supervisory powers. The weakening in the central bank controls gave impetus to a greater competition in the financial sector. This in turn through the fractional reserve banking sparked the unrestrained creation of credit and money out of “thin air.” The money out of “thin air” in turn has been further processed by creative entrepreneurs, who have converted this money into a great variety of financial products, thereby contributing to a wider dissemination of the monetary pollution.Frank Shostak, “Inflation, Deflation, and the Future,” Mises Daily, October 5, 1999.
On the basis of his analysis of the then-current economic utopia, Shostak concluded that the economy was poised for bad times ahead: “It seems therefore that the chaotic state of world financial markets will continue to get worse, unless gold is allowed to assume its monetary role. Notwithstanding that[,] there is very little reason for being optimistic in the current economic climate.”Ibid.
The most forceful prediction of both a stock market bubble and a stock market bust came from bearish economist George Reisman in an article published on August 18, 1999, at the height of the stock market bubble. He began with the observation that the conditions of reality were clearly askew, an observation that most market commentators made only in hindsight:
Clearly, something is wrong. It simply cannot be that we can have a society in which everybody lives by day trading in the stock market. While the stock market does make an important contribution to capital accumulation and the production of wealth, it is far from an unlimited one, and its contribution is not enlarged by hordes of essentially ignorant people dabbling in it on the basis of tips and hunches. Yet such an absurd outcome of practically everyone being able to live by means of buying stocks cheap and selling them dear is what is implied by an indefinite continuation of the bull market. As a result, it is inescapable that the bull market must end.George Reisman, “When Will the Bubble Burst?” Mises Daily, August 18, 1999.
For Reisman, predicting stock market bubbles and crashes is not a matter of measurement, but of cause and effect. He made the common sense observation that to understand the cause of a stock market bubble is to understand its ultimate effect: “To understand precisely how and when this will come about, one needs to understand what has been feeding the current bull market. Then one can understand what will put an end to it — what will constitute pulling its foundation out from under it.” He found the ultimate cause of extreme movements in the economy in general and in the stock market bubble in particular to be government intervention in connection with the money supply and interest rates: “The only thing that explains the current stock market boom is the creation of new and additional money. New and additional money, created virtually out of thin air, has been entering the stock market in the financing of corporate mergers and acquisitions and of stock repurchases by corporations.”Ibid. Shunning issues of technological change and psychology, Reisman concluded not only that excess financing for the stock market was the cause of the bubble, but that this money ultimately finds its way throughout the economy, spreading higher prices and bringing the stock market back to reality. He therefore separates technology and normal economic growth from inflation-financed bubbles in stock prices. Obviously, both phenomena occurred simultaneously and mingled during the 1990s:
The increase in the quantity of money exerts its favorable effect on stock prices only when, as in the last few years, the increase is concentrated in the stock market and has not yet sufficiently spread throughout the rest of the economic system. When it does spread throughout the economic system and begins substantially to raise commodity prices, the effect on the stock market becomes negative.
The application to the stock market is that the market will stop rising as soon as the Federal Reserve becomes sufficiently alarmed about the inflationary flooding of the economy as a whole that emanates from the stock market bathtub so to speak. When the Federal Reserve is finally moved to turn off the water — the new and additional money — flowing into the stock market, its rise will be at an end. Indeed, not only will the stock market stop rising, it will necessarily suffer a sharp fall.
The inescapable implication is that sooner or later, the stock-market boom must end. The bubble must break.Ibid.
Reisman, it appears, made an accurate analysis of the stock market, identified the cause of the bubble, and accurately predicted that the stock market would crash.For an updated analysis, see George Reisman, “It May Be Bursting Now, and Faulty Economic Analysis May Cost Investors Dearly,” Capitalism.net, February 26, 2000.
Economic and stock analyst Sean Corrigan also provided well-timed prognostication of the bubble and deep insight into its cause. He compared conditions during the fall of 1999 to those during the late summer of 1987, the Japanese bubble of the late 1980s, and the Roaring Twenties in the United States. He dismissed the idea that technology and a “new paradigm” could have been responsible for the run-up in stock prices in the late 1990s. In his view, debt of all kinds was expanding at high rates at a time when the saving rate was plummeting. The solution to this economic paradox was straightforward for Corrigan. He blamed Alan Greenspan for overly generous provision of high-powered money, and he then proceeded to explain the impact of this highly expansionary monetary policy:
Monetary pumping on this order, as the Austrians will tell you, leads to serious distortions in the price structure of an economy which cannot be captured in crude, aggregate, index numbers. These distortions between the value of goods, present and future, lead to mal-investments and a clustering of false decisions. Factories built and productive processes put in train based on a market rate of interest artificially lowered by the effulgence of fiduciary media are not backed up by real savings and thus become misaligned with a propensity for consumption which has, if anything, intensified.Sean Corrigan, “Will the Bubble Pop?” Mises Daily, October 18, 1999.
What effect do these distorted prices and investments have? Corrigan went on to make a bold and far-reaching prediction:
A raft of “entrepreneurial errors” lies ahead. This means not only the prospect of half-finished malls, hotels and offices, but also completed, now distinctly sub-par undertakings: businesses and plants which cannot possibly earn the returns projected at inception. Less visible, though more widespread, such an overhang will depress returns on capital where they do not wipe it out completely. The credit expansion, once it draws to its inevitable end, will impoverish everyone, everywhere.Ibid.
Writing at the end of the boom, bearish economist Hans Sennholz described both the direct cause (credit creation by the Fed) and its effects in creating the boom in both the stock market and the general economy, taking special note of the explosion in the use of derivatives:
Surely, the American economy looks very dynamic and the value of the stock market is the highest in U.S. history, but the private economy is incurring the biggest financial deficits since the Second World War. The country is suffering record current account deficits with net external liabilities now exceeding 20 percent of GDP and rising.
Wall Street may be celebrating the decline in government deficits, but other debts continue to grow by leaps and bounds. According to the Fed’s Flow of Funds, household debt (mainly home mortgages) is growing at an annual rate of 9.25 percent, total household debt as a share of personal income now exceeds 103 percent. Business debt is soaring at a 10.5 percent rate. Corporate debt of non-financial firms is rising at a 12 percent rate, the fastest in more than a decade.
While some of these debts are going into new investments, much is spent on share buybacks. In short, corporations are going into debt to boost their share prices. Margin debt in the stock market is growing faster than any other type of credit. In 1999 it soared by 46 percent, now exceeding $206 billion, which is the highest in U.S. history. Unfortunately, if this growth of debt should come to a halt, or merely slow down, it may break the fever of the boom and usher in the readjustment.Hans Sennholz, “Can the Boom Last?” Mises Daily, July 31, 2000.
Sennholz went on to describe the precarious position of the economy and the stock market. He described the contraction in the market as an inevitable consequence of the credit-induced boom and as something the Fed had no power to fix:
The American economy is in its 10th year of cyclical expansion, which is the longest on record. A grave risk in this setting is a sudden fall in share prices, a bear market, which would evoke a dramatic fall in consumer confidence and demand. Since consumption is driving more than two-thirds of American production and growth, a sharp decline of consumer demand would soon lead to a decline in production, which may trigger an international run from the dollar. In order to stem such a run and attract enough foreign capital to cover the current account deficit of more than 4 percent of GDP and carry external liabilities of more than 20 percent of GDP, the Federal Reserve would have to raise its rates. But such a raise at a time of falling stock prices and falling output would soon aggravate the decline and lead to a painful recession. The present pleasant scenario of rising productivity and income, high stock prices and a strong dollar would soon turn into the opposite — falling productivity and income, falling stock prices and a weak dollar, declining imports, rising inflation, rising interest rates, and rising unemployment. The longest economic boom in history would give way to a long recession.Ibid.
Just as clearly, the cause of the credit creation and therefore the boom is the Fed and the policy of central bankers:
The economic maladjustments due to many years of monetary manipulations by the Federal Reserve System are the prime source and mover of the inevitable readjustment. Once the market structure no longer reflects the unhampered choices of all participants, the readjustment is unavoidable. In the end, the laws of the market always prevail over the edicts of political controllers and regulators. They even reign over the wishes of a few central bankers. Surely, government officials and central bankers have the power to lessen or aggravate the stresses of readjustment as they have the power to interfere with the economic lives of their nationals.Ibid.
At a time when many were still unsure about the causes and consequences of the initial features of the bust, others such as William Anderson clearly saw the “beginnings of the end” and emphasized that this big cycle of boom and bust was nothing new to US economic history:
We have, supposedly, learned our lessons since the 1970s. Alan Greenspan knows more than previous Federal Reserve chairmen, Robert Rubin was a brilliant Secretary of the Treasury, the internet is providing new ways of doing business, and Bill Clinton has marvelously orchestrated the whole thing. The stock market is rising, and the government (or at least the current regime, according to Al Gore in his stump speeches) knows how to continue the prosperity. This time, we really are experiencing the New Economy.
Pardon me if I dissent. If history tells us correctly, we are in our third “New Economy” in the last 80 years. The first episode of “prosperity forever” came in the late 1920s, as the bull market, low unemployment numbers, and general good times led newly-elected President Herbert Hoover to declare, “In no nation are the fruits of accomplishment more secure.” We know the rest of that sorry story.William Anderson, “New Economy, Old Delusion,” Free Market 18, no. 8 (2000): 5.
Anderson was careful to distinguish the cause of the boom from the normal or natural features of economic growth. He also distinguished between a potential catalyst of the bust (the Microsoft trial) and its underlying causes:
But for all of the high-technology wonders and the gains made from deregulation, the one substantial part of the New Economy consists simply of an economic boom in all that the phrase implies. The engine behind the boom is also the locomotive behind the inevitable bust: the Federal Reserve and its inflationary policies.
As things stand currently, the once-vaunted bull market is in flux. This is partly due to the government’s arrogance in believing it could attack Microsoft without harming other high-technology firms that have been the most visible in the current economic expansion. That the NASDAQ has lost much of its value since Janet Reno’s Department of Justice [DOJ] won the first round of its attempt to dismember Microsoft bears testament to this administration’s foolishness regarding economic matters.
But even without the DOJ’s Microsoft follies, the high-technology sector of the economy faces real problems. First, the bubble that pushed so many of the “dot-com” initial offerings into the stratosphere had burst even before Reno’s pyrrhic victory. Second, the malinvestments as described by Ludwig von Mises and Murray Rothbard that occur as the result of wildly expansive monetary policies by the Fed have been centered in the high technology sector. The growth of new money that is the signature of inflation can come only through the fractional-reserve banking system in the form of loans, which, as noted earlier, have found their way into high technologies, real estate, and the stock market.
Should a large number of high technology investments go bust, or if profit rates disappoint potential investors, the new money will stop pouring into that sector. By that time, we will be seeing an increase of commodity prices, and inflation will be recognized as a serious problem. The next stage will be the beginning of the recession, as the malinvestments that grew willynilly during the period of monetary expansion will have to be liquidated.
The US economy the past five years has been able to absorb a large amount of new money, much more so than it could have done two decades ago. That does not mean, however, that it is inflation-proof or is impervious to malinvestments. The Misesian theory of the business cycle is a comprehensive theory. It has not lost its explanatory power in 2000 any more than it was irrelevant in 1969 or 1929.
While we may be currently celebrating a record boom, we have not overturned the laws of economics. No doubt when it happens, the usual Keynesians in the halls of academe and in the media will blame high interest rates and the Fed’s refusal to expand credit. In truth, there will be another explanation, one that people are ignoring now and will ignore then.Ibid., p. 6.
Supply-side economist Jude Wanniski (2000) attributed the bust in the stock market during April 2000 to tax liabilities accrued from capital gains in the late 1990s. Investors who had capital gains in 1999 had to pay taxes on those gains on April 15, and Wanniski suggested that investors selling shares in order to pay their taxes ignited the decline in the prices of the stocks composing the NASDAQ index. Although this observation provides insight into what might have initiated the bursting of the bubble, Wanniski himself did not believe in financial bubbles and encouraged his clients to jump back into the market after tax season was over.Jude Wanniski, “Letters to Clients,” March 30 to April 19, 2000.
Another important prediction came from economists Stan Liebowitz and Stephen Margolis, who were considering questions of competition and antitrust policy in high-technology markets. They correctly described these markets as displaying a speculative bubble near the apex of the bubble: “This is not to imply that a speculative bubble, which seems the proper description for Internet stocks as this book is being written [spring 1999], is required to assure sufficient financing.”Stan J. Liebowitz, and Stephen E. Margolis, Winners, Losers, & Microsoft: Competition and Antitrust in High Technology (Oakland, CA: Independent Institute, 1999), p. 115. Liebowitz later provided a more detailed examination (published after the bubble had burst) of why the bubble happened:
The book … focuses on understanding why financial events went so awry. … Many of the prognostications about the internet — rapidly increasing number of users, rapidly increasing advertising revenues, rapidly increasing sales — fertilized wildly optimistic prognostications for the performance of Internet firms, as if a virtual cornucopia of wealth would come streaming down upon investors in those companies [and it did for those lucky enough to get in early]. … But even if all the prognostications of users and revenue growth had been true, as some of them were, that would not have assured the rosy financial scenario that so many investors and analysts anticipated.Stan J. Liebowitz, Rethinking the Network Economy: The Real Forces That Drive the Digital Marketplace (New York: Amacom, 2002), p. 2.
Conclusions Such is the exuberance on Wall Street that only a brave man insists that the American stock market is overdue for a crash. Down the long history of bubbles ready to burst, it was ever thus. — Economist, March 25, 2000
The foregoing survey of predictions regarding the stock market bubble of the 1990s was conducted against a background condition that economists do not agree on either the role of prediction in economic science or the causes of stock market bubbles. The purpose was to identify who correctly ascertained the existence of a stock market bubble and who correctly predicted a stock market crash. The appendix at the end of this article provides a timeline of additional quotes reflecting insight, unawareness, or confusion regarding the macroeconomic contours of the bubble and the crash. More important, however, this survey has examined how the boom was identified and what its cause was. These issues are important because stock market booms and busts entail massive transfers and financial losses in the economy, and when associated with severe downturns in the business cycle, they can cause significant economic costs, distortions, and inefficiencies. Economic crises have often provided the occasion for a ratcheting upward of the size, scope, and power of government (Higgs 1987). In extreme cases, such radical changes in financial and economic conditions may give rise to social upheaval and political instability.
In general, the correct predictions fall into two categories. Those in the first group were based on the analysis of valuation. Using standard measures of stock market value, such as the price-to-earnings ratio, economists such as Robert Shiller and a small number of market analysts who were bearish in 1999 concluded that the stock market had become extremely overvalued and therefore was experiencing bubble-like conditions and was fated to decline steeply. Unfortunately, most of these forecasters did not provide detailed economic analysis of their predictions. The use of valuation measures is indeed helpful, but such measures are essentially only tools of historical analysis for comparing ratios and percentages from one time period to those from another period or to historical averages. In the recent bubble, most bulls always found a way to adjust the valuation measures to account for modern conditions and to make the stock market appear undervalued.
The second group of correct predictions came from outside the mainstream of the economics profession. Most came from economists associated with the Austrian school of economics, including academic economists, financial economists, and fellow travelers of the school. These predictions began to come forth in 1996 and continued until after the downturn in the stock market, but most of them occurred close to the peak in the stock markets. Austrians tend to have a negative view in general, and they are quick to emphasize the negative aspects of economic conditions, but they also distinguish bubbles and business cycles clearly from other economic phenomena and trends. Given that the Austrian economists are both relatively few in number and marginalized in the profession, their dominance in making correct predictions seems to be something of an elephant in the soup bowl, especially in light of their general disdain for forecasting and for the mainstream’s requirement of accurate prediction. In my survey, I tried to avoid the inclusion of “permabears,” or analysts who are perpetually bearish on the stock market. It should be noted, however, that James Grant is a self-admitted permabear and that his prediction came too early in terms of market timing. The predictions are summarized in table 2.
It is especially noteworthy that all the Austrian predictions provided an economic explanation of the bubble and that their explanations were relatively consistent across the group. To generalize, the Austrians perceived the Fed to be following a loose monetary policy that kept interest rates below the rates that would have prevailed in the absence of that policy. Individual writers emphasized the Fed’s willingness to bail out investors consistently during the 1990s, thereby desensitizing investors to risk. As a result, a period of “exuberance” and wild speculation took place, culminating in the hysteria of a stock market bubble. If the Austrian analysis is correct, the Fed has been a significant source of financial and economic instability. This analysis also suggests that the Fed’s bias toward keeping rates as low as possible may cause significant economic losses and that a better policy might be to let market forces determine interest rates without intervention.
Those who discovered the “boom” in the economy and the “bubble” in the stock market and who predicted either a “bust” in the economy or a crash in the stock market work within an analytical tradition dating back to Richard Cantillon, whose Essay on the Nature of Commerce in General was published in 1755. The Cantillon tradition was carried forward and extended in the works of Turgot, Say, Bastiat, Menger, Wicksell, Böhm-Bawerk, Mises, Röpke, Hayek, and Rothbard, and it is now a hallmark of the modern Austrian school of economics.
At the core of this mode of analysis is an emphasis on entrepreneurship and the study of what causes prices to rise and fall, encompassing wages, rents, profits, interest, and the purchasing power of money. With respect to the business cycle, the Cantillon tradition shows that disturbances in the supply of money and credit, especially when a monetary authority expands the supply of paper money, changes relative prices. Artificial reductions in interest rates encourage investment and increase the valuation of capital assets, longer-term assets increasing in value more than shorter-term ones. The resulting changes in the structure of production (buildings, technology, and the pattern of industrial organization) are called Cantillon effects. They occur during the boom, a phase when resources are misallocated, both to malinvestments and to misdirected labor. As relative prices correct themselves in the bust, resources are reallocated by mechanisms such as bankruptcy and unemployment. Capital-asset prices are extremely volatile during this process.
Although Austrian ideas have received more notice and attention in the financial media and in academic publications in recent years, a survey of economic textbooks at the undergraduate or graduate level would find hardly a word about Austrian business cycle theory or about Cantillon effects. It may be too early for a complete revision of economics textbooks and too much to ask that economics professors rewrite their class notes, but it certainly is time at least to introduce these concepts in classrooms and textbooks so that students can consider an alternative paradigm and evaluate its merits.
Appendix: Some Other Predictions Jerry Jordan: “The problem may … be … in asset [stock] markets, as suggested by historical episodes in this country, notably in the 1920s, and in Japan in the late 1980s.”Jerry J. Jordan, president of the Federal Reserve Bank of Cleveland in the minutes of the Federal Open Market Committee meeting, November 11, 1997. As a voting member of the Federal Open Market Committee, Jordan, president of the Cleveland Fed, voted unsuccessfully five times to raise interest rates, starting in 1998.Victor Zarnowitz: “The arguments in favor a [sic] new Golden Age are generally not persuasive.”Victor Zarnowitz, “Theory and History Behind Business Cycles: Are the 1990s the Onset of a Golden Age?” NBER Working Paper 7010 (Cambridge, MA: National Bureau of Economic Research), abstract. Zarnowitz is aware of the Austrian theory of the business cycle and considers it in his analysis.Lew Rockwell: “At some point, and nobody knows when, the stock market is going to reverse its climb. It may even collapse.”Llewellyn H. Rockwell, Jr. “Stock Market Bailout,” Free Market (November 1999): 4.Greg Kaza: “There is talk on Wall Street of a ‘New Economic Paradigm,’ that has repealed the business cycle. But surface appearances can be deceiving. … Eventually a recession will occur.”Greg Kaza, Greg, “Downsizing Detroit: Motown’s Lament,” Chronicles: A Magazine of American Culture (November 20, 1999), p. 20.Holman Jenkins: “The claim by Glassman and Hassett to have found a new value for the Dow is a wonderful marketing gimmick, but it is the least important part of their book. The authors are certainly right that Americans have gotten over their fear of the stock market — because the stock market works better than it used to. For investors, it has become safe to buy, hold, and forget.”Holman W. Jenkins, Jr., 1999–2000. “Of Bulls and Bubbles,” Policy Review 98 (1999–2000).Alan Greenspan: “I recognize there is a stock market bubble problem at this point,” and “I guarantee if you want to get rid of the bubble, whatever it is, [increasing margin requirements] will do it”.Alan Greenspan, minutes of the Federal Open Market Committee meeting, September 24, 1996.William McDonough: “I think the banking system is functioning just about where I would like it to be — that is, appropriate willingness to take risk but with good, sensible judgments in general being demonstrated.”William McDonough, president of the New York Federal Reserve, quoted by Reuters, September 26, 1999.The Economist: “Such is the exuberance on Wall Street that only a brave man insists that the American stock market is overdue for a crash. Down the long history of bubbles ready to burst, it was ever thus.”The Economist 2000, p. 84.Alan Greenspan: “It is very difficult to definitively identify a bubble [in US stock markets] until after the fact.”Alan Greenspan, speech at the Federal Reserve Bank of Kansas City’s annual conference at Jackson Hole, Wyoming, August 20, 2002.Nicholas Brady: “The present market collapse is different; it was caused by vastly overblown valuations. The stock market has been in a colossal bubble, a delusion born in the late 1990’s that reached its zenith in 2000. While not uncommon, bubbles have always been a fact of market life, a byproduct of runaway human emotions.”Nicholas F. Brady, “Every Market Collapse Is Different,” New York Times, August 11, 2002.Laurence Mayer: “There was a sense of frustration that we couldn’t deal better with the asset-price bubble. … But I don’t think anybody has come up with a strategy that people felt would have gotten the job done.”Federal Reserve governor Laurence Mayer as quoted in Carol Vinzant, “Two Schools of Thought on Economics,” Chicago Tribune, September 3, 2002.Matthew Spiegel: “The difficulty with declarations claiming that large stock price moves are ‘bubbles’ or ‘panics’ is that they rely on perfect hindsight, typically generated only a few months or a year following the event. But investors do not have that luxury. They must price securities based on the information they have at the time they make their decisions.”Matthew Spiegel, “2000 A Bubble? 2002 A Panic? Maybe Nothing?” Yale School of Management (New Haven, CT., 2002), p. 5.Robert Shapiro: “If not technology shocks or market pricing failures, what’s driving the current business cycle? It’s not terrorism or war. Terrorism doesn’t exact sufficiently large direct costs to drive the economy; and it’s hard to argue that its psychological effects have slowed growth, when the economy turned around in the quarter immediately following 9/11 and turned in its best performance in years in the quarter after that. Nor is there hard evidence that the prospect or reality of the war with Iraq punctured business investment and consumer spending.”Robert Shapiro, “Spin Cycle: Why Has the Business Cycle Gone Topsy-Turvy?” Slate.com. April 15, 2004.James Grant: “In the boom cycle, people are not so much interested in a message that says: a bust is simply a necessary part of the business cycle. In a false prosperity, good economic ideas are marginalized. That’s why Austrians should prepare right now to offer the best explanation when the tide turns, as it always does. Who knows? Maybe we’ll find ways to make the bust intellectually profitable. In time, Austrian economics could be again seen as the mainstream theory. It should be.”James Grant, “The Trouble with Prosperity: An Interview with James Grant,” Austrian Economics Newsletter 16 (1996): 8.
The skyscraper, that unique celebration of secular capitalism and its values, challenges us on every level. It offers unique opportunities for insightful analysis in the broadest terms of twentieth-century art, humanity, and history. — Ada Louisa Huxtable, The Tall Building Artistically Reconsidered
People have been seeking to discover the cause of the business cycle since the dawn of capitalism. For an even longer time people have sought a magic crystal ball that predicts the future. This book provides some insight for both quests.
The skyscraper is the great architectural contribution of modern capitalism, on par with the canals and railroads that transformed the economy of the nineteenth century. However, no one ever thought to connect it with the quintessential feature of modern capitalism — the business cycle. James GrantJames Grant, The Trouble with Prosperity: The Loss of Fear, the Rise of Speculation, and the Risk to American Savings (New York: Random House, 1996). did make a clear connection between real estate and skyscrapers on the one hand and the business cycle on the other in The Trouble with Prosperity, and that book could have been an inspiration to Andrew Lawrence.
In 1999, Lawrence published his Skyscraper Index, which purported to show that the building of the tallest skyscrapers coincides with economic booms. Specifically, he showed that the building of the world’s tallest skyscraper is a good proxy for dating the onset of a major economic crisis — the skyscraper curse. His index does not apply to the irregular ebbs and flows of the economy, only substantial economic crises.
Lawrence is an investment analyst whose Skyscraper Index records the history of the world’s record-breaking skyscrapers and major economic crises. According to his index, when there is a groundbreaking ceremony for a new world-record-height skyscraper the economy is booming, but when the record height is achieved a significant economic crisis soon follows. The “curse” is the economic crisis, which is usually self-evident by the time the opening ceremony occurs. The mystery is, how can record-breaking skyscrapers be connected to economic crises?
Does this represent a cause and effect relationship? Can building a skyscraper cause business cycles? Architectural historian Carol Willis describes a very similar empirical conundrum:
In the overheated speculation of the 1920s, as land prices rose, towers grew steadily taller. Or should the order be: as skyscrapers grew taller, land prices rose? The variables that contributed to real estate cycles were even more complex than this “chicken and egg” conundrum.Carol Willis, Form Follows Finance: Skyscrapers and Skylines in New York and Chicago (New York: Princeton Architectural Press, 1995), p. 88.
What is the nature of the relationship between skyscraper building and the business cycle? Surely, building the world’s tallest building does not cause economic collapse. Just as clearly, there are well-known economic linkages between construction booms and financial busts. So what theoretical connections can be made between skyscrapers and business cycles?
Lawrence considered overinvestment, monetary expansion, and speculation as possible explanations for the relationship his index revealed, but he did not explore these issues at length or come to a definitive conclusion. Instead he finished with the notion that his Skyscraper Index was an unhealthy hundred-year correlation. Without an established connection or theory for the Skyscraper Index there are strong reasons to doubt its usefulness.
For example, with the destruction of the World Trade Center and the increased threat of terrorism, the Skyscraper Index may have already lost its usefulness for prediction. However, Edward Glaeser and Jesse ShapiroEdward L. Glaeser, and Jesse M. Shapiro, “Cities and Welfare: The Impact of Terrorism on Urban Form,” NBER Working Paper 8696 (Cambridge, MA: National Bureau of Economic Research, 2001), p. 15. did not find a statistically significant link between terrorism and the numbers of skyscrapers built. They also note that because of government interventions — for example, building codes — as well as psychological reasons such as a builder’s desire for personal fame, the number of skyscrapers may not be market determined.
The business press reported on Lawrence’s Skyscraper Index, but without much fanfare. Investors’ Business DailyInvestors’ Business Daily, “Edifice Complex,” May 6, 1999. seemed somewhat sympathetic to his “impressive” evidence, but asked: “How could something bad come of building the world’s biggest skyscraper? After all, bigger is better. Having the biggest building on earth can be a source of national pride.”
Also positive was Barron’s, which seemed to agree that it was an “excellent forecasting tool for economic and financial imbalance.”William Pesek, Jr., “Want to Know Where the Next Disaster Will Hit? Look Where the World’s Biggest Skyscraper’s Going Up,” Barron’s, May 17, 1999, MW11. Business Week raised the question of how to connect skyscrapers with economic crisis as described by the Skyscraper Index.Gene Koretz, 1999. “Do Towers Rise before a Crash?” Business Week, May 17, 1999, p. 26. The first and most concerned report came from the Far Eastern Economic Review, which noted that China was planning on breaking the record for the world’s tallest building and was constructing three of the ten tallest buildings on the planet to be completed by 2010.Alkman Granitsas, “The Height of Hubris: Skyscrapers Mark Economic Bust,” Far Eastern Economic Review 162, no. 6 (February 11, 1999): 47.
The main reason for the muted response to the Skyscraper Index by the business press is that most economic indicators have eventually failed over time. There have been numerous indicators put forth to help us predict the business cycle and stock markets, but they have not passed the test of time. As Goodhart’s lawCharles A.E. Goodhart, “Problems of Monetary Management: The U.K. Experience,” in Charles A.E. Goodhart, “Problems of Monetary Management: The U.K. Experience,” in Inflation, Depression, and Economic Policy in the West, edited by Anthony S. Courakis (Lanham, MD: Rowman & Littlefield, 1981), p. 116. states: “Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” This is also a likely fate of the Skyscraper Index.
For example, the Super Bowl indicator predicts that if the championship team from the National Football Conference (the old NFL) beats the championship team from the American Football Conference (the old AFL) in the Super Bowl game it should be a good year for the stock market and ipso facto a good year for the economy. This is a classic case of a “coincidental indicator.” This type of coincidental indicator (with no causal connections) should be differentiated from the traditional type of coincidental economic indicators that track changes in the business cycle. For example, payroll statistics are clearly linked with economic activity over time. If payrolls increase, then there is more economic activity and GDP. There is a real reason why we expect both statistics to change roughly in unison.
When this Super Bowl connection was first noticed in the 1970s by sports writer Leonard Koppett it was nearly perfect.Jason Zweig, “Super Bowl Indicator: The Secret History,” Wall Street Journal, January 28, 2011. Since then it has lost much of its credibility, with an overall record of about 80 percent but only about 50 percent over the last fifteen years. Therefore, the early success of the Super Bowl indicator manifested just a coincidence and a statistical illusion, as Koppett himself professed.
There are also seasonal indicators like the “January effect,” which claims that if stock markets increase in January, then stock markets will increase that year as well. However, this effect has been given multiple justifications, such as year-end bonuses and tax-avoidance strategies. It is also not clear whether the January effect is based on the performance of the stock market during the first week of January or during the entire month. It is also unclear whether it applies only to small-company stocks or the entire stock market. The January effect also suffers from the fact that once everyone is aware of it, it becomes anticipated and therefore no longer offers reliable investment advice or insight into the economy. As a result, such indicators do not have a reliable record for predicting the stock market or business cycles.
Political indicators of the economy are based on the political business cycle theory. This theory maintains that politicians will use monetary and fiscal policy, along with other policy measures at their disposal, to boost the economy, job growth, and the stock market prior to an election in order to enhance the probability of being reelected. Then after the election they will reverse those policies, creating a recession. Despite its intuitive appeal, the political business cycle theory has found little consistent empirical support. This failure may be the result of the difficulty of knowing what ruling coalition is truly in charge of government or how the different levels of government are interacting over their respective election cycles. These and other problems leave the theory with only a weak link between politics and the economy.
According to Paul Cwik,Paul Cwik, “The Inverted Yield Curve and the Economic Downturn,” New Perspectives on Political Economy: A Bilingual Interdisciplinary Journal 1, no. 1 (2005): 1–35. indicators with good causal-economic links to the economy include the inverted yield curve. When short-term interest rates rise above long-term interest rates, the yield curve becomes inverted, and this indicates trouble ahead for the economy. High short-term lending rates may indicate that borrowers are desperate for funds and lenders are reluctant to loan due to the perception of increased risk. The Index of Leading Economic Indicators was once the official crystal ball of the economy. However, in recent years it has had less success predicting changes in the economy. Two other indicators that I use to gauge the global economy are the price of oil and the Baltic Dry Shipping Index, which is a measure of the cost of ocean transportation. When both are high, it is an indication of global economic expansion, a boom, or a bubble. When both are low, it is an indication of economic contraction, a bust, or an economic crisis. However, all of these indicators are error prone and generally only provide a limited advanced notice of cyclical change. Such indicators certainly cannot issue alerts far enough in advance to be helpful for large capital-investment decisions.
Economist Richard Roll explained that economic indicators have only questionable or fleeting value for real-world investing:
I’m not just an academic but also a businessman. … [W]e could sure do a heck of a lot better for our clients in the money management business than we’ve been doing. I have personally tried to invest money, my client’s money and my own, in every single anomaly and predictive device that academics have dreamed up. … I have attempted to exploit the so-called year-end anomalies and a whole variety of strategies supposedly documented by academic research. And I have yet to make a single nickel on any of these supposed market inefficiencies.Richard Roll, “Volatility in U.S. and Japanese Stock Markets: A Symposium,” Journal of Applied Corporate Finance 5, no. 1 (Spring 1992): 29–30.
The problems with stock market and economic indicators are many. Some have a poor track record of predictions, while others have a good track record but no economic rationale and thus offer little confidence that they are not just statistical anomalies.
The Skyscraper Index, in contrast, does have a good record in predicting important downturns in the economy. This index is a leading economic indicator. The announcement of building plans — and in particular, groundbreaking ceremonies — typically occurs during economic expansions long before the onset of an economic crisis.
The most important question about the Skyscraper Index is why it has had such a good record of predictive success. Why does it work? What can it tell us about the structure of the economy over the course of a business cycle? Before we answer those questions, let us first examine the history of the index’s success in predicting the curse.
Published 2018 by the Mises Institute. This work is licensed under a Creative Commons Attribution-NonCommercial-NoDerivs 4.0 International License.http://creativecommons.org/licenses/by-nc-nd/4.0/
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We don’t really know what starts the speculative bubbles. — Jesse Abraham and Patric Hendershott, “Bubbles in Metropolitan Housing Prices”
The Skyscraper Index was based on the most noteworthy business cycles of the twentieth century and can be explained using Austrian business cycle theory (ABCT). In contrast, there is no consensus within mainstream economics about business cycle theory. The Keynesians have several versions, but all are driven by psychology and changes in aggregate demand. This would include behavioral-finance economists such as Robert Shiller who believe that stock markets are irrational. There are also debt-cycle theories put forth by Irving Fisher, Hyman Minsky, and Joseph Schumpeter. There is the real business cycle theory (RBCT), which is associated with the Chicago school and embraces the role of external shocks, such as technological change. There is a political business cycle theory based on the election cycle, and there are even Marxist theories.
The problem with most business cycle theories is that they are really just descriptions of business cycles rather than economic theories of business cycles. Each description emphasizes particular features that are then elevated to the status of causal forces. Each stage of the business cycle is characterized by several features — for example, speculation, unstable supply of money, changes in aggregate demand, changes in social mood, and external real factors, or shocks. As a result, business cycle theories could be characterized as perspectives in which the economist has identified particular features of the economy to blame, along with their preferred remedies.
As such, business cycles are reoccurring sequences of varying length of expansions, downturns, contractions, and upturns in many types of economic activities such as production, employment, income, sales, housing starts, money, credit, and prices. Interest rates, inventories, fixed capital, and loans outstanding tend to be procyclical. Keynesian theories emphasize that business cycles must be fought with aggressive government policies, such as deficit spending, bailouts, public works projects, and monetary stimulus. Real business cycle theorists take the opposite approach and recommend a passive policy of letting the government and economy absorb the impact of external shocks.
Austrian business cycle theory has significant advantages over mainstream theories:
First, whereas mainstream theories find the cause of business cycles to be either psychological or technological, ABCT identifies a cause of the business cycle that is economic in nature — namely, artificially low interest rates, which start a chain of events that can be understood using simple economic tools, such as supply and demand.
Second, mainstream theories assume away the complexities of the real-world economy, while ABCT incorporates complexity in its analysis.Third, ABCT incorporates the psychological and technological features of mainstream theories and shows them to be predictable rather than random and unexpected shocks.
Fourth, by identifying an economic cause of the business cycle, ABCT reveals a solution for ending the business cycle and the endless cycle of psychological and technological shocks and wasted resources.
For ABCT, the cause of the boom and subsequent bust is when the central bank reduces the market rate of interest below the natural rate of interest by increasing the supply of money and credit. The natural rate of interest is the market rate of interest set by savers and borrowers in the absence of intervention by the central bank and is adjusted for both risk and price inflation. This rate, therefore, signals the general time preference of society. Artificially low interest rates are not calculable because we cannot know what the natural market rate would be except by indirect measures such as the amount of open-market operations conducted by the Fed — that is, its net government-bond purchases. However, we can understand the impact of artificially low interest rates by looking at another, more straightforward, example of a government price control — in this case, a price ceiling set by rent-control laws. Such laws keep the rental rates on apartments artificially low. These laws lead to shortages of apartments, physical depreciation of apartment buildings, and misallocation of apartments. For example, with rent-control laws, you might find a large family occupying a one-bedroom apartment and a single individual living in a three-bedroom apartment due to the shortage of apartments. The key difference with artificially low interest rates in the loanable-funds market is that the Fed can make up for any deficiencies and prevents a shortage by printing money out of thin air.
Prior to Fed involvement, the amount of savings and borrowing are equal at the market-determined interest rate. Actual loan rates of interest vary from loan to loan based on the combination of the base rate, risk premium, inflation premium, and processing costs. After the Fed has reduced this rate to artificially low levels it creates a shortage of loanable funds, which it then corrects by buying government bonds from banks for cash. Banks now have more cash, which they can use to make loans. The direct consequences of this policy are to reduce savings, increase lending and debt, and lower lending standards so that individuals with lower credit ratings obtain loans and individuals with higher scores can obtain a larger amount of loans.
For consumers this means a greater debt burden and a reduction of future income because of less saving and interest income. For entrepreneurs this means a larger amount of borrowing. The lower interest rates also make longer-term investments appear more profitable relative to shorter-term investments. For example, low rates might induce a farmer to switch from growing corn, an annual crop, to growing apples, a multi-decade-length project. Lower interest rates induce foresters to let their trees grow longer, winemakers to let their wine age longer, and publishers to have larger print runs of their books. It also induces entrepreneurs to make production structures more roundabout.
The simplest example concerning roundabout production is of an isolated person who catches fish by hand and obtains one fish per day. If that person spends one day not fishing, but instead makes a net, that person could obtain three or four fish per day. Fishing by hand is direct production, while making the net and then fishing is more roundabout.
For a more modern example, let us examine the alternative ways we can communicate with each other. The most direct way of communicating with someone is to walk over to them and begin talking. A more roundabout method would be to first run a telephone line between your location and their location and use telephones to communicate. Using phones to communicate implies the prior existence of a vast variety of capital goods for the production of wires, phones, telephone poles, and so on. The amount and complexity of capital goods for cellular phone service is even more astounding. Phones are therefore more roundabout than the “walk and talk” method, but are much more productive. Austrian economists focus on this process of technological change. Investment in more roundabout production processes means that investors are investing in new ways of doing things that were previously on the shelf but were not feasible or in general use. Spending money on research and development is investment in new technologies to be available in the future. These technologies generally involve even more-roundabout production processes. In this manner, ABCT shows how the interest rate plays a direct role in the so-called technological shocks of the RBCT.
ABCT also tries to deal with the complexity of the economy rather than assuming it away. Mainstream theories generally have a mathematical model manipulating aggregate statistics such as consumption, investment, and government spending. The mainstream approach treats capital as a homogeneous factor of production that can be retooled and relocated with a wave of a magic wand.
In contrast, ABCT examines structures of production that span from the discovery of raw materials to the final product available for sale in retail stores. There are many stages of production in every structure of production, and each stage employs specific and nonspecific labor and specific and nonspecific capital goods. For example, an oil refinery contains a multitude of capital goods that are very specific to refining oil, but also capital goods such as pipelines and tanker trucks that are nonspecific capital goods because they can be used to transport many different things. To these, the entrepreneur adds very specific labor (e.g., petroleum engineers), nonspecific labor (e.g., truck drivers), and other inputs from previous stages of production (e.g., crude oil) in order to produce gasoline, a consumer good. Therefore, ABCT can show that nonspecific capital and labor can more easily be reallocated if conditions in the gasoline market deteriorate, but highly specific capital and labor are much more difficult to reallocate. Either the market value of oil refineries and the salaries of petroleum engineers must fall dramatically or they must remain unemployed.
The structure of production of all goods and services is highly complex. It is so complex that mainstream economics assumes it away. Even being complex, we can know some things about it and some things that affect it. The structure of production of a new product begins with a very short and direct structure. For example, with the invention of the automobile hundreds of small companies started making their own hand-fitted parts and assembling cars one at a time.
My first “portable” computer was built just for me by a computer technician using purchased parts, and it was the first one in town. This “portable” was the size of a suitcase that would barely fit in the overhead compartment of an airplane and weighed almost twice as much as a fully packed suitcase. Over time structures of production tend to get longer and the number of companies that sell the final consumer product often decreases.
For example, mass-produced interchangeable parts and the assembly line production technique for automobiles were introduced and quickly adopted. These technologies made production more efficient and increased the specialization of labor. They also made the structure of production more roundabout: machines had to be created to make interchangeable parts and assembly lines, technologies had to be created to replicate those machines, and so on. Today we find the structure of the automobile industry incredibly complex, with thousands of firms spanning the globe. These firms provide everything from computer graphics software to design new automobiles to the caps for the air valves on tires. Parts are transported to assembly factories, and then automobiles are shipped to auto dealerships. For mainstream economists the idea of perfect competition is the initial chaos of thousands of individual automobile companies, while for Austrians the whole process of the initial chaos evolving over time into a small number of mega-sized automobile manufacturers is competition. Mainstream economics’ ideal market form requires a large number of buyers and sellers, perfect information, a homogenous product, and several other conditions. For Austrian economists the only requirement for competition is no government barriers for entrepreneurs entering or exiting an industry.
Another difference between Austrians and mainstream economists concerns the role of money. For the mainstream economists money is neutral and is similar to their view of capital. Money can be injected into any point in the economy and it will not cause disruptions, distortions, or redistributions of wealth. In other words, new money does not affect the real economy or relative prices. For them it only raises the so-called price level and reduces the purchasing power of money. In the mainstream view, new money seamlessly seeps throughout the economy without resulting in any relevant changes in demands, relative prices, or production.
In contrast, Austrians base their analysis on the real impacts money can have on the economy. Let us contemplate a doubling of the money supply in the economy, as Richard Cantillon did in 1730. He concluded that new money could not possibly be neutral and then gave several examples of new money and how it would disturb an economy and cause redistributions. His examples included the discovery of silver mines and a large number of wealthy immigrants moving into a nation with their money. He showed that new money changes prices and production to meet the new demands of wealthy mine owners, miners, and new immigrants.
Our example is a central bank that wishes to try an experiment with newly printed money. After carefully acquiring the names of all pickup truck and NASCAR enthusiasts in the economy, it credits each of their bank accounts with $10 million. Austrian economists would expect to see ticket prices for the Daytona 500 increase dramatically, and they might speculate about the introduction of a Daytona 1000, but mainstream economists would expect no change. Austrian economists would expect that the price of the Ford F-450, the most expensive pickup truck in the market today, would increase and that Ford would produce a larger quantity of such trucks and might even build a new assembly plant or even design more expensive versions of its line of pickup trucks.
The pickup truck and NASCAR enthusiasts, the Daytona 500, and the pickup truck producers would all gain relative to everyone else. However, when all the money was spent, what would happen to the new capital that the Daytona 500 and Ford have invested? Mainstream economists tell us that there would be no effect on incomes, wealth, production, and new products or that any such disturbance would only be short lived and unimportant.
In recent years, the Fed’s use of zero–interest rate policy (ZIRP) and quantitative easing (QE) has made it possible for hedge fund managers, Wall Street bankers, and bond dealers to become extraordinarily wealthy. As a result of this immense wealth, real estate prices in Manhattan have increased dramatically and many new luxury-condo skyscrapers have been constructed. The experience at art auctions also tells a similar story. The price of artwork of artists of the currently fashionable contemporary-art genre, such as Jean-Michel Basquiat, Christopher Wool, and Jeff Koons, has skyrocketed to millions of dollars, while the minor works of such famed artists as the impressionist Pierre-Auguste Renoir can be purchased for perhaps less than $100,000.
In reality, with conventional monetary policy there are some straightforward ways in which the economy is distorted by artificially low interest rates. There is more lending and investment and entrepreneurs tend to favor longer-term, more roundabout means of production. For example, in the current environment of extremely low interest rates, especially for large corporations, Amazon has found it profitable to use robots rather than employees to fulfill orders from customers, despite the low-wage environment. The most direct way to fulfill orders is to have employees read orders, retrieve products, and package the products for delivery. A more roundabout method would be to design and build robots to replace the employees; create software for the robots to fulfill orders; reorganize warehouses and order-fulfillment centers to operate with robots; and train some employees to maintain and interact with the robots.
To watch the robots move around Amazon facilities, one might get the feeling that the company is somehow cheating on its various competitors. Additionally, when one looks at the price of Amazon stock one might guess that the company is earning huge profits, akin to a worldwide monopoly. Sales in 2015 were an enormous $35.7 billion, up 22 percent over 2014. Profits were also up a staggering 125 percent at $482 million in 2015. However, that means they are only making about 1 percent profit on sales. Amazon has a market capitalization of $300 billion and a price-to-earnings ratio of over 500.David Goldman, “Amazon Shares Plummet as Profit Disappoints,” CNN.com, January 28, 2016. In other words, investors cannot imagine anything going wrong for the company. WilsonDavid Wilson, “Cisco, Apple Fail to Reach $1 Trillion. Is Amazon Next?” Bloomberg.com, May 9, 2016. reports that one analyst predicts the company will be worth $3 trillion in less than ten years.
Some of the conventional disturbances caused by an increased money supply include a redistribution of wealth from savers to borrowers because borrowers obtain loans at lower rates, savers get a lower return on their savings, and the value of savings and debt is diminished by price inflation. The biggest beneficiary of this redistribution is the federal government, which has trillions of dollars of debt. The other primary redistribution from an increased money supply is the redistribution from people working for wages or living on fixed incomes to people with variable incomes, primarily but not exclusively in the financial sector.
Keynesian business cycle theories are based on psychological factors while real business cycle theory rests on external shocks such as technological change. ABCT incorporates both psychology and technology. With artificially low interest rates the economy will experience more investment and consumption. The price of assets will increase and unemployment will fall, even below the so-called natural rate of unemployment. Wages, incomes, and profits will all increase. During this boom Austrians expect the psychology of investors and entrepreneurs to be highly positive. Retirement stock accounts will increase substantially, variable-income workers in the service economy, such as waiters and massage therapists, will earn higher incomes, and novices will earn windfall incomes by endeavors such as flipping houses and day trading stocks. Given the above story about Amazon, it would also not surprise Austrians that a great deal of new technology would come about; in fact with ABCT it would be expected. The very nature of making an economy more roundabout implies new recipes for production and the introduction of new technologies. So there is a built-in rationale for a technology shock during a boom.
Every boom eventually peaks, and then the economy enters into a corrective phase, or bust. The reasons for transition are important and will be discussed, but for now let’s stick to our example of the bust phase; in light of the mainstream business cycle theories, this is largely just reversing aspects of the boom phase. The price of assets will fall, and the unemployment rate will increase above the natural rate. Wages, incomes, and profits will fall, and the incomes of service workers will decline. House flippers will flop. Naturally the positive psychology of the boom will disappear and the social mood will turn gloomy. Austrians expect this to happen. We would be very surprised if it did not happen.
In terms of technological change, it is hard to undo technology once it is introduced, so Austrians generally expect large losses where there had been the largest investments in new technology, the real estate related to that new technology, and the people who financed that new technology. Some RBC theorists argued that the financial technology used in the housing bubble was responsible for both the bubble and the bust. They blamed the new financial instruments, such as collateralized debt obligations, mortgage-backed securities, and asset-backed securities. For RBCT this financial technology was both a positive shock up to 2007 and then a negative shock. Indeed, the financial technology is the primary, but not only, reason why it was, after all, a housing bubble. Without these new financial products, Fannie Mae, Freddie Mac, the Community Reinvestment Act, and the tax advantages of homeownership, it would have been simply a generalized bubble throughout the economy, rather than specifically a housing bubble.
For now let us look first at the process of economic growth and contrast it with the business cycle in light of ABCT. It is important to know that true economic growth is dependent on the existence of increased savings. When people spend less of their income on consumption goods and save their money, they leave more resources in the economy to be used by others. As compensation, they will have more savings and interest income so that in the future they can increase their consumption beyond their income, or even forgo working altogether.
Entrepreneurs need savings, whether it is acquired through bank loans, the sale of stocks and bonds, or retained earnings from their companies. They need money to acquire capital goods, to hire labor, and to pay other expenses. Companies will use savings to maintain their capital from physical depreciation and they will invest in new capital goods that present better profit opportunities because of technological advantages. This will make the production structures more roundabout, efficient, and productive. More savings makes it possible to pay for things such as more employee payroll and inventories prior to the consumer ultimately paying for the final product. In other words, all the resources hired and used from the acquisition of raw materials to the final assembly and sale of consumption goods have to be financed in some way. More savings results in greater productivity and production.
Now let us contrast economic growth with the business cycle. Instead of an increased preference for saving and future income, now the lower interest rate and source of new loanable funds comes as a result of the monetary policy of the central bank. At the lower interest rate people will save less, not more. They will consume more. Investment will increase, particularly in longer-run, more-roundabout production technologies, but also for consumption purposes.
Reducing saving and increasing consumption and debt makes consumers less wealthy and puts them in a more precarious economic position. Investing in more-roundabout production processes also puts entrepreneurs in jeopardy. For example, instead of two entrepreneurs developing two new factories for the production of new advanced computer chips, four such projects are proposed and financed at the artificially low rates. The entrepreneurs study their projects, which are not identical but are very similar, in order to determine where to construct such factories and what are the best places to find construction workers, engineers, scientists, and factory workers. Also, what are the best sources of the very-specific capital goods, such as chip-making machines and clean-room technology? With existing chips selling better than expected due to increased consumption in the economy and promises of a new advanced chip on the way and financed at low interest rates, the stock price of these companies goes much higher. With such activities happening in many industries, the economy is booming.
Now we turn our attention to supply and demand issues as the entrepreneurs start running into some unforeseen circumstances. With twice the normal number of factories under construction, the price of land best suited for the factories is higher than expected. The availability of labor — first construction workers, but eventually the engineers, scientists, and factory workers — is less than anticipated and therefore wages and benefits are higher than were projected. The demand for the advanced chip-making machines and clean-room technology is also much higher than anticipated, so their prices are also higher than expected. Because there are four factories instead of two, the cost of all four projects will be higher than anticipated. Some components of the projects could be ordered in advance to avoid such cost increases, but not all them.
As the factories come online and start producing, other problems arise. The industry-wide supply of advanced computer chips is much greater than the entrepreneurs originally anticipated. As a result, the price of such chips falls and is lower than anticipated when the projects were initiated. The result of having undertaken four projects instead of two is that prices and revenues are lower than anticipated. Computer chips can be sold in advance too, but such hedging provides only short-term protection.
The overall demand for such an advanced computer chip is also likely to be adversely affected by the artificial interest rates. Recall that artificial rates increased consumption and reduced saving. This means that consumers were busy buying things such as the previous generation of smart phones and other chip-containing products, but now they have less savings and more debt. If half of your intended consumer base now has $10,000 in credit card debt and only $100 in their checking accounts, there is going to be a reduced demand for new chip-containing gadgets. This means fewer chips sold and even lower prices. The central bank can try additional doses of artificial credit, but it cannot print resources. It can only create more malinvestments and greater consumer debt. Notice that if there is a general glut of production capacity in an economy the result could be price deflation, the bogie man for mainstream economists.
With market-determined interest rates, an increase in the demand for loans by chip-making companies and entrepreneurs more generally would result in higher interest rates. When the interest rate is determined by the central bank, there is nearly a perfectly elastic supply of loans at the policy interest rate.
You can see the impact of artificially low interest rates today in the boom in higher orders of capital goods: the record-setting stock markets and general weakness in goods of the lowest order, consumption goods. Central bankers have feverishly used their one tool of money printing, but that has only created asset bubbles, malinvestments, and relative weakness in the Consumer Price Index, which is what ABCT expects. Once central bankers give up and put away their tool, asset prices will crash, malinvestments will be revealed, and consumer prices will be relatively strong.
Some might wonder here about the Austrian view of entrepreneurs. How can the same people who can figure out such amazing ways of improving the economy and its structures of production be fooled, repeatedly, by the Fed? Yes, Austrian economists do view the entrepreneur as a critical player in the economy, but entrepreneurs are not omniscient and we expect them to fail on a regular basis, constrained and controlled by competition, the system of profit and loss, and their capitalist backers. Engelhardt shows how easy credit conditions provide low-quality entrepreneurs access to credit that they would not have access to under tighter credit conditions.
In a nutshell, ABCT warns that artificially low interest rates create malinvestments and a boom or bubble in the economy. This necessarily sets the stage for a recession, bust, or economic crisis when the cluster of entrepreneurial errors is revealed. This is an economic business cycle theory, although it anticipates and incorporates the technological shocks and psychological instability of the competing mainstream theories. ABCT shows us how the biggest policy errors by the central bank result in economic crises and skyscraper curses and more entries in the Skyscraper Index.
Money makes possible the good things in life: our ability to trade with one another and the ability to form groups to work for beneficial purposes, as well as saving, investing, economic growth, and development. Without some form of money, advanced society would not be possible. However, as we saw in the previous chapters, increases in the supply of money, which mainstream economists now view as indispensable, are really the source of many evils of economic life.
Increases in the supply of money result in higher consumer prices, a process now known as inflation. This means that many people with jobs suffer diminishing purchasing power of their wages over time. Economic historians have long agreed that such inflation is the enemy of labor. Free market monies, such as gold and silver, typically increase in value over time, which is beneficial for wage labor and encourages work and saving, as the purchasing power of wages and savings tends to increase over time.
Increasing the money supply causes an unnatural redistribution of wealth. People who receive the money first become wealthier because they spend the money before prices have risen. People who receive the money later or not at all become poorer because they pay the higher prices. In the case of money coming from the Federal Reserve, the biggest winners are the US government; its large contractors, such as weapons manufacturers, big banks, and Wall Street. As a result, the financial sector of the US economy has grown enormously and economic inequality, measured in terms of income and wealth, has increased dramatically since the United States went completely off the gold standard in 1971. The financial-services sector has grown from about 4 percent of the US economy then to over 8 percent now. Thomas PikettyThomas Piketty, Capital in the Twenty-First Century (Cambridge, MA: Harvard University Press, 2014). has famously shown that inequality of income and wealth has increased greatly in the United States and elsewhere. However, the entire increase in inequality has come after 1970 and the abolition of the Bretton Woods gold standard. The period beforehand, when we were on the gold standard, is one of increasing equality.
The big losers receive the money after prices have already risen. The losers would include private-sector workers and people on pensions or fixed income — in other words, the labor class. Inflation also harms savers and bond investors, as well as taxpayers who find themselves in higher tax brackets when wages catch up with price inflation. Simply put, paraphrasing Senator Phil Gramm of Texas, the people pulling the wagon are harmed and reduced in number, while the people sitting in the wagon benefit and increase in number.
Finally, inflating the money supply causes the business cycle, and this is the least well-understood aspect of the Fed’s increasing of the money supply. It is not just natural swings in the economy; it is artificial, squanders resources, and ruins lives. This will be illustrated with the case of skyscraper construction.
Inflating the money supply is directly connected to interest rate manipulation. When the Fed buys government bonds from banks, it gives them dollars, which they can reinvest in more government bonds, mortgages, commercial loans, and consumer loans. This process artificially reduces interest rates. It also completes the movement of government bonds from the US Treasury, to the big banks, to the balance sheet of the Fed. It can sit there until it comes due, at which time the Fed can purchase more government bonds. The Fed is required to return any leftover interest income from these bonds to the US Treasury, so this process is the equivalent of an interest-free loan. Also, as monetary expansion turns into price inflation and lowers the value of the dollar, it effectively reduces the value of the national debt, a process referred to as monetizing the national debt. It is a convoluted process, but you can see why those who benefit do not want to reform it. It is quite a racket for the politicians, the big banks, and their highly paid facilitators at the Fed. This is the process that brings about artificial gyrations in interest rates and creates Cantillon effects and business cycles.
The Cantillon effects that we can see in record-breaking skyscrapers are symptomatic of what is going on in the economy; it is just more difficult to point to some particular project or new technology and claim that it is a malinvestment caused by the Federal Reserve and artificially low interest rates. So remember, skyscrapers themselves do not cause business cycles, the Fed does.
Many people consider the skyscraper a form of art, but their construction is essentially a business that must respond to incentives and constraints. Therefore skyscraper construction can be expected to follow closely even small changes in relative prices. In reevaluating the early skyscraper artistically, Ada Louise HuxtableAda Louise Huxtable, The Tall Building Artistically Reconsidered: The Search for a Skyscraper Style (Berkeley: University of California Press, 1992). noted:
Essentially, the early skyscraper was an economic phenomenon in which business was the engine that drove innovation. The patron was the investment banker and the muse was cost-efficiency. Design was tied to the business equation, and style was secondary to the primary factors of investment and use. … The priorities of the men who put up these buildings were economy, efficiency, size, and speed.
That is not to say that the early skyscrapers were without artistic merit, or that later structures failed to improve artistically; quite the contrary. Nevertheless, post-WWI skyscrapers continued to emphasize profits and technology. The early skyscraper drew from existing technology and was considered an engine of innovation. Even in modern times, design continues to grow and evolve, but for Helmut Jahn,Quoted in ibid., p. 117. the “structural rationale for such a tall structure is technically and economically inescapable.” For Huxtable,Ibid., p. 105. “Architecture simply doesn’t count. … With pitifully few exceptions in the past, New York’s skyscrapers have never reached for anything but money.” Art, technology, government regulations, and even ego must be considered factors, but the skyscraper is essentially captive to economic forces and motives. Therefore when architects are asked what makes for the super skyscraper, economic forces are considered preeminent. Psychological factors related to ego are created in the credit driven boom.
In this context it is important to remember that changes in the price of land, building materials, and the interest rate will have important implications for skyscraper construction. Changes in the rate of interest have three separate Cantillon effects on skyscrapers. All three effects are reinforcing, and all three effects are interconnected to the transformation of the economy toward more roundabout production processes. When the rate of interest is artificially reduced, all three effects contribute to the desire to build taller structures. The world’s tallest buildings are generally built when the interest rate is reduced substantially below the natural rate for a sustained period of time. In contrast, when the interest rate is forced above the natural rate the economic effects reduce the value of existing structures and the demand for tall buildings. Construction can come to a complete standstill.
The first Cantillon effect is the impact of the rate of interest on the price of land. The most obvious cause of this result is that lower interest rates reduce the opportunity cost of borrowing to buy the land and to build structures. As a result, owners of land and real estate experience an increase in their wealth. This relationship is confirmed by Jeremy Atack and Robert Margo,Jeremy Atack, and Robert A. Margo, “‘Location, Location, Location!’ The Market for Vacant Urban Land: New York 1835–1900.” NBER Historical Paper 91, National Bureau of Economic Research (Cambridge, MA, August, 1996). who examined the market for land in New York City during the nineteenth century. Their evidence suggests that land values tended to increase during deflationary periods, when interest rates tend to be low, but less so during inflationary periods, when interest rates tend to be higher because of the inflation premium in interest rates. Paul CwikPaul Cwik, “Austrian Business Cycle Theory: Corporate Finance Point of View,” Quarterly Journal of Austrian Economics 11, no. 1 (2008): 60–68. demonstrates that the interest rate has an impact on the net present value of working capital and longer-lived fixed capital. As a casual observation, when interest rates are artificially low, you tend to see more “land for sale” signs along roads and interstate highways because land prices are higher in general.
A lower rate of interest also tends to increase the value of land, because the interest rate is used by entrepreneurs as a proxy for the discount rate. In evaluating any investment project, entrepreneurs estimate the net present value of a project by looking at the projected income stream from the investment over a long period of time and adjusting it for interest payments over time. The income in the first year does not have to be discounted much at all, that is, just one year’s interest expense, but that same income in year twenty-five has to be discounted by twenty-five years of interest expenses and may be worth nothing in terms of net present value. Net present value of an income stream has to exceed risk-adjusted cost of an investment for the project to be undertaken. High interest rates lead to heavy discounting of income streams, whereas low interest rates lead to less significant discounting, which makes long-term projects seem relatively more profitable.
For example, consider an investment project that is expected to produce $1 million in income above operating costs per year for ten years. In the tenth year of operation, if the discount rate is 4 percent, the calculated net present value of that year’s $1 million net income is $675,000. However if the discount rate is 8 percent then the calculated net present value of that year’s income is only $463,000.
From this we can see that land values rise because lower rates of interest reduce the opportunity cost, or full price, of owning land and drive up the net present value of income streams from using land. Treating the rate of interest as the cause, a reduction in the interest rate will increase the demand for land and result in an increase in land prices. The impact of lower discount rates will tend to favor longer-term investment projects using land, such as skyscrapers.
It has been often said that the three most important things about real estate are location, location, and location. When the rate of interest is falling, the land best suited for the production of the longer-term, more capital-intensive, and more roundabout methods of production will increase in price relative to land better suited for shorter-term, more direct methods of production. As land prices rise, the yield required from any piece of land to make ownership of it profitable must also rise. Combined with a lower cost of capital brought about by a lower rate of interest, land owners will seek to build more-capital-intensive structures, and at the margin, this will cause land to be put to alternative uses.
In the central business district this means more-intensive use of land and thus taller buildings. Higher prices for land reduce the ratio of the per-floor cost of tall vs. short buildings and thus create the incentive to build taller buildings to spread the land cost over a larger number of floors and more leasable space. Thus, higher land prices lead to taller buildings. In my hometown there are a variety of one- and two-story structures currently being demolished to make way for the construction of multifloor structures. These projects are stimulated by artificially low interest rates and the search for yield on investment funds. In this manner, the height aspect of the projects is driven by land prices.
The second Cantillon effect from lower rates of interest is the impact on the size of firms. A lower cost of capital encourages firms to grow in size and to take advantage of economies of scale, such as the example of the dairy industry in transition. Here, companies that expand based on artificially low interest rates benefit, at least temporarily, at the expense of companies that do not and exit the industry. As part of this larger-scale, more roundabout production process, firms develop central offices or headquarters for their accounting, management, marketing, human resources, and product-development departments. This increases the demand for office space in central business districts. This demand in turn raises rents and encourages the construction of taller office buildings within the central business district.The phenomenon of firms growing in size and scope in response to artificially low interest rates can be seen in the history of merger-and-acquisition waves. Mergers between two firms occur when both firms believe they can profit from combining their operations. Acquisitions and takeovers occur when one firm believes it can manage the combined assets of the firms in a more profitable manner. Lower interest rates reduce the cost of the capital to buy out investors of the other firm. Mergers and acquisitions have occurred in clusters or waves during periods of low interest rates and easy credit conditions (the boom), and because they often start operating as a united company during the bust, their record of success has not been great.
SaraviaJimmy A. Saravia, “Merger Waves and the Austrian Business Cycle Theory,” Quarterly Journal of Austrian Economics 17, no. 2 (Summer 2014): 179–96. shows that waves of mergers and acquisitions that have been experienced in the past are consistent with Austrian business cycle theory (ABCT). Not only do low interest rates help finance mergers and especially acquisitions, but the demand for such business deals is a reflection of the “resource crunch” of ABCT as shown in the previous example of the expansion of the advanced computer-chip industry. Ekelund, Ford, and ThorntonRobert B. Ekelund, George Ford, and Mark Thornton, “The Measurement of Merger Delay in Regulated and Restructuring Industries,” Applied Economics Letters 8, no. 8 (2001): 535–37. show that when mergers are delayed by government “red tape,” the resulting acquisitions and mergers tend to be unprofitable because they are often completed during an economic downturn. ThorntonMark Thornton, “Review of The Synergy Trap: How Companies Lose the Acquisition Game, by Mark L. Sirower,” Quarterly Journal of Austrian Economics 2, no. 1 (Spring 1999): 85–86. has furthered the discussion of why so many mergers and acquisitions turn out to be miscalculations.
The third Cantillon effect is the impact of interest rates on the technology of constructing record-tall buildings. Record-breaking skyscrapers require innovation and new technology in order to be profitable. Buildings that reach new heights pose numerous engineering and economic problems relating to such issues as building a sufficiently strong foundation, ventilation, heating, cooling, lighting, transportation (e.g., elevators, stairs, and parking), communication, electrical power, plumbing, fire protection, and security systems, as well as wind resistance, structural integrity, and even window cleaning. There are also a host of public issues connected with increases in employment density brought about by tall structures, such as transportation congestion and environmental concerns. For example, Sukkoo KimSukkoo Kim, “The Reconstruction of the American Urban Landscape in the Twentieth Century,” NBER Working Paper 8857, National Bureau of Economic Research (Cambridge, MA, April 2002). showed how increases in skyscraper-building and, in particular, improvements in skyscraper technology lead to increases in employment density. Here, advanced technology businesses benefit at the expense of incumbent technology businesses.
Beyond the mere technology it takes to build the world’s tallest building, every vertical beam, tube, cable, pipe, or shaft in a building takes away from leasable space on each floor built, and the more floors in the structure, the greater the required capacity of each system in the building, whether it is plumbing, ventilation, or elevators. So designers, architects, and building contractors cannot simply increase the size of each system to increase capacity. They must come up with new, more efficient systems to reach record heights. Consequently, there is a tremendous desire to innovate with technology in order to conserve on the size of these building systems or to increase the capacity of those systems. Therefore, as the height of construction rises, input suppliers must go back to the drawing board and reinvent themselves, their products, and their production processes.
M. Ali and Kyoung Sun MoonM. Ali, and Kyoung Sun Moon, “Structural Developments in Tall Building: Current Trends and Future Prospects,” Architectural Science Review 50, no. 3 (September 2007): 205–23. describe how designers and engineers have a tremendous need to innovate to conserve on the requirements of building systems. For example, one elevator shaft with a floor size of 2×2 meters would take up the space equivalent of ten efficiency-sized apartments in a hundred-floor building. At standard speeds it would take about ten minutes to get to the top floor of the Burj Khalifa tower, plus the time it took for the elevator to arrive on your floor and any additional stops on the way to your destination. AmesNick Ames, “Elevator Installation Prep Begins at Kingdom Tower,” ConstructionWeekOnline.com, May 10, 2015. reports that KONE Corporation engineers have created a new elevator cable that weighs less than 7 percent of the weight of traditional steel cables, which each weigh over twenty tons for a 400-meter-high building. Obviously, a twenty-ton cable would require an enormous amount of power to operate. Therefore, as building heights rise, technology must be advanced to conserve on the building systems’ footprint.
Another example of this type of technological effect is in heating and cooling systems for especially tall skyscrapers. Record-breaking skyscrapers require a tremendous capacity for heating and cooling; and traditionally, hot and cool air or water would have to be pumped long distances, which is both inefficient and requires a great deal of space for all the ductwork and plumbing. A recent solution to this problem is a system called variable-refrigerant-flow zoning and split-ductless systems. Instead of massive amounts of air or water transported throughout a building, only the refrigerant — for example, Freon — is moved to each zone. It is transported in small copper tubing rather than bulky ductwork or water pipes, which take up horizontal space between each floor as well as vertical space. Each zone can have its own temperature, and the flow of refrigerant is variable according to the needs, rather than just on and off. The total amount of equipment is less, it is easier to maintain, and it is said to be 25 percent more energy efficient. Surely this is a great invention, but one that would not have come along as early as it did in the age of the mega-skyscraper. In other words, enormous amounts of resources were expended to obtain small gains in efficiency due to the artificially high demand to build very tall skyscrapers. When the next economic crisis comes, the demand for these advanced technologies could collapse because either no one is building such skyscrapers or they are only building much smaller buildings.
Construction systems must also be reinvented to tackle new record-breaking construction projects. For example, pumping concrete higher to build taller structures requires innovation in concrete-pumping technology; the same can be said for cranes and moving laborers to and from their worksite on the building. Again, in the economic crisis that follows, these systems and all the capital combinations that support them could either go unused or used at greatly diminished levels.
All three Cantillon effects resulting from lower rates of interest are interrelated and reinforcing. All three are generally recognized by people involved in the construction of large office buildings including architects, bankers, contractors, design specialists, engineers, entrepreneurs, government regulators, often the tenants themselves, and finance specialists such as bond dealers.
Higher interest rates discourage the construction of taller buildings and of construction in general because capital is scarcer and land is less in demand and available at lower prices. Higher interest rates also create financial difficulties for the owners of existing structures because of the decreased demand for office space and condos. Companies engaged in construction and their suppliers face a decrease in the demand for their services, the impact of which falls hardest on those firms that specialize in the production of the tallest buildings and the suppliers of the specialized construction systems and building systems for ultrahigh construction.
In other words, the technologies and industrial capacities that were induced by the artificially low interest rates are now greatly incapacitated and mostly idle. The buildings themselves are likely to have excess capacity, with too few tenants and lower-than-expected leasing rates.
The interest rate is what makes the construction business, in part, such a speculative business. Homebuilders build spec houses and face the risk of finding a buyer at a profitable price. Developers build speculative office buildings, which in contrast to many corporate headquarters are investments that rely on an uncertain flow of rental income. Separating the winners from the losers is not so much a matter of greed as it is a matter of time and calculation. Skyscraper expert Carol Willis explained the difference between normal times and boom times:
In normal times, when costs of land, materials, and construction are predictable, developers use well-tested formulas to estimate the economics of a project. These calculations are based on the concept of the capitalization of net income. This value takes into account the net income for thirty or forty years. … [T]he conventional market formulas and the concept of economic height were widely known and followed in the industry. Most speculative building was not risky, but reserved in its calculations and highly responsive to market desires.Carol Willis, Form Follows Finance: Skyscrapers and Skylines in New York and Chicago (New York: Princeton Architectural Press, 1995), p. 157.
All of these normal calculations that help ensure profit and avoid loss are not, however, reliable during the boom phase of the business cycle.
In booms, the so-called rational basis of land values is disregarded, and the answer to the question “What is the value of land?” becomes “Whatever someone is willing to pay.” Some speculators estimate value on new assumptions of higher rents; others simply plan to turn a property for a quick profit. … But due to the cyclical character of the real estate industry, the timing of a project is crucial to its success, and the amount a property reaps in rents or sale depends on when in a cycle it is completed or comes onto the market.Ibid., pp. 157–58.
Building the world’s tallest building has been a matter of particularly bad timing by entrepreneurs, and even if they were able to successfully steal away enough tenants from the remaining pool of renters, the economic problem for society is that valuable resources are lost in the process of constructing buildings that are bad investments and underutilized. See, Patric Hendershott and Edward Kane,Patric H. Hendershott, and Edward J. Kane, “Causes and Consequences of the 1980s Commercial Construction Boom,” Journal of Applied Corporate Finance 5, no. 1 (Spring 1992): 68. who estimated that there was more than $130 billion wasted in the commercial construction boom of the 1980s. The Empire State Building was nicknamed the Empty State Building because of its high vacancy rates until after World War II.
However, it is not the entrepreneur’s formula that is at fault, but a system-wide failure that has occurred periodically throughout the twentieth century and before, and is known as the business cycle. HoytHomer Hoyt, One Hundred Years of Land Values in Chicago: The Relationship of the Growth of Chicago to the Rise in Its Land Values, 1830–1933 (Chicago: University of Chicago Press, 1933). found the building cycle was a “motion of a definite order” lasting eighteen years, on average, from peak to peak. Willis raised the key issue as it relates to skyscrapers:
Indeed, a key question about cycles is, if their pattern is so predictable, why don’t people foresee the inevitable bust? This conundrum can perhaps be answered by looking more closely at the dynamics of speculation and at a typical skyscraper development.
Hoyt suggested that the cycle is long enough for people to forget the lessons of the previous cycle and thus not be able to apply it to the next cycle. However, the building cycle is much more volatile and unpredictable than this eighteen-year average would suggest. Together with the impact of local economic conditions and government intervention, the combination of factors blurs any usefulness of the simple knowledge that business cycles exist and have an average duration. Indeed, the people who experience one business cycle are often not even the same as the people who experience the next cycle. As Willis noted:
After the collapse of an inflated market, it is easy to look back on the grave errors of judgment that preceded a crash; yet the basic indicators of the twenties economy seemed to promise unimpeded growth. Pent-up demand for office space after World War I, the expanding numbers of the white-collar workforce, and the increasing per-person average for office space all fueled the building industry. Each year, the summaries of annual construction figures reported record numbers.Willis, Form Follows Finance, p. 159.
Willis did correctly identify that “easy financing underlie[s] all booms,” but this does not answer her conundrum, because easy financing and low interest rates are also at the heart of genuine economic growth. The entrepreneur’s problem is that profit calculations cannot show for sure whether interest rates will remain low and projects will succeed (i.e., economic growth), or rates will rise and projects will fail (i.e., the business cycle). Furthermore, it should be made clear that in ABCT, low interest rates and “easy financing” are terms defined not on the basis of their magnitudes, but in relation to their natural rates, which of course are not calculable outside of a free market.
It was on a weekend during the winter of 2004 and I was getting suspicions of the coming of another Fed-induced bubble like the one of the late 1990s. Social psychology seemed to be becoming more optimistic. However, it was not perfectly clear if it was just a general boom throughout the economy, or a bubble in a particular sector. I decided to take a look for myself.
It would be hard to deny that the American stock exchanges are experiencing bull markets. Last year (2003) the NASDAQ was up over 50 percent while the Dow 30 and S&P 500 had gains of 25 percent, and it seems that everyone is bullish this year. The Dow Theory (which is not much of a theory) tells us that we are in a bull market. If you are a follower of the “January effect,” where the month of January somehow determines the fate of the market for the year, you should also have a bullish outlook because all the stock market indexes ended the month in positive territory.
Only the New England Patriots’ victory would seem to have spoiled the party. The Super Bowl indicator predicts a good year for the stock market if a team from the old NFC wins and a bad year when a team from the AFC wins. Then again the Super Bowl indicator has lost some of its magic in recent years. Maybe we should switch to political indicators, which would suggest big gains in stocks during an election year.
But is the stock market truly showing signs of prosperity, or is it just BS?
I would like to suggest the latter and that it might not be a good time for you to obtain a home-equity loan to invest in hot tech stocks. We are going through a housing bubble, and stock valuations as measured by stock price-to-earnings ratios are at bubble levels. The buy low, sell high philosophy would lead you to sell stocks now, not buy them.
I’m not suggesting that you sell your house or cash in your retirement funds, only that you don’t throw caution to the wind and abandon traditional guidelines. Over 90 percent of stocks are now trading above their two-hundred-day moving average. I usually think of selling stocks, or at least stop buying them, when this indicator approaches 80 percent and then throw the cash back into the market when it gets down to the 20–30 percent level. At a minimum, investors should take the time to evaluate their assets and portfolio allocations between stocks, bonds, cash, and gold — between speculation and safety.
What is the case for a BS stock market based on?
First, the Federal Reserve has pushed short-term interest rates down to historically low levels. This has certainly buoyed stock prices, but it also has stymied savings and encouraged increases in consumption and debt. Americans have low levels of savings and high levels of debt, and this is simply not good for the health of the economy. In fact, statistics indicate that Americans have been taking money out of saving accounts and putting it into the stock market, but are not increasing their overall savings.
Second, the federal government has increased spending and debt at a rapid rate. Both are bad for the health of the economy, but do serve to keep up the appearance of prosperity in economic statistics such as GDP and the unemployment rate. When economic recovery is fueled by government spending, combined with stimulated consumption spending and housing construction, how real can the prosperity be?
Looking backward, we should also remember the decrease in the value of the dollar. Thanks to the Federal Reserve, the US dollar index lost approximately 15 percent of its value in 2003. If you had parked your money in a foreign bank or foreign bonds you could have avoided the loss plus earned interest, making the 25 percent gains on US stocks hardly spectacular in comparison.
Looking forward, we should note that the percentage of investment advisors who are bullish on the market is near the highest level experienced over the last four years. The percentage of investment advisors who are bearish is near the lowest level over the same time period. This psychological indicator is a contrarian indicator in that the larger the number of bulls and the smaller the number of bears, the more likely is a “correction” in the stock market. It is not a perfect indicator — nothing is — but it does line up with economic analysis in finding some trouble ahead in the US stock market.
This takes me to my disclaimer. If investment advisors as a group tend to be wrong about the future of the stock market, then how good can my advice and analysis be? The answer is caveat emptor, and that’s no BS.
Razorbacks are wild pigs that are bulky, strong, fast, and ferocious. They inhabit a very large range in large numbers and are omnivorous and highly adaptable. Wolverines are the largest species of weasel, about the size of a small bear. This fast, muscular carnivore has a well-deserved reputation for strength and ferocity. Do these creatures have anything to do with the skyscraper curse?
No, they don’t, but they did inspire an important article by Greg Kaza.
When I give public lectures on the skyscraper curse, I am inevitably asked whether it can be applied on continental, national, and state levels, rather than just a global scale. For example, would a national-record-breaking skyscraper result in a national curse? My answer to those questions is yes, but that is only based on anecdotal evidence.
Greg KazaGreg Kaza, “Note: Wolverines, Razorbacks, and Skyscrapers,” Quarterly Journal of Austrian Economics 13, no. 4 (Winter 2010): 74–79. examined the Skyscraper Index evidence at the state level in the United States. He chose the states of Arkansas and Michigan. Greg is from Michigan and earned his master’s degree in international finance from Walsh College, in Michigan. He has served as executive director of the Arkansas Policy Foundation since 2001. The team names for the University of Arkansas and the University of Michigan are respectively the Razorbacks and Wolverines.
He used the National Bureau of Economic Research’s (NBER) estimates of economic expansions and contractions in the US economy. He compared that data with data on the tallest buildings in both states. What he found was confirmation of the Skyscraper Index at the state level. According to Kaza:
Michigan’s tallest skyscrapers in the early 20th century, Detroit’s Dime Building and Penobscot Annex, were completed in 1913, a recession year. Detroit’s Guardian and Penobscot buildings were finished in 1928–29 on the Great Depression’s eve. Today, Michigan’s tallest building is the Detroit Marriott at the Renaissance Center, completed in an expansion (1977). Its final tower, however, was finished in the July 1981–November 1982 contraction.Ibid., p. 76.
So the experience in Michigan would seem to confirm the Skyscraper Index. It should also be pointed out that with regard to the Detroit Marriott, the American automobile industry, centered in Detroit, Michigan, was still a vital force relative to the rest of the economy in the 1970s, although that would soon change.
The results were similar in the state of Arkansas. The state is largely an agricultural economy, although that has changed some with the rise of Wal-Mart, which has its headquarters in Bentonville, Arkansas. According to Kaza the state followed the familiar pattern:
A similar effect can be observed in Arkansas. Little Rock’s Pyramid Life Building (1907), Union Life Building (1913), Donaghey Building 2 (1926), Tower Building (1960), Bank of America Building (1970) and Region’s Bank Building (1975) were all completed around NBER contractions. The lone exception, Metropolitan Tower (formerly the TCBY Building) was completed in 1986, a year of expansion.Ibid., pp. 76–77.
The Metropolitan Tower might have been completed during a national expansion of the economy, but such was not the case in Arkansas. As the building was being built, the state of Arkansas was entering a very strong economic contraction. According to Henderson, Gloy, and Boehlje:
U.S. agriculture could not sustain the 1970s prosperity and, similar to the 1920s, U.S. export activity collapsed during the 1980s. After peaking at $96 billion in 1980, real U.S. agricultural exports fell sharply. A weak global economy, world debt problems, a strong exchange value of the dollar and trade barriers — including a Russian grain embargo — cut U.S. agricultural exports (Drabenstott 1983). In 1986, agricultural exports bottomed at $47 billion, half the levels posted five years earlier.Jason Henderson, Brent Gloy, and Michael Boehlje, “Agriculture’s Boom-Bust Cycles: Is This Time Different?” Economic Review (4th quart. 2001): 88.
So the lone failures of the Skyscraper Index in Arkansas and Michigan are really about the difficulties that can arise using national statistics on state-level phenomena.
Kaza raises two other important points. The first point is that the tallest buildings in twenty states were completed in years of NBER contractions. It might be interesting to examine the other thirty buildings to see whether their record-breaking dates, in contrast to completion dates, might have occurred during an economic expansion. The second point is that he found, using NBER dating, that the Woolworth Building, which opened in April 1913, did so in a twenty-three-month-long contraction in the US economy between January 1913 and December 1914. This was a long and severe contraction. However, it was not long enough or deep enough to gain a moniker achieved by other skyscraper-cursed buildings.
While Lucas EngelhardtLucas Engelhardt, “Why Skyscrapers? A Spatial Economic Approach.” Unpublished manuscript, 2015. shows that the skyscraper-curse analysis can be integrated into the microeconomic analysis of labor markets and location theory, KazaKaza, “Note: Wolverines, Razorbacks, and Skyscrapers.” has shown that it can also be situated into lower levels of geographic analysis.
If I go there will be troubleAnd if I stay there will be double.So you gotta let me knowShould I stay or should I go? — The Clash, Should I Stay or Should I Go
The decision of where to locate your residence is difficult to make. Most of the factors that play a role in your decision-making are basically economic factors. So might this kind of decision-making process be somehow involved in the skyscraper curse? Economist Lucas Engelhardt thought so and wrote an insightful paper about it.
I have reiterated throughout this book that record-breaking skyscrapers and the skyscraper curse are merely symptomatic of what is going on throughout the economy when it is influenced by artificially low interest rates for a long period of time. We have already seen that it causes such things as local-record-breaking building heights in places such as Auburn, Alabama, advanced construction technologies, and advanced architectural innovations.
Many factors come into play with respect to the choice of the location of your residence. A big factor is that the cost of your house or apartment is one of your biggest expenses. Rent or mortgage payments are typically the largest single payments in your monthly budget. Once you have paid off your mortgage your standard of living can increase significantly.
Another big factor is that the decision is a long-term choice. If you plan to buy a house or condominium, then there are transaction costs such as moving expenses, realtor commissions, and attorney fees. You can reduce some of these expenses by placing a greater work burden and risk burden on yourself, but you cannot make them go away. Such costs occur every time you move.
These cost considerations also impact decision-making on the choice of apartments. If you sign a lease, then you are obligated to pay rent over the length of the lease. You also have moving costs, whether you pay a moving company or do the moving yourself. The upshot is that people typically spend time and effort acquiring information to make such decisions and typically do not make thoughtless and abrupt choices. So when you ask yourself, “Should I stay or should I go?” remember that there is a significant cost of moving.
Some of the factors that people consider when contemplating moving are housing prices and the amount of the monthly payment; the amount of property, income, and sales taxes; local amenities; the quality of local schools and shopping opportunities; crime rates; and commute time. The location of churches will also affect some people’s choices. There are trade-offs among all these factors. For example, people with young children will tend to put up with higher taxes if the local schools are good and crime rates are low. Another example is that some people would be willing to put up with long commute times if housing prices and taxes are low, local amenities and schools are good, and crime is low.
Lucas EngelhardtLucas Engelhardt, “Why Skyscrapers? A Spatial Economic Approach.” Unpublished manuscript, 2015. made a contribution to our understanding of the Skyscraper Index by providing a fuller theoretical explanation of why we should expect an uneven increase in land prices, rather than a general, even increase in land prices. By using location theory, Engelhardt shows theoretically why we should focus on very high skyscrapers rather than just tall buildings in general. In other words, he does not reject the notion that lower interest rates increase land prices and the height of buildings, but he provides theoretical support for the idea that land prices will increase relatively more in central business districts.
Of the three Cantillon effects, his focus is on the first effect, where artificially low interest rates change land prices, which leads to taller buildings. In my 2005 paperMark Thornton, “Skyscrapers and Business Cycles,” Quarterly Journal of Austrian Economics 8, no. 1 (2005): 51–74. the justification for taller buildings in this first effect was not really based on economic theory, but on real estate economics. However, I did provide some theoretical support for the uneven increase in land prices in the second Cantillon effect, where low interest rates caused an increase in company size, which in turn caused an increased demand for office space in central business districts.
Engelhardt uses William Alonso’sWilliam Alonzo, Location and Land Use: Toward a General Theory of Land Rent (Cambridge, MA: Harvard University Press, 1964). bid-rent model with a purely residential city where all employment opportunities are in the central business district. While not realistic, these assumptions are reasonable. In the model, each household budgets part of its income to pay rent and commuting expenses, and part of its time to cover the commute. The further you get from the central business district, the higher the commuting costs, which diminishes the amount you are willing to pay for rent. As you get closer to the central business district, your commuting time and expense decreases and your willingness to pay higher rent increases.
This trade-off is pretty familiar to many people: do you live near your job and pay higher rent, or do you live in the suburbs and endure substantial commuting cost and time? It is a trade-off between housing costs and commuting costs.
If commuting costs are very high, rents will be very high near the central business district (i.e., a steep trade-off), but if transportation costs are very low (e.g., free, ubiquitous high-speed trains), then rents will be similar near the center to what they are on the periphery (i.e., a shallow trade-off). But what determines the steepness of the trade-off? The quality of transportation services is obviously important, but also very costly to manipulate. For example, Dana RubinsteinDana Rubinstein, “Where the Transit-Build Costs Are Unbelievable,” Politico, March 31, 2015. reports that government transportation projects are notorious for being long delayed and over budget, with some projects exceeding $2 billion per mile. Engelhardt chose to focus on wage rates and interest rates, which pertain more generally across cities.
Here he employs Murray Rothbard’sMurray N. Rothbard, Man, Economy, and State (Auburn, AL: Mises Institute, 1962). concept of the discounted marginal revenue product of labor. Normally the difference between this and the mainstream concept of marginal revenue product is negligible, but Rothbard’s concept does introduce the interest rate and time preference into our theorizing about decision-making by adding time discounting to the mainstream concept.
When interest rates are very low you are less concerned with when you are paid because you lose very little interest. If interest rates are very high, then you want to receive your wages very quickly. Likewise, people who are paid daily are unconcerned about the interest rate, but people who are paid monthly or annually could be very concerned about changes in interest rates.
With respect to the skyscraper curse, when interest rates become artificially low, the discount rate on future sales of products decreases and thereby creates an increased demand for products; and this creates an increased demand for labor and higher wages rates. For example, if the interest rate on inventory paid by an automobile dealership falls from 10 percent to 1 percent, the dealer will want to carry a much larger inventory to better approach maximal profits. This increased inventory, reflected across the economy, will cause higher levels of production, employment, and wages.
What impact will these higher wages have on choice of location? Higher wages will have two distinct effects. First, higher wage rates will result in larger household budgets and a larger budget to pay for rent and commuting costs. Second, the higher wage rate makes a person’s commute time more expensive in terms of opportunity costs. For example, a lawyer who makes $500 per hour serving clients would have to consider a move from a 60-minute commute per day to a 120-minute commute per day as increasing their opportunity cost by $125,000 per year! Likewise, a lawyer who moved and reduced commute time from 60 minutes per day to living in his office and having no commute time would potentially increase their revenue by $125,000 per year.
Engelhardt finds that falling interest rates have an unambiguous impact on higher-wage individuals and the land closest to the central business district, although with lower-wage individuals and land near the periphery the effect is ambiguous. This means that artificially low interest rates induce people to want to move closer to the central business district. This in turn tends to increase land prices and causes taller buildings to be built. So during an artificial boom we would expect things like very tall condominium buildings to be built in central business districts.
If you relax the model and allow for office buildings the results are even stronger because businesses want to minimize travel costs for their employees, customers, and input suppliers. Therefore, they want to locate in the central business district, thereby driving land prices even higher. Engelhardt’s findings provide additional evidence for the Skyscraper Index and the skyscraper curse and his research highlights how artificial interest rates can influence our lives on a very personal level.
As of November 2013, it was official. New York City had won the title of having the nation’s tallest structure. The heated controversy between New York and Chicago was settled when the Council of Tall Buildings and Urban Habitat, based in Chicago, decided that the 408-foot spire sitting atop One World Trade Center could be included in the total height of the building.
The revised height of 1,776 feet made One World Trade Center the tallest structure in the United States. We are told that One WTC is more than a building. It both serves as a monument to those murdered on 9/11 and honors our Declaration of Independence. Not to disrespect those who died, but this “record” is a sham because the useable, productive height of the building is only 1,368 feet. The remaining 400-odd foot difference is just uninhabitable window dressing.
This dubious record should nonetheless be a kind of warning to us that the skyscraper curse, the forerunner of economic crisis, is lurking near.
The Shard Building, in London, broke ground in 2009 and was completed in 2012, becoming the tallest building in Europe. This was a clear signal of the European economic crisis, the PIIIGS fiscal disaster — in Portugal, Italy, Ireland, Iceland, Greece, and Spain — and the grave and ongoing concerns over the long run viability of the euro. Japan joined the fraternity with the Tokyo Skytree broadcasting tower, which was completed in 2012 and is now the tallest structure in Japan. Not to be outdone, China set a new national skyscraper record with the Shanghai Tower, which opened in 2014. China also broke ground but suspended construction on Sky City tower in part because of fear of the skyscraper curse. It too would have set a new world record.
World-record-breaking skyscrapers are a signal of economic crisis. Like world-record-breaking art prices, such as the $142 million selling price of a painting by Francis Bacon of his friend Lucian Freud at Christie’s in New York in 2013, such records are signs of economic excess. Just remember that such excess usually occurs in markets manipulated by central banks.
These are the spectacular results associated with the skyscraper curse, but you also might be able to see signs of it at work in small-town America. For example, there are no true skyscrapers being built in Auburn, Alabama, home of Auburn University and the Mises Institute. But there has been a great deal of building big and tall for this small city in eastern Alabama.
Luxury student-apartment building leads the way, followed by high-end restaurants and retail space. Recently two student-apartment buildings were torn down to make room for yet bigger buildings. The city government is also spending truckloads of money on street improvements and a state-of-the-art high school. More recently, old single-floor buildings have been demolished downtown to make room for multistory high density apartments.
What are people thinking? Don’t they realize we are in one of the weakest recoveries on record and headed for another recession? Has no one in Auburn realized there is an enormous amount of student debt and that the job market for holders of college degrees is weak? Is it greedy bankers and construction companies run amuck? Is it out-of-control architects and chefs that are to blame? Or is it the spoiled rich college kids who demand luxury apartments and locally grown veggies at the high-end restaurants they frequent?
The rush to build bigger, taller, and more luxurious buildings actually has little to do with any of these groups, but it has divided us as a city. On the one hand, there are many people upset because all this construction is changing “the loveliest village on the plains.” Local residents are seeing “Keep Auburn Lovely: Save Our Village” signs popping up all over town. They oppose the building spree.
On the other hand, construction workers, cement dealers, building-supply companies, and heavy-equipment operators must love the fast-paced business and full-time jobs with overtime. They love it while heavy dump trucks and cement trucks rush their loads through town.
The problem actually starts in Washington, DC, in an unremarkable building at Twentieth Street and Constitution Avenue NW that houses the Board of Governors of the Federal Reserve. The board, along with the president of the New York Fed, and a rotating selection of regional Federal Reserve Bank presidents, forms the Fed’s Open Market Committee (FOMC), which sets the policy targeting the interest rate that banks charge other banks for very short-term loans — the federal funds rate.
When the Federal Reserve’s Open Market Committee sets the target lower, it sets off a tendency for interest rates to fall across the economy. When it raises the target for the federal funds rate, interest rates tend to rise across the economy. For the last seven and a half plus years they have kept the target under a quarter of 1 percent. This type of policy has never been pursued before. This explains the ultralow rates on your savings account and home mortgage over the last several years.
It also explains the luxury-building mania. When the Federal Reserve first lowered rates, bankers who were burned by bad mortgages after the collapse of the housing bubble, along with luxury game-day condo builders, would not take the bait. Once bitten, twice shy. However, eventually low interest rates become too tempting to resist, especially as new bankers and construction companies come onto the scene.
Lower rates have several effects, including less saving and more spending. Low rates also increase stock market prices because lower rates increase the value of corporations, reduce the cost of borrowing, and induce individuals to move money from bank accounts to stock market accounts and to be more fully invested in stocks. When the policy is successful at increasing stock prices, people reduce savings further and spend more on luxury goods. Lower rates also boost borrowing and investment.
If you think that the combination of reduced savings and increased luxury spending sounds contradictory and dangerous, you are correct.
In any case, lower interest rates also tend to increase the price of land, particularly in the central business district. In contrast, higher interest rates encourage land and real estate owners to part with their properties at lower prices. Higher land prices make development deals harder to generate profits. The solution is to build more intensively and to make buildings taller. A $1 million piece of land could be made profitable by building just one story, but if that same lot is $2 million then you might have to build three stories to make it profitable. A one-story building is relatively inexpensive to build compared to a three-story building, which requires stairways, elevators, and sturdier construction techniques. However, the three-story building also produces two and a half times more rentable space.
Is it better to just build something, even if it is the wrong something? Well, even if interest rates could stay near zero forever, it would still mean we are deploying our resources incorrectly. The things we are building will not be as profitable as originally projected, and the excess capacity means that long-existing projects will also become less profitable. In other words, eventually, their economic values will be less than the amount invested in them. It will also make it more difficult to pay back the loans, especially if you reduce savings and increase your borrowing and luxury spending.
These circumstances are in no one’s long-term best interest. But apparently, eliminating the cause in Washington is currently beyond our collective ability.
During the 1960s, when Keynesian economics came to completely dominate the economics profession, there was a large influx of the so-called new economists into government service. The disastrous results included the “Keynesianization” of the economy and what is best described as an economic depression that lasted throughout the 1970s and into the early 1980s. The long economic expansion of the 1960s came to a screeching halt just as 1 and 2 World Trade Center started to impact the Manhattan skyline.
Like the 1920s and 1990s, the decade of the 1960s was a period of remarkable prosperity in the United States as measured by statistics such as GNP and the unemployment rate. In contrast, the 1950s included several periods of stagnation and mild recessions. During the 1960s the economy grew at a brisk pace, and employment and wages grew as well. America was able to fight the Cold War, the Vietnam War, the War on Poverty, and win the space race, simultaneously. The only noticeable negative effect was a mild uptick in price inflation toward the end of the decade.
According to academic economist Arthur OkunArthur Okun, The Political Economy of Prosperity (Washington, DC: Brookings Institution, 1970), p. 57. the economic expansion was the result of two primary factors. The first was scientific management of the economy by the “new economists” who were brought to Washington to help fine-tune the economy with fiscal and monetary policy — that is, Keynesian economics. The second was the new technology that was introduced in the economy — particularly computer technology, consumer electronics, and technological advances related to space exploration.
Okun was the chairman of President Nixon’s Council of Economic Advisors from 1968 to 1969. Right before the crash he described the economic expansion as “unparalleled, unprecedented, and uninterrupted.” Okun believed that the economy was on a new “dramatic departure” from the past. According to Okun:
The persistence of prosperity has been the outstanding fact of American economic history of the 1960s. The absence of recession for nearly nine years marks a discrete and dramatic departure from the traditional performance of the American economy.Ibid., p. 31.
After declaring the business cycle dead, he went on to demonstrate that research on the business cycle was now a thing of the past and that a “new” approach to the economy had replaced it. In fact, he even took the precarious step of ridiculing those who stubbornly stuck to the old economics, where business cycles were viewed as an inevitable feature of the market economy. In fact, he charged this old school with viewing recessions in a positive light for correcting past excesses, just as Dr. Pangloss, a character in Voltaire’s play Candide, preaches optimism: everything, including negative things, is for the best, and we have the best of all possible worlds. Here I believe he is referring to Austrian economists, such as Ludwig von Mises and F. A. Hayek. Okun’s “latter-day Machiavellis” probably refers to political-business-cycle theorists who at this time were political scientists:
When recessions were a regular feature of the economic environment, they were often viewed as inevitable. Indeed, the Doctor Panglosses saw them as contributors to the health of our best of all possible economies, correcting for the excesses of the boom, purging the poisons out of our productive and financial systems, and restoring vigor for new advances. And the latter-day Machiavellis saw potentially great political significance in the timing of turning points. They spun out fantasies, suggesting or suspecting — depending upon whether their party was in or out of office — that the business cycle would be controlled so that the inevitable recession would come between elections and would be replaced by a vigorous economic recovery during the campaign period.Ibid., p. 32.
Okun confidently declared that the death of the business cycle was “proof par excellence” that economic controversies can be solved. How was the business cycle killed? Okun found that the slayer was not new theories or policy tools, but simply a more confident and scientifically rigorous implementation of existing tools, which resulted in efficient scientific management of the economy — that is, Keynesian economics:
More vigorous and more consistent application of the tools of economic policy contributed to the obsolescence of the business cycle pattern and the refutation of the stagnation myths. The reformed strategy of economic policy did not rest on any new theory.Ibid., p. 37.
For Okun, the New Deal had employed fiscal stimulus, which would later be espoused by Keynesian theory.Ibid., p. 43. He believed the old canard that WWII got us out of the Great Depression. As far as he was concerned those two episodes provided evidence of the success of countercyclical fiscal policy. He also viewed the old “fiscal religion” of limiting the size of government and keeping its budget in balance as nothing more than myth and superstition. Overthrowing those fallacies of the past and embracing scientific management of the economy had allowed economists to fully apprehend and subdue the business cycle: “The activist strategy was the key that unlocked the door to sustained expansion in the 1960s.”Ibid. All remaining errors could be dealt with by fine-tuning of the activist strategy.
It was unfortunate for Okun that the publication of his book, The Political Economy of Prosperity, occurred just one month before the next economic recession began. Civilian unemployment increased from well below 4 percent to just over 6 percent by the end of 1970. The rate then retreated to 5 percent in 1973 only to skyrocket to 9 percent in mid-1975 — the highest rate since the Great Depression. The unemployment rate remained above the “natural rate” of 5 percent for the next two decades, including ten months of double-digit unemployment during 1982–83.
The experiment of the new economists also resulted in higher price inflation, as would be expected from the “stimulating” fiscal and monetary policy of the 1960s. From the beginning of 1946 to the beginning of 1965 — twenty years — the Consumer Price Index increased by 71.4 percent, but it then increased another 20 percent by the end of the 1960s. From 1965 — when the experiment began in earnest — to the end of 1980 the CPI increased by 176.6 percent. The grand experiment greatly increased the price inflation experienced by consumers.
More importantly, revolutionary changes occurred in money and banking. The US Treasury stopped issuing silver coins in 1964, and Gresham’s law ensured that Americans were soon using nothing but “clad” coins that only looked like the old silver coins. Silver-certificate notes were recalled in 1968 in exchange for Federal Reserve Notes. Then, in August 1971, Nixon initiated a “new economic policy” that closed the international gold window (where foreign central banks could still redeem dollars for gold), the last vestige of the pre-1913 classical gold standard.
The United States had printed too much money during the 1960s and had caused a “run” on the dollar by foreign central banks, which sought to cash in their dollar holdings for gold. Despite US promises to the contrary, Nixon also instituted comprehensive wage and price controls in an attempt to block the rising price inflation before his reelection campaign. The Bretton Woods system, where currencies had fixed values in terms of gold, inevitably collapsed. Thus the last links between gold and money were broken and a completely fiat monetary system was established.
The bubble of the 1960s and the subsequent collapse have been well chronicled by John Brooks in his book The Go-Go Years. The “go-go ’60s” refers to the market for technology stocks during the 1960s, when the “Nifty Fifty” emerged as a list of “one decision” stocks that could be bought and held forever. This list of stocks included Coca-Cola and IBM as well as troubled companies of the future, such as Kodak and Polaroid. Like the investment trusts of the 1920s, mutual funds were touted as the fastest path to riches for the common man. As the bubble expanded, investment gurus such as Gerald Tsai used aggressive investment techniques to generate huge increases in the value of their mutual fund shares, while others made millions building the conglomerate corporations that spanned many industries and nations.
John BrooksJohn Brooks, The Go-Go Years: The Drama and Crashing Finale of Wall Street’s Bullish 60s (New York: Allworth Press, 1973), pp. 137–39. well captured the euphoria that emanated from this new-era stock market: “As mutual-fund asset values went up, new money poured in. Tsai and others like him seemed to have invented a money-making machine for anyone with a few hundred or several thousands of dollars to invest.” He even labeled Tsai “the first big-name star of the new era.” Unfortunately, Brooks was unable to properly diagnose the cause of the mania, attributing it largely to greed and irrationality:
Where were the counsels of restraint, not to say common sense, in both Washington and on Wall Street? The answer seems to lie in the conclusion that in America, with its deeply imprinted business ethic, no inherent stabilizer, moral or practical, is sufficiently strong in and of itself to support the turning away of new business when competitors are taking it on. As a people, we would rather face chaos making potsfull of short-term money than maintain long-term order and sanity by profiting less.Ibid., p. 187.
Brooks noted that “man’s apparent capacity to learn from experience is an illusion.” Man is able to benefit from experience, but our collective ability to learn and pass knowledge on to future generations depends on our ability to formulate correct theories regarding our experiences. Like many others, Brooks seems oblivious to the usefulness of economic theory in this regard, although his analysis regarding experience and lack of a stabilizer does reflect favorably on Austrian business cycle theory.
However, Brooks is correct and quite methodical in showing the similarities between the 1920s and the 1960s. In each case there was a new era and a new way of economic thinking. Both episodes had their investment stars that fell into disgrace. In both cases there were charges of corruption and malfeasance that led, after the fact, to attempts at reform via legislation. At the heart of both eras — the vehicle of mania and deception — was technology. By the history of Wall Street, Brooks was able to show that the collapse in the stock market was actually much worse than the Dow Jones stock index indicated. Many of the best-performing stocks of the decade turned into the worst-performing stocks of the next decade, but were not in the Dow index. This spelled trouble for many investors for years to come.
An even better indicator of trouble in the stock market can be found in the fact that in May 1970, a portfolio consisting of one share of every stock listed on “the Big Board” was worth just about half of what it would have been worth at the start of 1969. The highfliers that had led the markets of 1967 and 1968 — conglomerates, computer leasers, far-out electronics companies, franchisers — were down precipitously from their peaks. Nor were they down 25 percent, like the Dow, but 80, 90, or 95 percent. This was vintage 1929 stuff, another economic depression, with all the economic pain and emotional hardship that mired both stock markets and the economy for years to come.Ibid., p. 4.
The stock market as measured by the Dow did decrease 25 percent between 1969 and 1971 and then, after the publication of Brooks’s book, lost another 20 percent by mid-1975. However, the inflation-adjusted losses in the stock market were larger and longer lasting than an ordinary price chart of the Dow might suggest. The inflation-adjusted or “real” purchasing-power measure of the Dow indicates that it lost nearly 80 percent of its peak value during this time period. When Brooks drew out the similarities between 1929 and 1969, he stopped short of declaring a second Great Depression. However, while the economic pain of the 1970s and early 1980s may not have matched the Great Depression of the 1930s, it could easily qualify as an economic depression.
The decade began with recession and the abandoning of the gold monetary system and saw the emergence of “stagflation” — that is, stagnation and inflation. It ended with the highest monthly misery index in 1980. The index is calculated by adding the inflation rate to the unemployment rate. The 1970s is not generally recognized as a depression by economists. However, it certainly was part of a twelve-year period of economic pain and uncertainty compounded by price controls, the gasoline shortages, Watergate, and defeat in the Vietnam War. It should also be noted that mainstream economists have changed the meaning or application of terms such as depression, panic, and crisis, substituting milder-sounding terms such as recession and correction.
Statistical evidence clearly demonstrates that the 1970s was a turning point in the wrong direction for the American economy. The Bretton Woods gold standard was abandoned, prices increased, and the dollar rapidly depreciated. Unemployment and underemployment increased, and they set post-WWII highs in the early 1980s. The federal government abandoned a longstanding tradition of balanced budgets for the current regime of ever-increasing deficits and a skyrocketing national debt. The personal saving rate of Americans — which had been on an increasing trend until 1971 — flattened out and began its current declining trend toward a zero savings rate.
It was the 1970s when the trade balance first destabilized, and then began the trend of escalating trade deficits. Naturally when the people are saving less and the government is borrowing more, the new loans have to come from foreigners. Going back to the 1930s, net exports of goods and services hugged the zero line. Then in the 1970s it broke below the zero line and continued to head lower. For the fifteen years leading up to 2010, the trade deficit averaged over $500 billion. The stability of the past had been replaced with the instability and erosion that fiat paper money inevitably brings.
Another crucial factor is the impact of the monetary regime on income distribution, one of the most glaring issues of our times. Money is one important factor that is largely ignored by those both on the political left and the political right. It is also largely ignored by mainstream economists, such as Thomas Piketty (2014).Thomas Piketty, Capital in the Twenty-First Century (Cambridge, MA: Harvard University Press, 2014). However, the choice of monetary system and monetary policy does have predictable and historically validated effects on economic inequality.
A monetary system that is dominated by a central bank, such as the Federal Reserve, and uses fiat money, as in our current monetary system, can expect to benefit certain people, such as bankers, financiers, and people with debt. Likewise, because such a system is inflationary, it tends to hurt wage workers and savers. Such a system can be expected to hurt the lower- and middle-income classes and enrich those in the financial industry and the upper-income class.
A gold standard has historically had a tendency for prices to be stable or slightly deflationary. This means that wage rates, cash balances, savings, and bonds tend to gain purchasing power over time. This type of monetary system rewards the hard-working and frugal classes, which leads to an expansion of the middle-income class and the economy.
This graph from the Pew Research Center provides enticing evidence of the differential impact of gold versus fiat paper money.
The graph shows that economic inequality declined in the United States from 1917 to the early 1970s, when Nixon took the United States off of the Bretton Woods gold standard. The darker shaded areas of the graph represent the 99 percent, while the light area at the top represents the percentage of total income of the upper 1 percent. Economic inequality increased during the inflationary 1920s, but the lower-income classes rapidly improved versus the 1 percent when the gold standard was restored after WWII. The graph shows both marginal improvement and stability in economic inequality from the late 1940s to the early 1970s. Since going off the gold standard in 1971 the trend has been for much greater economic inequality.
All of these problems were not due to the laziness of the American people. Females moved into the workforce in record numbers, and the two-income family was established, mostly to try to maintain standards of living. Unfortunately, the 1960s and 1970s were two decades when government employment expanded the most, so that much of this increased labor effort produced little of value. Working for government can even be a net negative for the economy in the sense that government employees can do actual harm to the production of useful goods and services. The “new economists” in the service of the state are a good example of that.
Mises wrote this book for the ages, and it remains the most spirited, thorough, and scientifically rigorous treatise on money to ever appear. It made Mises's reputation across Europe and established him as the most important economist of his age.
Narrated by Jim Vann. The full text is available online here.
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Quarterly Journal of Austrian Economics 20, no. 2 (Summer 2017)The International Monetary System and the Theory of Monetary Systemsby Pascal SalinEdward Elgar, 2016
The present volume is an accomplished theoretical inquiry into the workings of the international monetary system. As the author himself explains in the introduction, the book is intended to provide readers with a good understanding of the economic principles and economic problems of international monetary economics, while drawing on sound general economic theory. Salin fully succeeds in painting a clear and concise picture of the current issues in international monetary relations, and of the theoretical discussions and proposed solutions surrounding them.
Adopting an almost exclusively theoretical point of view, Salin guides his readers in textbook-like fashion through the intricate core propositions of international monetary economics. The first two parts of the book discuss the basic statements and analyses in the field, such as the theory of exchange, the demand for money, the exchange rate, and the fundamental principles of balance of payments analysis. Part III delves into the issue of international monetary equilibrium, touching on the concepts of inflation and devaluation, the formation of international prices, and a range of exchange rate systems including fixed and flexible exchange rates. In Part IV, Salin concludes his investigations with a brief analysis of monetary policy, monetary crises, and monetary integration.
From the beginning, the building blocks of Salin’s arguments are excellently set up, and together they form an almost self-contained and complete system of thinking about monetary problems. But the strength of the book comes primarily from the fact that this system is grounded in general economic theory. While particular discussions are specialized, and thus somewhat narrow, the overall volume adds to the big picture of the workings of monetary macroeconomics, with a solid foundation in microeconomic theory. Each chapter neatly draws a conclusion on which Salin builds further arguments, but which also constitutes a valuable lesson in itself. Eventually, his analyses lead up to a refreshing overarching remark: “a surprising paradox in monetary theory: people debate about the best monetary policy, although the best solution would be not to have any monetary policy. This was the case in a pure gold standard (that is, without central banks)” (p. 245).
In relation to this welcome insight, three of the valuable lessons that Salin’s short volume offers warrant particular attention. In each case, the author sews up a competent critique of the widespread misunderstandings that surround these issues in modern literature.
First, Salin completes the discussion in Part II with a pointed analysis of the balance-of-payments—or external equilibrium—policies. He shows that such policies are “doomed to failure because [they are] based on an a priori and arbitrary definition of equilibrium and disequilibrium” (p. 100) with regard to individual cash-balance decisions. In consequence, he argues, attempting to equilibrate balance of payments accounts often leads to disequilibrium in the market, “since it is forbidding individuals to allocate their resources over time in a way which would be optimal for them” (p. 100). With regards to the disputed relationship between the balance of payments and the exchange rate, Salin also correctly points out that, contrary to popular belief, “the exchange rate is not the price of the balance of the trade balance, which would obviously be meaningless… [and since] a deficit is not a symptom of disequilibrium, it therefore has no reason to cause a change in the exchange rate” (p. 102).
Second, Salin devotes an entire chapter (chapter 12) to a detailed explanation of why inflation is a monetary phenomenon (pp. 112–118), in the case of a closed economy, as well as in an international setting with imported inflation. This discussion is not only relevant on its own, but ends up excellently supporting Salin’s subsequent analysis of the international transmission of money creation across national borders in varying currency and exchange rate regimes (ch. 16, pp. 137–149) and its congeneric impact on international monetary equilibrium (ch. 17, pp. 150–163). Third, the same chapter contains an almost taboo opinion in monetary economics, i.e. that deflation is not only unproblematic, but actually beneficial (pp. 118–119). Salin returns to this point throughout the book (pp. 41–42; 157–158; 226), reiterating the idea that “contrary to widely held ideas, deflation is preferable to inflation.”
Other similarly discerning analyses are found throughout, and towards the end of the volume, Salin offers some highly quotable turns of phrase: for example, in discussing monetary integration in Europe, he argues that “the euro is the outcome of an approach which mixes monetary nationalism, politicization of money, substitution of pseudo-independence to an external control by competition, and the use of a compulsory and constructivist process instead of a spontaneous one” (p. 241).
It should come as no surprise that this volume resonates with classical and Misesian monetary theory, and is often at odds with the great majority of modern monetary models and their conclusions. And yet, Salin’s system of monetary analysis does contain a few idiosyncrasies. Some are due to the author using his own terminology in perhaps unnecessary situations, such as substituting ‘coercion’ for ‘government intervention,’ or introducing ‘hierarchy’ in discussions of money creation (p. 102) to refer to the existence of a central bank.
Other idiosyncrasies, of greater weight, are I believe remnants of the author’s familiarity with mainstream economic analysis. One such instance is the chapter on the demand for money, which contains a discussion of the roles of money and the definition of money. Divergent views between monetary schools of thought originate from these aspects: modern analyses effectively downplay the function of money as a medium of exchange in relation to its role as a store of value or unit of account when constructing models based on a barter economy in which a numéraire is later introduced. Mises (1953, pp. 30–37), however, considered the two latter roles of money as secondary functions which can only derive from a currency’s primary function as medium of exchange, and often drew attention to the dangers of the “barter fiction” (Mises, 1998 [1949], p. 202), as he called it, for sound economic analysis.
Salin, however, is rather unconventional in his approach: while espousing the importance of money functions, he avoids differentiating between the role of money as medium of exchange and that of store of value over time. Historically, he argues, “it is likely that these roles have emerged gradually and more or less simultaneously, so that it is not possible to consider that one clearly preceded the other” (p. 30); and he suggests that theoretically, “the role of a standard of value [numéraire] is not necessary for a good to be considered currency, unlike the other two roles” (p. 30). However, this discussion is followed by a rather confusing account of how money, if introduced as only numéraire, would leave relative prices unchanged compared to a state of barter. Salin does not specify though whether this is a useful abstract exercise, or rather a fictitious assumption contrary to economic reality.
Later in the volume, this precarious analysis seems to taint the discussion on real growth and monetary growth under fixed exchange rates, for which Salin uses the example of communicating vessels (p. 162). This hydraulic view of balance-of-payments adjustment—often seen in business cycle theories as well—disregards the Cantillon effects of monetary inflation responsible for the gradual and irreversible changes in prices and wealth distribution that money creation inevitably produces in a closed or open economy. More to the point, such a view actually contradicts Salin’s overall monetary analysis in terms of individual cash-balance decisions. At best, the author’s views on these points are confusing and thus easily misunderstood; at worst, they detract from the otherwise strong case he makes against monetary and balance-of-payments policies.
These issues notwithstanding, this little volume is overall a pleasure to read. Fluent in the language of modern monetary economics, Salin makes ample use of equations and graphs in a pertinent and user-friendly way: coupled with clear and concise explanations, these mathematical elements usually provide rigor and structure to the analysis. While they may not be indispensable, they do enhance some of the arguments, and are carefully weighed not to hinder the overall flow of the narrative. Some readers may also find that Salin’s sole focus on monetary theory has perhaps deprived some of the discussions of their historical color—in particular Chapter 20, which analyzes the long-term evolution of monetary systems. Joseph Salerno’s collection of monetary essays (2010), which focuses on the history of monetary systems, the development of monetary and balance-of-payments policies, and the history of monetary thought, can be a welcome companion to Salin’s volume.
In conclusion, The International Monetary System and the Theory of Monetary Systems is replete with well-grounded arguments and thought-provoking insights. It is thus both a useful and distinctive resource for economics scholars and students, and an intellectually compelling journey into the principles of domestically sound currencies, and into how to build sound international monetary systems.
Carmen Elena Dorobăţ, Ph.D. is Assistant Professor (Lecturer) in Business at Leeds Trinity University, U.K.
Quarterly Journal of Austrian Economics 20, no. 2 (Summer 2017)ABSTRACT: This paper deals with the relationship between deflation and economic growth. Although there are numerous theories on the potential effects of deflation on real output, empirical evidence in this field is still incomplete. In order to explore the relationship between prices and output in a more comprehensive way, I use a large panel data set of 20 countries over roughly 150 years, which contains frequent deflationary episodes. Since mainstream macroeconomists often refer to alleged bad historical experience with deflation, I employ an econometric model to examine both contemporaneous and lagged correlation between prices and output. There are two important results. First, there is no general relationship between price growth and output growth. Coefficient estimates have very small magnitude in both the whole sample and in different monetary regimes. Second, well-known episodes of deflation differ a lot. The Great Depression is the only period where deflation seems to be strongly associated with recession. By contrast, Japan in the 1990s and 2000s bears no resemblance to it. Here, both empirically and theoretically, deflation is highly unlikely to have caused economic stagnation.
KEYWORDS: deflation, price level, economic growth, monetary systems, panel data, economic historyJEL CLASSIFICATION: E31, E42, C33, N10
The devaluationary spiral of the peso began with the fall in oil prices in mid-2014. At the time, the depreciation was easy to explain in terms of the deterioration of the balance of trade. With Mexico being a net oil-exporting country, the fall of oil prices meant a fall in the country’s foreign currency revenue. This situation explains the depreciation of the peso of mid-2014 and all of 2015.
In 2016 the situation gets complicatedThe victory of the Brexit referendum in June 2016 deteriorated expectations of the Mexican economy’s performance, lowering the price of the peso against the dollar.
Things got worse for the Mexican peso in November 2016, when Donald trump was elected as President of the United States. At the time, the pessimism that took hold of investors and speculation lead to a depreciated Mexican peso. As we explained in another article, the peso depreciated 14% in only three days after Trump’s victory.
Banxico reacted without success…With this scenario, the Bank of Mexico (Banxico) begun a series of efforts to try to defend the peso by raising the benchmark interest rate in 2016. The following graph shows the price of the peso against the dollar on the left axis; on the right it shows the reference interest rate of Banxico. Banxico practically doubled its reference rate between July 2016 and July 2017.
Graph 1:
Source: BanxicoTwo factors helping the peso in 2017In 2017, things seem to be different for the Mexican peso. Between January and July of 2017, the peso appreciated on average 17% against the dollar. What are the reasons for this behavior? There are at least two.
1.The pessimism caused by Trumps victory has considerably decreasedIf in November 2016, investors were nervous after Trumps victory: they anticipated an attack on NAFTA that would harm the Mexican market. On Wednesday, August 16 Canada, the US, and Mexico started renegotiating NAFTA.
Although there is much expectation for the results, most recognize that Mexico could gain from a NAFTA renegotiation. When the agreement was signed more than 20 years ago, the energy sector was controlled by the government. Since the energy reform by Peña Nieto, there have been proposals to integrate the energy market between the three countries.
This has reassured investors, and it is reflected in the peso’s price. Perhaps the speculative alarms launched the peso away from its “fundamental value” and today the markets reflect it with the peso’s appreciation
2.A weaker dollarIn 2017, the US dollar has weakened against other currencies. There was talk that the dollar traded at its lowest level against the euro in two years. However, the Bloomberg dollar spot index is a better indicator, since it compares the dollar against a basket of the world’s top ten most important currencies. Each currency in the basket and its weight are determined annually based on its share in international trade and its liquidity.
Graph 2:
In the graph we see how the dollar strengthened at the end of 2016, just after Trump’s victory and in subsequent months. When Trump announced major tax cuts, the optimist environment was reflected in a strong dollar. But the Republican’s failed attempt to dismantle the Affordable Care Act make a tax cut less likely.
What about Banxico’s efforts?We could debate whether or not the Mexican central bank has been a decisive factor in the recovery of the exchange rate. In general, as seen in graph 1, we see that Banxico’s efforts were considerable in terms of the increase in reference rates. However, even though interest rates increased, the peso continued its trend to depreciate.
It is also not a Banxico mandate to have a determined exchange rate. Banxico had in mind its inflation target, which for now should be its concern as we mentioned in our last quarterly report. At least we can say that Banxico protected itself and resisted an attack that seems to have ended for the moment.
Originally published by UFM Market Trends the Universidad Francisco Marroquin.
Quarterly Journal of Austrian Economics 16, no. 2 (2013)[This is the 2013 F.A.Hayek Memorial Lecture presented at the Austrian Economics Research Conference, March 22, 2013.]
This article has a twofold purpose. Its first goal is to pay tribute to Friedrich von Hayek as an outstanding monetary theorist. Its second objective is to further elaborate, on the ground of Hayek’s main findings, the deficiencies of the contemporary monetary order, namely by presenting the phenomenon of monetary imperialism. Against this background, the article also contains a re-interpretation of present-day monetary institutions and a critique of internationally sponsored economic stabilization policies.
The first section offers a presentation of Hayek’s early monetary thought, especially in the policy area of monetary nationalism. This presentation, even though a due tribute to Hayek, is delivered in full awareness of the fact that Hayek is not the Austrian economist par excellence. Indeed, a number of scholarly articles have demonstrated that, with respect to a few critical issues, Hayek’s economic and social thought is not fully reconcilable, not to say contradictory, with the praxeological methodSee in particular Salerno (1993), Block and Garshina (1996) and Hoppe (1996), as well as Stalebrink (2004). or libertarian ethics.Hoppe (1994) and de Jasay (1996). The second section expands Hayek’s approach to monetary phenomena in order to show how monetary nationalism leads to monetary imperialism. In that respect, a special emphasis is put on the political nature of multiple paper monies and on the fractional reserve banking principle. Finally, within this analytical context, the third section appraises the recent increase in cooperation between governments, as observed since the policy response to the banking and public finance crises in Europe.
THE IMPERFECTIONS OF THE CONTEMPORARY MONETARY SYSTEMIn a series of five lectures delivered in 1937, and published under the title Monetary Nationalism and International Stability, Hayek offers an in-depth analysis of the main deficiencies of the present-day monetary system. In a nutshell, he identifies two factors that disrupt international economic relations: the fractional reserve commercial banks and the national central banks. The former are the primary source for the international transmission of the business cycles, while the attempts of the latter to correct the imbalances de facto amplify the resulting instability.
THE FRACTIONAL RESERVE AND THE SWINGS IN THE MONEY SUPPLYThe instability generated by the fractional reserve banking system, or a banking system working on the proportional reserve principle as Hayek puts it, is rooted in the fact that a relative change in the demand for the different types of media of exchange results in a nominal change in the aggregate supply of money.Hayek does not present an elaborate classification of the monetary objects into money proper (or money in the narrow sense) and money substitutes, i.e., claims on money proper, such as the one that Mises elaborates in his Theory of Money and Credit (Mises, 1953 [1924], pp. 50–59). Nevertheless, it is clear from his exposition of the problem that these are the categories in which he develops his analysis. For instance, a decline in the aggregate demand for cash is followed by an increase in the supply of bank credit and bank-created fiduciary media. Indeed, because banks keep fractional reserves only, the lower demand to hold cash, even though it is offset by an equally higher demand to hold deposits, creates extra liquidity for the banks. This extra liquidity serves then as a foundation for a bank credit expansion that is much larger in size. In Hayek’s own words “the most pernicious feature of our present system” is that “a movement towards more liquid types of money causes an actual decrease in the total supply of money and vice versa” (Hayek, 1989 [1937], p. 82).This is a point from which Hayek would not divert in his later writings: “The special difficulties caused by the fact that under existing arrangements the reduction of the distinct cash basis of one country requires a contraction of the whole separate superstructure of credit erected on it would no longer exist [under his proposal of competitive paper monies]” (Hayek, 1990 [1976], p. 103).
Hayek’s chief interest lies in the implications of the fractional reserve principle for the process of economic adjustment to relative changes in international demand. At the international level, the “pernicious feature” implies that gold movements between countries lead to a contraction of bank credit and the overall money in the gold-exporting country, while credit and money expand in the gold-importing country. Hayek emphasizes that under a purely metallic currency, i.e., under a 100 percent commodity standard, there is no systematic relation between an outflow of money and the level of interest rates. However, the situation changes in that mixed metallic standard where banking is organized along national lines according to the principle of national proportional reserves. The outflow of money, because it contracts credit at home and expands credit abroad, does imply an increase of the domestic interest rate beyond its natural level and a decline in the interest rate abroad (ibid., pp. 17, 28). Interest rates become disconnected from the social time preference and propagate malinvestments.
On the grounds of this central finding, Hayek concludes that a crucial ingredient for international monetary stability is to reform banking in line with the 100 percent reserve principle. As a consequence, the solution to current monetary problems is rooted in a far-reaching reform of the banking sector itself: “It seems to follow from all this that the problem with which we are concerned is not so much a problem of currency reform in the narrower sense as a problem of banking reform in general” (ibid., p. 80). In addition to his explicit support for the 100 percent reserve banking, Hayek elaborates an acute critique of a national monetary policy that would aim at correcting the imbalances in the banking sector.
CENTRAL BANKING, THE ECONOMIC CYCLE AND MORAL HAZARDHayek’s critique of central bank monetary policies debunks the alleged benefits of what he calls monetary nationalism, namely the doctrine according to which the aggregate money supply on the territory of the nation should not be determined in line with the market forces that govern the flows of money among the different regions of that same nation (ibid., p. 4). Put simply, this corresponds to the case of independent national currencies, which are produced under the privileged control of inter-independent central banks. Under such a system, the adjustment process to relative changes in international demand is meant to take place by means of relative changes in the currency values, not through actual money transfers. Hayek demonstrates that such a purely monetary adjustment, far from bringing about the necessary real changes, introduces new disturbing factors.
Changes in the currency exchange rates put in motion a redistribution of income among all industries, including those for which demand has not changed. This redistribution is not sustainable, in the sense that it is inconsistent with the new consumer preferences. Imagine that the international demand is shifting away from some national sector. Under a homogeneous monetary standard, the redirection of the monetary flows brings in itself a change in relative income and profits which then redirect the factors of production so that the new production structure is consistent with the new demand structure. This natural equilibrating force is not available in the case of multiple and independent paper currencies. Here, the uniform depreciation of the currency does not bring about the required change in relative prices, which alone would reflect the new demand structure. Rather, it creates a generally inflationary environment, in which the adjustment process comes about by an increase in the prices and incomes in all other sectors. Hayek emphasizes that “the final positions will not be the same as that which would have been reached if exchanges had been kept fixed; because in the course of the different process of transition all sorts of individual profits and losses will have been made which will affect that final position” (ibid., p. 40).
The inflationary impact of the depreciation brings about a purely monetary, i.e., ultimately self-reversing, disturbance because it brings about a temporary boom in some sectors. The boom, however, is clearly unsustainable as the eventual rise in costs will reveal that there are no real funds to finance the expansion of the production (ibid., p. 41). Hayek does not detail, in these essays, the operation of the trade cycle. Nevertheless, he makes it clear that the inflationary policy of the central bank leads to investment decisions that ultimately will have to be reversed. Whatever its other alleged benefits, monetary nationalism will always disturb the economy because of the boom-bust cycle that it generates.
Hayek also adamantly explains the fallacy behind that other most celebrated benefit of inflation, namely to allow economic adjustment in the event of rigid wages, or alternatively to avoid the need for painful cuts in nominal wages. Nowadays, this is still an often referred-to argument in favor of recovering competitiveness by means of an external devaluation, when internal devaluation is considered politically unacceptable or simply impracticable. Here again, Hayek emphasizes that inflation is in no way a substitute for the natural decline in the wage of that specific type of labor which faces a negative demand shock relative to all other types of labor. It merely brings about a generalized decline in all real wages, which cannot restore equilibrium in the relative cost structure. Moreover, the decline in real wages might be expected to be short-lived, as wage earners will be quick to learn the negative impact of inflation on their real incomes and will require an adjustment. In anticipation of the rational expectations doctrine, Hayek clearly states that it will soon prove illusory that it is easier to depreciate wages by creating inflation rather than to allow specific nominal wages to go down:
But of one thing we can probably be pretty certain: that the working class would not be slow to learn that an engineered rise of prices is no less a reduction of wages than a deliberate cut of money wages, and that in consequence the belief that it is easier to reduce by the round-about method of depreciation the wages of all workers in a country than directly to reduce the money wages of those who are affected by a given change, will soon prove illusory (ibid., p. 53).
Furthermore, Hayek argues convincingly that a system of independent central banks suffers from a built-in inflationary bias. First, if the central bank adopts the policy to stabilize the national revenue, group pressures will prevent it from engineering a deflation when a deflation would be needed in order to offset an increase in the international demand for the products of some industries. For all practical purposes, a stabilization policy would be followed in one direction only, and most notably in the countries where prices tend to fall lowest relatively to the rest of the world. In this sense, “The possibilities of inflation which this offers if the world is split up into a sufficient number of very small separate currency areas seem indeed very considerable” (ibid., p. 43). Second, Hayek points out that, whatever the specific policy the central bank chooses to follow, it will always act as a lender of last resort. This empowers it to provide all the money that would be needed by banks in the event of a bank run. In full knowledge of this, commercial banks lend less prudently and expand their balance sheets beyond natural limits. In a sense, central banks lose the full control of the money supply and are bound to accommodate an inflationary boom started by the banks.This is another point that the later Hayek would reiterate:The ultimate victory of the advocates of the centralisation of the national note issue was, however, in effect softened by a concession to those who were mainly interested in the banks being able to provide cheap credit. It consisted in the acknowledgment of a duty of the privileged bank of issue to supply the commercial banks with any notes they needed in order to redeem their demand deposits—rapidly growing in importance. This decision, or rather recognition of a practice into which central banks had drifted, produced a most unfortunate hybrid system in which responsibility for the total quantity of money was divided in a fatal manner so that nobody was in a position to control it effectively (Hayek, 1990 [1976], p. 91). Hayek identifies the control of the money supply as “the fundamental dilemma of all central banking policy,” and stresses that the only means to restrain banks’ credit expansion would be to credibly commit not to act as a lender of last resort. Such a commitment, however, would be contradictory with the very idea of independent national currencies and central banks (ibid., p. 13).
Thus, Hayek’s early monetary thought reached two main conclusions. First, a system of multiple national central banks, which act as lenders of last resort for the domestic financial systems, is inherently inflationary. Second, such a system is marked by a high degree of economic instability, as the generalized inflation prevents the necessary real adjustments and introduces monetary disturbances which culminate in the business cycle.Quite consistently, Hayek’s ideal monetary system would be based on a single international currency with banks holding 100 percent reserves. Most notably, Hayek considers an international paper standard to be preferable, as it would avoid the cost of diverting a useful commodity from its other possible uses. He sees the international gold standard as a second best to the international paper standard. However, he recognizes that such a second best is still preferable in a world that is fragmented politically and “so long as an effective international monetary authority remains an utopian dream” (ibid., p. 93). This bias for an international paper standard should be seen as contradictory to some extent, as Hayek himself points out how critical the management of monetary institutions is for a successful implementation of the rule they are meant to implement: “Whatever the permanent arrangements in monetary policy, the spirit in which the existing institutions are administered is at least as important as these institutions themselves” (ibid., p. xii). What is then the guarantee that in a politically unified world, the single monetary authority will be indeed effectively immunized against inflationary temptations? To Hayek’s credit, he clearly sees that political unification is a pre-condition to establishing a world paper money (ibid., p. 75). Some forty years later, and still in the absence of political unification, he would offer an alternative proposal for monetary reform, based on repealing legal tender laws and on effective rivalry between privately-issued paper monies (Hayek, 1990 [1976]). Let me develop Hayek’s first conclusion by further exploring the immanent tendencies of a system of multiple central banks.While it is not the goal of this article to show the differences between the young Hayek and the later Hayek, let us emphasize here that Hayek’s later monetary analysis is entirely rooted in a specific and erroneous view of the monetary equilibrium that could be qualified as the “nominal monetary equilibrium approach.” This approach implies a need for elasticity of the money supply, so that changes in the (nominal) demand for money do net remain unsatisfied, and thereby a source of disturbances. Within this approach, notions such as “the optimal quantity of money” (Hayek, 1990 [1976], p. 81) and “the needs of the trade” (ibid., p. 89) make sense. It is this view of the monetary equilibrium, which makes Hayek a defender of rival paper monies, and an opponent of a commodity (and in particular gold) standard. Indeed, under the assumption that the nominal supply of money should adapt to the demand for money, a growing economy would need a growing money supply, that a commodity standard might not be able to accommodate. Hence, the stunning conclusion: “There just is not enough gold about” (ibid., p. 110). Hayek’s fatal error consists in ignoring that the demand for money is really a demand for real cash balances. This means that, with respect to the very fundamental monetary analysis, Hayek has gone in a direction that is the very opposite of the Mises-Rothbard approach.
MULTIPLE MONEY PRODUCERS AND THE DRIVE TOWARDS MONETARY IMPERIALISMHayek offers a sophisticated analysis of the economic consequences of the doctrine and policy of monetary nationalism. But he does not show much interest in an investigation of the very nature of independent central banks. Such an essentialist study would be a needed complement to his analysis and would put existing and emerging monetary institutions in a new perspective.
THE POLITICAL NATURE OF PAPER MONIESThe distinctive feature of modern central banks is their political and privileged position within the economy. Indeed, the very framework in which paper monies are produced and introduced into circulation is fundamentally different from that of commodity monies. Commodity monies, which evolve out of direct voluntary exchanges, are subject to the rules of both horizontal and vertical competition. On the one hand, different commodities can be competing for fulfilling simultaneously the function of a medium of exchange. Additionally, various producers of the same commodity can be competing for offering certification services with regards to the specific monetary objects. On the other hand, and much more importantly, the producers of any of the commodities which serve as media of exchange must compete, in the context of generalized scarcity, with the producers of any other good. This implies that on the market an expansion of the money supply is costly, as factors of production must be bid up from other sectors. Thus, the price mechanism, through its influence on the expected relative profitability of any business venture, naturally regulates the quantity of money in the economy.
This natural regulation of the production and purchasing power of commodity monies also ensures that the entrepreneurs who venture into supplying media of exchange do not benefit from a privileged position. Their income and wealth are positively affected if the demand for money relative to other commodities, including other media of exchange, rises; inversely, a negative income effect occurs if competition intensifies or demand declines. Competitive money producers must cope with the uncertainty related to the management of private property, and could occasionally be driven out of business, exactly as any other capitalist entrepreneurs. Most significantly, the fact that they supply the economy with a medium of exchange does not confer on them any special status that would allow them to claim more of the aggregate output of the economy than what they earn on the market, i.e., what other property owners transfer voluntarily to them through free and mutually beneficial exchanges.
Things are altogether different with paper monies. To begin with, it should be emphasized that the acceptability of paper monies in the daily exchanges is rooted exclusively in the government’s fiat. Given that they have no non-monetary utility, and therefore no alternative source of valuation, the foundation for ever agreeing to hold paper monies comes from the legal certainty that any attempted rejection will be defeated by fiat intervention. Paper monies owe their existence entirely to legal tender regulations, enforced by coercive states. This conclusion is important as it underlines that states and paper monies share a common essential feature, namely their coercive nature. In a sense, states and paper monies are consubstantial.For further developments on the inter-linkages between states and money production, see Hoppe (1990).
One implication of this political nature of paper monies is that their production and supply escape the discipline imposed by the market. Competition-driven cost considerations and consumer-determined return expectations are absent from the calculus of paper money producers. Indeed, the costs of producing one or ten units of a given paper money are all identical, which implies that the marginal cost of increasing the money supply is zero. This grants a very special privilege to any paper money producer—namely, the capacity to acquire for free goods and services already produced by others. A paper money producer could “consume without producing, and thus seize the output of the economy from the genuine producers” (Rothbard 1991 [1962], p. 23).Interestingly enough, the later Hayek seems to be in agreement with Rothbard: “But it is really a crime like theft to enable some people to buy more than they have earned by more than the amount which other people have at the same time foregone to claim. When committed by a monopolistic issuer of money, and especially by government, it is however a very lucrative crime which is generally tolerated and remains unpunished because its consequences are not understood” (Hayek, 1990 [1976], p. 105; our emphasis). Notice, however, that Hayek would attribute the quality of crime to the monopolistic and legally protected nature of the government-issued paper money, as he sees no contradiction in the very notion of competitive private paper monies: “Voluntarily accepted paper money therefore ought not to suffer from the evil reputation governments have given paper money” (ibid., p. 111). The supplier of paper money is then involved in nothing else but a special kind of exploitation, which could be labeled monetary exploitation, to be distinguished from exploitation by means of taxation or direct regulation of the economic activity. It is now understandable why paper money production is always legalized, protected, and de facto controlled by the states, which do not admit of any rivalry in the exercise of their local monopoly of expropriation.
LIMITS ON PAPER MONEY PRODUCTION AND MONETARY IMPERIALISMGiven the lack of any natural, i.e. market-driven, check on the quantity of paper monies produced, the question of the limits on their supply is of particular interest. As a matter of fact, this is a problem with which money producers themselves have been confronted—how should monetary policy be conducted? Much, if not all, of the mainstream monetary research of the past century can be seen as an attempt to provide an answer to that apparently simply question. However, the large variety of mainstream practical advice has left untouched the core of the problem.
The problem itself is not a trivial one, especially in the light of not infrequent cases of hyperinflation. A hyperinflation develops when expectations for a continual loss of purchasing power lead to a significant drop in the demand to hold money.For a recent case study of this phenomenon, see Coomer and Gstraunthaler (2011). Such expectations arise when monetary prices have been increasing already for a significant timespan, which in itself is the result of major increases in the money supply. The typical central bank response is to further increase the money supply, in order to address an alleged shortage of money; this only feeds the inflationary expectations. The end-result of this vicious circle is a galloping increase in prices and a deteriorating capacity for money to intermediate exchanges. Money users might then turn spontaneously to an alternative medium of exchange, produced either by the market, or by another central bank. From the outset, this would suggest that a paper money producer faces no strict quantitative limit, save for the extreme risk of eviction by a foreign rival. However, this risk is crucial from the point of view of the state, as it implies a significant loss in its exploitation capability. It also highlights an important limiting factor, namely the very existence of, and rivalry between, other paper money producers.
The extreme case of hyperinflation also makes it clear that a paper money producer, despite all legal tender legislation, ultimately relies on the individuals’ consent to continue to accept its product. This consent, which must be renewed time and again, is always relative to the quality of services rendered by rival monies. Indeed, any state which alone intensifies monetary exploitation faces either a gradual depreciation or a sudden devaluation of its currency relative to foreign currencies.The foreign exchange regime, fundamentally, matters little. Under flexible exchange rates, the depreciation is gradual, though not necessarily immediate. Under a fixed exchange rate, a point in time comes when the central bank cannot any longer support the peg, in which case the depreciation (devaluation) is sudden. This very fact limits its capacity to further increase the money supply through two channels. First, the loss of purchasing power means that a stronger increase in the supply of money would be needed in order to yield the same expropriation effect. Second, the public consent is endangered, which could lead to a further depreciation of the currency.
It is clear that the obstacle confronting a single state wishing to expand its monetary exploitation is the very existence of multiple paper money producers. The solution to this conflict situation is to deprive rivals of their capacity to act independently. This not only helps the state to increase monetary exploitation internally; it also allows it to grow externally and to enlarge the territory that it dominates. This tendency to expand monetary exploitation above the internal limits and beyond the current political boundaries is best characterized as monetary imperialism.This concept has been introduced to Austrian analysis by Hoppe (2003). However, it was coined some thirty years ago in Michael Hudson (2003 [1972]). Indeed, the conflict situation persists and the tendency to expand does not vanish so long as the last rival has not been deprived of the independent control of its money supply. Monetary imperialism is in the very nature of paper monies and can be seen as a specific expression of the general conflict between rival states, in particular with regards to money production.
As long as there are multiple paper money producers, the policy of monetary imperialism could not be avoided. Moreover, its expansion is guaranteed by the fractional reserve banking itself. Because they are regularly weakened by the bust phase of the economic cycles they themselves create, the inherently bankrupt fractional reserve banks regularly drag the domestic state into bailing them out, thereby significantly endangering its financial condition and capacity to act independently. It follows that at any given moment, some paper money producers are weaker than others. According to a generalized progression theorem, political centralization and ultimate unification is in the interest of both the financially strong and the financially weak political entities (Hülsmann, 1997). Hence, the same weaknesses of fractional reserve banks that bring national central banks into existence also make sure that the centralization process is fully completed internationally. Commercial bankers might even actively promote submission to a stronger foreign paper money producer, given that they critically depend on the reliability of a lender of last resort.
We could distinguish two general forms of monetary imperialism: unification and cooperation. Unification results in the effective reduction of the number of paper money producers. Monetary cooperation is a less intuitive and more subtle case of imperialism, as the number of paper money producers is not reduced, even though they act as one for all relevant purposes. This broad classification offers a reinterpretation of the present-day monetary arrangements.
PRESENT-DAY MONETARY INSTITUTIONS IN THE LIGHT OF MONETARY IMPERIALISMThree distinct institutions bring about monetary unification, in which case the dominant central bank expands the territory on which it controls the money supply: dollarization, currency boards and monetary unions.
Dollarization occurs in cases of hyperinflation when people spontaneously quit the domestic money and begin using a foreign paper money of better quality. The domestic money producer is evicted, while the foreign central bank gains an extension to its territorial monopoly. Cases of official dollarization have also occurred recently. An official agreement allows the otherwise evicted central bank to keep some form of existence, and maybe even to get back a portion of the seigniorage it used to earn. The most prominent current examples of dollarization include Ecuador, El Salvador, East Timor, Uruguay, Nicaragua, Kosovo, Montenegro, and most recently Zimbabwe.
The currency board addresses the issue of sharing seigniorage by design. The set-up of a currency board always proceeds from an official agreement, by virtue of which the domestic central bank declares that it will produce cash banknotes and replenish domestic banks’ accounts exclusively in exchange of the foreign “reserve” currency according to a pre-fixed conversion rate. From an economic point of view, the domestic currency is no longer money per se, but a simple money substitute redeemable in the foreign money. Hence, a currency board effectively transfers the monopoly of money production to the foreign central bank. Its own specificity lies in the fact that the evicted central bank keeps its physical existence, while its economic nature is transformed from a money producer into a deposit bank. Real-world examples of currency boards, such as those in Hong Kong, Lithuania, Estonia and Bulgaria, have all operated on the fractional reserve principle. This means that only a small portion of the foreign currency received has been effectively kept in reserves as such; the vast majority has always been invested in interest-yielding securities denominated in the foreign currency. The yield on these securities has functioned as a partial compensation for the lost seigniorage that the currency board used to earn as money producer, and explains why a central bank might prefer transforming itself into a currency board rather than accepting a spontaneousFor an Austrian interpretation of currency boards, see Gertchev (2002). dollarization.
The third form of monetary unification, namely the set-up of a monetary union, is not much different in essence. Should the single money of the union be already produced by one of the member states, then the union is tantamount to official simultaneous and multiple dollarizations. If a new paper money is introduced, then the set-up of the union must undergo an initial stage where the member states peg their currencies to the new money, to be issued by a new central bank. In a sense, the new paper money, which lacks a history of prices, must be born as a money substitute, initially produced by a de facto currency board. The next stage consists in interchanging the nature of the monetary objects, whereby the money substitute becomes money and vice versa. In the final stage, the money substitutes, i.e., the previous paper monies, disappear physically. The different stages of the European Monetary Union, until the eventual physical introduction of the euro in January 2002, perfectly fit into this sequence. Currently, both the East African Community and the Gulf Cooperation Council countries are contemplating completing their plans for establishing currency unions.The French Franc Zone, which combines a large number of countries from Central and Western Africa, and as many as four different currencies, might also mistakenly be taken for a monetary union. After the euro replaced the French franc, the peg is now to the euro. However, the so-called “monetary institutes” in the four geopolitical areas of the Zone must hold their reserves in French government bills, these holdings being administered by the Banque de France. Hence, the French Franc Zone consists of four currency boards.
Because the monetary union reduces the number of rival paper money producers, it diminishes the limit on monetary exploitation and contributes to global inflation. The expected end result is higher inflation than otherwise and strengthening of the tendency towards further monetary centralization. Monetary unions also facilitate the less straightforward form of monetary imperialism, namely the inter-government and inter-central bank cooperation.
By coordinating their policy actions, i.e., by increasing monetary exploitation together, paper money producers eliminate the disturbing divergent developments in the currencies’ purchasing powers. Thus, users’ consent is better secured, as no viable alternative is left. The permanent risk of bankruptcy of fractional reserve banks encourages cooperation between paper money producers on an ongoing basis.
Assume that a central bank decided to remain conservative and not to expand the money supply together with the other central banks. Its money would then appreciate relative to the other currencies, and will keep appreciating so long as users expect the conservative central bank to keep its policy. Because its money maintains purchasing power better, its international demand increases, which would result in higher inflows of deposits at the commercial banks. Paradoxically enough, the conservative central bank loses its capacity to control domestic banks’ liquidity. Furthermore, a sudden change in users’ expectations could reverse the international flows of liquidity and cause the illiquidity of the commercial banks, especially if they have used the deposit inflows for credit expansion, at home or abroad. The attempts of the central bank to recover control over the liquidity of the banks, for instance by means of a sterilization policy, de facto imply that a foreign-induced monetary policy has to be followed. The extreme policy tool for insulating the national banking sector from the phenomenon of “hot money” is to abandon the conservative policy early enough, i.e., to accept monetary cooperation. A recent case in point is the decision of the Swiss National Bank not to let the Swiss franc appreciate below 1.20 francs for a euro since July 2011.
From the point of view of the more expansionist central banks, it is also in their own interest to cooperate even ex post, i.e., to provide support to foreign central and commercial banks in difficulty. A severe banking crisis in one country could undermine the stability of fractional reserve banks elsewhere, not only because banks’ balance sheets are interlinked through the international inter-bank market, but also due to the very low degree of divisibility of confidence in banking. Despite their inherent rivalry, paper money producers do share a common interest, in particular the avoidance of bank runs. The coordinated policy decisions between the five major central banks since 2008, and especially the US dollar/euro swaps which were meant to provide dollar liquidity to illiquid European banks, are good real-world examples of monetary cooperation.
Monetary cooperation is an instance of general inter-government cooperation, which can also take the form of direct financial assistance through inter-government loans. These official loans, which have become lately very prominent in Europe, merit examination on their own.
OFFICIAL LOANS AND THE IMPACT OF ECONOMIC STABILIZATION PROGRAMSThe structural weaknesses of the fractional reserve banks lead to often unforeseen bailouts, the magnitude of which is unknown upfront and results in sizable budgetary deficits.Hayek himself makes very clear the link between government monopoly on money production and chronic budgetary deficits. Moreover, he has no illusions about the redistributive implications under democracy: “The ease with which a minister of finance can today both budget for an excess of expenditure over revenue and exceed that expenditure has created a wholly new style of finance compared with the careful housekeeping of the past. […]. Under the prevailing form of unlimited democracy, in which government has power to confer special material benefits on groups, it is forced to buy the support of sufficient numbers to add up to a majority” (Hayek, 1990 [1976], p. 119). This puts governments in a difficult financial situation, due to ever-increasing funding costs. Beyond a point, the costs become so high that governments decide to stop issuing new securities and look for an alternative funding option. Such an alternative is offered by the so-called official international assistance, which is typically dispensed either bilaterally or, most often, by the International Monetary Fund. The outburst of the public finance crisis in the European Union has led to a wave of unprecedented inter-government solidarity that brought about a number of specific and dynamically evolving instruments for granting aid to fellow members of the Union. The latest is the European Stability Mechanism, which is a permanent financial institution, mandated to lend up to EUR 500 billion to euro area member states. Other instruments exist also for members of the Union who have not adopted the euro yet.
Since 2008, seven out of the twenty-seven member states of the Union have received official assistance.The specific experiences of some of these economies are schematically presented in Stein (2011). Typically, funding has come from the IMF for one third and from the applicable instruments of the Union for the remaining two thirds, while the active involvement of the European Central Bank has been sought to ensure continuous liquidity provision to the national banking sectors. Once the total loan envelope is determined, effective disbursements take place in quarterly installments after experts of the lending institutions review, and deliver a positive opinion upon, the implementation progress with a pre-defined so-called economic stabilization program. This program details the specific policies and attached deadlines that the government must follow with respect to fiscal, structural and banking issues. It is a de facto conditionality agreement between the lenders and the borrower that is meant to ensure the imbalances in the economy will be resolved and the funds are properly spent.These agreements are laid down in a Memorandum of Economic and Financial Policies, signed between the national authorities and the IMF, and in a Memorandum of Understanding signed between the national authorities and the European Union. These documents are public and freely available on the internet. The process of granting official assistance starts by a written request from the national authorities in a so-called Letter of Intent, which officially acknowledges the existence of imbalances and shows pre-commitment to a number of key policies. As a matter of fact, the Letters of Intent are drafted by the administration of the international institutions (IMF, European Commission, and European Central Bank). Thus, the overall impact of the inter-government cooperation is determined by the economic stabilization program itself.
ADMINISTRATIVE STABILIZATION VERSUS MARKET-DRIVEN RESTRUCTURINGIn order to grasp the essence and impact of an official foreign-funded stabilization program, we must compare it to its counterfactual, namely how fiscal and economic imbalances would have been addressed without foreign assistance. In a nutshell, this counterfactual would have consisted in a market-driven restructuring of both the economy and public finances.
To begin with, the government’s funding difficulties would have resulted in a restructuring of its spending. Expenditure cuts would have been simply unavoidable in the absence of official assistance. The economic role of the high interest rates that private lenders start to ask is precisely to signal the increased scarcity of funds and to impose a lower expenditure pattern on the government. A self-imposed correction based on higher taxes would not convince financial markets. First, higher taxes would not address the structural problem that is at the origin of the high public debt. Second, they would undermine future productivity and the capacity of the government to easily generate additional revenues, should further contingencies arise.
The adjustment of government expenditure to the available tax revenues would also automatically contribute to addressing weaknesses in the private sector. A cut along all forms of subsidies would lead to the bankruptcy of businesses which were artificially maintained at a cost for taxpayers. The subsequently released factors of production, including labor, would be redirected to sectors where they would be better employed, even though at a lower nominal remuneration. A market-driven restructuring in government finances would, in a sense, free the economy from that part of the government’s interventions that private lenders consider excessive.
The market-driven solution would also make lenders aware of their own responsibilities. Beyond a point, the restructuring of government activities would also include a rescheduling of the outstanding public debt, which would imply losses for the investors in sovereign securities. Such losses would result in an appreciation of the risk associated to public debt, and then in higher yields asked for funding governments. This is the ultimate sanction that guarantees long-term discipline in public spending, both ex post and ex ante. In a sense, the very possibility for a market-driven correction of government excesses prevents the excesses from arising in the first place.
Against this background, an official economic stabilization program clearly thwarts the natural adjustment process.The point that government solutions to international bankruptcies are precluding more efficient private solutions has been made in Vasquez (1996, 1999). In essence, the cheap official funding allows the government to maintain its overall size without scaling down. Nevertheless, because the reality of the imbalances could hardly be denied, the necessity for adjustment is fully recognized both by the official lenders and the borrower. Because the market-driven correction is precluded, the adjustment must then take the form of administratively decided and implemented policy actions. This sheds new light on the nature of the so-called conditionality, often presented as a means for avoiding the build-up of moral hazard caused by the cheaper-than-the-market funding granted by official lenders (Vaubel, 1983). Conditionality appears to be much more fundamental and implied in the very notion of inter-government support. Not to say that its historical record in effectively preventing moral hazard is rather poor.
The key problem is that this administratively decided stabilization program faces an irreconcilable contradiction. On the one hand, the provision of sufficient financing to cover the government’s funding needs over the next years reduces the urgency to adjust public finances and to undertake long-term oriented structural reforms. On the other hand, the policy conditionality itself is rooted in the awareness that an economic adjustment is much needed. This fundamental contradiction leads to very low incentives to implement unpopular, though deemed necessary, reforms.
In practice, this contradiction implies that an official stabilization program is unlikely to succeed. The official creditors do not have sufficient knowledge about from where the imbalances originate. It is not enough to point at excessive public deficit and debt; one must also find which government programs and policies are at the origin of the unsustainable spending. At the same time, assisted governments have little incentive to sort their finances and to terminate policies and practices that create financial holes. Why would a government fight bureaucratic resistance if funding is after all available? The typical response to this knowledge and incentives problem is to impose only a very gradual correction path on the general public deficit, and to subsequently adjust the conditionality requirements to the effective progress made by the government.Such adjustments of the requirements result in regular quarterly modifications of the Memorandum of Economic and Financial Policies and of the Memorandum of Understanding. The regular review reports serve then a double purpose: check progress with implementation and identify areas for adjustment. This alone speaks a lot about the strictness of the “imposed conditionality.” Thus, while some broad expenditure cuts are imposed, it is fundamentally up to the borrowing government to specifically identify them and to ensure their implementation.
Let me now examine the direct and indirect consequences of economic stabilization programs in some further detail.A number of detailed and authoritative articles, which present the inefficiencies of IMF-sponsored bailouts, can be found in Smith (1984), Schwartz (1998), Meltzer (1998), Calomiris (1998), Bordo (1999) and Niskanen (1999). Some of these authors make the point that the IMF should be abolished, while others (Bordo and Meltzer) argue that international assistance should be limited to cases of illiquidity only, not of insolvency.
LONG-TERM CONSEQUENCES OF OFFICIAL LOANS: INFLATION AND THE DEBT ECONOMYFrom the outset, an official loan implies the bailout of holders of public debt, i.e., domestic and international banks or other investors, such as pension funds and insurance companies, to which commercial banks also have exposure. Because the official loan reduces the likelihood of losses for private investors, the market price of public debt does not decline as much as it would have otherwise. An official loan contributes then to maintaining the value of assets of investors in public debt above what their portfolio would be worth in the case of a market-driven restructuring. It produces a counterfactual redistribution of wealth from taxpayers to the government’s creditors. Indeed, in fine the official loan is to be repaid out of future taxes. Hence, an economic stabilization program implies higher future taxation, i.e., a heavier government weight on the economy—the exact contrary of the natural solution.
An immediate first-round impact of an official foreign loan is to increase the liquidity of the domestic banking sector. This is due to the fact that part of the additional funding is spent on goods and services, including publicly employed labor, offered by residents. As the government spends more than it would have spent otherwise, revenues of state-employed factors of production are higher, and so are their owners’ deposits at commercial banks. The banks, which are the ultimate beneficiaries of the increased liquidity, can use it for repaying their own creditors or otherwise improving their profitability by expanding bank credit into the economy. Thus, a foreign-funded economic stabilization program is immanently inflationary. Even when it is nominally limited to supporting the government alone, it contributes to refinancing all debt-based relationships created by the fractional reserve banking system. Given that they prevent local episodes of deflation and contribute to coordinated global inflation, official loans and the inter-government cooperation that puts them into place are definitely driven by monetary imperialism.
The specific economic policies that accompany the official loan can be categorized in three areas: fiscal, structural and banking. In the area of fiscal issues, it is required that the government gradually reduce its deficit over a number of years to a level considered sustainable. The sustainability is determined mechanically, based on the growth projections and the subjectively determined acceptable level of public debt. While in the European Union the sustainability threshold for public debt has long been put at 60% of GDP, it has been doubled since the crisis. Similarly, deficit requirements are not determined in terms of effective nominal targets, but relative to structural targets, i.e., allowing for cyclical slippages in public spending during the bust. Finally, only part of the deficit correction comes from expenditure cuts; tax hikes or an expansion of the taxable base are equally popular tools. Thus, an official foreign loan becomes an effective instrument for international tax harmonization. Tax optimization opportunities are reduced, which is a clear benefit to the foreign creditor states.
The so-called structural policies relate to the fundamental conditions of conducting economic activity, such as labor contracts, pension arrangements, state monopolies, protected professions or trade barriers. The required adjustments in these areas are meant to increase the economy’s overall productivity and its international competitiveness in order to generate sufficient surpluses that would allow timely repayment of the overhang of foreign debt. However, structural policies are also extending the notion of improved efficiency to areas such as tax collection, public finances framework, or tax evasion. While structural policies do introduce higher economic freedom in some sectors, they also lead to a stronger government in general. In addition, much bolder and genuine reforms would have been implemented, had the national authorities not received an official foreign loan. It is alleged quite often that the conditionality attached to the foreign loan is the best opportunity for politicians to carry out reforms that would have not been implemented otherwise, for lack of social consensus. The truth, however, is that this argument wrongly compares the structural reforms under the loan conditionality to the situation prior to the government’s financial difficulties, and that it ignores the impact of the cheap official financing.
Finally, the third policy area included in a program covers the banking sector. Measures aim at ensuring that banks are adequately capitalized and provided with sufficient liquidity. Undercapitalized banks, whether effectively or in light of the projected results of stress tests, receive state-funded capital injections, which are financed by the foreign official loan. In the event where the undercapitalized bank is also deemed nonviable, restructuring and resolution are applied, such as dividing the bank into two institutions or consolidating it with another entity.The international lenders have at their disposal readily available solutions, of which Parker (2011) has made a good summary. Without going into the detail of all possible banking sector measures, a common feature can be recognized: the fractional reserve principle of modern banking is maintained, while accidental changes in the business landscape are voluntarily admitted and even imposed. The banking sector is even more regulated, supervised, and controlled by governments. In substance, everything is done to avoid the far-reaching reform Hayek has called for.
This summary of the stabilization policies required by an official foreign lender shows that genuine problems are addressed by half-measures. Even though some benefits could be expected in the long run, they are immediately offset by increased government involvement in economic life. As a consequence, administrative programs are bound to yield poor results, which would quickly be used as evidence for the need for further government involvement.This could be seen as an application of Mises’s general theory of interventionism according to which interventionism tends to expand due to its own failures. In a nutshell, economic stabilization programs promote anti-free market reform sentiments. This raises the broader question whether such programs are not anti-reformist in their very nature.
THE ANTI-REFORMIST NATURE OF THE ECONOMIC STABILIZATION PROGRAMSI have noted already that in the absence of official foreign funding, national authorities could not do without major reforms. As a corollary, the economic conditionality attached to a loan delays, or even precludes, some critical reforms. In addition to this general pattern, the macroeconomic consequences of the foreign loan are fundamentally anti-reformist. Indeed, the loan brings about a generalized bailout of all creditor-to-debtor relationships and an increase in the money supply, both of which tend to maintain the social and economic status quo. The higher future taxes, which are the necessary implication of a foreign bailout, put a burden on the future wealth to be produced by the economy, i.e., on the younger generation. At the same time, current owners of wealth, which has been accumulated in an unsustainable manner, are mostly shielded from bearing the losses. Thus, a bailout hinders free entrepreneurship and precludes the natural renovation of the economic elites, which market-driven bankruptcies would have generated.
These conclusions are strengthened when we consider what would have been the specific impact of the market-driven restructuring on the banking sector. The unavoidable cuts in government spending would have resulted in a lower income for state employed factors of production and subsequently in lower liquidity with banks. This would result in a lower capacity of the economy to reimburse debts, to a surge in the non-performing assets on banks’ balance sheets, and hence to the need to acknowledge unforeseen losses. A market-driven restructuring would have resulted, therefore, in an initial contraction of the money supply, which would have been further amplified by banks’ own financial difficulties, and most certainly bankruptcies. The fractional-reserve banking system would have imploded in such a deflationary environment, due to its own structural vulnerabilities.
The main macroeconomic achievement of an official foreign loan is to preclude precisely this outcome. It makes sure that the money supply contraction is avoided, or at least significantly dampened, and that bank bankruptcies are contained. The end result is that financial instability remains embodied in the system, despite all official attempts to limit crises and their international transmission. The preservation of fractional reserve banking, which might be seen as the very rationale of the inter-government cooperation, becomes then a cause for the build-up of additional imbalances, and then for further cooperation and monetary expansion.
CONCLUSION: THE IMPORT OF THE BANKING REFORMIn conclusion, Hayek’s early work on international monetary relations is strikingly topical. He has argued convincingly that the fractional reserve principle is a major cause of imbalances in the international economy. My goal here has been to further substantiate this insight on the ground of paper monies’ political nature. This specific aspect of modern banking is an independent source of international conflicts, which find a temporary resolution in the phenomenon of monetary imperialism. Its current outcome is increased inter-government cooperation and further political centralization. The structural weaknesses of fractional reserve banking are the main driving force of these developments. Their ultimate consequence will be global monetary unification and inflation. This highlights once again Hayek’s crucial insight that a fundamental banking reform is a prerequisite for any monetary reform aiming at international stability.
Growth in the supply of US dollars fell again in August, this time to a 108-month low of 4.2 percent. The last time the money supply grew at a smaller rate was during August 2008 — at a rate of 4.1 percent.
The money-supply metric used here — an "Austrian money supply" measure — is the metric developed by Murray Rothbard and Joseph Salerno, and is designed to provide a better measure than M2. The Mises Institute now offers regular updates on this metric and its growth.
The "Austrian" measure of the money supply differs from M2 in that it includes treasury deposits at the Fed (and excludes short time deposits, traveler's checks, and retail money funds).
M2 growth also slowed in August, falling to 5.3 percent, a 75-month low.
Money supply growth can often be a helpful measure of economic activity. During periods of economic boom, money supply tends to grow quickly as banks make more loans. Recessions, on the other hand, tend to be preceded by periods of falling money-supply growth.
Thanks to the intervention of central banks, of course, money supply growth in recent decades has never gone into negative territory.
Nevertheless, as we can see in the graph, significant dips in growth rates show up in years prior to a economic bust or financial crisis.
For insights into what's affecting money supply growth, we can look at loan activity, such as the Federal Reserve's measure of industrial and commercial loans.
In July of this year, growth rate in loans fell to a 75-month low, dropping to 1.5 percent. In August, loan growth rebounded slightly, climbing back to 2.1 percent. Loan growth has not been this weak since April of 2011, in the wake of the last financial crisis.
We find similar trends in real estate loans and in consumer loans, although not to the same extent.
The current subdued rates of growth in the money supply suggests an economy in which lenders are holding back somewhat on making new loans, which itself suggests a lack of reliable borrowers due to a lackluster overall economy. This assessment, of course, is reinforced by the Federal Reserve's clear reluctance to wind down it's huge portfolio, and to end its ongoing policy of low-interest rates — concerned that any additional tightening might lead to a recession. Growth in consumer loans hit a 27-month low in August, and real estate loans hit a 28-month low during the same period.
For the second time in less than two months, the Bank of Canada has raised interest rates.
On Wednesday, the central bank raised its overnight lending rate by a quarter per cent to 1 per cent.
The move surprised many who weren’t expecting a rate increase until later this Autumn.
Just like last time, the rationale behind higher rates was centred around the Bank of Canada’s belief that the economy is growing faster than expected.
Bank of Canada Governor Stephen Poloz said, “The level of GDP growth is now higher than the bank expected.”
Of course, this assumes that GDP measures anything.
The Canadian loonie surged after the announcement, climbing to 82 cents U.S.
The decision reinforces the message that easy money and low-interest rates are coming to an end. Of course, the bursting of Canada’s real estate bubble could reverse direction for the bank, using these recent rate gains as leverage to cut rates in order to “stimulate” the deflating economy.
But until then, analysts are expecting more rate hikes since many have confused consumer indebtedness and rising prices as economic strength.
The Bank of Canada won’t confirm these predictions since, according to the central bank’s statement, price controls on interest rates are, “predetermined and will be guided by incoming economic data and financial market developments.”
Of course, the Bank of Canada isn’t clueless when it comes to higher rates and indebted Canadian households. In the rate hike statement, the bank promised that “close attention will be paid to the sensitivity of the economy to higher interest rates,” given “elevated household indebtedness.”
The bank’s next scheduled rate-setting is Oct. 25.
All in all, today’s announcement puts interest rates back to where they were in January 2015, before Poloz made two surprising “emergency rate cuts” to deal with falling oil prices.
Reprinted from Mises.ca.
In April 2017, the Bank of Mexico transferred an unprecedented figure to the federal government: 321,653 billion Mexican pesos from its operating surplus. How much is this figure? It is equivalent to 1.7% of Mexico’s GDP — 25% of Guatemala’s GDP — and to 22% of the total revenue budget of the Mexican government.
What is Banxico’s Operating Surplus? Essentially all of Banxico’s profits are a result of the appreciation in the value of the bank’s foreign exchange reserves in pesos. At the beginning of 2016, the Bank of Mexico’s dollar reserve was of 176,736 billion dollars. By the end of 2016, the bank had almost the same amount in reserves. However, in January the peso was trading at 17.35 to the dollar, and in December at 20.62 a dollar.
The Mexican peso depreciated by 19% in 2016. As a consequence, the value of Banxico’s foreign exchange reserves reported a gain of 582.8 billion pesos. It is from this profit that Banxico transferred the 321,653 billion to the Mexican federal government — a transfer the bank was obligated to carry out as established in article 55 of the Banxico law by no later than April of each year.
A Blessing for Public Finances This “gift” that the central government received came as a blessing to a government that had announced a modest fiscal consolidation plan. It is important to take into account that from early 2013 until the end of 2016, the Mexican public debt went from 5202.77 billion pesos to 8657.62 billion.
By legal provision, 70% of the operative surplus that Banxico transferred to the Mexican government must be directed to repayment of debt. Undoubtedly, the aid fell from thin air: the operative surplus came from the peso’s depreciation caused by Donald Trump’s victory last November.
Will Banxico Continue to Profit? What will happen now that the peso is appreciating against the dollar? If we review the Banxico’s results from the valuation of its foreign currency reserves as a consequence of the variation in the exchange rate, we find that in the first quarter of 2017 Banxico lost 310,911 billion pesos. This means that only in the first quarter of the year Banxico lost 53% of what it earned in 2016. This is not a reason to believe that Banxico is going bankrupt, but the bank is definitely decapitalizing.
What Should We Expect for the End of the Year? Everything depends on the trend of the Mexican peso against the dollar. Experts do not expect a strong appreciation in the rest of the year. The high inflation rate does not suggest that the peso can appreciate too much. There are only two things that are certain: Banxico will report operational losses this year, and the Mexican government will not receive another “gift” in 2018 to pay for the public debt. The government will have to tighten its belt if it wants to reduce the high level of public debt it has.
Originally published by UFM's Market Trends.
On 23 August 2017, the president of the European Central Bank (ECB) gave a speech titled “Connecting research and policy making” at the annual assembly of the winners of the Nobel Price for Economics in Lindau, Germany.See Draghi, M., The interdependence of research and policymaking, speech at the Lindau Nobel Laureate Meeting, Lindau, Germany, 23 August 2017. What Mr Draghi talked about on this occasion — and especially what he didn’t talk about — was quite revealing.
Any analysis of the causes of the latest financial and economic crisis is conspicuously absent from Mr Draghi’s remarks. One gets the impression that the crisis came basically unexpected, out of the blue. There is no mention of the role of central banks, the monopoly producers of unbacked paper (or: fiat) money, played for the crisis.
No word that central banks had for many years manipulated downwards interest rates — accompanied by an excessive increase in credit and money supply — causing an unsustainable “boom.” When the bust set in — triggered by the spreading of the US subprime crisis across the globe — the ugly consequences of this central bank monetary policy came to the surface.
In the bust, many governments, banks and consumers in the euro area found themselves financially overstretched. The economies of Southern Europe especially do not only suffer from malinvestment on a grand scale, they also found themselves in a situation in which they have lost their competitiveness.
Mr Draghi, however, doesn’t deal with such unpleasant details. Instead, he lets his audience know how well the ECB pursued a policy of "crisis solution." His narrative is straightforward: Without the ECB’s bold actions, the euro area would have fallen into recession-depression, perhaps the euro area would have broken apart.
The analogy to such a line of argumentation would be praising a drug dealer, who provides the drug addict (who became a drug addict because of him) with just another shot. Repeated consumption of drugs does not heal but damages drug addict. Who would applaud what the drug dealer does? Likewise: would it be appropriate to praise the ECB’s action?
Mr Draghi presents himself as a fairly modest, intellectually ‘undogmatic’ central bank president stressing the importance of the insights produced by economic research for real life monetary policy making (thereby dutifully applauding the output of the economics profession). But the policy maker’s approach is far from being scientifically impartial.
Draghi's Flawed Methods Today’s economics research — as it is pursued, and taught, by leading mainstream economists — rests on a scientific method that is borrowed from natural science and builds on positivism-empiricism-falsificationism. For a critical analysis see Hoppe, H.-H. (2006), Austrian Rationalism in the Age of the Decline of Positivism, in: The Economics and Ethics of Private Property. Studies in Political Economy and Philosophy, 2nd edition, Ludwig von Mises Institute, Auburn, US Alabama, pp. 347 – 379. This approach, used in economics, does not only suffer from logical inconsistencies, its embedded skepticism and relativism has, in fact, has let economics astray.
Under the influence of positivism-empiricism-falsificationism economic theory – in particular monetary theory and financial market theory – has become the intellectual stirrup-holder of central banking, legitimizing the issuance of fiat money, the policy of manipulating the interest rate, the idea of making the financial system ‘safer’ through regulation.
In this vein, Mr Draghi praises especially the independence of central banks — for it would shield central bankers from destabilizing political outside influence. One really wonders how this argument — one-sided as it is — could find acceptance, especially in view of the fact that independent central banks have caused the great crisis in the first place.
The Central Bank's Many Friends Why is there hardly any public opposition to Mr Draghi’s narrative? Well, a great deal of experts on monetary policy — coming mostly from government sponsored universities and research institutes — tends to be die-hard supporters of central banking. The majority of them would not find any fundamental, that is economic or ethic, flaw with it.
These so-called “monetary policy experts,” devoting so much time and energy for becoming and remaining an expert on monetary policy, unhesitatingly favor and accept without reservation the very principles on which central banking rests: the state’s coercive money production monopoly and all the measures to assert and defend it.
The upshot of such a mindset is this: “Once the apparatus is established, its future development will be shaped by what those who have chosen to serve it regard as its needs,”Hayek, F. A. v. (1960), The Constitution of Liberty, The University of Chicago Press, Chicago, p. 291. as F.A. Hayek explained the irrepressible expansionary nature of a monopolistic government agency – like a central bank.
Experts, keenly catering to the needs of the state and the banks, will make monetary policy increasingly complex and incomprehensible to the general public. Just think about the confusing abbreviations the ECB uses such as, say, APP, QE, CBPP, OMT, LTRO, TLTRO, ELA etc.APP = Asset Purchase Programme, QE = quantitative easing (issuing new money by purchasing bonds), CBPP = Covered Bond Purchase Programme, OMT = Outright Monetary Transactions, LTRO = Long-term Refinancing Operations, TLTRO = Targeted Long-term Refinancing Operations, ELA = Emergency Liquidity Assistance. In this way central bankers effectively sneak themselves out from public and parliamentary control.
Has the ECB Violated its Mandate? It comes therefore as no surprise Mr Draghi hails “non-standard policy measures” such as quantitative easing through which the central bank subsidizes financially ailing governments and banks in particular. Mr Draghi, however, does not leave it at that. He also suggests that monetary policy should shake off remaining restrictions that hamper policy maker’s discretion:
[W]hen the world changes as it did ten years ago, policies, especially monetary policy, need to be adjusted. Such an adjustment, never easy, requires unprejudiced, honest assessment of the new realities with clear eyes, unencumbered by the defence of previously held paradigms that have lost any explanatory power.
These remarks come presumably because the German Constitutional Court has found indications that the ECB’s government bond purchases may violate EU law and has asked the European Court of Justice to make a ruling. The German judges say that ECB bond buys may go beyond the central bank's mandate and inhibit euro zone members' activities.
The issue is no doubt delicate: If the ECB is prohibited from buying government bonds (let alone reverse its purchases), all hell may break loose in the euro area: Many government and banks would find it increasingly difficult to roll-over their maturing debt and take on new loans at affordable interest rates. The euro project would immediately find itself in hot water.
Without a monetary policy of ultra-low interest rates and bailing out struggling borrowers by printing up new money (or promising to do so, if needed) the euro project would already have gone belly up. So far the ECB has indeed successfully concealed that the pipe dream of successfully creating and running a single fiat currency has failed.
The crucial question in this context is, however: What has changed in economics in the last ten years? Unfortunately, economists that follows the doctrine of positivism-empiricism-falsificationism feel encouraged to question, even reject, the idea that there are immutable economic laws, preferring the notion that ‘things change’ that ‘everything is possible’.
However, sound economics tells us that there are iron laws of human action. For instance, a rise in the quantity of money does not make an economy richer, it merely reduces the marginal utility of the money unit, thus reducing its purchasing power; or: suppressing the interest rate through the central bank must result in malinvestments and boom and bust.
In other words: Sound economics tells us that central bankers do not pursue the greater good. They debase the currency; slyly redistribute income and wealth; benefit some groups at the expense of others; help the state to expand, to become a deep state at the expense of individual freedom; make people run into ever greater indebtedness.
What central bankers really do is cause a "planned chaos." Unfortunately, the damages they create — such as, say, inflation, speculation, recession, mass unemployment etc. — are regularly and falsely attributed to the workings of the free market, thereby discouraging and eroding peoples’ confidence in private initiative and free enterprise.
The failure of such interventionism — of which central bank monetary policy is an example par excellence — does not deter its supporters. On the contrary: They feel emboldened to pursue their interventionist course ever more boldly and aggressively to achieve their desired objectives. Mr Draghi made a case in point when he said in July 2012:
“[W]e think the euro is irreversible” and “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”Draghi, M., Verbatim of the remarks made by Mario Draghi, speech held at the Global Investment Conference in London, 26 July 2012. Hayek’s warning in his book Fatal Conceit (1988) goes unheard: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."Hayek, F. A. v. (1988), Fatal Conceit. The Errors of Socialism, edited by W. W. Bartley, III, Routledge, London, p. 76.
Mr Draghi’s speech should not convince us that monetary policy rests on sound economics, or that the ECB works for the greater good. If anything, it shows that economics has been twisted and deformed to service the needs of the state and its central bank – which increasingly erodes what little is left of the free market to keep the fiat money system going.
Holding up the fiat euro will result in a coercive redistribution of income and wealth among people, within and across national borders, to an extent historically unprecedented in times of piece. As a tool of an effectively anti-democratic policy, the single European currency will remain a source of interminable conflict, injustice, and it will be a drag on peoples’ prosperity.
The FT recently ran an article that states that “leading central banks now own a fifth of their governments’ total debt.”
The figures are staggering.
Without any recession or crisis, major central banks are purchasing more than $200 billion a month in government and private debt, led by the ECB and the Bank of Japan.The Federal Reserve owns more than 14% of the US total public debt.The ECB and BOJ balance sheets exceed 35% and 70% of their GDP.The Bank of Japan is now a top 10 shareholder in 90% of the Nikkei.The ECB owns 9.2% of the European corporate bond market and more than 10% of the main European countries’ total sovereign debt.The Bank of England owns between 25% and 30% of the UK’s sovereign debt. A recent report by Nick Smith, an analyst at CLSA, warns of what he calls ”the nationalization of the secondary market.”
The Bank of Japan, with its ultra-expansionary policy, which only expands its balance sheet, is on course to become the largest shareholder of the Nikkei 225’s largest companies. In fact, the Japanese central bank already accounts for 60% of the ETFs market (Exchange traded funds) in Japan.
What can go wrong? Overall, the central bank not only generates greater imbalances and a poor result in a “zombified” economy as the extremely loose policies perpetuate imbalances, weaken money velocity, and incentivize debt and malinvestment.
Believing that this policy is harmless because “there is no inflation” and unemployment is low is dangerous. The government issues massive amounts of debt and cheap money promotes overcapacity and poor capital allocation. As such, productivity growth collapses, real wages fall and purchasing power of currencies fall, driving the real cost of living up and debt to grow more than real GDP. That is why, as we have shown in previous articles, total debt has soared to 325% of GDP while zombie companies reach crisis-high levels, according to the Bank of International Settlements.
Government-issued liabilities monetized by the central bank are not high-quality assets, they are an IOU that is transferred to the next generations, and it will be repaid in three ways: with massive inflation, with a series of financial crises, or with large unemployment. Currency purchasing power destruction is not a growth policy, it is stealing from future generations. The “placebo” effect of spending today the Net Present Value of those IOUs means that, as GDP, productivity and real disposable income do not improve, at least as much as the debt issued, we are creating a time bomb of economic imbalances that only grows and will explode sometime in the future. The fact that the evident ball of risk is delayed another year does not mean that it does not exist.
The government is not issuing “productive money” just a promise of higher revenues from higher taxes, higher prices or confiscation of wealth in the future. Money supply growth is a loan that government borrows but we, citizens, pay. The payment comes with the destruction of purchasing power and confiscation of wealth via devaluation and inflation. The “wealth effect” of stocks and bonds rising is inexistent for the vast majority of citizens, as more than 90% of average household wealth is in deposits.
In fact, massive monetization of debt is just a way of perpetuating and strengthening the crowding-out effect of the public sector over the private sector. It is a de facto nationalization. Because the central bank does not go “bankrupt,” it just transfers its financial imbalances to private banks, businesses, and families.
The central bank can “print” all the money it wants and the government benefits from it, but the ones that suffer financial repression are the rest. By generating subsequent financial crises through loose monetary policies and always being the main beneficiary of the boom, and the bust, the public sector comes out from these crises more powerful and more indebted, while the private sector suffers the crowding-out effect in crisis times, and the taxation and wealth confiscation effect in expansion times.
No wonder that government spending to GDP is now almost 40% in the OECD and rising, the tax burden is at all-time highs and public debt soars.
Monetization is a perfect system to nationalize the economy passing all the risks of excess spending and imbalances to taxpayers. And it always ends badly. Because two plus two does not equal twenty-two. As we tax the productive to perpetuate and subsidize the unproductive, the impact on purchasing power and wealth destruction is exponential.
To believe that this time will be different and governments will spend all that massive “very expensive free money” wisely is simply delusional. The government has all the incentives to overspend as its goal is to maximize budget and increase bureaucracy as means of power. It also has all the incentives to blame its mistakes on an external enemy. Governments always blame someone else for their mistakes. Who lowers rates from 10% to 1%? Governments and central banks. Who is blamed for taking “excessive risk” when it explodes? You and me. Who increases money supply, demands “credit flow,” and imposes financial repression because “savings are too high”? Governments and central banks. Who is blamed when it explodes? Banks for “reckless lending” and “de-regulation”.
Of course, governments can print all the money they want, what they cannot do is convince you and me that it has a value, that the price and amount of money they impose is real just because the government says so. Hence lower real investment, and lower productivity. Citizens and companies are not crazy for not falling into the trap of low rates and high asset inflation. They are not amnesiac.
It is called financial repression for a reason, and citizens will always try to escape from theft.
What is the “hook” to let us buy into it? Stock markets rise, bonds fall, and we are led to believe that asset inflation is a reflection of economic strength.
Then, when the central bank policy stops working — either from lack of confidence or because it is simply part of the liquidity — and markets fall to their deserved valuations, many will say that it is the fault of “speculators,” not the central speculator.
When it erupts, you can bet your bottom dollar that the consensus will blame markets, hedge funds, lack of regulation and not enough intervention. Perennial intervention mistakes are “solved” with more intervention. Government won on the way up, and wins on the way down. Like a casino, the house always wins.
Meanwhile, the famous structural reforms that had been promised disappear like bad memories.
It is a clever Machiavellian system to end free markets and disproportionately benefit governments through the most unfair of competitions: having unlimited access to money and credit and none of the risks. And passing the bill to everyone else.
If you think it does not work because the government does not do a lot more, you are simply dreaming.
Originally published at DLacalle.com
Although today high levels of inequality in the United States remain a pressing concern for a large swath of the population, monetary policy and credit expansion are rarely mentioned as a likely source of rising wealth and income inequality. Focusing almost exclusively on consumer price inflation, many economists have overlooked the redistributive effects of money creation through other channels. One of these channels is asset price inflation and the growth of the financial sector.
The rise in income inequality over the past 30 years has to a significant extent been the product of monetary policies fueling a series of asset price bubbles. Whenever the market booms, the share of income going to those at the very top increases. When the boom goes bust, that share drops somewhat, but then it comes roaring back even higher with the next asset bubble.
The Cantillon Effect The redistributive effects of money creation were called Cantillon effects by Mark Blaug after the Franco-Irish economist Richard Cantillon who experienced the effect of inflation under the paper money system of John Law at the beginning of the 18th century.Blaug, M. (1985) Economic Theory in Retrospect, 4th edition, Cambridge: Cambridge University Press. Cantillon explained that the first ones to receive the newly created money see their incomes rise whereas the last ones to receive the newly created money see their purchasing power decline as consumer price inflation comes about.
Following Cantillon and contrary to Fisher and other monetary theorists of his time, Ludwig von Mises was the first to emphasize these Cantillon effects in terms of marginal utility analysis. With an increase in the stock of money, the cash balances of the early receivers of the newly created money increase. Correspondingly, the marginal utility they give to money decreases and the individuals in question buy either investment or consumption goods, thus bidding up the prices of those goods and increasing the cash balances of their sellers. With this step by step process, the price of goods will increase only progressively and affect both the distribution of income and wealth as well as the different price ratios.
Financialization, Asset Price Inflation and Inequality In accordance with the Cantillon effect, inflation can increase inequality depending on the channel it takes, but increasing inequality is not a necessary consequence of inflation. If it happened that the poorest in society were the first receivers of the newly created money, then inflation could very well be the cause of decreasing inequality.
Under modern central banking however, money is created and injected into the economy through the credit channel and first affects financial markets. Under this system, commercial banks and other financial institutions are not only the first receivers of the newly created money but are also the main producers of credit money. This is so because banks can grant loans unbacked by base money. In a free-banking system, this credit creation power of banks is strictly limited by competition and the clearing process. Under central banking however, the need for reserves is relaxed as banks can either sell financial assets to the central bank in open market operations, or the central bank can grant loans to banks at relatively low interest rates. In both cases, central banks remove the limits of credit expansion by determining the total reserves in the banking system. In other words, commercial banks and other financial institutions are credited with so-called base money that has not existed before. Thus, the economics of Cantillon effects tells us that financial institutions benefit disproportionately from money creation, since they can purchase more goods, services, and assets for still relatively low prices. This conclusion is backed by numerous empirical illustrations. For instance, the financial sector contributed massively to the growth of billionaire’s wealth (see table below).
We can list four main reasons why the growth of financial markets is triggered by an expansion of the money supply:I owe the three first reasons to Mises Fellow Karl Friedrich Israel. See: Israel, K. F. (2016a). In the long run we are all unemployed? The Quarterly Review of Economics and Finance. (64). 67-81. (1) because financial titles are often used as collateral in debt contracts; (2) because the anticipation of price-inflation, which is a common trait among all fiat money regimes, discourages the hoarding of money thus encouraging both the demand for and the supply of financial titles; (3) because the production of money through central banks is a matter of sheer human will and is therefore prone to developing moral-hazard in the financial world. This leads to an artificially high demand for financial titles and increases the supply of such titles by the same token. And (4) because the manipulation of credit by central banks and banks, by lowering the interest rate in the short run, particularly affects the demand for capital and the capital structure during the course of the business cycle.
One of the most visible consequence of this growth of financial markets triggered by monetary expansion is asset price inflation. In a completely sound money system where credit only depends on the amount of saving rather than on fiduciary credit, there is very little room for generalized and persistent asset-price inflation as the amount of funds which can be used to purchase assets is strictly limited. In other words, the phenomenon of asset-price inflation is a child of credit inflation.
Asset price inflation in turn benefit mostly the richest in society for several reasons. First, the wealthy tend to own more financial assets than the poor in proportion to his income. Second, it is easier for the richest individuals to contract debt in order to buy shares that can be sold later at a profit. Since credit easing lowers the interest rate and therefore funding costs, the profits made by selling inflated assets bought at credit will be even greater. Finally, asset price inflation coming with the growth of financial markets will benefit the workers, managers, traders, etc. working in the financial sector. It will also benefit the CEO's of the publicly traded companies who will be paid more as the capitalization value of their company increases. Hence, the correlation between asset prices and income inequality has been, as expected, very strong.
However, most monetary economists ignored — and continue to ignore — asset-price inflation and do not see it as a consequence of an inflated money supply. A reader of A Monetary History of the US (1963) by Friedman and Schwartz or of Allan Meltzer's A History of the Federal Reserve (2004) will not find one mention of asset price inflation. This oversight leads to the effects of inflation on inequality to be underestimated or ignored. Periods of growing inequality and monetary inflation such as the 1920's or the 2000's were associated with a high rate of asset-price inflation but relatively stable consumer prices. Therefore, to focus on consumer price inflation as the only variable accounting for monetary policy leaves out most of the effects of money creation on inequality.
Since the 2008 financial crisis, the so-called unconventional monetary policies have often been justified on the ground that something must be done in the short run since, as would have said J.M. Keynes, "In the long run, we are all dead." But as our monetary system tends to increase inequality, and if the goal is to improve the standards of living of the least well-off in society, then central banking and artificial monetary creation may be more costly than usually assumed by policy-makers.
If you invest your money, you will have to deal with numerous risks. For instance, if you buy a bond, you run the risk of the borrower defaulting or being repaid with debased money. As a stock investor, you face the risk that the company's business model will not live up to expectations, or that it, at the extreme, will go bankrupt. In an unhampered financial market, prices are formed for these and other risk factors.
For instance, a bond with a high default risk will typically carry a high yield. The same goes for debt denominated in an unsound currency. Stocks of companies that are deemed risky tend to trade at a lower valuation level than those considered low risk. All these risk premiums, if determined in the unhampered market, constitute a portion of an asset’s price, be it a bond or a share. They play a vital role in the way capital is allocated in an economy.
Risk premiums are meant to compensate investors for the risk of losses resulting from adverse developments. If you buy a stock at a depressed price relative to the firm’s earnings power, it tends to reduce your downside (while offering the chance of great gains). At the same time, risk premiums increase investors’ cost of capital. This, in turn, discourages them from engaging in overly risky investments.
Decline in risk premiums:
In other words, risk premiums determined in an unhampered market align the interests of savers and investors. Of course, one cannot be sure that ex ante risk premiums are always correct. Sometimes it turns out that risks were overestimated, sometimes they were underestimated. However, the unhampered market is still the best and most efficient means to determine the price of risk.
Central Banks Suppress Risk Premiums Central banks, however, interfere and corrupt the best practice of the formation of the price of risk. In the last financial and economic crisis, central banks had lowered interest rates to unprecedented low levels and ramped up the quantity of (base) money to keep financially ailing governments and banks afloat and the economy going. In fact, they effectively put out a ‘safety net’, providing insurance to financial markets against potential systemic losses.
Decline in risk premiums:
By doing so, central banks have put investor risk aversion to sleep: Under their guidance, financial markets are now betting on, and have high confidence in, monetary policy makers successfully fending off any new problems in the economic and financial system. This seems to be the message the price action in financial markets is conveying to us. For instance, stock price fluctuations have returned to very low levels, accompanied by strong stock market gains and high valuations.
The yield spread of risky corporate bonds over US Treasuries has returned to levels last seen in early 2008. Or look at the prices for credit default insurance for bank bonds. They also have returned to pre-crisis levels, suggesting investor credit concerns have markedly declined. In other words, investors are back again, eagerly taking on additional credit risk and willingly financing corporates’ investments at suppressed costs of capital.
Central banks have thus not only artificially reduced interest rates by lowering credit costs, they have also artificially reduced risk premiums by (explicitly or implicitly) signaling to the financial markets that they are prepared to basically ‘do whatever it takes’ to prevent another meltdown as witnessed in 2008/2009. The consequence is that financial markets and economies depend on central bank action more than ever before.
There is no easy way out of this situation. If interest rates go up — be it through rate hikes or the elimination of the ‘safety net’ — the current recovery will most likely come to a halt, if it does not turn into a bust straight away: With higher interest rates, the economic structure, built on artificially low interest rates, would run into serious trouble. The idea of central banks ‘normalizing’ interest rates without output losses or even a recession appears illusionary at best.
Against this backdrop, it is interesting to see that, for instance, the US Federal Reserve and the European Central Bank (ECB) may want to bring short-term interest rates back up (further). At the same time, however, there is no evidence that monetary policymakers have any plans to remove the ‘safety net’ that has so successfully brought down risk premiums in asset markets and thus the cost of capital.
That said, even an increase of central banks’ short-term funding will not bring about a normalization of the cost of capital — as risk premiums will most likely remain artificially suppressed. Capital misallocation will continue and the artificial boom is kept alive and well. Investors, therefore, face quite a challenge: Malinvestments continue, and downside risks increase, while it might be too early to jump ship.
Growth in the supply of US dollars fell again in May, this time to a 105-month low of 5.4 percent. The last time the money supply grew at a smaller rate was during September 2008 — at a rate of 5.2 percent.
The money-supply metric used here — an "Austrian money supply" measure — is the metric developed by Murray Rothbard and Joseph Salerno, and is designed to provide a better measure than M2. The Mises Institute now offers regular updates on this metric and its growth.
The "Austrian" measure of the money supply differs from M2 in that it includes treasury deposits at the Fed (and excludes short time deposits, traveler's checks, and retail money funds).
M2 growth also slowed in May, falling to 5.6 percent, a 20-month low.
Money supply growth can often be a helpful measure of economic activity. During periods of economic boom, money supply tends to grow quickly as banks make more loans. Recessions, on the other hand, tend to be preceded by periods of falling money-supply growth.
Thanks to the intervention of central banks, of course, money supply growth in recent decades has never gone into negative territory.
Nevertheless, as we can see in the graph, significant dips in growth rates show up in years prior to a economic bust or financial crisis.
For insights into what's affecting money supply growth, we can look at loan activity, such as the Federal Reserve's measure of industrial and commercial loans.
In this case, we find that the growth rate in loans has fallen to a 74-month low, dropping to 1.9 percent. Loan growth has not been this weak since April of 2011, in the wake of the last financial crisis.
We find similar trends in real estate loans and in consumer loans, although not to the same extent.
The current subdued rates of growth in the money supply suggests an economy in which lenders are holding back somewhat on making new loans, which itself suggests a lack of reliable borrowers due to a lackluster overall economy. This assessment, of course, is reinforced by the Federal Reserve's clear reluctance to wind down it's huge portfolio, and to end its ongoing policy of low-interest rates — concerned that any additional tightening might lead to a recession.
On Tuesday, Fed Governor Lael Brainard downplayed past talk of numerous rate hikes from the federal reserve and suggested that he Fed may "not have much more" to do in terms of rate hikes. "In light of recent policy moves, I consider normalization of the federal funds rate to be well under way," Brainard said.
Today, speaking before Congress, Janet Yellen built upon Brainard's earlier comments, but simultaneously suggested that there will be "gradual rate hikes" over "the next few years," and hinting that many more rate hikes won't be necessary because "the neutral rate is low by historical standards."
Markets took this to mean — probably correctly — that the Fed is moving in a more dovish direction.
The "Neutral Rate" Canard Note that both announcements are based on the idea that the "neutral rate" is unusually low, so while a target rate of 1.5 percent may seem quite low by historical standards, it's not really low. It is near the neutral rate — also known as the "natural rate."
In other words, the "natural rate" has fallen below where it was in the past, so now, the interest rates we saw in the days of yore — those around 3 per cent or 5 percent — would today be much too high.
Bloomberg explained a bit more of the Fed's logic here last year:
When Fed Chair Janet Yellen wants to explain why the Fed is keeping rates so low, she cites the natural rate. At the press conference following the FOMC’s June meeting, she said the neutral interest rate—which is essentially synonymous with the natural rate—“is quite depressed by historical standards.” She added: “I think all of us are involved in a process of constantly reevaluating where is that neutral rate going.”
Politically speaking, identifying this "natural rate" as being very low allows the Fed to create the perception that its very-low target rates aren't really all that stimulative at all. They're practically neutral! Just look at the natural rate, they'll tell us.
The problem however, is that all good economic theory tells us that the Fed has no idea what the natural rate actually is. Earlier this year, Mark Spitznagel explained:
How do we even know what that neutral rate is? The neutral rate is, by its current definition, inherently unobservable, as there is no discovery process in short-term interest rates (and there hasn’t been for as long as any of us have been around). Central banks calculate the neutral rate based on their formulas and identifying assumptions about output gaps and what interest rates, according to those models, will close those gaps. Here we have an immense circularity problem: Policymakers think they know the neutral rate because the assumptions of their interventionist model that they impose on the data say so, not because they have any insight that the market would actually clear at that rate, sans intervention. There is an underlying assumption that “markets, left on their own, are wrong, while our model is right.” Moreover, they are using observable data as model inputs that are the result of interventions that are already in effect. There are no controlled experiments in economics. Only market participants, acting freely in borrowing and lending at whatever interest rates make sense for that borrowing and lending, can ever discover what the neutral rate should be.
Joseph Salerno explains this in even further detail in his article "The Fed and Bernanke Are Wrong About the Natural Interest Rate."
All this talk about the natural/neutral interest rate thus provides political cover for the Fed, and allows the FOMC to claim that they're using economic science in determining the "correct" target rate. In truth, the Fed has no idea what the natural rate is but is really just proceeding with great caution because the Fed's leadership knows that allowing interest rates to increase beyond the current low levels would upset the fragile economy.
The Fed's Balance Sheet Thus, the question of the target rate remains constantly in flux, just as the Fed would like to have it.
Equally amorphous is the question of reducing the Fed's balance sheet. This reduction, according to both Brainard and Yellen, will come "soon" (whatever that means). One thing we know for sure: it will take a while to implement:
Ms. Yellen told the House Financial Services Committee that unwinding a $4.5 trillion-plus balance sheet that includes $2.5 trillion in Treasuries and the rest in mortgage-backed securities will probably take until 2022 before it shrinks to pre-crisis levels. Fed officials have not decided yet on longer-term policy framework that will affect the size of reserves, she said.
This assumes, of course, there is no worsening in the economy between now and 2022, which is a tall order, to say the least.
Moreover, what are the details of how this balance-sheet wind-down will occur? It's a great mystery. Also mysterious is why, in an age of massive home price inflation, the Fed still isn't unloading those mortgage-backed securities.
All in all, there's extremely little to see here in Yellen's testimony. It's the usual routine: the economy is experiencing "moderate" growth. We'll raise rates — but not too much! We'll wind down the balance sheet "soon."
Meanwhile, the Fed continues to invent new explanations of why it needs to remain accommodative. The totally arbitrary 2-percent inflation target continues to serve as a justification for continued low rates. And, more recently, the "natural rate" explanation is starting to serve as a convenient excuse as well.
With the economy expected to “grow by 2.8% in 2017” up from their April forecast of 2.6%, the Bank of Canada has decided to raise interest rates for the first time in 7 years to 0.75%
It may be minor, but it should be just enough for the Bank of Canada's Stephen Poloz to cut them again when things start to get tough, and the 2.8% growth vanishes just as quickly as it was envisioned.
Of course, higher borrowing costs are just what the doctor ordered. Often disparaged as the flawed “hangover theory” by Keynesians who believe consumption equals wealth creation, the idea that we’ve been on an unsustainable economic path, fuelled by low-interest rates, is about as outside the mainstream as you can get.
Source: Bank of Canada. Graph by Ryan McMaken.
But as the popularity of Mises grows faster than the 2.8% economy, the “hangover theory,” or, rather, the Austrian business cycle theory, will be harder and harder to suppress and ignore. Especially as the truth of its statements outperform the lies of the Keynesian doctrine.
That said, moving up a one-quarter of a percentage point from 0.50% to 0.75% isn’t as earth-shattering as, say, moving the rate up to 2.75%. While the latter may bankrupt a good number of Canadians, the decision would cease punishing savers and allow the painful but necessary correction and restructuring of the economy to commence.
But as Stephen Poloz himself has said, “When you’re looking at making an investment that you think will make you 20 percent or more over the next 12 months, and you have to borrow the money to make that investment, is a quarter point or a half a point (in extra interest) going to make a difference?”
So the rate “hike” was not an attempt to get household debt under control but actually a consequence of a robust economy that has been fuelled by household spending.
Leave it to the central bank to confuse and ignore the causal-realist tradition in economics. Nowadays the bankers in charge just run data through a computer and make decisions based on that. But as Murray Rothbard points out, if economists can predict future trends then why are they wasting their time “putting out newsletters or doing consulting when he himself could be making trillions of dollars in the stock and commodity markets?”
Household spending isn’t growing the economy. A rate hike is just giving the Bank some room to cut rates again when the financial house of cards starts to sway in the wind.
This is the first overnight rate increase since August 2010 when Mark Carney was leading the central bank. Poloz took over in 2013 and cut rates twice in 2015 due to the slow-down caused by crude oil prices.
Caleb McMillan writes from Vancouver, British Columbia.
Originally posted at Mises.ca.
There are a number of things you don’t want to hear a central banker say. One of those things just popped out of Janet Yellen’s mouth – “I don’t believe we will see another financial crisis in our lifetime.” That has to be up there with Irving Fisher’s deathless observation from 17 October 1929 that "Stock prices have reached what looks like a permanently high plateau" or John Maynard Keynes’ comparably adept forecast from 1927 that "We will not have any more crashes in our time."
So far, so anecdotal. How about some data to back up the thesis that, as Thorstein Polleit puts it, the super bubble is in trouble ?
First, define your Super Bubble. We can do this in two ways. One relates to longevity (how long has the bull run lasted ?), the other to valuation (how expensive is the market now ?). The global bond bull began back in 1981, when 30 year US Treasury yields peaked at 15.2%. Now, over 35 years later, long bond yields are below 3%.
Polleit expresses it a little differently, citing the p/e ratio of bonds so that they might more fairly be compared to stocks. To calculate the p/e ratio of a government bond, he divides 1 by the 10 year government bond yield. His results are shown below.
Source: Thomson Financial / Thorstein Polleit
¹For bonds, calculated as 1 divided by the 10 year government bond yield
In his words,
You do not need to be a financial market wizard to see that especially bond markets have reached bubble territory: bond prices have become artificially inflated by central banks’ unprecedented monetary policies. For instance, the price-earnings-ratio for the US 10-year Treasury yield stands around 44, while the equivalent for the euro zone trades at 85. In other words, the investor has to wait 44 years (and 85 years, respectively) to recover the bonds’ purchasing price through coupon payments.
Meanwhile, however, the US Federal Reserve (Fed) keeps bringing up its borrowing rate; and even the European Central Bank (ECB) is now toying with the idea of putting an end to its expansionary policy sooner rather or later.
Those of us who are hostile to central planning are doubly hostile to governmental interference in the price mechanism, which is what the misguided policies of QE and ZIRP effectively are. The definitive text on this topic is Forty Centuries of Wage and Price Controls. Spoiler alert: government attempts to rig prices always fail, sometimes catastrophically.
The problem facing the likes of Janet Yellen, Mark Carney [makes sign of the cross and looks urgently for garlic] and Mario Draghi is that, having now weaponized short term lending rates, the nukes can’t be put back in their silos. How can interest rates be raised meaningfully above zero without crashing the financial system ? Perhaps they can’t. Perhaps unelected monetary bureaucrats should never have been allowed to take them there in the first place. But we are where we are. Any commentary surrounding monetary policy can now only echo that tired old joke about the lost traveller who, when seeking advice, is told that he shouldn’t start from here.
[First published by Rare, July 1, 2017]
Speaking in London, Federal Reserve chair Janet Yellen Tuesday predicted that the “the system is much safer and much sounder” and explained that the Federal Reserve is prepared to deal with numerous enormous shocks to the economy.
In her conversation with Lord Nicholas Stern, Yellen also went on to list the reasons that, thanks to central bank intervention, there is unlikely to be another financial crisis “in our lifetimes.”
For those who have lived through more than one business cycle, however, alarm bells tend to go off every time an economist, central banker or high-ranking government official declares that there’s little to no danger of economic turmoil in the near future.
There is a long history of spectacularly bad predictions being made shortly before economic crises. Famously, shortly before the Crash of 1929 — one of the earlier crises that occurred on the Federal Reserve’s watch — Herbert Hoover proclaimed that “We in America today are nearer to the final triumph over poverty than ever before in the history of any land.” But, we certainly don’t have to go back that far.
Indeed, in the late 1990s, it became nearly routine to hear economists announce that “the internet changes everything” and “the business cycle is dead.”
Economist Rudi Dornbusch — a close associate of current Fed vice chair Stanley Fischer — even wrote a July 1998 column in the Wall Street Journal titled “Growth Forever.” Dornbusch concluded that the possibility of an imminent recession “is remote” and the country “will not see a recession for years to come.” So sure of the benefits of the “new economy” was Dornbusch, in fact, that he declared, “This expansion will run forever.”
Then came the dot-com bust of 2001. After that came a short expansion from 2002 to 2007. After that came the Great Recession.
Meanwhile, from 2000 to 2015, according to the federal government’s data, real median household income was flat. Only over the past two years have we seen any of that expansion that many were venturing to say was permanent back in the late 1990s.
Economists and policymakers were no more insightful when examining the possibility of a new crisis post-2007.
In 2005, for example, Milton Friedman could have been paraphrasing Yellen’s Tuesday comments when he concluded that “the stability of the economy is greater than it has ever been in our history. We really are in remarkable shape.” Friedman went on to give Alan Greenspan credit for the expansion.
In early 2007, Ben Bernanke predicted, “We’ll see some strengthening in the economy sometime during the middle of the new year.”
As late of mid-2007, Bernanke was downplaying any problems associated with the sub-prime housing market, allaying any fears of a bubble or bust and claiming, “I don’t know whether prices are exactly where they should be, but I think it’s fair to say that much of what’s happened [i.e, enormous home price growth during the housing bubble] is supported by the strength of the economy.”
If housing bubbles do prove to be a problem, Bernanke concluded, it’s “mostly a localized problem and not something that’s going to affect the national economy.”
The US would officially begin to contract in December 2007, followed by a financial crisis the following autumn.
Even on the eve of the crisis — in September 2008 — John McCain announced that “the fundamentals of our economy are strong.”
A year later, the unemployment rate would reach 10 percent, foreclosure rates were surging and total employment would collapse from 116 million to 107 million. Employment would not return to pre-crisis levels until late 2013.
Millions of workers would need to change careers, be retrained, scratch for other forms of income to avoid foreclosure or eviction and put off retirement indefinitely. The economy was so weak for so long, in fact, that the Fed felt it necessary to keep the key target interest rate near zero for seven years to add “stimulus.”
Of course, just because Janet Yellen says the economy won’t experience a crisis anytime soon doesn’t mean a crisis is imminent. A truly strong economy isn’t going to be “jinxed” by a declaration that things are fine. On the other hand, given the record of eminent economists and Fed board members in the past, Yellen’s predictions are hardly anything that should inspire confidence.
The attacks on physical cash from a phalanx of economists, central bankers, commercial banks, and politicians have not diminished in recent years. On the contrary, in the face of the worldwide increase in terror attacks, particularly in Europe, and ongoing pressure on public budgets, the cash ban issue is increasingly dragged into the spotlight.
In a highly-recommended study entitled “Cash, Freedom and Crime. Use and Impact of Cash in a World Going Digital,” Deutsche Bank Research demolishes numerous popular myths surrounding cash, inter alia in the context of crime and terrorism. Without cash there are no longer bank robberies at gun point, instead there are now electronic bank robberies. Fraud involving credit cards and ATM cards is massively increasing in Sweden, the country considered the pioneer of the cashless society. The argument that adopting a cashless payment system would facilitate the fight against terrorism doesn't hold water either:
As regards terrorism in Europe, an analysis of 40 jihadist attacks in the past 20 years shows that most funding came from delinquents’ own funds and 75% of the attacks cost in total less than USD 10,000 to carry out — sums that will hardly raise suspicions even if paid by card.
Moreover, many terrorists, particularly if they are prepared to risk their own death, won't be deterred by prohibitions, just as stricter gun laws have no impact on people who must use unregistered weapons for their crimes. Often, they are unable to get hold of a weapon by legal means anyway if they have a criminal record. Planned terror attacks are as a rule characterized by a meticulous and careful approach. At best a cash ban might make financing of terrorism more difficult (even that is doubtful), but at the price of subjecting the law-abiding peaceful population at large to even more intrusive surveillance.
Legislators have passed additional regulations in the past 12 months which at least restrict the use of cash; bans of high-denomination banknotes (e.g., the 500 euro note) and (lower) thresholds for legal cash payments. There are however also technological developments that are significantly reducing the transaction costs of cashless payments and are therefore making cash comparatively unattractive.
In Sweden, an app called “Swish” introduced by the country's leading banks has revolutionized cashless payments. To this point, the app has been downloaded 5.5 million times. In the Scandinavian country only 2% of all payments are settled in cash these days.
Sweden's central bank expects that this percentage will decline by another three-quarters to 0.5% by the end of the decade. 900 of the 1,600 bank branch offices in the country no longer have any cash in store.
The academic debate continues unabated. A paper that has recently triggered intense debate is the IMF working paper “The Macroeconomics of De-Cashing,” which was published in March 2017. Its author Alexei Kireyev examines the possible macroeconomic consequences of abolishing cash. His central conclusions are:
A cashless payment system would make the monetary policy transmission mechanism more efficient, as there would be very little or no cash available anymore. In particular, it would become possible to implement negative interest rates on a broad front, in order to boost consumption.Since a decline in cash holdings would go hand in hand with an increase in demand deposits at banks, the banking sector would be able to extend more loans. That would lower the level of interest rates and boost economic growth.A sudden increase in the demand for cash is a sign of an imminently impending financial crisis. Shortly before the collapse of Lehman Brothers in September 2008, demand for cash currency increased significantly. That was a sign that bank customers increasingly lost confidence in the solvency and liquidity of commercial banks. This warning signal would no longer be available if cash were abolished.A cashless economy makes tax collection easier, as the example of Sweden illustrates. Regardless of a superficially balanced approach in large parts of the text, the article clearly evinces an underlying bias toward supporting the abolition of cash. Several arguments in the paper are fallacious and represent little more than intellectual kowtowing to the prevailing zeitgeist. Thus a cashless economy is supposedly going to improve “financial inclusiveness” — as every citizen and economic actor would be forced to open a bank account; it would reduce illegal immigration — as employment of illegal immigrants would become more difficult; and it would help protect the environment — because the production of paper or polymers for banknotes has a greater impact on the environment than electronic money.
Whether the given objective of fighting crime and black markets can be realized by banning cash remains a highly controversial issue. Thus, Professor Friedrich Schneider, one of the most renowned experts in the areas shadow economy and tax evasion, shows that a cash ban would reduce illicit employment be a mere 10% and organized crime by less than 5%.
The paper's conclusions ultimately read like a political manual for the abolition of cash by means of salami tactics. In other words, to prevent the population from getting alarmed, it is to be weaned off cash in tolerable doses through a piecemeal approach. Economic incentives for cashless payments are to be put in place, i.e., specifically, fees for cash payments are supposed to be introduced or raised. In our assessment, the most important point though concerns the notion that “de-cashing” would be “critical for the efficiency” of a negative interest rate policy.
Quarterly Journal of Austrian Economics 19, no. 4 (Winter 2016)
ABSTRACT: The aim of this article is to examine the impact of shadow banking on credit expansion and the business cycle. I focus on two main functions of the shadow banking system: securitization and collateral-intermediation. The former enables traditional banks to expand their credit activity, while the latter allows the shadow banks to create new money by themselves. Shadow banking shows that non-banking institutions can also conduct credit expansion and generate the business cycle. Thus, the Austrian business cycle theory should be extended to take into account the way in which shadow banking activity changed the conduct of credit expansion.
KEYWORDS: shadow banking, business cycle, credit expansion, Austrian business cycle theory, securitization, collateralization
JEL CLASSIFICATION: B53, E32, E51, G21, G23 Published on the Mises Wire
Quarterly Journal of Austrian Economics 19, no. 4 (Winter 2016)
Whenever a new book on money and the business cycle from an Austrian perspective is published, the hope is that it will be another monumental contribution setting before the reader the best of monetary and business cycle theory. Alas, while Brian P. Simpson’s Money, Banking, and the Business Cycle includes 509 pages of small dense print stretching over two volumes, such hope is unfounded. While making numerous helpful contributions to our understanding of the economic history of business cycles in the United States, the way Simpson develops his business cycle theory leads to more confusion than clarification. So much so that the work is ultimately disappointing. One should not turn to Money, Banking, and the Business Cycle to learn Austrian business cycle theory. For those looking for a modern, book-length treatment of business cycle theory from an Austrian perspective, Huerta de Soto’s Money, Bank Credit, and Economic Cycles and Roger Garrison’s Time and Money are still preferable.
In our last update on money supply — using the "Austrian" measure of money supply developed by Murray Rothbard and Joseph Salerno — we found that money supply growth hit a 46-month high of 11.2 percent in October.
Growth has moderated since then, however, with year-over-year growth in US dollars dropping to 10.3 percent in November and 8.8 percent in December.
This change somewhat follows a change in M2 over the same time period as M2 growth hit a multi-year high of 7.5 percent in October, but fell to 7.3 percent and 7.0 percent in November and December, respectively.
The Rothbard-Salerno measure of money supply tends to see bigger swings than M2, and in this case the bigger swing is due partially to continued changes in US Treasury deposits at the Fed, which is not included in M2. In October and November, these deposits hit new highs unprecedented in scope, with total growth in October topping 500 percent. As described by the Atlanta Fed, "These deposits are roughly akin to the Treasury's checking account, which is to say the amount held in the account is determined by the Department of the Treasury based on its needs."
During the 2008-2009 period of historically large stimulus spending, Treasury deposits reached unprecedented growth levels. In late 2016, we saw some of the highest growth levels seen since 2008-2009, and this has helped to drive up money supply totals.
With the Trump administration's focus on fiscal policy stimulus — including large increases in military and infrastructure spending (plus the proposed border wall) Treasury spending looks to increase again the near future, and this would likely contribute to ongoing increases in money totals.
What is the significance of this in relation to the business cycle?
Historically, periods of significant decline in the money supply have preceded periods of economic recession. This was the case in the period before the 1990-1991 recession, the 2001-2002 recession, and the 2008-2009 recession. with money supply growth at or above 8 percent right now, however, this does not point to a recession in the immediate future. As with any economic indicator, however, it's impossible to guess when the current trend may substantially change.
2017 is off with a drab whisper as the FOMC, as expected, kept the Fed Funds rate target unchanged at .5-.75%. Further, there was no mention of the alleged three 2017 hikes, which “experts” might consider as to be a dovish move.
The press release was optimistic about the economy and cited a strengthening labor market, economic expansion, and consumer sentiment. Perhaps they haven’t seen the delicate fourth quarter GDP numbers?
One of the themes of 2017 is the issue of the Fed Balance Sheet and whether the Fed is going to be talking up some sort of effort toward shrinking it. On this front, we read:
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way.
Because the Fed would likely begin balance sheet changes by halting — or at least slowing down — the amount of “reinvestments,” this statement is indicating that it has no actual plans to address the balance sheet in the foreseeable future. Go figure. But the statement also emphasizes that addressing the balance sheet won’t take place if the Fed Funds rate normalization process is much further down the road.
This, coupled with the decisions to not touch the Fed Funds target and not even mention 2017 rate hikes indicates that the balance sheet topic probably won’t be seriously discussed for some time. Of course, touching the balance sheet is something the Fed is quite fearful of. Pricking the bubble is a massive no-no that the bureaucrats in every position in Washington want to avoid like the plague.
The FOMC (non)decision is typical of what we have come to expect from the Fed. They pretend they are optimistic about the economy, while at the same time bend over backward to not upset those who depend on such radically “loose monetary policy.”
It’s the most damaging and devastating example of “kicking the can down the road” that the world has ever seen. But those in power and their lobbyists are addicted to easy money. And so they keep it flowing and never look back.
Now that the Fed has slightly upped its Fed Funds rate target twice, there is talk of a much more ominous issue: shrinking the balance sheet. Late last year, St. Louis Fed president James Bullard affirmed that 2017 “possibly might be a good time to play that card.”
What that would entail, of course, is reversing the years of a ballooning balance sheet by selling the securities that it previously attained. In selling assets, the Fed sops up bank reserves and they can no longer be used in the economy.
The entire economy — as well as the so-called recovery — since the Fed began it’s unprecedented asset purchase has been a giant mirage. It rests on the band-aid of financial moves from the Fed that papers over the reality of the situation. The problem with band-aids (monetary expansion) in our context is that no one notices the rot underneath (the destruction of real capital).
If the band-aid is ripped off, the underlying reality is exposed. There is some worry that “the market” will respond poorly. Indeed! Why? Because the whole reason that “the market” has achieved new heights over the years is because it knew the Fed was there to backstop losses and buy assets! Reversing this trend doesn’t create a new crisis, it allows — finally — the healthy correction to complete itself.
It is for this reason that the Fed and the Official Economists want to delay this as long as possible. Hence, in his most recent post, Ben Bernanke urges extreme “patience” [sic for “I hope we never have to do this”] in addressing the size of the balance sheet.
Bernanke had “indicated in testimony in 2013 that the FOMC was considering slowing asset purchases” and this resulted in the so-called “taper tantrum” in which the financial markets roared in disapproval. As Bernanke recalls, “FOMC members pushed back” against the idea that all this talk meant rates were going to rise. In other words, the market threw a fit at the possibility to lessen cheap money and the FOMC rushed in to promise open spigots.
With all the talk in Fed circles of “avoiding [market] disruptions” in the fake quest to shrink the balance sheet it appears to be a brewing financial theme without much substance. Just as the Fed undertook a 7 year narrative of raising the Fed Funds rate, it may take the entire Trump era to “talk about” shrinking the balance sheet.
The Curse of CashKenneth S. RogoffPrinceton University Press, 2016
Kenneth Rogoff would sharply disagree with Peale, a character in the 1915 novel It Pays to Advertise, who said that the most beautiful word in the English language is “cash.” For Rogoff, a distinguished monetary economist (and chess grandmaster) who teaches at Harvard, cash, especially in large denominations, ought to be eliminated.
Rogoff has two main arguments for his proposal; but, before examining them, let us look at exactly what he wishes to do. In his suggested plan, which “can be adapted and tweaked in many directions,” “All paper currency is gradually phased out, beginning with all notes of $50 and above (or foreign equivalent), then next the $20 bill, leaving only $1, $5, and (perhaps) $10 bills. ... The government provides all individuals the option of access to free basic-function debit card/smartphone accounts, either through banks or through a government option. ... Regulatory and legal framework aims to discourage other means of making large-scale payments that can be completely hidden from the government. ... Government helps facilitate ... real-time clearing for most transactions.”
One word reverberates throughout this proposal: “government.” For Rogoff, the government must combat nefarious characters in the “underground economy,” not to mention tax cheats, who transact business in paper money. Think of all the revenue the government has lost, owing to the selfishness of these miscreants!
The problems posed by the underground economy, Rogoff tells us, are far-reaching in scope: there is a great deal of “missing” cash, mostly in large denominations. “The bulk of US cash in circulation cannot be accounted for by consumer surveys. Obviously, if consumers are holding only a small fraction of all cash outstanding, they cannot possibly be holding more than a small fraction of the $100 bills in circulation, since $100 bills account for nearly 80 percent of the value of US currency.”
Where are the missing $100 bills? Much of it is used in illegal activities, like the drug trade. “The drug trade is a famously cash-intensive business at every level. ... The RAND Corporation has estimated the combined size of the market for four major illegal drugs in the United States to be more than $100 billion in 2010. ... Eliminating cash would hardly eliminate drug cartels. Nevertheless, it would be a significant blow to their business model at many levels.”
But could we not instead deal with this problem by ending the drug war? In a legal market, could the drug cartels survive? Rogoff has in part anticipated this response, but he rejects it summarily. “Obviously there are other ways of reducing drug-related crime. A simple one would be to legalize marijuana ... [but] hard drugs would remain problematic.” The thought that the drug war should be ended entirely has not entered his head.
He might reply in this way: “Even if you crazed libertarians would make all drugs legal, you still have to acknowledge that some activities that should be illegal, like human trafficking, depend on dealing in cash. This fact by itself suffices to justify my proposal.”
And this is not all that concerns Rogoff. Cash transactions enable people to avoid paying taxes. “The largest holdings and use of cash in the domestic underground economy likely derive from residents of all types ... who are broadly engaged in legal activities but who are avoiding taxes, regulations, or employment restrictions ... the tax gap is sufficiently huge that if eliminating cash can close it by as little as, say, 10 percent, the revenue gains would be quite substantial ... the gains would be on the order of $50 billion from federal taxes alone and perhaps another $20 billion for state and local taxes.” Rogoff recognizes that many people do not want tax regulations to be “rigidly enforced” but responds that tax evasion creates a “horizontal equity” problem: if you evade your taxes, others, who do not, will have to pay more. But once again, the libertarian response does not occur to him: taxes are unjust exactions that violate people’s rights.
Suppose, though, that one grants to Rogoff that taxes are legitimate and also that ready access to cash makes some crimes much easier to commit. Has he made his case for the abolition of cash? As he recognizes, the advantages of his proposal must be balanced against concerns about privacy: “It is important to separate out protection from government snooping and protection from relatives, friends, employers, or other private entities. Of course, people will always want to keep some expenditures or income secret from spouses, parents, and friends. The government can perfectly allow such transactions as long as they do not entail recurrent large expenditures and income to be completely hidden from the government.”
Incredibly, he fails to realize that many of us do not want the government to monitor what we are doing. As long as our neighbors cannot snoop on us, everything is fine. Where liberty is concerned, Rogoff just does not “get it.” He points that a critic of his proposals quoted against him Dostoevsky’s remark, “Money is coined liberty,” but notes that the remark in The House of the Dead describes life in prison. “To draw an analogy between life in a Tsarist prison and life in the modern liberal state as a defense of large-denomination notes borders on the absurd.” The modern liberal state is your friend; why worry?
What we have discussed so far is only Rogoff ’s first argument for the abolition of cash: he has another as well. If the economy is in a recession, the monetary authorities may need to “turbocharge” the economy by pushing interest rates down. Doing so, they hope, will stimulate production and increase aggregate demand. But at present an obstacle blocks these plans. The money rate of interest has already fallen to zero. Further reductions require negative rates. But if these are imposed, depositors will withdraw their funds. Why keep money in the bank if part of your money will be confiscated?
Rogoff describes the problem of the “zero bound constraint” in this way: “paper currency can be thought of as a zero-interest-rate bond. ... As long as people have the choice of paper money, they are not going to be willing to accept an interest rate that is significantly lower on any kind of bond ... the zero bound has essentially crippled monetary policy across the advanced world for much of the past 8 years since the financial crash of 2008. If unconstrained negative rate policy was possible ... central banks would never ‘run out of bullets’ (i.e., room to keep cutting interest rates)” (p. 5).
If paper money is eliminated, depositors will no longer be able to withdraw their money. What could be simpler?
It is disappointing that Rogoff fails to mention Austrian arguments that stimulating aggregate demand through monetary expansion is not the appropriate response to recession. He has read Rothbard and cites him on paper money in the colonial period (p. 235, note 26). But the Austrian theory of the business cycle is notwithin his range of vision.
He does, though, address an argument by Milton Friedman that is highly relevant to stabilization policy. “Friedman perfectly well understood that monetary policy could be a potent tool for economic stabilization, but he argued that central banks were so incompetent and so prone to inflationary finance that life would be simpler and better if the whole concept of Keynesian activist monetary policy was simply forgotten” (p. 188).
He replies that Friedman’s alternative of limited monetary expansion according to a fixed rule has not worked. Friedman thought that there was a fixed relationship between the quantity of money and prices, but this has not always proved to be the case. Rogoff may be right, but he has not responded to Freidman’s argument against central bank discretion. The fact, if it is one, that a particular alternative to discretionary policy fails is irrelevant. If someone argues that policy A will fail, claiming that alternative B is no better is hardly a response.
Regardless of whether Rogoff ’s way of dealing with the zero bound constraint is economically sound, though, is it not unfair on its face? If you deposit money in a bank, why should it be subject in part to confiscation? Rogoff answers that those who press this objection are victims of a “money illusion”: “Many people will likely regard negative interest rates as a violation of the trust citizens place in their government. ... To see negative nominal interest rates as unholy but moderate inflation as just bad is to suffer what economists call ‘money illusion’ ” (emphasis in original). But why not take this point to be an argument against government-mandated inflation rather than, as Rogoff wishes, a defense of negative interest rates? Rogoff complains of the “zero bound constraint,” but he is himself bound by statist assumptions.
In a cry of desperation, Tim Duy takes to Bloomberg to warn the world about the possibility of “hard-money” advocates getting into the Fed. Why, there’s potential that new Fed governors might not be “divorced from political pressures.” Wouldn’t that be a radical shift.
The hilarity of this article is that the “hard money” label is being applied to defenders of a policy rule; specifically, John Taylor of “Taylor Rule” fame. Yes, the advocates of formula based interest rate shifts, who deride the true hard money of the classical gold standard, are now in the extremist hard money camp.
This is a classic case of taking a minuscule difference between apologists for monetary interventionism and blasting it out of proportion to redefine the debate. After all, if the rule-based advocates are the dangerous fringe, then the current fiat regime is normal and orthodox! Indeed, Duy makes it crystal clear that it is the Bernanke/Yellen clique that has saved the world and the “hard money” Taylorites are about to ruin it. This is the entire spectrum of monetary theory! No mention whatsoever of the true hard money camp: the Austrians and defenders of the 100% gold backed currency.
Duy warns that if these hard money villains had been in charge, their monetary policy would have been too tight and recession would have come by now. Of course, the job of the Fed shouldn’t be to avoid recession at all; it is the boom, not the bust that we ought to criticize. A recession, a liquidating of all the malinvestments caused by a loose Fed, is the healing process that we desperately needed. But we never got it. Hence the current sluggish economic condition.
To finish off, Duy complains that these rule-based advocates would turn policy far too tight, given “underlying economic conditions.” That’s always the ironic rub in the mainstream narrative. The Fed was allegedly the hero who saved the global economy, brought it forth into harmonious recovery. But this “recovered economy” isn’t even ready for a few rate increases after 8 years? Swell recovery.
The Quarterly Journal of Austrian Economics
Vol. 19 | No. 3 | 248–266Fall 2016
An Analysis on the Relationship between Hoarding, Investment and Economic GrowthAlexandru Pătruți
Alexandru Pătruți (alexandru.patruti@rei.ase.ro) is assistant professor in the Department of International Business and Economics at the Bucharest University of Economic Studies, Romania.
ABSTRACT: The relationship between investment, hoarding and economic growth is a rather complex one. Although both investment and monetary hoarding can be considered different instances of capital accumulation in the long run, their short term effects on economic growth can diverge. These transitory variations are based precisely on the fact that money has a driving force of its own, i.e. it is not neutral. I argue that hoarding necessarily implies a longer period of time between the moment when resources are saved and the moment when new consumer goods reach the market (economic growth), as opposed to the case in which the same amount of resources would be invested through the banking system.
KEYWORDS: capital theory, gross market rate of interest, structure of production, investment, economic growth, hoardingJEL CLASSIFICATION: B13, E14, E22, E31, E41, E43, O40INTRODUCTIONEconomic growth is the declared goal of virtually every policymaker in the world. From a pragmatic point of view, one can argue that the main purpose of political economy is to prescribe public policies which generate prosperity (Fetter, 1928). It is beyond the scope of the present article to systematically analyze all the determinants of economic growth. I will focus instead on the relationship between capital accumulation and economic growth, in the attempt to link any increase in a country’s welfare to a previous increase in its stock of capital goods. However, in a monetary economy, capital can be accumulated in more ways than in a simple barter economy. The general medium of exchange grants people the possibility to accumulate resources simply by adding to their personal cash balances—an economic process which is usually referred to as hoarding.
It is thus the fact that money has a driving force of its own—i.e., it is not neutral in the short run—that offers the foundation for the present study. I argue that increasing a society’s cash balances will generate economic growth, but at a later date as compared to the situation in which the same amount of money would be directly invested. This can be proven in an a priori fashion by resorting to capital theory and using the method of comparative statics.
Output growth will lag behind its potential rate in the short run if people increase their cash balances because of the inability of factors’ costs, especially the market rate of interest, to rapidly adjust to the variations in the demand for money. Using an organized market for saving (e.g. the financial market) could probably offer additional benefits in terms of speed. Thus, although hoarding is a growth-promoting tool in the long run, it is probably not the optimal one due to lagged adjustment in interest rates.
LITERATURE REVIEW ON HOARDING AND ECONOMIC GROWTHAs an economist, I hold that capital accumulation is the fundamental cause (or determinant) of economic growth.It would probably be over-simplistic to say that total production is a function of capital and labor, as the familiar Cobb-Douglas function pictures it (Cobb and Douglas, 1927). Although we cannot determine a numerical relationship between the two variables, it seems clear there is a direct link between capital accumulation and economic growth. This is by no means equal to saying that it is the only cause. One can coherently argue that there are at least three determinants of economic growth (Hülsmann, 2011): (1) capital accumulation; (2) an increase in the division of labor; and (3) technological innovation. The present article is a ceteris paribus analysis of economic growth, which assumes technological progress and the level of specialization (i.e. division of labor) to be constant. This idea of linking capital accumulation to economic growth is a rather common one. The history of economic thought teaches us that it goes as far back as Adam Smith’s Wealth of Nations (2007 [1776], p. 213), in which the author writes that: “…the accumulation of stock is previously necessary for carrying on this great improvement in the productive powers of labour, so that accumulation naturally leads to this improvement.” However, it was not until the writings of Eugen von Böhm-Bawerk (1890, 1930) that capital theory became a self-standing branch of political economy, having a distinct and systematic set of economic principles. Later, capital theory came to be associated with the so called Austrian school of economics, flourishing in the works of Hayek (1936, 2008 [1931], 2009 [1941]), Mises (1998 [1949]), Strigl (1934) and Rothbard (2009 [1962]).Two extremely interesting exceptions here would be J. A. Schumpeter and Carl Menger. Schumpeter (1934) differentiated himself from the “main body” of the Austrian school by focusing on technological innovation (and not capital accumulation!) as the main determinant of economic growth. Although he does mention that there is a strong link between credit and growth, “savings” as such do not play a significant role in promoting innovation, which is the Schumpeterian driving force of economic development (Croitoru, 2012, pp. 142–143). Carl Menger is the other notable member of the Austrian school who does not endorse Böhm-Bawerkian capital theory (Hayek, 2009 [1941], p. 46). In a comment made to Schumpeter by Menger, the latter points out that “…time will come when people will realise that Böhm-Bawerk’s theory [of capital and interest] is one of the greatest errors ever committed” (Endres, 1987, p. 291). This was the case mainly because Böhm-Bawerk’s approach towards the capitalist production process was much more objectivist/materialistic than that of his master (Endres, 1987).
The phenomenon of hoarding, on the other hand, was less noticeable in the history of economic thought. It took the forefront of economic disputes for a short while in the famous debate between Keynes and Hayek in the 1930s. Briefly put, in 1932 J. M. Keynes, A. C. Pigou and four other economists drafted and cosigned a letter in which they discouraged savings and advocated public spending in order to fill the gap caused by the “reluctant” private sector. The letter was published by The Times and became what was later known as “the paradox of thrift.”For a detailed analysis of the “paradox of thrift” see Hayek (2008 [1931], pp. 131–189). A response letter written by F. A. Hayek, Lionel Robbins, T. A. Gregory and Arnold Plant was published only two days later in the same newspaper (Leeson, 2014, pp. 90–91). The famous LSE economists argued that although the deflationary perils of hoarding are well known since the writings of the classics, it would be a disaster for the economy if the public would stop saving through deposits in banks or securities (ibidem). After Keynesian economics became the mainstream theory, hoarding generally became classified as an antisocial and detrimental economic habit. The desire to hold cash at hand, which is in Keynesian terms determined by people’s liquidity preference (Keynes, 1936), was considered to be a process which drags the economy backwards. Nearly all policymakers today embrace the Keynesian paradigm of trying to boost aggregate demand through increased consumption in order to generate growth.
Interestingly enough, scattered theoretical insights related to this particular subject can be found in the discussions around the doctrine of forced savings. This should not come as a surprise, since the two topics are connected. The forced savings doctrine largely analyzes a classical case in which the producers benefit in the short run from an increase in the quantity of money to the detriment of fixed income earners (Ahiakpor, 2009). Thus, it represents an analysis on how a general increase in prices gives producers a surplus purchasing power in the short run, because of the lagged adjustment of producers’ costs (wages, rent and interest). Entrepreneurs can use their increased real earnings to lengthen the structure of production and boost economic growth. The present article, on the other hand, studies a reverse situation. The goal is to demonstrate that hoarding (i.e. an increase in monetary capital accumulation) is a rather suboptimal growth promoting tool, because of the short run lagged adjustment of the market rate of interest.
I argue that Hayek (2008 [1931], pp. 131–187), in particular, and the Austrian school (De Soto, 2006; Rothbard, 2009 [1962]), in general, have given abundant arguments as to why consumption cannot increase prosperity by itself. However, there seems to be a lack of economic literature which comparatively analyzes whether in a monetary economy hoarding is in any way different from investment with regards to economic growth. There are of course some notable exceptions, two of which, in my opinion, give us a glimpse of the possible attitudes one can adopt towards hoarding.It is worth mentioning that the two conflicting views are present within the same school of thought. In spite of the fact that numerous researchers accuse “Austrians” of being too dogmatic, one can easily show that there is wide disagreement between its main proponents, even on critical discussion points.
The first type of attitude towards this issue is revealed to us by Eugen von Böhm-Bawerk (1930, pp. 115–116) in “The Positive Theory of Capital”:
“[…] an economically advanced people does not hoard, but puts out what it saves—in the purchase of valuable paper, in deposits in a bank or savings-bank, in loan securities, etc. In these ways the amount saved becomes part of productive credit; it increases the purchasing power of producers for productive purposes; it is thus the cause of an extra demand for means of production or intermediate products; and this, in the last resort, induces those who have the regulation of undertakings to invest the productive powers at their disposal in these intermediate products.”
It becomes clear from this quotation that according to Böhm-Bawerk, economic progress stems from the ability of a people to invest their saved resources. By doing so, economizing individuals transfer their excess purchasing power to producers, who can now start longer and more industrious production processes.
Rothbard, on the other hand, takes a somewhat different stand on the issue. He (Rothbard, 2009 [1962], p. 776) states that:
“[Hoarding] is simply an increase in the demand for money, and the result of this change in valuations is that people get what they desire, i.e., an increase in the real value of their cash balances and of the monetary unit.[…] No other significant economic relation—real income, capital structure, etc.—need be changed at all.”
From this last sentence, the message we seem to get from Rothbard is that hoarding does not have any generalized effect on the structure of production, and implicitly, on economic growth. This would mean that the dynamic of the capital structure is not affected by an increase in people’s desire to hold cash and that no direct relation can exist between hoarding and economic growth.
I aim to prove in the following passages that one can present economic arguments in defense of the first view and against the second. Comparative statics can be used to show that hoarding essentially implies a lengthening of the structure of production in the long run. However, increasing monetary cash balances does not represent the optimal growth promoting tool, because of its short run transitional effects on the configuration of prices.
A SHORT GLOSSARYAlthough such a list of terms is usually found at the back of a book, given the high level of dissent among economists concerning the particular notions we are going to use, I find it useful to define them before starting the exposition.
The first terms that we should dwell on are consumption, savings and hoarding, and the particular relations between them. At this point in the discussion it has hopefully became clear that I define savings as non-consumption. Therefore, savings and consumption are two mutually exclusive notions—i.e. a person can either consume a certain quantity of resources or not, in which case he is saving resources.
In a monetary economy savings can take twoIt is true that the individual also has a third possible option, namely non-monetary hoarding. This would be the somewhat pathological stashing away of physical goods without a clear goal in mind. However, we consider that this is only a marginal phenomenon and therefore has a negligible impact on an aggregated level. main forms, which are additions to private cash balances (i.e. hoarding) or investments (time deposits, buying stocks or bonds, or directly procuring capital goods and starting new production processes on the market).The terminology employed here is essentially a Keynesian one. Hayek (2008 [1931], pp. 442, 443) employs the same terms in his Reflections on the Pure Theory of Money of Mr. J. M. Keynes:Clearly recipients of income must make a choice: they may spend on consumption goods or they may refrain from doing so. In Mr. Keynes’s terminology the latter operation constitutes saving. Insofar as they do save in this sense, they have the further choice between what one would ordinarily call hoarding and investing or, as Mr. Keynes (because he has employed these more familiar terms for other concepts) chooses to call it, between “bank-deposits” and “securities.”However, the careful reader will immediately observe that the analysis is not a Keynesian one. For Keynes a decrease/increase in saving is assumed to be the only independent factor which impinges on a relatively rigid structure of production (Hayek, 2008 [1931], p. 429). The aim of the present article is precisely to analyze how the structure of production adapts to different monetary stimuli. We agree in this respect with Milton Friedman who points out in an interview that one of the benefits of Keynes’ influence on economic theory was the fact that he developed a terminology which proved useful even for those economists who do not agree with his theory (Blaug, 1990, p. 89). It is clear that both hoarding and investing are instances when acting man foregoes present consumption, having in mind greater future satisfactions. They have fundamentally the same nature in the sense that they are dependent on people’s time preferences, i.e. their willingness to sacrifice present consumption for the prospect of increasing future consumption (Mises, 1998 [1949], pp. 483–490). When people hoard, they normallyI say normally because, at least theoretically, there is a possibility that hoarding can come from disinvestment. But this is, to my mind, a rather improbable outcome. Why would an investor rationally choose to withdraw his investments and keep the cash stocked away for a significant amount of time? This would mean that he would willingly choose to forgo the amount he used to receive as return on his past investment, for no income whatsoever. The only probable reason I can think of for such an action would be the fact that our would-be investor would need to make an imminent payment (i.e. he needs liquidity to buy something else), either for a consumption good, or another investment. In this case, the hoarding he generates is an extremely transitory phenomenon and can be neglected from our analysis. withdraw a certain sum of money from their present income, a sum which they would have previously used for consumption purposes, and hold on to it for future use.
Now that we hopefully cleared out all possible confusions around the conceptual relationships between savings, consumption, monetary hoarding and investment, we can move on to the even more complicated, if not impossible, issue of defining economic growth. In this article I will follow Hülsmann (2011, pp. 36–37) in defining economic growth as a systematic increase in the physical output of consumer goods. I am fully aware of the shortcomings of the chosen definition. However, we consider that it is almost impossible to define economic growth in monetary terms, because there is no possibility of subtracting the overlapping effects triggered by variations in the purchasing power of the monetary unit over a certain period of time from the underlining effects caused by real forces. Thus, the increase in monetary value of final goods produced in, let us say, a year, is irrelevant since the purchasing power of the monetary unit could have varied in any way because of cash induced variations (i.e. changes in the supply of or demand for money).For a detailed analysis regarding cash induced and goods induced changes in purchasing power see Ludwig von Mises’s Human Action (1998 [1949], pp. 419–424). To my mind, if we are not willing to drop the term of “economic growth” altogether, we must be willing to refer to it in physical terms. It is true on the other hand that we are now facing another serious problem, namely that in a society which is producing nonhomogeneous goods, there can be situations in which the production of some goods has increased, while the production of others has decreased. The economist finds himself in this case in the impossibility of deciding ex post whether society has experienced growth or not. Hence, the solution I propose is to refer to economic growth as a systematic upward trend in the production of nearly all final goods. If this general tendency exists, we can say that a society has experienced growth.I fully concede that it is probably more rigorous from a theoretical point of view to define economic growth as an increase in the overall value in a society. But monetary calculation is the only way value can be gauged in a complex economy, and as I previously explained, variations in the purchasing power of the monetary unit can render this concept almost useless in practice.
THE CAUSAL RELATIONSHIPS BETWEEN HOARDING, INVESTMENT AND ECONOMIC GROWTHGiven the fact that we have already defined the economic notions that will be employed in the present analysis, and that we put the discussion into historical context, one can now proceed to the main topic of the article, which is the study of the causal relationships between hoarding, investment and economic growth. The way in which I aim to conduct this study is by using comparative static analysis applied on two hypothetical scenarios. After showing that both monetary hoarding and investments are growth promoting tools, I will briefly give additional arguments to suggest that hoarding brings about certain short term vagaries which can postpone future economic growth.
The Thesis
I aim to demonstrate that both hoarding and investments lead to a lengthening of the structure of production and consequently to future economic growth in the long run. However, I argue that savings through investment does generate additional benefits in terms of speed (i.e., economic growth will be somewhat faster) and that these advantages stem from the impossibility of the price structure to adjust instantaneously to variations in the total demand for money.One would be tempted to use the term “time lag” to describe this adjustment process of the price structure from the old equilibrium point to the new equilibrium point. However, this would probably not be the best strategical option because this notion gives an econometric connotation to the phenomenon, which by its specific nature is unquantifiable. This is the same thing as saying that both hoarding and investments are growth-promoting tools in the long run, but the latter appears to be the optimal one because of its additional short run positive effects.
It is useful to point out that when I refer to “the long run,” I am merely indicating that there is a tendency law involved, in the classical sense of the word. Thus, there is a systematic trend in the economy to push the market towards a certain equilibrium point, even though that point will never be reached in real life.For a systematic analysis of tendency laws from the perspective of economic thought, see Blaug (1997, pp. 59–62). For a detailed inquiry of the role of imaginary constructions (including the final equilibrium model) see Mises (1998 [1949], pp. 236–251).
Now in order to prove the above mentioned thesis, respectively that both hoarding and investment have the same effects in the long run, but that investment offers increased benefits in terms of speed, a few additional theoretical premises are necessary. Thus, one requires the Hayekian theory of the structure of production, as presented in Prices and Production (Hayek, 2008 [1931])I was tempted to include here also a third reference, namely Böhm-Bawerk’s (1930, p. 20) famous thesis that longer production processes are necessarily more productive from a physical point of view. However, this was already included in Hayek’s work (2008 [1931], p. 156): “The proposition that savings can only bring about an increase in the volume of production by permitting a greater and more productive ‘roundaboutness’ in the methods of production has been demonstrated so fully by the classical analysis of Böhm-Bawerk that it does not require further examination.” and Ludwig von Mises’s analysis on the interest rate from Human Action (1998 [1949], pp. 538–550).According to some sources (Hayek, 2008 [1931], p. 454; Ahiakpor, 2009, p. 167), this type of analysis in which the market rate of interest diverges from the equilibrium rate of interest is originally associated with the Swedish economist Knut Wicksell. Aside from these two pieces of theoretical knowledge, all that is needed is to employ the method of comparative static analysis on a hypothetical example which includes two scenarios.
The Two Scenarios
Let us assume a closed economy where, for the purpose of simplification, people have only three options: to consume, to hoard cash or to open time deposits in banks (i.e. consumption, hoarding and investment). Again, for the same purpose let us assume that we are dealing with a 100 percent reserve banking system, where the only available saving products offered by the bank are time deposits, i.e. deposits that carry interest, and once you opened them you cannot withdraw the money until the specific date is due.I willingly avoid fractional reserve banking because it allows the possibility of credit expansion, in which case the market rate of interest can virtually deviate permanently from its equilibrium level.
In this hypothetical economy we can build two scenarios: one in which all the saved resources are invested and one in which part of the saved resources are kept in individual cash balances. The purpose of the exercise is to use capital theory to demonstrate that both scenarios lead to the same result in the long run,I will argue further in the article that an underlining tendency to push the market to the same equilibrium point is present in both scenarios, but the two “paths” towards this point are rather different. but also to gather sufficient arguments to suggest that investment would promote faster growth.
Scenario One
The first scenario consists in the assumption that equilibrium is reached in our hypothetical society and that people invest—i.e. make time deposits of—20 percent of their annual income and use the rest for consumption purposes. Now let us again suppose that (for whatever reasons) the social rate of time preference changes and that people now save 40 percent of their annual income. Society will now move from the previous equilibrium point to a new one, in which the structure of production will be lengthened. Certain additional economic assertions can be made in this case.
First of all, the decrease in the social time preference has caused an increase in savings from 20 to 40 percent of the total income of the society (which in this particular case is equal to investment because we assumed that all the money was deposited in the banks). This means that the market rate of interest must decrease, because there are more resources that entrepreneurs can advance. Businessmen are now free to invest in longer production processes since credit is cheaper.They are stimulated to follow this course of action by the variations in the net present value of different investment projects. A decrease in the market rate of interest, which in this scenario coincides with the pure rate of interest, makes longer production process more attractive to investors. They now have the necessary purchasing power to drag resources away from production processes which are closer to final consumers, towards superior stages of productions. For a detailed analysis on the role of the net present value in Austrian economics see Fuller (2013). By doing this, they increase future economic growth, since longer production processes are necessarily more productive from a physical point of view, as we know from the above cited Böhm-Bawerkian principle. In the theoretical framework we designed, this practically means that there will be an increase in the future production of consumption goods, as a consequence of the present increase in capital stock.
This should all sound rather simple and clear cut to anyone familiar with Austrian capital theory. The only thing I would like to highlight is the role played by banks as financial intermediaries in the whole process. After receiving the new funds, the banks can use them to give productive credit. The only way they can accommodate these credits on the market is, ceteris paribus, at a lower rate of interest. Thus, the interest rate will almost immediately drop on the loan market because of the monetary influx.
However, the situation gets more complicated when we introduce a new “disturbing” factor into the picture—monetary hoarding.Again, I am using the term disturbing factor not because hoarding is detrimental to the economy, but because it is a temporary variation which superimposes itself over the long term trend. This will be done in the following scenario.
Scenario Two
The second scenario consists basically in the same economic tendency, i.e., a society which increases its savings from an aggregated level of 20 percent to an aggregated level of 40 percent of total annual income. However, we will now introduce a further assumption, in the sense that the newly saved monetary resources (representing 20 percent of total annual income) will not be invested via the banking system, but hoarded away in people’s homes. The question which arises is whether there is any difference between this situation and the first one.
…and yes, there is. The key is to keep in mind that money has a driving force of its own and that any variation in the supply or demand for money will affect the purchasing power of the monetary unit. But the problems concentrated around the rate of interest are even more interesting and they should attract our attention in order to answer the research question.
When referring to interest, one usually has in mind the premium obtained over a principal sum of money which is being lent. This natural occurring phenomenon is nothing else than the market rate of interest, i.e., interest on short to medium term loans on the money market (Mises, 1998 [1949]). This is the relevant real life indicator for gauging people’s time preference and thus the one that entrepreneurs use to adjust the structure of production (Strigl, 1934; Mises, 1998 [1949]). We know that a decrease in the rate of interest causes a lengthening of the structure of production and that this will in turn increase future economic growth (Hayek, 2008 [1931]). This is one of the main theses of Austrian capital theory and one on which the whole argument of the present paper is built. However, in order for this increase in the structure of production to take place in real life, there must be a prior decrease in the market rate of interest. But it is exactly this particular reason that differentiates the second scenario from the first. In the short run, the market rate of interest does not drop when people hoard a part of the saved resources. This happens because the newly saved money does not reach the capital market and is thus not transformed into productive credit. Still, this does not mean that hoarding is neutral on the structure of production, as some economists appear to suggest (Rothbard, 2009 [1962], p. 776), for the reasons that I have previously suggested.
Let us go one step further with the analysis. In order to tackle the theoretical problems surrounding the concept of interest, economists (Mises, 1998 [1949], pp. 538–545) break down the market rate of interest in three main components: the natural rate of interest, an entrepreneurial component and a purchasing power component. In our particular case, we are not interested in the second component, the entrepreneurial one, so we will hold it under the ceteris paribus clause and further discus the remaining two elements. The natural rate of interest represents the interest rate that is achieved when a society reaches equilibriumEconomists have used a myriad of names to refer to the equilibrium rate of interest, including but not limited to: originary interest (Mises, 1998 [1949]), natural rate of interest (Wicksell, 1989) or pure rate of interest (Rothbard, 2009 [1962]). Regardless of the denomination, all terms refer to the same underlining phenomenon, i.e. the rate of interest which is formed after all the current tendencies have completely run their course and no further changes in market data occur. and it depends entirely on the social time preference.
However, there are situations when an underlining equilibrium tendency can be in the short run affected by disturbing causes, to use Blaug’s (1997, pp. 51–66) terminology. Some of the most important factors which can cause a divergence of the market rate of interest (MRI) from the pure rate of interest (PRI) in a monetary economy are variations in the relationship between the supply and demand for money. This is the reason why the market rate of interest contains a third element, a purchasing power component which adjusts the short and medium term interest rate to variations in the purchasing power of money. This third component is either a positive or a negative price premium: if all prices rise, it has a positive value, if all prices fall, its value will become negative. We will see further that this short theoretical discussion will help us answer our research question.
Scenario two is intended to present us with an example of a society in which there will be a short run discrepancy between the market rate of interest and the pure rate of interest. The former will remain basically the same in the short run, because the extra funds will not pour in directly on the credit market, while the latter will decrease because of the corresponding drop in the social time preference. However, as economists we know that such a situation cannot persist, given that the market has a natural tendency to eliminate such discrepancies. Ludwig von Mises (1998 [1949], pp. 538–539) is extremely eloquent on this particular subject in his economic treaty “Human Action”:
Changes in the money relation may under certain circumstances first affect the loan market rate of interest on loans, which we may call the gross money (or market) rate of interest. Can such changes in the gross money rate cause the net rate of interest included in it to deviate lastingly from the height which corresponds to the rate of originary interest, i.e., the difference between the valuation of present and future goods? Can events on the loan market partially or totally eliminate originary interest? No economist will hesitate to answer these questions in the negative.
This is the main reason I claimed that hoarding and investment necessarily have the same effect in the long run. The market mechanism has a driving force which assures that resources are allocated in an optimal fashion. No idle resources can exist in the long run. Every time someone decides to spend less money on consumption purposes, there is a corresponding change in the productive forces of society. For every penny saved, there will be, in the long run, an entrepreneur who will marginally alter the structure of production, in the sense of making it more roundabout, and thus, more productive.
But we still have not answered our question. As I mentioned before, scenario one and scenario two describe two slightly different paths towards the same equilibrium point. The social time preference is the same in both of them, i.e. they both represent societies in which people increase their savings from 20 percent to 40 percent of the total income. Then how do the saved resources in the form of hoarded cash manifest themselves on the market rate of interest? This is the point where the purchasing power component becomes an extremely useful tool in our analysis.
In scenario one, where all the people keep their saved money in banks, the market rate of interest falls almost immediately in accordance with the change in social time preference. However, in the second scenario, there will be a short run deviation between the MRI and the PRI. This deviation will be corrected through the purchasing power component. When people hoard money, the purchasing power of the monetary unit steadily increases and the price structure gradually changes. However, this is a complicated process through which every price in the economy must be altered, and the adjustment of the MRI through the purchasing power component will always lag behind the price movements. This process is described by Mises (1998 [1949], p. 545):
We have shown one reason why the price premium can at best practically deaden, but never eliminate entirely, the repercussions of cash-induced changes in the money relation upon the content of credit transactions. […] The price premium always lags behind the changes in purchasing power because what generates it is not the change in the supply of money […], but the—necessarily later occurring—effects of these changes upon the price structure.
Thus, although monetary hoarding is in the long run nothing more than a particular case of capital accumulation, it does generate in the short run something which can be called a “time-efficiency” problem. This is the case because the market rate of interest cannot instantaneously adapt itself to the new situation, and it is exactly this indicator that enters in the entrepreneur’s decision making process. If people increase their monetary holdings for a significant period of time, all prices must gradually adapt before the market interest rate can be adjusted through the purchasing power component.
On the other hand, if we recall scenario one, in which all people directly invested (in our particular example all savings were kept in time deposits), the situation was much simpler in the sense that the market rate of interest adapted almost instantaneously and entrepreneurs could reap directly the benefits of increased capital accumulation. This is the reason for which I claim that although both hoarding and investment are growth promoting tools, the former does necessary bring about short term vagaries in the money relation which relatively delay economic growth.
THE BENEFITS OF AN ORGANIZED MARKETI consider that the main thesis of the present paper is a rather intuitive one. The theoretical apparatus employed had the sole purpose of elaborating a formal argument in favor of showing that hoarding is a particular form of capital accumulation in the long run. However, monetary hoarding does appear to create a time lag in the short run as opposed to direct investment of the saved resources, lag which is caused by the necessary adjustments of the market rate of interest to the variation in the purchasing power of the monetary unit.
In the present section I will attempt to give further reasons why saving via banksOf course, I am referring here to a non-inflationary banking system. If the banks use their fractional reserve privileges to create an artificial credit expansion, the above mentioned speed benefits will unequivocally be overcompensated by the negative consequences of the boom-bust cycle. For a detailed analysis of the negative effects of the business cycle, see the Mises-Hayek theory of economic crises (Mises, 1998 [1949]; Hayek, 2008 [1931]). can offer additional benefits by accelerating economic growth. The previous and rather straightforward argument which I provided was that when all the saved resources go into the banking system, the market rate of interest will adjust almost immediately. Entrepreneurs can benefit in this way from the smaller interest rate faster, which enables them to lengthen the structure of production and accordingly increase future economic growth. The adjustment process will be more intricate if people decide to hoard the same amount of money. In this case, only after all the price movements come to a halt (i.e. after all the prices become fully adjusted to the new purchasing power) can the market rate of inters drop, based on the negative purchasing power premium. If this line or argumentation has not yet fully convinced the reader, let us briefly try an additional approach.
Banks can do a better job in terms of speed of adjustment because the banking system is an example of an organized market. Organized markets generally tend to perform better than non-organized ones because they can decrease transaction costs.
This happens since banks are a specialized kind of intermediary. They are wholesalers, i.e., they collect money from numerous scattered individuals and they generally lend to a small number of businessmen. It is a known fact that intermediaries play a beneficial role for society, in the sense that they quickly diminish price gaps, pushing the market towards equilibrium. In a world based on the international division of labor, specialized producers should be more efficient than non-specialized ones. Our analysis here is nothing more than a particular case of Adam Smith’s (2007 [1776]) theory of specialization.
It is not the goal of the present paper to elaborate on the theory of the organized market, nor the theory of the wholesaler. However, I do consider that both of them are prima facie arguments that add to my previous demonstration, and that they are extremely interesting topics for further research.
CONCLUSIONSWe have shown in the present paper that hoarding is a particular form of capital accumulation, which permits entrepreneurs to lengthen the structure of production and increase future economic growth. However, I argue that hoarding necessarily implies a longer period of time between the moment when resources are saved and the moment when the new consumer goods are brought to the market (i.e. economic growth), as opposed to the case in which saved resources would be invested through the banking system (or any other type of direct investment).
The reason for which this happens lies within the specific features of the monetary economy. When people hoard cash, the only way in which entrepreneurs can employ the newly saved productive forces is through an increase in the purchasing power of the monetary unit. But this implies a gradual change in virtually all the prices in an economy, a process which is necessarily time consuming.
On the other hand, by using the banking system to save money, financial intermediaries can almost immediately adapt the market rate of interest and supply businessmen with the necessary resources to lengthen the structure of production. In this way, the previously discussed time lag is reduced and economic growth will be somewhat faster because the market rate of interest can adjust before the whole price structure. The fact that banks are also producers of specialized services and that the financial market is an organized market are supplementary arguments that add to the present demonstration. They both represent eventual directions for further research.
REFERENCESAhiakpor, James C. W. 2009. “The Phillips Curve Analysis: An Illustration of the Classical Forced-Saving Doctrine,” Journal of the History of Economic Thought 31, no. 2: 143–160.
Blaug, Mark. 1990. John Maynard Keynes: Life, Ideas, Legacy. New York: Palgrave Macmillan.
——. 1997. The Methodology of Economics or How Economists Explain. 2nd ed. Cambridge: Cambridge University Press.
Böhm-Bawerk, Eugen von. 1890. Capital and Interest: A Critical Analysis of Economic History. London: Macmillan and Co.
——. 1930. The Positive Theory of Capital. New York: G. E. Stechert and Co.
Cobb, Charles W., and Paul H. Douglas. 1927. “A Theory of Production,” American Economic Review 18, Supp.: 139–165.
Croitoru, Alin. 2012. “Book Review: Schumpeter, J.A., 1934 (2008), The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest and the Business Cycle,” Journal Of Comparative Research In Anthropology And Sociology 3, no. 2: 137–148.
De Soto, Jesus Huerta. 2006. Money, Bank Credit and Economic Cycles. Auburn, Ala.: Ludwig von Mises Institute.
Endres, Anthony M. 1987. “The Origins of Böhm-Bawerk’s ‘Greatest Error’: Theoretical Points of Separation from Menger,” Journal of Institutional and Theoretical Economics 143, no. 2: 291–309.
Fetter, Frank A. 1928. Economic Principles. New York: Century Company.
Fuller, Edward W. 2013. “The Marginal Efficiency of Capital,” Quarterly Journal of Austrian Economics 16, no. 4: 379–400.
Hayek, Friedrich A. von. 1931. Prices and Production and Other Works. Auburn, Ala.: Ludwig von Mises Institute, 2008.
——. 1936. The Mythology of Capital. Auburn: Ala.: Ludwig von Mises Institute, 1936.
——. 1941. The Pure Theory of Capital. Auburn: Ala.: Ludwig von Mises Institute, 2009.
Hülsmann, Jörg Guido. 2011. The Structure of Production Reconsidered. Angers: GRANEM.
Keynes, John Maynard. 1936. The General Theory of Employment, Interest and Money. London: Macmillan.
Leeson, Robert. 2014. Hayek: A Collaborative Biography: Part III, Fraud, Fascism and Free Market Religion. New York: Palgrave Macmillan.
Mises, Ludwig von. 1949. Human Action: A Treatise on Economics. Scholar’s Edition. Auburn: Ala.: Ludwig von Mises Institute, 1998.
Rothbard, Murray N. 1962. Man, Economy and State with Power and Market. 2nd ed. Auburn: Ala.: Ludwig von Mises Institute, 2009.
Schumpeter, Joseph A. 1934. Theory of Economic Development. Cambridge: Harvard University Press.
Smith, Adam. 1776. An Inquiry into the Nature and Causes of the Wealth of Nations. 4th ed.. Amsterdam: Metalibri, 2007.
Strigl, Richard von. 1934. Capital and Production. Vienna: Julius Springer.
Wicksell, Knut. 1989. Interest and Prices. New York: Sentry Press.
Quarterly Journal of Austrian Economics 19, no. 3 (Fall 2016): 248–266ABSTRACT: The relationship between investment, hoarding and economic growth is a rather complex one. Although both investment and monetary hoarding can be considered different instances of capital accumulation in the long run, their short term effects on economic growth can diverge. These transitory variations are based precisely on the fact that money has a driving force of its own, i.e. it is not neutral. I argue that hoarding necessarily implies a longer period of time between the moment when resources are saved and the moment when new consumer goods reach the market (economic growth), as opposed to the case in which the same amount of resources would be invested through the banking system.
KEYWORDS: capital theory, gross market rate of interest, structure of production, investment, economic growth, hoardingJEL CLASSIFICATION: B13, E14, E22, E31, E41, E43, O40
The End of Alchemy: Money, Banking, and the Future of the Global Economyby Mervyn W. KingW.W. Norton & Co. 2016xv + 431 pages
Mervyn King is the British Ben Bernanke. An eminent academic economist, who now teaches both at New York University and the London School of Economics, King was from 2003 to 2013 Governor of the Bank of England. In short, he is a very big deal. Remarkably, in The End of Alchemy he frequently sounds like Murray Rothbard.
King identifies a basic problem in the banking system that has again and again led to financial crisis. “The idea that paper money could replace intrinsically valuable gold and precious metals, and that banks could take secure short-term deposits and transform them into long-term risky investments came into its own with the Industrial Revolution in the eighteenth century. It was both revolutionary and immensely seductive. It was in fact financial alchemy — the creation of extraordinary financial powers that defy reality and common sense. Pursuit of this monetary elixir has brought a series of economic disasters — from hyperinflation to banking collapses.”
How exactly is this alchemy supposed to work? “People believed in alchemy because, so it was argued, depositors would never all choose to withdraw their money at the same time. If depositors’ requirements to make payments or obtain liquidity were, when averaged over a large number of depositors, a predictable flow, then deposits could provide a reliable source of long-term funding. But if a sizable group of depositors were to withdraw funds at the same time, the bank would be forced either to demand immediate repayment of the loans it had made, … or to default on the claims of depositors.” Readers of Rothbard’s What Has Government Done to Our Money? will recognize a familiar theme.
Many have sought to salvage the alchemy of banking by resorting to a central bank. By acting as a lender of last resort, a central bank can bail out banks in need of funds to satisfy anxious depositors and thus avert the danger of a bank run. The alchemy of transforming deposits into investments can now proceed.
Though he was one of the world’s leading central bankers, King finds fault with this “solution.” A local bank can be rescued by getting money from the central bank, but the process generates new problems. Thomas Hankey, a nineteenth-century Governor of the Bank of England, pointed out some of these in response to Walter Bagehot, the classic defender of the central bank as the lender of last resort:
[i]f banks came to rely on the Bank of England to bail them out when in difficulty, then they would take excessive risks and abandon “sound principles of banking.” They would run down their liquid assets, relying instead on cheap central bank insurance — and that is exactly what happened before the recent [2008] crisis. The provision of insurance without a proper charge is an incentive to take excessive risks — in modern jargon, it creates “moral hazard.”
Given the dangers of financial alchemy, what should we do about it? Again, King strikes a Rothbardian note. He writes with great sympathy for one hundred percent reserve banking.
Even though the degree of alchemy of the banking system was much less fifty or more years ago than it is today, it is interesting that many of the most distinguished economists of the first half of the twentieth century believed in forcing banks to hold sufficient liquid assets to back 100 percent of their deposits. They recommended ending the system of “fractional reserve banking,” under which banks create deposits to finance risky lending and so have insufficient safe cash reserves to back their deposits.
Like Rothbard, King calls attention to the insights of the nineteenth-century Jacksonian William Leggett. King cites an article of 1834 in which Leggett said:
Let the [current] law be repealed; let a law be substituted, requiring simply that any person entering into banking business shall be required to lodge with some officer designated in the law, real estate, or other approved security, to the full amount of the notes which he might desire to issue.
King may to an extent resemble Rothbard; but unfortunately he is not Rothbard; and alert readers will have caught an important difference between King’s idea of one hundred percent reserve banking and Rothbard’s. King’s notion, unlike Rothbard’s, still allows banks to expand the money supply. The “liquid assets” need not be identical with the deposits: they need only be easily convertible into money should the need arise to do so.
King’s own plan to “end the alchemy” allows for substantial monetary expansion. He calls his idea the “pawnbroker for all seasons (PFAS)” approach. This is a form of “liquidity” insurance. Banks would have to put up in advance as collateral with the central bank some of their assets. This would act as a “form of mandatory insurance so that in the event of a crisis a central bank would be free to lend on terms already agreed.” So long as the insurance had been paid, though, the central bank would still bail the bank out in a crisis by giving it more money. Contrast this with the plan suggested in the quotation from Leggett, in which if a bank could not redeem its notes, depositors could proceed directly against the bank’s assets. This allows no monetary expansion; and Rothbard’s plan is of course more restrictive still.
Having come so close to Rothbard, why does King shrink from the final step? Why does he still allow room for monetary expansion? He fears deflation.
Sharp changes in the balance between the demand for and supply of liquidity can cause havoc in the economy. The key advantage of man-made money is that its supply can be increased or decreased rapidly in response to a sudden change in demand. Such an ability is a virtue, not a vice, of paper or electronic money. … The ability to expand the supply of money in times of crisis is essential to avoid a depression.
But if the demand for liquidity suddenly increases, when the monetary stock is constant, cannot falling prices for goods satisfy the demand? King, here following Keynes, is skeptical. “Wage and price flexibility does help to coordinate plans when all the markets relevant to future decisions exist. But in practice they do not, and in those circumstances cuts in wages and prices may lower incomes without stimulating current demand.” Prices may keep falling indefinitely.
Other possibilities of coordination failure also trouble King, and underlying them is an important argument. Following Frank Knight, he distinguishes between risk and uncertainty.
Risk concerns events, like your house catching fire, where it is possible to define precisely the nature of that future outcome and to assign a probability to the occurrence of the event based on past experience. … Uncertainty, by contrast, concerns events where it is not possible to define, or even imagine, all possible future outcomes, and to which probabilities cannot therefore be assigned.
We live in a world of radical uncertainty, and thus we cannot be sure that relying on market prices to adjust to changes in the demand to hold money suffices to avert catastrophe. It is for this reason that resort to monetary expansion sometimes is needed.
This argument moves altogether too fast. It does not follow from the fact that Knightian uncertainty prevails widely that one must take seriously the possibility that prices and wages would fall indefinitely. In a situation of uncertainty, we cannot, by hypothesis, calculate probabilities; but this does not require that we take outlandish possibilities as likely occurrences that must be averted by the government. Some reason needs to be given for supposing that prices will continue to fall indefinitely. Why would entrepreneurs not be able to correct the situation, without resorting to monetary expansion? We are not faced with a dichotomy between exact mathematical calculation, in the style of an Arrow-Debreu equilibrium, and blind groping in the dark.
King himself acknowledges that in the American depression of 1920 to 1921, no resort to the government was needed.
The striking fact is that throughout the episode there was no active stabilization policy by the government or central bank, and prices moved in a violent fashion. It was, in the words of James Grant, the Wall Street financial journalist and writer, “the depression that cured itself.”
It is encouraging that King cites the Austrian economist James Grant, but he draws from his work an insufficient message. “The key lesson from the experience of 1920–21 is that it is a mistake to think of all recessions as having similar causes and requiring similar remedies.” In view of the manifold invidious consequences, fully acknowledged by King, of government intervention, should we not rather emphasize the need to rely on the unhampered market? King nevertheless merits praise for coming close, in his own way, to many Austrian insights.
Even well-read fans of Austrian economics often have a hard time understanding and conceptualizing what the Fed really does. So we asked our good friend Dr. Jeffrey Herbener to join us and make sense of it all. We cover the basic blocking and tackling of central bank mechanics: how commercial bank reserves are created, the difference between the monetary base and the money supply, and how the Fed Funds rate impacts lending and the structure of production. We consider how Austrian business cycle theory describes the distortions created by artificially low interest rates, and how interest rates ought to operate as price signals. Finally, we discuss how early recipients of newly created money and credit benefit in ways that ordinary citizens don't.
This show is a great primer on the Fed from an Austrian perspective.
Featuring lectures by Philipp Bagus, Joseph T. Salerno, and Murray N. Rothbard, this three-lecture course gives the student a coherent Austrian economics approach to money and banking, with sound economic theory applied to the origins and development of money, fractional reserve banking, and central banks.
The Quarterly Journal of Austrian Economics
Vol. 19 | No. 2 | 200–213Summer 2016
Book Review
The Ontology and Function of Money: The Philosophical Fundamentals of Monetary Institutions
Leonidas ZelmanovitzLanham, MD: Lexington Books, 2015, xxi + 447 pp.
Nikolay GertchevNikolay Gertchev (ngertchev@gmail.com) holds a Ph.D. in economics from the University of Paris II Pantheon-Assas, and currently works for an international organization based in Brussels, Belgium.
This ambitious new book on the foundations of money and monetary institutions, based on the author’s Ph.D. dissertation defended in 2011 at the Universidad Rey Juan Carlos in Madrid, Spain (supervised by Gabriel Calzada), is an impressive interdisciplinary exercise. Part I of the book, “Metaphysics,” dwells into the nature, origin, and valuation of money. Part II, “Epistemology,” discusses what could possibly be known about monetary phenomena, and how this knowledge can best be acquired. Part III, “Ethics,” proposes a framework for a moral assessment of monetary arrangements and institutions. The last part, “Politics,” which spreads over one third of the book, addresses various issues, such as the history of fiat paper money in the USA, the optimum supply of money and credit, contemporary monetary policy and considerations about the future evolution of money. Five appendices, totaling fifty pages, detail the author’s thoughts on topics as diverse as coined money in Greece, dollarization, financial repression and even the resource curse. The book also contains a ten-page glossary and an extensive index, both of which are meant to help the reader cope with the abundant concepts and authorities to which the author refers. Capitalizing on his interdisciplinary approach, Zelmanovitz hopes to reach a large audience that goes beyond the limited circle of scholarly economists. His plan will certainly be challenged by the book’s price (in excess of hundred dollars).
The author’s research project, though immense, is striking by its clarity: a normative prescription for improving a society’s monetary institutions requires knowledge about the nature and value of money, a proper understanding of the limits of that knowledge and a realistic view about how it could be implemented practically, given the political constraints of the real world. This clarity results in a structural consistency that excites the reader’s curiosity and renders the book pleasant and engaging. The trouble with it is that, despite bringing together different views from several social disciplines, the book is not entirely convincing. Zelmanovitz possesses a vast knowledge of both authors and issues that he puts on show; but he fails to develop a step-by-step criticism-proof argument that alone could gain the reader’s endorsement. The remaining of this review will substantiate this opinion with a discussion of Zelmanovitz’s views in three areas that are foundational of his project: the moral assessment of social institutions in general, the moral justification of central banking in particular, and the theory of monetary equilibrium.
WHAT DISTINGUISHES RIGHT FROM WRONG SOCIAL ARRANGEMENTS?In the author’s intellectual framework, a proper answer to this question is essential for grasping the essence of money, because “the idea is to approach money as a social institution” (p. 1). Thus, the ethical appraisal of present-day monetary arrangements becomes encapsulated in the much broader question of the ethical assessment of social arrangements in general. Zelmanovitz’s preferred criterion for right and wrong is heavily influenced by the objectivist philosophy of Ayn Rand: “It seems difficult to think about a better criterion to define what is right and wrong with social arrangements than measuring them in light of their capacity to allow and to promote human flourishing” (pp. 167–167). The more an institution contributes to the development of the individual persona, the more appropriate it is: “Humans by nature have conscience and intelligence and the very purpose of their social arrangements is to enhance their individual opportunities to reach the limits of their potential, to flourish as individuals” (p. 4). This natural tendency of the human being to purposefully seek his own flourishing would, presumably, have the added benefit of deriving irrefutable normative statements from the very essence of beings and things. Whatever promotes individual flourishing would be right and good, and hence morally justified. This criterion would offer a solution to the alleged impossibility to derive normative claims from descriptive statements: “In the same way, that exception to the fallacy of deriving an ‘ought’ from an ‘is’ applies to what is instrumental to living beings to realize their potential” (p. 2).
As attractive as might appear this functionalist version of a naturalistic moral philosophy, it is a source of deep confusion. First of all, it lacks universality. What exactly does “human flourishing” mean, and does it have the same meaning for any single individual? Is it to be approximated by improved material welfare, longer life expectancy, more profound spiritual development, reduced frequency of military conflicts, intensified trade, etc.? The author is never explicit about his own understanding, though at some point he declares that “the more a system allows the division of labor, the better it is” (p. 14).Notice that this would imply that monastic communities, compared to worldly cities, are inferior social orders. The book somehow conveys the impression that human flourishing is to be understood as the individual pursuit of happiness, and that this would naturally result in an ever-growing division of labor. However, a systematic analysis of the practical means to achieve this very abstract goal, and of its concrete working and implications, is lacking.
Second, Zelmanovitz is conflating social with political institutions. To be more precise, he sees the latter as ordinary human organizations: “[….] because political societies are no more than groups of individuals and their institutions are no more than forms of interaction among those individuals, with everyone pursuing his or her own interest in different fields” (p. 3). This general description, while not necessarily wrong, fails to make the very important distinction between the two mutually exclusive organizational principles of groups of humans: voluntary cooperation and forceful exploitation. It would hardly be an exaggeration to state that all progress in political and moral philosophy is due to the analysis of the implications of this simple but crucial distinction. While it is hard to believe that the author might not be aware of this, he prefers to avoid a rigorous discussion of how individual cooperation restrained by rightfully acquired private property differs from centrally imposed collaboration. Rather, he prefers to confine his discourse within the framework of notions like unintended consequences and spontaneous outcomes.
An obvious problem with that approach is that it grants to the political means of acquiring wealth as much legitimacy as to the economic means, to borrow a famous distinction made by Franz Oppenheimer (1926, pp. 24–27). Spoliation of others’ production and their accumulated property, i.e. the political means, becomes as moral as the initial appropriation through one’s own labor, production and exchange, i.e. the economic means. Put differently, violence becomes legitimized in all circumstances. Such a conclusion, which incidentally empties any social political theory from its scope and meaning, could not possibly be true: a society that would admit indiscriminate violence is self-destructing by design.
The insufficient analysis of what is or is not legitimate violence implies that the very important distinction between the social class of the exploited and the social class of the exploiters is missing from the book. Hans-Hermann Hoppe has shown that these categories are crucial for understanding social evolution (Hoppe, 2001, 2012). In addition, there can be no proper understanding of the state-organized redistribution of resources, as opposed to the market-driven distribution of incomes, without recourse to this same opposition between producers and exploiters. Thus, it comes as no surprise that the author does not discuss at all state monopolies of money production in relation to their impact on wealth redistribution. Nowhere is there any mention of the well-known Cantillon effects, which have become the cornerstone of the Austrian economic and political analysis of fiat paper monies (Thornton, 2006; Dorobăt, 2014). Furthermore, had the author given a proper place to the analysis of political institutions, he would not have sought to integrate, at any cost, the catallactic with the chartalist theories of money. This endeavor, which is the core of Part I of the book, arrives at a dubious conclusion: “One must ask, can the state create value? I think that the answer to that question is undoubtedly yes and all forms of fiat money in circulation today are evidence of that” (p. 44, our emphasis). That fiat money, or for that matter any other good supplied by a monopoly, has value is no proof that its value is created by the monopoly producer. Fiat money value still springs out of its usefulness as appreciated by money users. Consequently, the determination of its purchasing power is subject to the market process, not to a decree that spells out the will of the monopoly producer. Any accommodation with the chartalist view implies a contradiction with the subjectivist theory of value, and hence great difficulties with providing a realistic account of monetary phenomena.A case in point is an extreme monetary phenomenon such as a hyperinflation. A consistent chartalist must take hyperinflations as desired and designed by the state.
IS CENTRAL BANKING LEGITIMATE?The entire chapter seven is dedicated to a discussion of the rationale for central banking. Zelmanovitz rightly discards, even though without much discussion, the most common economic justifications. The question he raises is whether a good political reason for government involvement in money production could be found. He believes he has identified such a good reason thanks to the “qualitative distinction, both legal and moral, between taxation and expropriation” (p. 197). While the book does not offer a systematic presentation of that distinction, the author’s argument is quite clear. There are emergency situations when the protection of society against enemies could not be organized efficiently without confiscating individual resources. Inflationary money printing, which is one method of resource confiscation, is therefore admitted. This is confirmed by monetary history itself, which shows that governments have monopolized money production when they needed resources for their war efforts. This fact of life proves that central banks are morally justified. Each one of these three steps of the rationalization of state monopolies in monetary affairs deserves individual scrutiny.
First, is it true that centralized confiscation of individual property is an efficient means for gathering the supposedly large pool of resources needed to defeat a foreign enemy? The author himself explicitly provides the arguments for negating centralized confiscation, but oddly enough he draws the opposite conclusion: “Therefore, if protection of life and property is of personal value for all individuals, in different circumstances, different efforts may be necessary, regardless of their individual preferences” (p. 210, our emphasis). To the extent that this confiscation is at odds with individual preferences, it is undesired and thereby revealed as reducing people’s welfare. As a matter of fact, in the absence of individual agreement, the confiscator is no longer protector; he becomes the aggressor. Consequently, centrally commanded expropriation could not logically be a means for defeating a foreign enemy. After all, an enemy is defined precisely by his assaulting on individuals’ private property! It is still possible that the author has in mind a kind of a “market failure” situation, in which for technical reasons the “public good” security could not be provided in any other way but through central planning. However, the point that the market could not provide the much needed security against foes would have needed to be substantiated much more deeply, especially in light of the argument that either there is an economic science that establishes the superiority of the competitive principle in all areas of human activity, or there is no economic science at all (Molinari, 2009). Similarly, the author could have subjected the efficiency analysis of a centrally organized war economy to the logical test of the economic calculation argument (Mises, 2008, pp. 201–232).Generally speaking, Zelmanovitz adheres to the Hayekian intellectual universe, in which the achievements of the economic science are closely linked to the deeper integration and application of such notions as subjectivity, knowledge and expectations. The author is definitely not a proponent of the Misesian approach, which is firmly anchored in the entrepreneurial market process itself and its prerequisites, one of which are the objective conditions for rational economic calculation.
Based on this premise, which we believe is contestable, the author builds up his moral case for central banking: “If a central bank is understood as a modern proxy to the monetary prerogatives of government in general, only to be used in cases of extreme emergencies, then a moral defense for its existence may be found in this work” (p. 232). Let us note first that nowhere does the author discuss the mechanisms through which monopolized money production and inflation allow the central authority to seize the resources deemed necessary. The proof of the so-called “fiscal proviso” would have been a welcome occasion to present the Cantillon effects, which we already noted are missing in this work. Moreover, given that other means for collecting resources, such as taxation or bond issuance, are also available, the superiority of inflation should have been established. As far as the argument itself is concerned, it is straightforward that even if the premise were valid, it would justify central banking exclusively in the very specific cases of presumably rare emergencies. Would not this imply that, once the emergency has been resolved, the central bank should be declared unjustified in the new circumstances, and therefore dismantled? Fearing this type of criticism, the author comes up with a really astonishing defense.
Zelmanovitz provides a condensed summary of Rothbard’s monetary history of the United States (Rothbard, 2002), in which he shows how fiat paper money and central banking became institutionalized in the context of budget deficits in need of funding. The whole point of this narrative is to convince the reader that the historical events rendered the acceptance of the “fiscal proviso” inevitable: “[….] to understand the ‘fiscal proviso’ as a mere act of force, deprived of any moral justification, even utilitarian ones, seems very unrealistic in light of the future events in the monetary history of the United States” (p. 220). In the concluding remarks to this chapter, the author becomes even more explicit: “This attitude of disregard for individual property rights is the ‘natural’ response of different governments in different historical moments. It is a ‘fact of life’“ (p. 231). In other words, the very existence of central banks, understood as the natural response of governments to somehow inevitable historical circumstances, provides a moral case in their defense.Another general feature of Zelmanovitz’s work is that practical facts often take pre-eminence over theoretical considerations. A case in point is his confession that “Ultimately, the argument in favour of a 100 percent reserve requirement that convinced me is Buchanan’s argument that once base money is no longer expensive to produce, there is no more reason to have a banking system designed to economize on it” (p. 342). But this practical argument only begs the question why, then, fractional reserve banking still persists. The answer would require a thorough theoretical study, inter alia of redistribution effects and their links to vested political and economic interests. Two objections could be spelled out. First, the argument confuses historical explanation and moral justification, which are two distinct thought processes. Were they one and the same, all things would be right by virtue of their merely being what they are. Second, and this is related to the observations from the previous section, a full-fledged theory of the government would have been needed in order to show how the progressive setting-up of a central bank as a monopolist producer of fiat paper money is, indeed, in the nature of growing governments.
Even though the author believes that he has proved a moral case for central banking, he still describes himself as an advocate for a monetary reform that would allow the individual to fully accomplish his potential. This is the last point that needs to be reviewed in some detail.
THE THEORY OF MONETARY EQUILIBRIUM AND ITS IMPLICATIONS FOR MONETARY REFORMIt is unfortunate that, in his quest for an interdisciplinary approach to money and banking, the author does not present a structured exposé of the economic analysis of money, and more specifically of an economy’s monetary equilibrium. Nevertheless, several of his comments suggest that he is a proponent of the real bills doctrine, which puts him at odds with the Austrian approach to money and banking.Zelmanovitz is heavily influenced by the monetary disequilibrium theory of Leland Yeager. However, while Yeager (1986) conceptualizes about the monetary (dis)equilibrium in real terms, Zelmanovitz’s discussion is exclusively in nominal terms. Both authors share the view that prices convey information and incentivize human action. As a result of this view about monetary equilibrium, he is advocating a reform that would ensure the flexibility of the money supply in order to accommodate changes in the demand for money, while guaranteeing the stability of money’s value. Finally, this reform would be driven by an ongoing tendency towards a higher level of abstraction and a growing dissociation between the unit of account and the medium of exchange functions. Let us elaborate on each of these points.
Zelmanovitz introduces the supply of and the demand for money in two very short paragraphs (pp. 238–239) and represents a neoclassical type of equilibrium in a chart (p. 244). He does not explain which forces actually bring about the monetary equilibrium, and what their impact on prices is. Had he done so, he would have discovered the real cash balances doctrine, according to which changes in the demand for money imply increased selling or buying of other goods against money, and hence changes in monetary prices. Whatever the stock of nominal units of money, i.e. whatever the supply of money is, price changes always guarantee that this nominal stock can satisfy any demand for real cash balances. The conclusion that changes in the purchasing power of money ensure monetary equilibrium at any time is the greatest achievement of the Austrian theory of money and banking. Building upon its foundations, Murray Rothbard declared “that there is no such thing as ‘too little’ or “too much” money, and that, whatever the social money stock, the benefits of money are always utilized to the maximum extent. An increase in the supply of money confers no social benefit whatever; it simply benefits some at the expense of others, […]” (Rothbard, 2009, p. 766, original emphasis).
The author adopts the exact opposite view, claiming that there are great social benefits to be expected from a flexible supply of money:
A relatively constant amount of money chased by a sudden increased demand will force fire sales and economic disruption. Even under relatively calm circumstances, a relatively inflexible monetary supply is not necessarily one that would adjust automatically to changes in the demand for money without somewhat important changes in money value. (p. 326)
The idea that deflationary pressures are disruptive is recurrent: “If the government keeps the supply of money constant in face of an increased demand for money, or worse, allows its contraction, it will force asset liquidations beyond the misallocations that need to be corrected, producing even bigger economic devastation, human suffering, and social unrest” (p. 242). The contraction referred to is specific to the fractional reserve banking system where loss of confidence during the downturn implies a decrease in the money supply: “[…] the banks are forced to ‘deleverage,’ that is, to call back the loans they made in order to repay the investors/depositors. Since the very essence of the system is the creation of multiple financial claims over the same amount of base money, […], that liquidation becomes problematic” (p. 207). Only an accommodative monetary policy would alleviate these alleged problems:
Therefore, while the current monetary constitution remains in place, any decision by the central bank of not providing more liquidity for the banks, and consequently forcing all economic agents, in their increased demand for cash balances, to compete for a fixed supply of money, would represent an additional effort of adaptation from society on top of the effort required to liquidate all the existing misallocations. (pp. 253–254)
There are at least three major problems with the contention that changes in the demand for money need to be matched by changes in the supply of money in order to avoid economic disruptions. First, as already pointed out, the monetary equilibrium is restored through market-driven price changes that both reflect individuals’ new preferences to hold more or less money relative to other goods and adjust the demand to hold real cash balances to the existing nominal supply of monetary units. Second, the alleged social disruptions and hardship triggered by liquidations that would go beyond those necessary to correct malinvestments are pure myths (Bagus, 2015, pp. 94–108). Should prices go below what they would have been, this would imply that those entrepreneurs that buy assets at below-equilibrium prices make profits that are explained by the corresponding losses of the selling asset-holders.Notice also that the deflationary recovery situation is fundamentally different from that of an inflationary unsustainable boom. The deflation facilitates the redistribution of existing assets from failed entrepreneurs to capitalists that consider themselves better at the art of managing assets. The deflation does not lead to waste of resources. On the contrary, the inflationary boom consists in wrong investment decisions that imply aggregate net losses and waste of resources due to the non-convertibility of some capital goods. Speculation and arbitrage would consume these possible gains until prices are restored to their equilibrium levels. From that point of view, it is even difficult to claim that there is an optimal level of liquidations corresponding to some needed adjustments, as these adjustments and liquidations are determined by the market process itself. Third, one of the book’s themes is that limitations on our individual knowledge lead to a skepticism that is “reflected in doubts about the ability to know what the quantity of money existing in society is at any given time” (p. 141). If according to the author even the supply of money cannot be known exactly, how could the authorities know what the changed demand for money is, and how could they know how to accommodate it? It seems to us that if there were knowledge limitations, they would immediately discard the very possibility for a designed policy that could do better than the natural market process.
Based on his approach to monetary equilibrium, Zelmanovitz offers a very general blue-print for monetary reform that relies on the need for a built-in flexibility of the money supply. He sees two salient features of such a reform, which he also considers historically inevitable: “The time for a monetary system in which the unit of account will be entirely abstract and all monetary merchandise will be securities is very close” (p. 318). In other words, a double dematerialization of money should occur. First, securities alone would become the most commonly used media of exchange. The author does not provide a complete explanation of why this would be so. However, one could imagine that this is the case because the issuance of securities would provide the needed flexibility for the supply of money to automatically adjust to changes in the demand for money. Second, accounting would be conducted in an independent abstract unit, so that the flexibility of the medium of exchange would not be restrained in any way whatsoever.
How realistic is this proposal for reform? Without entering into much detail, let us mention what we consider as two stumbling blocks. First, while a unit of account could exist without also being used as the unit of measure for the medium of exchange, both units are bound to be linked to each other. If that were not the case, then the function of unit of account would be overtaken by the medium of exchange itself. For instance, the French livre has been indeed a pure accounting unit. However, at any given moment, it was defined as a specific quantity of sous, deniers or francs. Even though this specific quantity has varied at different times, the link itself between the livre as a unit of account and the units of the circulating medium of exchange has been permanent. This practical example is not the result of a historical contingency; things could not have been otherwise. A completely abstract unit of account would imply that accounting itself has become abstract, i.e. disconnected from reality. This is logically impossible, as accounting has one purpose only, namely to provide the most faithful possible account of reality in monetary terms. For that account to be inter-subjectively communicable within a given community of individuals, the monetary terms in which it is expressed must be universally accepted within that community. This already implies that securities, each with its own characteristics and risks, could not become universal media of exchange, i.e. money. To the contrary, money appeared precisely as a solution to the tremendous problem of appreciating the liquidity of goods and assets with unknown marketability. To consider that securities could ever become the “monetary merchandise” implies one of two things. Either this would be a de facto return to barter, with all its implications in terms of hindered economic calculation, and hence reduced division of labor. Or this would imply that each security issuer has become an issuer of his own money. The result of this type of monetary freedom has been predicted long ago by the banker Henri Cernuschi (Mises, 2008, p. 443).
CONCLUSIONOverall, despite the weaknesses highlighted above, Zelmanovitz’s book will be appreciated by the initiated reader. It raises a very large number of relevant questions and puts together, in a thought-provoking way, a wealth of notions and concepts. However, these very same qualities that distinguish the diversified erudite are also pretext for some uneasiness, mostly related to the approach chosen.
First, the interdisciplinary approach is bound to economize on a systematic presentation of any of the specialized branches of knowledge that it exploits. This makes any such project both very difficult to understand by beginners and exposed to easy criticism by specialists. Given these unavoidable pitfalls, Zelmanovitz succeeds rather well in this delicate exercise in versatility. However, the question remains to what extent this approach deepens our knowledge of money and of monetary institutions and policy. In particular, what is its superiority to an exclusively economic study of a very specific issue that would carefully elaborate on the existing (narrow) theory?
Second, interdisciplinarity often goes hand in hand with an attempt at reconciling various epistemologies and schools of thought. This is also the case with Zelamnovitz’s book, which expresses his “convictions about the possibility in the future to recreate a consensus about good economics” (p. xxi). However, in science, truth alone is the single criterion for goodness. To the extent that concessions and compromises with the truth are needed for deriving an ecumenical position, consensus-building appears unscientific. Moreover, progress in science does not need consensus. Truth is out there to be studied and analyzed by all interested students, and arguably the discoveries of its various aspects have been consensus-breaking, rather than consensus-building. Admittedly, this is a much broader debate, which falls beyond the limited scope of this review.
REFERENCESBagus, Philipp. 2015. In Defense of Deflation. London: Springer.
Dorobăt. Carmen E. 2014. “Cantillon Effects in Contemporary Monetary Thought.” In M.V. Topan, and D.O. Jora, eds., The Cure for Crises. Bucharest: Rosetti International.
Hoppe, Hans-Hermann. 2001. Democracy, The Gold That Failed: The Economics and Politics of Monarchy, Democracy, and Natural Order. New Brunswick, N.J.: Transaction Publishers.
——. 2012. The Great Fiction. Auburn, Ala.: Ludwig von Mises Institute.
Mises, Ludwig von. 1949. Human Action: A Treatise on Economics. Auburn, Ala.: Ludwig von Mises Institute. Scholar’s Edition. 2008.
Molinari, Gustave de. 1846. The Production of Security. Auburn, Ala.: Ludwig von Mises Institute. 2nd edition, 2009.
Oppenheimer, Franz. 1914. The State: Its History and Development Viewed Sociologically. New York: Vanguard Press. 1926.
Rothbard, Murray N. 1962. Man, Economy, and State with Power and Market. Auburn, Ala.: Ludwig von Mises Institute. 2nd edition, 2009.
——. 2002. History of Money and Banking in the United States: The Colonial Era to World War II. Auburn, Ala.: Ludwig von Mises Institute.
Thornton, Mark. 2006. “Cantillon on the Cause of the Business Cycle.” Quarterly Journal of Austrian Economics 9, no. 3: 45–60.
Yeager, Leland B. 1986. “The Significance of Monetary Disequilibrium.” Cato Journal 6, no. 2: 369–399.
Quarterly Journal of Austrian Economics 19, no. 2 (Summer 2016)This ambitious new book on the foundations of money and monetary institutions, based on the the author's Ph.D. disseration defended in 2011 at the Universidad Rey Juan Carlos in Madrid, Spain (supervised by Gabriel Calzada), is an impressive interdisciplinary exercise. Part I of the book, “Metaphysics,” dwells into the nature, origin, and valuation of money. Part II, “Epistemology,” discusses what could possibly be known about monetary phenomena, and how this knowledge can best be acquired. Part III, “Ethics,” proposes a framework for a moral assessment of monetary arrangements and institutions. The last part, “Politics,” which spreads over one third of the book, addresses various issues, such as the history of fiat paper money in the USA, the optimum supply of money and credit, contemporary monetary policy and considerations about the future evolution of money. Five appendices, totaling fifty pages, detail the author’s thoughts on topics as diverse as coined money in Greece, dollarization, financial repression and even the resource curse. The book also contains a ten-page glossary and an extensive index, both of which are meant to help the reader cope with the abundant concepts and authorities to which the author refers. Capitalizing on his interdisciplinary approach, Zelmanovitz hopes to reach a large audience that goes beyond the limited circle of scholarly economists. His plan will certainly be challenged by the book’s price (in excess of hundred dollars).
The Quarterly Journal of Austrian Economics
Vol. 19 | No. 2 | 178–186Summer 2016
“Finance Behind the Veil of Money”: A Rejoinder
David HowdenDavid Howden (dhowden@slu.edu) is professor of economics at Saint Louis University, Madrid Campus
In Finance Behind the Veil of Money, Eduard Braun (2014, pp. 30–36) takes the minority view that opportunity costs are not only unnecessary but even unhelpful to understanding choice.Although Braun claims that “the main arguments in [his] book do not depend on [his] approach to the cost problem”, there is no doubt that his variant of cost theory derives a distinct theory of interest which is of utmost importance in valuing financial assets, one of the main themes of his book. In doing so he follows George Reisman (1996, p. 460) who also views the “doctrine of opportunity cost” as not only unnecessary to ascertain how one makes better decisions, but that its “sole contribution is obfuscation, not perception.” Both Braun and Reisman believe that it is unnecessary to include foregone alternatives in the calculus of cost since it implies that “one must suffer by virtue of possessing the very qualities that create one’s success [i.e., better opportunities]” (Reisman, 1996, p. 460).
Such a view errs by overlooking the difference between the actor’s ex-ante expectations of an action with the ex-post results. More importantly, it mistakes what role costs in general, and opportunity costs by extension, serve in economic theory.
In his “Reply” in this issue, Braun demonstrates this misunderstanding of the ex-ante and ex-post roles of opportunity costs when he criticizes Rothbard's (1962, p. 606–607) analysis of the relationship between monetary and psychic profits.Although Reisman does not cite this example from Rothbard, he argues against several similar examples (1996, pp. 459–460). In Rothbard's example, an investor spends 5,000 gold oz. to earn 1,000 oz. net profit. The foregone alternatives are comprised of 1) 250 oz. he could have earned by investing his capital at the prevailing interest rate of 5 percent, 2) 500 oz. he could have earned by working for a competing firm, and 3) 400 oz. of lost income since he used his factory instead of renting it out. With total opportunity costs of 1,150 oz., Rothbard concludes that the “entrepreneur suffered a loss of 150 ounces over the period. If his opportunity costs had been less than 1,000, he would have gained an entrepreneurial profit” (Rothbard, 1962, p. 607).
Braun objects to Rothbard’s conclusion for two reasons. First, he finds it questionable that Rothbard constructs “arbitrary” figures to define the investor’s opportunity costs. Yet while these figures may seem arbitrary to Braun, they are an assumption by Rothbard and real to the hypothetical investor. The 1,150 oz. in foregone income is actually what the investor could have earned had he used his resources differently. The investor knows these figures through the benefit of hindsight, and from them he can determine from an ex post facto perspective the sum his foregone opportunities could have yielded.
Second, Braun objects to the conclusion that the entrepreneur made a loss. He did, after all, come out of his investment 1,000 oz. richer than he started and this is, as Braun correctly states, profit according to “traditional accounting principles.” The point of Rothbard’s example is not to show that the investor did not earn a monetary profit, but rather to show that he could have done better. The fact that he earned an entrepreneurial loss provides a signal that he must do better in the future or be forced out of the market. To forestall one objection to this conclusion, one could counter that as long as the firm earns positive monetary profits it will not risk insolvency and thus will remain in the market. Such an objection fails to realize that the firm would be forced out of the market if all other competing firms changed their activities in a way that maximized their entrepreneurial profits while one firm continued incurring entrepreneurial losses (as in this example). This is because a firm must not only earn positive (absolute) monetary profits to remain in business, but must also earn positive entrepreneurial profits relative to other firms, lest those firms undercut its business and steal market share (as in Carilli and Dempster, 2001, p. 326; Huerta de Soto, 2006, pp. 664–671). No firm can continue earning entrepreneurial losses indefinitely, and so an ex post facto assessment of the relevant opportunity costs is an essential part of the entrepreneurial process.
Constraining cost to a specific monetary expenditure instead of a general opportunity foregone does a great injustice to the decision-making process. The beauty of Rothbard's (1962, 606–607) example is that the entrepreneur now realizes he has erred. Braun places the goal of maximizing money income as primal for the entrepreneur (Braun, 2014, pp. 109, 115, 116 and passim), yet his approach leaves no method for the entrepreneur to see if he has, in fact, done so.
Although Braun focuses on this example from Rothbard, his (and Reisman’s) largest objection to the opportunity cost doctrine is that it leads to the conclusion that having more options is worse for the individual, since they believe that the more options one has, the greater will be the cost of the foregone alternative. In this regard, I will (re)address Braun's (2014, p. 32) apple example:
Let us suppose friends X and Y are on a trip in the mountains. X has two apples in his bag. Y loves apples, but has forgotten to pack one. During the first break, X permits Y to take one of the apples. Well, one could say this is a great deal for Y! However, things look differently if one takes into account opportunity cost. As soon as Y takes one of the two apples, he abstains from taking the other one. If we assume, for simplicity, that the two apples are alike, then the disadvantage in this decision is just as great as the advantage. According to opportunity-cost theory, Y is not better off at all although he has received an apple for free. His preference for one of them cost him the other one.
This case has two solutions. The first is to treat the two apples as they are in the example: alike (or, as I [Howden, 2016, p. 125fn1] have shown in more conventional terms, that X is indifferent between the two apples). I addressed previously the unconventional nature of this problem for the Austrian-school economist, not least because the assumption of indifference is not well accepted (see, e.g., Rothbard, 1956), and I provided one method to analyze this problem within an Austrian framework (Howden, 2016, p. 126).A second objection to Braun’s analysis is that Braun combines two choices into one alternative. In actuality, the hiker first has the option of choosing an apple or starving, and second he must choose between which apple to consume. I (2016, p. 125) alluded to the similarities with Buridan’s ass in the first of the two choices, and I thank Jonathan Newman for pointing out the second.
In his “Reply” in this issue, Braun relaxes the assumption that the hiker is indifferent between the two apples. His basic result is the same, which leads Braun to conclude that “[t]he purpose of the example is to show that if one takes the opportunity cost concept seriously, having options is worse and leads to less profit than having no options at all.”
On the one hand, if Braun's hiker had “no options at all,” he would starve, which is likely a worse outcome than having two apples to choose from. But there is an apparent grain of truth to the statement. The more options one has at his disposal, the more satisfying will be the “next-best alternative” the actor must forego for any course of action. While one might believe that this leads to an increase in opportunity cost for the actor a close analysis reveals this is not the case.
Assume the thirsty and hungry hiker has the following preference ranking:
Table 1: The Hiker’s Preference Ranking
Faced with the option of consuming either the red or yellow apple, the hiker chooses the more highly valued red apple and expects to earn the psychic profit from the difference in his preference between the red apple and the best foregone alternative, the yellow apple, leaving him with the expectation of psychic profit x as in Table 2.
Table 2: Revenues, Costs and Profit
Now assume that the offer of the yellow apple was retracted, and the hiker was offered the choice between only the red apple and a granola bar. Using Braun and Reisman’s logic, since the granola bar is less highly valued than the yellow apple, his foregone alternative will be less and thus his psychic profit will increase. Taking this extension to its conclusion, if the friend only offers a red apple, the foregone alternative will be death. Forgoing this lowly valued alternative would leave the hiker with the largest amount of psychic profit. It is this logic that Braun and Reisman have in mind when they consider having more options to be bad for the actor since more options seem, ceteris paribus, to reduce psychic profits.
As any hungry hiker can attest, the fact that the hiker is nourished but will only receive a seemingly small amount of psychic profit (both ex ante and ex post) must strike the reader as odd. He did, after all, forestall death by having one apple presented to him, and surely being offered either of two apples must be better yet. The reconciliation to this paradox comes from using the opportunity doctrine within its proper domain.
The first use of opportunity cost is to determine which alternative to pursue by focusing on that which foregoes the least valuable alternative. In Table 3 we can see that there are only two possible best foregone alternatives. For the 2nd through nth ranked options the best foregone alternative will be the 1st ranked alternative (i.e., the red apple). For the 1st ranked option, the best foregone alternative will be the 2nd most highly ranked alternative (i.e., the yellow apple). Since the red apple is preferred to the yellow apple, pursuing the 1st ranked alternative will result in the lowest opportunity cost.
Table 3: Opportunity Costs
Alternatively, one can see that choosing the most highly ranked option will also result in the highest amount of expected psychic profit. The first ranked alternative will be the only one that incurs an opportunity cost valued less highly than it is. Thus only the first ranked alternative can create a positive amount of expected psychic profit, as in Table 4.
Table 4: Psychic Profit
Note that adding more options does not change this analysis. The hiker will still choose the red apple even if we add a new alternative (except if the new alternative is more highly ranked than the existing red apple). Braun is incorrect in stating that “having options is worse and leads to less profit than having no options at all.” Adding a new option to the actor’s preference ranking will either: 1) create a new negative expected psychic profit (which is of no relevance since the option will not be pursued), if the alternative is ranked 2nd or lower on the preference rank, or 2) increase the expected psychic profit if the newly introduced option takes the 1st place on the preference rank.
The second use of opportunity costs is an ex post facto assessment to determine if the chosen option was the correct one. It is this use that Braun and Reisman invoke often, though to illustrate (incorrectly) buyer’s remorse.Strangely, Reisman does not use this ex post role of opportunity costs in “ascertaining how one might do better” (1996, p. 460). In a similar way, Braun does not realize that when he laments that the opportunity cost doctrine “neglects costs when they actually arise—in action” that it is this ex-post facto assessment that allows the actor to use opportunity costs with the benefit of the hindsight that his action allows for (Braun, 2014, p. 33). (I deal with this latter objection by Braun in Howden (2015, pp. 579–580).) While the previous ex ante role of opportunity cost rests on expectations of both revenues and profits, in the ex post role we actually know how events did turn out. Of course it could be that we chose wrong, e.g., the red apple might have been rotten. With this new knowledge we can revise our preference ranking, perhaps shifting the red apple lower in the expectation that other similar apples may also be rotten. In this way, we partake in a trial-and-error process that improves our decisions in light of newly revealed information concerning the nature and relationship of expected psychic revenues and resultant opportunity costs. Buyer’s remorse is not a sign that the use of opportunity costs is deficient, but that our estimations of what those costs could have been differed from their actual realization.
Braun insists that all costs be treated as historical money costs. Of course it is one of the great advantages of the price system that money prices provide a common denominator in which all values can be distilled to and compared with. The common denominator of money is thus essential to compare different foregone alternatives on an even footing, so Braun is half right when he focuses on money costs. He errs, however, to the extent that money revenues comprise only some of the opportunities foregone.
In the simplest example used by every Principles of Economics instructor, the cost for the student to pursue a university degree is four years of tuition plus four years of time foregone. Four years of tuition is easily valued and (before discounts and scholarships) equal for all students (e.g., four years at $40,000 per year). The time foregone can only be compared with this monetary cost if it is valued in money terms. Since the particular monetary value on time will differ depending on one’s opportunities the easiest method to value these four “lost” years is with wages foregone. If one could have worked at a job for $20,000 per year, the value of these four years will be $80,000. Taken together, the total opportunity cost of a university education is $240,000, of which $160,000 will be an actual money outlay and the remainder lost wages. The student will register for university if he values the four-year degree more than the value of the foregone alternatives, $240,000.
Braun wants to throw the baby out with the bathwater in ignoring the lost wages, since they are not a historically incurred monetary cost. This would set the bar much lower for students to decide to go to university (among other decisions) since, e.g., in the above example only two thirds of the foregone alternatives were in a historically incurred monetary form. It is trivial to state the importance of the value of the non-monetary foregone alternatives since they can, in many cases, make the monetary costs negligible.I would venture that the vast majority of our decisions have no monetary component, and can only be decided on by comparing expected psychic revenues. My decision to watch Real Madrid play soccer instead of FC Barcelona can be explained with tables 1 through 4 by substituting watching Real Madrid as my most preferred alternative and FC Barcelona as my second ranked option. No money changes hands, but only one choice will have a positive expected psychic profit. Braun could counter that he focuses on business decisions, which generally have a money component. This would only beg the question as to why a different decision-making process is necessary for businesses than individuals.
I will close by asking how Braun would solve the following question without resorting to non-historically incurred monetary costs.
Students A and B value a university education the same, and also must pay the same tuition rate. A has few opportunities in life and the best foregone use of the four years is a minimum wage job (i.e., $80,000). B has an offer to play basketball for the Cleveland Cavaliers for $13 mn. for the first three years, with an option to play a fourth year for $6 mn. B opts to not go to university, while A registers in an undergraduate economics program.
Given that the preferences and historically incurred monetary costs are identical, how does Braun propose to explain the difference in choice?The interested reader can find the correct answer in Howden (2016b).
REFERENCESBraun, Eduard. 2014. Finance behind the Veil of Money: An Essay on the Economics of Capital, Interest, and the Financial Market. Liberty.Me.
Carilli, Anthony M., and Gregory M. Dempster. 2001. “Expectations in Austrian Business Cycle Theory: An Application of the Prisoner’s Dilemma,” Review of Austrian Economics 14, no. 4: 319–330.
Howden, David. 2015. Review of “Finance Behind the Veil of Money: An Essay on the Economics of Capital, Interest, and the Financial Market, by Eduard Braun,” Quarterly Journal of Austrian Economics 18, no. 4: 578–583.
——. 2016a. “Finance Behind the Veil of Money: Response to Dr. Braun’s Comment,” Quarterly Journal of Austrian Economics 19, no. 1: 124–128.
——. 2016b. “On Opportunity Costs.” Working paper.
Huerta de Soto, Jesús. 2006. Money, Bank Credit, and Economic Cycles, trans. Melinda A. Stroup. Auburn, Ala.: Ludwig von Mises Institute.
Reisman, George. 1996. Capitalism. A Treatise on Economics. Ottawa, Ill.: Jameson Books.
Rothbard, Murray N. 1956. “Toward a Reconstruction of Utility and Welfare Economics.” In The Logic of Action, vol. 1. Cheltenham, U.K.: Edward Elgar, 1997.
Rothbard, Murray N. 1962. Man, Economy and State, Scholars ed. Auburn, Ala.: Ludwig von Mises Institute, 2007.
Quarterly Journal of Austrian Economics 19, no. 2 (Summer 2016)In Finance Behind the Veil of Money, Eduard Braun (2014, pp. 30–36) takes the minority view that opportunity costs are not only unnecessary but even unhelpful to understanding choice.Although Braun claims that “the main arguments in [his] book do not depend on [his] approach to the cost problem”, there is no doubt that his variant of cost theory derives a distinct theory of interest which is of utmost importance in valuing financial assets, one of the main themes of his book. In doing so he follows George Reisman (1996, p. 460) who also views the “doctrine of opportunity cost” as not only unnecessary to ascertain how one makes better decisions, but that its “sole contribution is obfuscation, not perception.” Both Braun and Reisman believe that it is unnecessary to include foregone alternatives in the calculus of cost since it implies that “one must suffer by virtue of possessing the very qualities that create one’s success [i.e., better opportunities]” (Reisman, 1996, p. 460).
Such a view errs by overlooking the difference between the actor’s ex-ante expectations of an action with the ex-post results. More importantly, it mistakes what role costs in general, and opportunity costs by extension, serve in economic theory.
The Quarterly Journal of Austrian Economics
Vol. 19 | No. 2 | 187–191Summer 2016
Book Review
Monetary Regimes and Inflation: History, Economic, and Political Relationships, Second Edition
Peter BernholzCheltenham, U.K.: Edward Elgar, 2015, 240 pp.
Patrick NewmanPatrick Newman (patrick.newm@yahoo.com) is a visiting assistant professor in the Economics and Finance Department at Florida Gulf Coast University.
The recent financial crisis of 2007–2008 generated a debate among economists over whether the leading central banks’ unprecedented monetary intervention would spark a massive inflation and depreciation of currencies in the near future. During the meltdown of the banking system, central banks engaged in enormous monetary expansion and drastically increased member bank reserves in an effort to save the financial system and stimulate the economy. Despite this, inflation, at least judged by reported consumer price indexes, has grown at a relatively moderate rate in the period since the crisis. Why is this? Have we entered into a special period where monetary economics is no longer valid, and inflation is no longer a monetary phenomenon? Can central banks around the world now increase their respective money supplies ad libitum without suffering any consequences?
Answering these questions is partly one of the justifications for Peter Bernholz, renowned historian of inflation, to publish a second edition of Monetary Regimes and Inflation. The first edition of the book, which was published in 2003, concentrated on providing a concise overview of various inflationary episodes over the centuries. Bernholz analyzed inflation under different monetary regimes, such as metallic (i.e. gold or silver) and fiat standards, and what caused them. He also looked at eras with either moderate inflation or hyperinflation, and how they were ended. Overall, the book is a nice, concise survey of various periods of inflation on what caused them, how they compare with other episodes, and what ended them.
With a favorable reception to the first edition in 2003, Bernholz has decided to keep most of the slim volume (roughly 230 pages) intact and add only two new revisions to the second edition in 2014 (pp. x–xi). The first is a section in Chapter 2 about the recent financial crisis and why central banks’ monetary expansions have not led to present day inflation, and whether or not they will lead to it in the future. The second is an entirely new Chapter 9 about how historically stable monetary regimes (that is, monetary regimes that were constrained and did not lead to significant inflation) were eroded. Given that these are the two new additions to a book originally published over ten years ago, I will spend the rest of the review on them.
In the new Section 2.1, Bernholz tries to answer the question that everyone was asking in the years after the financial crisis: Where is all of the inflation everyone was worried about? For example, in the United States, from December 2007 to April 2014 M0, or the monetary base (currency in circulation plus member bank reserves) increased by 363.87 percent, yet the rise in consumer prices was nowhere near that amount (p. 4).
Bernholz first answers this using a number of illustrative figures. He first shows that the enormous increase in M0 in various countries led to moderate increases in M2 (p. 5). Although the rise in M0 has not led to a rise in M2 now, Bernholz concludes that it provides a permanent potential for inflation in the years to come, once banks start to engage in credit expansion (p. 8). Then, even with the current increase in M2, Bernholz argues that the rise in consumer prices was mitigated because velocity during this period fell (i.e., money demand rose) and most of the new money was not spent on consumer goods, but on goods not included in a cost of living index, such as houses and stocks (pp. 8–9). Bernholz concludes by arguing that many banks have not engaged in credit expansion because they are pessimistic about the state of the economy (pp. 9–10).
At the outset, it would have helped Bernholz’s argument enormously if he not only provided illustrative figures but also numerical figures. Aside from the precise increases in M0 in the USA, the euro area, and Switzerland from December 2007 to April 2014, he only provides illustrations of M2, the M2 money multiplier, and velocity. Why not also provided quantitative estimates for them as well? For example, it would have been nice to know that from the beginning of December 2007 to the beginning of December 2013 (the latter being the last full year before the book came out), despite the enormous M0 growth of 334.99 percent (27.76 percent per annum), M2 growth in the U.S increased only 47.42 percent (6.68 percent per annum), and the CPI increased even less than that at 10.99 percent (1.75 percent per annum).Data for these numbers is obtained from BLS (2015), BOG (2015), and FRED (2015). And so on for velocity, the money multiplier, and housing and stock prices. The figures, while helpful illustratively for understanding the big picture, are not really helpful for those interested in using this section of the book for research.
In addition, when discussing why the increase in M0 did not translate into a concurrent increase in M2, Bernholz should have also mentioned, at least for the United States, the use of the contemporary new policy tool by the Federal Reserve to pay interest on member bank deposits. With this new proviso, banks no longer have as much of an incentive to engage in credit expansion in order to earn interest and to cover the cost of inflation eroding away idle balances. Certainly this, in conjunction with the regime uncertainty and economic malaise from the contemporary political climate, goes a long way towards explaining why the equally sizable M0 increase has not translated to an equally sizable M2 increase.
Although not directly related to current events, the other new addition of the book, Chapter 9, seeks to answer two questions: Why did some stable monetary regimes arise when there was no large inflation beforehand to incentivize their adoption, and under what circumstances did stable monetary regimes become abolished? Bernholz answers the first question with the theory that countries enacted stable monetary regimes so they would have an international currency that could be used in foreign trade. Bernholz uses examples from antiquity, such as the Athenian drachms and Corinthian staters, and argues that the sovereigns did not engage in debasement because the long term benefits from having an internationally used currency outweighed the short term benefits of debasement. Bernholz also argues that for some time the US dollar and British pound before World War I enjoyed relative stability for similar reasons. Bernholz answers the second question by arguing that countries are able to dismantle their stable monetary regimes and engage in inflationary policies whenever there is an “emergency.” Bernholz provides a brief table of various governments that suspended gold convertibility or devalued their currency with a list of emergencies, ranging from domestic and international wars, government bankruptcy, and economic calamity (such as the Great Depression). To anyone familiar with Robert Higgs’ Crisis and Leviathan (1987), the idea that emergencies, or crises, allow governments to engage in unprecedented usurpations of economic liberties (which includes money) is unsurprising. But it is nice to see the idea being taken seriously by others. A passage on the inherent incentive of governments to call a “national emergency” is all too revealing:
Given the inflationary bias of governments and politicians we should not be surprised that they grasped any critical situation to declare an emergency with the purpose of eroding or abolishing the factual legal or constitutional limits on their control of the currency. For it is only in emergencies that important changes appear to be warranted. As Carl Schmitt [German professor and early Nazi] pointed out: … “Sovereign is he who decides on the state of emergency.” (p. 209)
Bernholz also argues that the reintroduction of stable monetary regimes has occurred when countries try to mimic other countries who have already adopted a stable monetary regime. But without a first mover, the only other reasons have historically been after the end of a war or a hyperinflation. This empirical reality is quite unfortunate for anyone who wishes to enact some form of monetary constitution that ensures price stability or deflation (such as a return to the gold standard) in the United States. Will it take a hyperinflation and destruction of the dollar in order for the public and politicians to learn that our present practices are unsustainable?
Overall, the book is informative about inflation in all periods of human history, and researchers looking for concise overviews will find much use in it.
REFERENCES
BLS. 2015. Consumer Price Index for All Urban Consumers: All Items. Retrieved from FRED, Federal Reserve Bank of St. Louis: https://research.stlouisfed.org/fred2/series/CPIAUCSL/, December 14, 2015
BOG. 2015. M2 Money Stock. Retrieved from Fred, Federal Reserve Bank of St. Louis: https://research.stlouisfed.org/fred2/series/M2/
FRED. 2015. St. Louis Adjusted Monetary Base. Retrieved from FRED, Federal Reserve Bank of St. Louis: https://research.stlouisfed.org/fred2/series/BASE/
Higgs, Robert. 1987. Crisis and Leviathan. Oakland, Calif.: The Independent Institute, 2012.
Quarterly Journal of Austrian Economics 19, no. 2 (Summer 2016)The recent financial crisis of 2007–2008 generated a debate among economists over whether the leading central banks' unprecedented monetary intervention would spark a massive inflation and depreciation of currencies in the near future. During the meltdown of the banking system, central banks engaged in enormous monetary expansion and drastically increased member bank reserves in an effort to save the financial system and stimulate the economy. Despite this, inflation, at least judged by reported consumer price indexes, has grown at a relatively moderate rate in the period since the crisis. Why is this? Have we entered into a special period where monetary economics is no longer valid, and inflation is no longer a monetary phenomenon? Can central banks around the world now increase their respective money supplies ad libitum without suffering any consequences?
Answering these questions is partly one of the justifications for Peter Bernholz, renowned historian of inflation, to publish a second edition of Monetary Regimes and Inflation.
One of the most important concepts in economic theory is the quantity of money. However, when going from theory to practical application, things get messy. In the real world, it’s not obvious how to count up the amount of “money” in the economy at any given time.
Because of this ambiguity, economists have developed several different “monetary aggregates,” i.e., different definitions that include and exclude various components that are more or less related to our intuitive notion of what “money” is. In the present article I’ll outline the major aggregates and then relate them to the “Austrian Money Supply” definition devised by Murray Rothbard and Joe Salerno.
The Theoretical Definition of MoneyAustrian economists generally follow Mises in defining money as a “generally accepted medium of exchange.” Mises felt that this was the essence of money, and that its other “functions” (as described in mainstream textbooks) flowed naturally from this.
To be clear, all economists would agree with the Austrians that money is a generally accepted medium of exchange, though they might not have chosen such terminology. But standard texts may say that money has other functions, that it (for example) serves as a store of value, and as a unit of account. But in Mises’s view, these functions are an outgrowth of the fact that money is a generally accepted medium of exchange; that’swhy it can also serve as a store of value, a unit of account, and so on.
To use the somewhat old-fashioned terminology that money is a “medium of exchange” means that the money commodity is the one through which the ultimate exchange is effected. For example, if I sell an economics lecture for $20 (you get what you pay for), and then use the $20 to take my son to the movies, then ultimately I traded my lecture for the movie tickets. The $20 bill was a medium through which the exchange occurred, in the same way that air is a medium through which sound waves travel. (For more on the Austrian approach to money, see this article.)
M0Money is the commodity or good that everybody in the community is willing to accept in trade. Historically it was often the precious metals gold and silver, but in today’s United States the money is clearly Federal Reserve Notes, i.e., little green pieces of paper featuring pictures of the presidents. (Most Austrian economists are not happy about this fact, but it is a fact for the time being.) Coins such as quarters, dimes, and nickels are also clearly “money” if anything is.
For sure, then, the green $20 bill in one’s wallet or purse, as well as any change in one’s pockets, must be a part of any sensible definition of “money.” And in fact, currency in the form of paper Federal Reserve Notes as well as coins constitute M0,According to Wikipedia, in the United Kingdom they include bank reserves on deposit with the central bank in M0, making M0 equivalent to the monetary base. the narrowest monetary aggregate. (Note that the currency can be either in the hands of the general public, or in bank vaults.)
The Monetary BaseIn our current system, there is something that is treated as practically equivalent to paper currency, and that is commercial banks’ reserves held on deposit with the Fed. To understand this, first some context: Commercial banks are required to set aside reserves to “back up” a fraction of their customers’ checking account balances. For example, if a particular commercial bank’s customers have a total of $1 billion in their checking accounts, then the bank might be required to keep (say) $100 million in reserves.
Obviously, if the bank keeps $100 million in paper currency in its own vault, that’s fine. But it can also keep a portion of its legally required reserves on deposit with the Federal Reserve. The bank might only have, say, $30 million in green pieces of paper in the vault on its premises, but it might also have a “checking account” as it were with the Federal Reserve, with a balance of $70 million. Thus the bank’s total reserves would still be $100 million.
The crucial point is that the Fed itself doesn’t need to have $70 million in green pieces of paper, corresponding to the commercial bank’s balance. That $70 million can just be an electronic bookkeeping entry. If the commercial bank ever wants to withdraw its money, the Fed can simply have the currency printed up. That’s the sense in which a commercial bank having $70 million on deposit with the Fed, is equivalent to having that $70 million in green paper in its own vault.
Because of these considerations, the monetary base consists of currency (held by the general public as well as stored in bank vaults) and commercial bank reserves on deposit with the Federal Reserve. This amount of money is the “base” upon which the larger monetary aggregates are pyramided. For the purposes of creating more money (which we will explain in the next section), there is no distinction between currency and electronic reserves on the Fed’s books. That’s why M0 isn’t the monetary base; M0 doesn’t include electronic reserves, which can support the broader monetary aggregates just as well as actual paper currency can.
M1When going from the monetary base to M1, we need to be careful, because we don’t merely add another component, but we also subtract two. Specifically, M1 consists of Federal Reserve notes and coins held by the general public (but not in bank vaults), plus demand deposits and other checkable deposits (e.g., NOW accounts), plus traveler’s checks issued by non-bank institutions. That means M1 does not include commercial bank reserves, whether they consist in notes and coins in the vault, or as electronic entries on the Fed’s books.
The intuition behind this classification is that M1 measures the amount of money and “very close money substitutes” held by the general public. A money substitute, as the name suggests, is a claim on actual money that everyone in the market expects to be honored at par.
Money on deposit in a standard checking account is an obvious example of a money substitute. To have $100 in a checking account with a reputable (and nowadays, FDIC-insured) commercial bank is not literally the same thing as having a green $100 bill in one’s hands, but for most purposes they are economically equivalent. (That’s why M0 includes just the actual currency and coins, while the broader M1 adds demand deposits and other checkable accounts.)
Incidentally, the reason M1 excludes notes and coins in bank vaults, is to avoid double-counting. Under a 100%-reserve system, where a person who put $100 in his checking account would have that $100 bill sitting in the vault with his name on it, the existence of checking accounts would simply be a matter of convenience. Rather than walking around with the actual cash on their persons, people would carry much lighter checkbooks or debit cards, while the bank was a warehouse for their actual money. In that scenario, it would clearly be wrong to count the checkbook balances and the cash in the vault as independent components of the quantity of money.
In reality, our banking system is one of fractional reserves. That means when the public deposits some of its physical currency into commercial bank vaults, the banks in turn lend some of it out again. When all is said and done, the public’s total checkbook balances are higher than the total amount of physical currency in the bank vaults. That is why M1 counts the outstanding demand deposits; it takes the bigger of the two, and includes that portion of demand and other checkable deposits that isn’t “backed up” by cash in the vault.
Incidentally, this relationship explains why “the money supply” fell by a third from 1929 to 1933. It wasn’t that the Federal Reserve started burning actual currency. Rather, a series of bank runs and bank failures led the public to withdraw a large portion of its deposits from commercial banks during these awful years. Because commercial banks were legally obligated to maintain a certain reserve to support or “back up” a larger amount of checking deposits, the banks had to restrict their outstanding loans when customers wanted to take their money out.
For a simple numerical example, suppose the legal reserve ratio is 10 percent, and initially the public has $1 billion in checking deposits with commercial banks. The banks therefore have $100 million in paper cash in their vaults. Now if some of the customers get nervous and withdraw $20 million from their checking accounts, the banks’ outstanding checking deposits will have dropped to $980 million, but their cash reserves will have dropped to $80 million. That means in order to restore the 10% reserve ratio, the banks will need to call in $180 million of their loan portfolio (if they can’t get more deposits), because the $80 million left in the vaults can only support $800 million in outstanding checking balances.
Notice in the example above—assuming those listed numbers represent all the money in the economy—M0 is constant at $100 million. But M1 starts at $1 billion and drops to $820 million.Initially, there are $1 billion in demand deposits and (as far as we know from the example) $0 in currency held by the public. After the public withdraws some of its funds, there are $800 million in demand deposits and $20 million in currency held by the public. The public’s decision to withdraw $20 million in cash out of the commercial banking system led to the “destruction” of $180 million of money from the economy. (For more on fractional reserve banking, see this article.)
Higher Monetary AggregatesThe broader monetary aggregates—M2, M3, MZM, etc.—simply widen the definition, each adding more and more items that are less and less obviously money. (For a convenient table summarizing the classification, see the Wikipedia entry.)
The purpose of the present article isn’t to lay out all the definitions, but rather to explain why there are different aggregates in the first place. The reason, to repeat, is that some things (such as a checking account balance) are not actually money in the narrow sense, but they are close to it because of the ease with which they can be converted into money in the narrow sense.
Liquidity Is Not the Same as Money-nessWe should clarify one potential source of confusion: For something to be a money substitute, it is not enough to be very liquid. Very example, a block of shares of stock in a major corporation is very liquid, meaning that the owner could exchange it for actual money in a fairly short time. However, shares of corporate stock are not money by any stretch; they don’t appear in any of the standard monetary aggregates.
The reason is that the price of a share of stock is constantly changing. When a person owns, say, 100 shares of IBM stock, his property is not denominated in dollars. Rather, what he owns are 100 shares of stock. The amount of money into which he can transform this property depends on the market price of a share of stock, at the time of sale.
In contrast, someone who has $100 on deposit in her checking account, has property that is denominated in dollars. The ownership is of legal claims to $100 in currency. Such claims are also very liquid—the person can swing by the bank during business hours, or an ATM anytime—but the crucial point is that they will be redeemed at par (absent a bank failure).
The Austrian Money SupplyAbove I have sketched the logic behind different monetary aggregates, and the components in the first few popular measures. However, Austrian economists Murray Rothbard and Joe Salerno developed an alternative monetary aggregate, variously called the True Money Supply or the Austrian Money Supply.
There is no need for me to explain this rival concept, because Joe Salerno has done an excellent job contrasting it with the standard definitions here. The basic problem is that some of the components in various mainstream aggregates (such as Money Market Mutual Funds) don’t really satisfy the requirements of a money substitute, and so these components do not belong in the “True Money Supply.” On the other hand, Salerno includes some things (such as Treasury deposits with the Fed) that the conventional aggregates inexplicably exclude. (Here is a chart comparing the Austrian Money Supply with other aggregates.)
ConclusionThe supply or quantity of money in an economy is an important theoretical concept. Yet when trying to apply theory to the actual world, things get messy. The various monetary aggregates become wider as they include components that are less and less substitutable for actual money.
Depending on the application, one aggregate may be preferable to another. The Austrian Money Supply is the aggregate that most consistently reflects the defining characteristics of money.
A private graduate seminar. Recorded at the Mises Institute in Auburn, Alabama, on 29 July 2016.
THE AUSTRIAN: What is the “Great Monetary Experiment” you refer to in your book?
Brendan Brown: The Federal Reserve has sought by using non-conventional monetary tools to produce a stronger than normal economic expansion following the Great Recession. The resort to such tools has occurred in a context where money market rates have already fallen to near zero, meaning that the conventional tool of rate cuts is not available. The ECB and Bank of Japan joined in the experiment with a considerable lag behind the Federal Reserve.
The non-conventional tools have included massive expansion of the monetary base, manipulation of long-term interest rates — and in the case of Europe — sub-zero interest rates. The tools have been applied toward achieving an inflation rate over the medium-term (in practice two years) of 2 percent per annum.
The setting of an inflation target pre-dates the Great Monetary Experiment. Transcripts reveal that at an FOMC meeting in summer 1996, then-Governor Janet Yellen presented a paper (invited by then-Chair Greenspan) arguing that the aim of “price stability” should be interpreted to mean perpetual “low” inflation.
The architects claim the monetary experiment has been a great success even though this is the slowest US economic expansion ever. And of course we cannot estimate the full costs including malinvestment until the record of the full business cycle including its asset price deflation phase is available.
TA: What does it mean that investors have become starved for yield? In your book you call it “interest-income famine.”
BB: The nineteenth-century English financial journalist Walter Bagehot coined the concept of “yield starvation” when he said that “John Bull will stand for many things but not interest rates below 2 percent.” He meant that in such a situation the investor would act “madly.” In today’s terms, we could translate that into the observation that if interest income from safe investments is very low, then investors, in their desperation for yield, chase uncritically a succession of speculative ideas. These apparently justify high and rising prices (relative to sober valuations) in presently hot asset classes. Investor decision-making reveals abnormally flawed mental processes.
Of course, sometimes even under a sound money regime interest rates would reach very low levels as during a recession. But so long as these are regarded as transitory and there is no serious danger of an erosion of wealth by the eruption of inflation, rationality would dominate especially as longer term interest rates would remain substantially positive. But under the Great Monetary Experiment investors have been deeply troubled by the far-out danger of inflation — especially given the bloated size of the monetary base. They also fear that the Experiment will eventually bring a crash which would be followed by an even bigger experiment.
Time-horizons also shorten for many investors as they enter into desperate gambles to make returns before the Day of Reckoning. Companies get rewarded by the equity markets for paying out cash and making profits from financial engineering rather than for undertaking bold long-gestation investments.
TA: You speak often of asset-price inflation. It seems that measuring inflation is easier said than done, however. What are some of the challenges in measuring inflation?
BB: Asset price inflation is hard to measure and diagnose because it involves a comparison between actual capital-market prices as influenced by strong irrational forces, and hypothetical prices that would exist under conditions of sound money. Moreover, asset price inflation does not affect all markets simultaneously. Indeed there is a mid-phase of the disease when speculative temperatures may be rising in some markets at the same time as falling in others.
These difficulties in measurement and diagnosis of asset price have been seized on by some critics to say that the disease does not exist. Other critics admit that there are periods in economic history when irrational exuberance in various forms is evident but maintain that the essence of the phenomenon is purely psychological (i.e., created by “animal spirits”). One answer to these criticisms is to take these episodes through history and demonstrate each time that monetary disorder has been present in a big way. The other part is to outline a clear chain of causality between monetary disorder and the growth of the irrational forces in asset markets. I try to do both in my book.
TA: In the past, we’ve seen the dot-com boom and the housing boom. This time around, the boom is different. What are the boom industries right now, and why has money gravitated toward those industries?
BB: This time the boom has been in the oil industry (including shale), in other commodity extraction industries, in emerging markets (including their real estate sectors), in export sectors in the advanced economies supplying the emerging markets especially China, and in Silicon Valley. Much of this boom (but not all) has turned to bust.
These stories fueled the flow of funds into high-yield credits and currencies in the pursuit of yield. Fantasy prices for high-yield credits were an essential condition for the boom in the private equity industry which in turn invested in the sub-prime auto finance and aircraft leasing sectors on a highly leveraged basis. Similar things happened in the shale gas and oil industry. Alongside there has been the boom in the currency carry trade into China and emerging markets whose economies were very dependent on the China boom. This speculative inflow into Chinese and wider emerging market currencies and credits as driven by the Great Monetary Experiment created economic boom and bust. The closest historical parallel to the carry trade boom in this cycle was perhaps the huge inflows of capital into the Weimar Republic between 1924–28 as fueled by the combination of monetary disorder as generated by the Benjamin Strong Fed, and the fantastic speculative activity surrounding the German “miracle economy” emerging from the destruction of war and hyperinflation.
TA: There are a lot of people out there who have been predicting a meltdown for years. You, on the other hand have identified several reasons as to why the current boom has not yet collapsed. What are some of these reasons?
BB: Each episode of asset price inflation disease through history has some elements common with others and some distinct. Since the early years of this episode — back in, say, 2010–12 — I have sought to diagnose the stage of the disease that we are in. Yet in my work I have been very aware of Mises’s advice against firm predictions in such matters. The weak overall economic expansion in the US and other advanced economies meant that an early end to the cycle was not going to come from general overheating accompanied by a substantial rise in interest rates. Indeed the economic sluggishness could be explained by huge monetary uncertainty weighing on business confidence. Instead, the end phase of the disease this time could arrive through a speculative burn-out — a disappointing reality causing rose-colored spectacles to splinter.
We need Mises now more than ever. The Federal Reserve is weighing which month to increase their target rate by a quarter of a percentage point, sending the media into a flurry whenever Janet Yellen so much as sneezes. As millions of US voters fall behind a self-avowed socialist, Venezuela’s socialist experiment is crashing and burning: Coca-Cola has shut down operations, toilet paper is a luxury item, power outages are regular, and violence and looting are on the rise. This is a prime opportunity to show others the prescience of Mises.
Only the strong Misesian arguments against central banking and socialism can explode (as Mises himself would say) the claims of their contemporary defenders. Mises’s arguments are the strongest because of his unyielding dedication to constructing and maintaining an economic methodology that produces unassailable conclusions. His business cycle theory carries the same certainty as the laws of diminishing marginal utility, comparative advantage, time preference, and other rock-solid economic principles, as an outgrowth of the same line of logical thinking. His critique of socialism is unparalleled among other critiques in its inescapable consequences for socialism in both theory and practice.
Weaker arguments do not rely on the absolutely certain conclusions of economics and are easily parried by opponents. Saying the Federal Reserve needs to be reformed because the policymakers are not representative of the demographics of the US population would fit into this category. Another is the claim that socialism doesn’t work because people don’t have an incentive to work hard or because the government just doesn’t have enough computing power to calculate the optimal prices of goods. These kinds of weak arguments become cannon fodder and straw men for detractors of unhampered markets and private property.
The Problem with Central BankingMises made the strongest case against central banking. He showed that the business cycle is not an inherent part of an unhampered market economy, but the result of artificial credit expansion. Whenever the money issuing authority inflates through credit markets, it pushes interest rates down to artificially low levels and sets in motion investment in lines of production that only appear to be profitable. The new money and low interest rates also fuel increased consumption spending.
Thus the boom is marked by malinvestment and overconsumption — not based on a voluntary expression of real time preferences, but the whims of the central bank officials. The plans of the entrepreneurs cannot be completed due to the prices of the factors of production becoming prohibitively high from the increasing scarcity of capital goods and because much of the remaining capital is employed in the wrong ways. The bust comes when these errors can no longer be sustained by new money flowing in through credit markets. The malinvested capital is liquidated and laborers too must find new employment in profitable lines of production.
This is a rhetorically strong explanation for business cycles, and there are many examples of economists and historians applying Mises’s theory to specific episodes like the Great Depression and the most recent housing boom and bust.
The Real Reason Why Socialism Doesn’t WorkMises also made the strongest case against socialism. With private ownership of the means of production, entrepreneurs hire laborers and purchase capital and natural resources based on their contribution to the productive process as measured by consumers’ willingness to pay for the final output. Anticipated revenues from the sale of output guide production and investment decisions. Any deviation from the consumers’ wishes results in lower profits or even losses.
Under socialism, in which the private ownership of the means of production is abolished, there can be no meaningful prices of the inputs to production processes. Production decisions are merely “groping in the dark,” as Mises put it in Economic Calculation in the Socialist Commonwealth. Mises showed that there is no forward-looking way to compare anticipated revenues to the costs of production and there is no way to retrospectively measure the success of any production process. Economic calculation, essential to any growing and flourishing market economy, is impossible.
Socialism, then, must result in the participants’ wants and needs going unsatisfied. This is another rhetorically strong argument, and it is especially fortified by the observed tragic failure of every socialist “experiment” (if you can call the deaths of millions of people something so mundane).
Real-World Human Action Is at the CoreMises didn’t just haphazardly stumble upon these brilliant insights. They were the product of careful logical deduction and rigorous self-scrutiny along the lines of his own contributions in the epistemology of economic science.
The logic of human action starts with means and ends and proceeds through exchange, prices, production, money, credit, and the necessary consequences of interventions in these areas. Mises showed that economics does not produce generalities or vague guidelines that may be overcome if only governments are smart and powerful enough. The science of economics reveals laws that cannot be broken. Our persuasive efforts are dramatically improved if we can convey these arguments from Mises and build on his strong foundation.
Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 116–120
The most recent financial crisis has engendered various actions by institutions aiming—or at least pretending to aim—to end the crisis and to stabilize the economy in general and the banking sector in particular. Not only have central banks flooded the markets with cheap money, but governments have also introduced new regulations intended to prevent the banking sector and, consequently, the entire economy from blundering into another crisis. These initiatives will in fact make everything worse, or are—at best—pointless. Apart from revised rules for banking supervision (“Basel III”), laws concerning the restructuring or formal liquidation of banks were passed in several countries. In Germany, the government created a Banking Restructuring Act (“Gesetz zur Reorganisation von Kreditinstituten”) aiming at 1) the successful restructuring of (especially) so-called “systemic” banks without affecting the stability of the banking system as a whole and 2) the involvement of both equity and debt holders in solving a bank’s crisis rather than the taxpayer.
While the German Banking Restructuring Act has been the subject of thorough jurisprudential research, David Rapp was the first to analyze the Banking Restructuring Act from a business economics perspective, based upon Austrian insights.
Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 29–64
ABSTRACT: One hundred percent reserve banking is an essential foundation and prerequisite for a country to establish long-term financial stability and sustained economic growth. It is also an essential element for a country contemplating the adoption of a stable gold standard monetary system. Debt money, i.e., debt created by banks, was once called malum per se, a thing that is evil in its nature. It has supported excessive government debt, inflated speculative bubbles, fueled inflation, reduced investment and growth, and resulted in an unjust redistribution of wealth. In this paper, we discuss some of the detrimental consequences of fractional reserve banking and outline its abolition as the principal reform before one or more countries can establish a viable gold standard.
KEYWORDS: fractional reserve banking, financial repression, gold standard, inflation, money JEL CLASSIFICATION: E00, E4, E52, F33, G01, G21 The most challenging monetary reform in any country is the adoption of 100 percent reserve banking, or 100 percent money. Governments and banks have resisted this reform. A domestic gold standard becomes simply an appendix to 100 percent reserve banking or money by connecting money to the supply of gold. A 100 percent reserve banking system separates money from debt obligations; a bank can no longer create money in the form of demand deposits; and money would be independent of fluctuations in debt. A 100 percent reserve banking system was practiced by the Bank of Amsterdam (1609), the Bank of Hamburg (1619), the Postal System, and other 100 percent depository institutions that restricted their business to purely safe depository and transfer functions.
A fundamental condition for establishing a stable banking system has been the abolishment of fractional reserve banking, i.e., debt money, in favor of 100 percent reserve banking. This condition was stipulated by David Hume (1752), William Gouge (1833), Amasa Walker (1873), Charles H. Carroll (1850s), Frederick Soddy (1934), the authors of the Chicago PlanThe authors of the Chicago Plan were: Henry Simons, Frank Knight, Aaron Director, Garfield Cox, Lloyd Mints, Henry Schultz, Paul Douglas, and A. G. Hart. Professor Irving Fisher of Yale University was a strong supporter of the Plan. His book, 100 Percent Money (1936), was an attempt to win support for the plan among academics and policy makers. (1933), Irving Fisher (1936), Ludwig von Mises (1953), Murray Rothbard (1962), Maurice Allais (1999), and a number of other economists and authors. They essentially proposed a two-tier banking system:
i. 100 percent reserve banking strictly for depository and payments operationsii. Investment banking for financial intermediation and channeling savings into investments
One hundred percent reserve banking has been recommended for a number of reasons that include avoiding: (i) frequent bank failures and losses suffered by depositors;The Bank of England, founded in 1694, suspended convertibility of its notes into gold and silver as early as 1696, and not infrequently thereafter. It suspended convertibility during 1797–1821. (ii) wide expansion and contraction of the money supply that created speculative bubbles, crashes, deep recessions, and loss of output and employment; (iii) unjust wealth redistribution via fictitious credit in favor of borrowers and speculators; (iv) debt money that was too costly to use, since interest has to be paid on outstanding debt; and (v) debt money contracts if interest cannot be paid. With fractional reserve banking, many banks have been bankrupted with ominous financial losses for their depositors, or by taxpayers through subsidized deposit insurance schemes and bailouts. Hence, many writers deemed it essential to separate the deposit of money from the lending and debt obligations.With this separation, there is no need for insuring the safety of bank deposits through corporations such the Federal Deposit Insurance Corporation (FDIC). This separation was needed to sever the relation between the money supply and debt, so money would not fluctuate with debt, and to insure that banks hold and lend true savings and do not issue fictive credit. Money should not be created and destroyed through debt expansion and contraction via the credit multiplier.
The depository system is a fundamental feature of a modern economy and could be provided by private banks, or the state (e.g., Bank of Amsterdam and Bank of Hamburg). It accepts deposits for safekeeping and undertakes domestic and foreign payments against fees paid by the depositors. Some authors have suggested that the government could provide the deposit system through a banking and postal system so as to minimize fees and increase the quantity of money for the economy (Gouge, 1833; Simons, 1947). Investment banks in implementing their investment banking function create no money and accept no demand deposits; they borrow or issue equities and debt securities; and lend or buy securities. Essentially, investment banks would operate as other businesses, they issue shares and attract capital that they invest on behalf of their shareholders.
Debt-based money is associated with the advent of fractional reserve banking. By definition, the state grants a charter for a bank to create money. In countries with fractional reserve banking, debt money made economies navigate from booms to busts (Juglar, 1862) and destroyed the gold standard.Eminent writers stressed that debt money would certainly evict gold: David Hume (1752), Charles Jenkinson (1805), US Presidents Thomas Jefferson and Andrew Jackson, William Gouge (1833), Charles Holt Carroll (1850s), and Amasa Walker (1873). Ironically, it was the United Kingdom, the cornerstone of the gold standard and the world financial center, that dealt a fatal blow to the gold standard in 1931, which many of its eminent economists called a barbarous system. It was followed immediately by the United States, another model of the gold standard, abolishing gold money and sequestering the gold from its citizens in 1933, with the rest of the world following along. Proponents of debt money referred to the gold standard as gold shackles. But it was debt and paper money that have led to frequent financial crises after the gold standard was abolished (e.g., Greece 2009–2015, US and Eurozone 2009–2015, etc.). Moreover, debt-money system cannot stand on its own; it needs a central bank for liquidity and occasional government bailouts. It was the debt system that undermined the Bretton Woods gold exchange standard in 1971. Endless regulations in the 19th and 20th centuries have not prevented rapid creation of debt and financial booms and busts.
Money has been considered a principal pillar of the human civilization; it has enabled the development of commerce, industry, exchange and travel within and across countries and continents, and high level of scientific progress. If this pillar is undermined, economic decline follows, and social stability is put at risk.Examples of horrifying hyperinflations that ruined the real economy were John Law’s system in France (1716–1720), the French assignats (1789–1795), the US continental currency (1785–1790), and the German hyperinflation (1919–1923). In all these episodes, paper became worthless, the economy lost its money, and famine spread in the country. With the advent of fractional reserve banking, debt-based money has risen to prominence. In the pursuit of gains from interest on fictitious loans, banks and central banks kept issuing debt money, out-of-thin air, until the breakout of a financial crisis. Debt money calls for more debt to provide for rapidly rising prices, replace repaid debt, and pay interest. The central bank and banks validate any price and wage rise through more debt money. As soon as the debt process slows down or hits general bankruptcy, a severe financial crisis breaks out and wipes a large part of the debt money causing severe economic and financial disorders.Irving Fisher (1936) noted that US money was reduced by 35 percent during 1929–1933 following the collapse of debt money. He strongly advocated 100 percent reserve money so to eliminate the banks’ power in creating and destroying money. With debt organized as currency (Carroll, 1850s), financial crises became frequent; the most ominous was the Great Depression (1929–1936). The 2008 financial crisis was another ominous collapse of the debt money. Each financial crisis destroys money (Frederick Soddy, 1934; Irving Fisher, 1936), paralyses the economy, and spreads bankruptcies and human hardship. Governments resort to even pushing more interest-debt in order to cope with the disorders of the financial crisis. Hence, each economy is entangled in a vicious circle of debt followed by crises.
A 100 percent (or at least a long way toward 100 percent) reserve banking system or 100 percent money has become pressing in view of growing money disorders in the world. Many eminent writers had urged the abolition of debt-money and proposed reforms along the principles of 100 percent reserve banking and risk-sharing investment banking.We may cite David Hume (1752), Thomas Jefferson, Andrew Jackson, William Gouge (1833), Charles. H. Carroll (1850s), Amasa Walker (1873), Irving Fisher (1936), the numerous authors of the Chicago Plan (1933), Ludwig von Mises (1953), Murray Rothbard (1994), and Maurice Allais (1999). Despite repeated calls for reforms during the 18th–20th centuries, both governments and financial interests have remained adamantly against abolishing debt money. In what follows, we address the following themes:
• The nature of debt money• Inherent inflationism, instability, and uncertainty of debt money• Some notable rejections of debt money and proposals for 100 percent reserve banking• Suggested reforms for reintroducing 100 percent reserve banking and a domestic gold standard• 100 percent reserve banking and a convertible 100 percent domestic gold standard• Structural reforms to support 100 percent money
The Nature of Debt Money Debt money has been rising without limit in almost every country at rates that far exceed real GDP growth. Money supply, measured by M2 (currency plus deposits) may increase at a double-digit rate for decades in many countries. The source of this increase is simply debt. Simons (1947) stated:
We have reached a situation where private-bank credit represents all but a small fraction of our total effective circulation medium. ... Thus the State has forced the free-enterprise system, almost from the beginning, to live with a monetary system as bad as could well be devised. ... An enterprise system cannot function effectively in the face of extreme uncertainty as to the action of the monetary authorities or, for that matter, as to monetary legislation. We must avoid a situation where business venture becomes largely a speculation on the future of monetary policy. (p. 55)
If we examine the balance sheet of the US Federal Reserve (Fed), we see that gold and foreign assets ($30 billion) are negligible in relation to total liabilities ($4,452 billion), i.e., 0.6 percent. All money expansion was through money creation, with money becoming overly dependent on domestic debt. Moreover, as the latter expands, imports tend to rise faster while exports tend to shrink, which results in reduced net foreign assets. Moreover, debt money is costly; banks earn interest and commissions on the outstanding debt.
Debt money has fueled inflation.Two definitions of inflation are proposed. The most common one is a persistent general rise of prices. Another definition considers the general rise of prices as an effect of a rise of money supply that is not offset by a corresponding increase in the demand for broad money so that a fall in the objective exchange-value of money must occur. In this definition, inflation is measured by the increase in broad money supply. The latter has been considered as a form of fraud, which has to be eradicated.Inflation is an inherent feature of paper and debt money. It emanates from money created out-of-thin air in form of a monetization of fiscal deficits or issues of unbacked loans. Commodities are purchased against paper and not commodities. The practice of appropriating wealth unjustly was severely condemned by John Locke (1691). It is a fallacy that inflation stimulates employment and growth.Bastiat, The Seen and the Unseen, 1877. Inflation is a tax that unduly transfers free wealth to one group at the expense of another group. The income distribution is altered by a heavy inflation tax, which deprives labor from a sizable part of its real contribution to real GDP. At a high rate of money depreciation, holders of cash will get rid of it as soon as they receive it. Financial savings is discouraged (McKinnon, 1973; Shaw, 1973). Forced savings will replace voluntary savings, imposed upon creditors and workers through the inflation tax (Hayek, 1932). Production will be discouraged as producers hike prices and reduce output.In an inflationary context, producers reconstitute their money working capital through increasing prices and reducing quantities. In a non-inflationary context, they have to generate money working capital through higher quantities sold. They are compelled to produce much more to generate cash. The drop in prices improves in turn external competitiveness and exports. Exports will be reduced. Figure 1 portrays the Consumer Price Index (CPI) for the US and the Retail Price Index (RPI) for the UK under the metallic system during 1800–1913. In both countries, there was a significant trickling down of productivity gains and technical change in form of long-term trends of price declines. In 1913, the US CPI stood at 79 (1800 = 100) and the UK RPI stood at 82 (1800 = 100). Workers had shared in the fruits of growth (Farrer, 1898). Such sharing has been diminished under the debt money in almost every country where this system is in effect. Figure 2 portrays the inherent inflationary feature of the debt-money system supported by central banking in the UK and the US. Inflation tax has become permanent, penalizing the holders of the currency, workers, pensioners, and creditors. The inflation tax benefits the government, debtors, and speculators. Inflation is vital for the perpetuation of the debt system. There has been little trickling down of productivity gains to consumers.Mises (1953) noted that CPI underestimated inflation during 1922–1929, a period characterized by high productivity gains. Let the recorded CPI be 3 percent, let productivity gains be 7 percent; the true CPI would be 10 percent. In 2013, US CPI stood at 1,294 (1945 = 100), and the UK RPI stood at 3,766 (1945 = 100).
Figure 1: The United Kingdom and the United States Annual Price Indices, 1800–1913
Figure 2: The United Kingdom and the United States Annual Price Indices, 1945–2013
Inherent Inflationism, Instability, and Uncertainty of Debt Money The debt money model has resulted in adverse social consequences in many countries where it has been adopted.Interest-based bank money has been severely condemned by Thomas Jefferson, William Gouge, Charles Holt Carroll, Frederick Soddy, Amasa Walker, and many others. Mises, Rothbard, Irving Fisher, authors of Chicago Plan, Maurice Allais, and many authors proposed abolishing debt money and its replacement by a non-interest money. Recurring financial crises and ensuing economic dislocation have been its inherent features. In each debt crisis episode, economic prosperity was reversed into decline and mass-unemployment as demonstrated by the 2008 financial crisis. Being interrelated by a web of trade, banks and capital flows, a crisis breaking out in one country spreads to other countries. Fractional reserve banking was a violation of the original and authentic 100 percent reserve banking that characterized goldsmith houses as well as the Bank of Venice, the Bank of Amsterdam, and the Bank of Hamburg.These institutions were created as depository and payments institutions and not to economize on gold and silver, which were abundant in supply to the point of causing high inflation worldwide. It developed very fast in Europe and the US during the 18th–19th centuries mainly because of the leverage it provides to bank owners from the emission of banknotes and discounts, and ease of obtaining charters.
Figure 3: Monthly Central Bank Interest Rates, 2000–2013
By turning money into a policy tool, to secure full-employment of labor, devalue exchange rates, and inflate asset and housing prices, central bank actions could become somewhat arbitrary.Friedman (1959) opposed the discretion power of the Fed; he proposed a fixed rule according to which money supply ought to increase at about 2 percent-3 percent. He reiterated that the Fed could only control the money supply; it cannot control the unemployment rate, the interest rate, or the rate of inflation. Simons deplored money as an instrument policy and called discretionary policy as a form of lawlessness. He urged the abolition of fractional reserve banking and central banking, and the creation of a “National Monetary Authority” that controls money according to fixed rules. The systemic risk and uncertainty could be described by the cheap money policy of major central banks as portrayed by the interest rates in Figure 3. The Fed practiced a repressive policy, which lowered money rate to 1 percent during 2002–2004 under the guise of fighting deflation at a time the economy was operating at near full-employment for more than a decade. Credit rose at 12 percent year at the expense of creditworthiness; asset, housing, and commodities prices spiked. A financial collapse followed thereafter in 2008, creating massive unemployment in the US and Europe. After 2008, the Fed forced interest rates to near zero, this time, to fight unemployment. Hence, the Fed used a cheap money policy as a panacea for both diseases. The Fed decided to inflate money under quantitative easing programs; it hiked up without any restraint its credit to $4.5 trillion in 2015 from $0.8 trillion in 2008 (Figure 4).Excess reserves of banks at the Fed were $2.5 trillion in December 2015. If this amount is drawn down, credit expansion will be too gigantic and will increase credit risk as well as inflation. This gigantic money-out-of-thin air printing was aimed at monetizing record fiscal deficits and pushing cheap loans in the economy. The Fed, and most politicians and academics are convinced that near-zero interest and unlimited money were most appropriate policy for full-employment and economic growth.
Fed’s policy has in part led the Eurozone and other countries into monetary difficulties. As long as the dollar is a reserve currency, the Fed faces no external constraint in printing as much money as it wishes and in setting interest rates at near zero. The latter measure is dangerously distortive and assumes that real capital supply is overly abundant in relation to demand for capital. The danger of this policy was already established by the 2008 financial crisis.
Figure 4: The Federal Reserve Credit, 2002–2014 (Trillions of Dollars)
Debt money created too much uncertainty. The monetary base, credit, interest rates, exchange rates, asset prices and commodity prices are all moving in a most unpredictable and volatile way. Huge resources are devoted to hedging against high volatility of exchange rates and asset prices, which increases inefficiencies. In stable markets, hedging resources would have been used for productive investment.
With near-zero interest rates and cheap money, the US government debt skyrocketed to about $18 trillion in 2014 (103 percent of US GDP) and is still rising due to large deficits. Private debt had already reached bankruptcy point in 2008 and is still rising fast. The huge indebtedness makes inflation the only way out of debt. Most likely, the Fed will maintain ultra-cheap policy for some time, since any tightening of money policy will send debt into bankruptcy and result in a crash of asset prices.
Only reserve currency countries, today principally the United States, can afford the luxury of near-zero interest rates without setting off hyperinflation as happened in Germany 1919–1923. In 2015, central bank interest rates were 0.08 percent (US), 0.20 percent (Eurozone), 10 percent (Brazil), and 10 percent (India) (Figure 4). The contrast is obvious. Being non-reserve currency countries, Brazil and India could not afford to set interest rates at near zero. They face a foreign exchange constraint. Low interest rates would fire up inflation, undermine their banking sector, and destroy their export sector.
Setting interest rates at zero or near zero is most distortive policy. It leads to unlimited borrowing by subprime markets, encourages consumption through loans that may never be repaid, it consumes savings and depletes capital, and by introducing distortions enables mal-investment. It confiscates real capital from one group in favor of the group who benefits from cheap money. It exposes the banking sector to significant interest and credit risks. It pushes up asset and commodity prices, and creates an environment of economic uncertainty. Speculation becomes intense. Income and wealth inequality becomes aggravated. The harmful effects of cheap money policy appear only when a financial crisis breaks out. Abolition of fractional reserve banking is the reform that would reduce the depletion of capital, volatility, and ominous free redistribution of wealth via inflationism. Under a gold standard, low interest rates would immediately drain all the gold from the country, and force gold suspension as happened in the UK in 1931 and the US in 1971.
Some Distinguished Criticisms of Debt Money and Proposals for 100 Percent Reserve Banking Fractional reserve banking has provided the foundation for high leverageIn 1694, the Bank of England made a loan to the government; it immediately monetized the loan and issued banknotes in equal amount, extending more loans to both the government and business. Through leverage, the bank earned interest income on capital, which it did not possess. and swindling schemes, inflation of banknotes, financial crises resulting in economic dislocation and bankruptcies. As a result, numerous authors have called for a definitive end of fractional reserve banks, a cancellation of their charters, and the re-introduction of 100 percent reserve banking and money. A partisan of gold and 100 percent money, David Hume (Political Discourses) wrote: “of those institutions of banks, funds, and paper credit, with which we are in the kingdom so much infatuated. These render paper equivalent to money (i.e., gold), circulate it throughout the whole state, make it supply the place of gold and silver. ...” (Hume, 1752) The same discredit was held by Charles Jenkinson, Earl of Liverpool (1805): “Paper currency, which is carried to so great an extent, that it is become highly inconvenient to Your Majesty’s subjects, and may prove in its consequences, if no remedy is applied, dangerous to the credit of the kingdom.”
Aware of the danger of debt-money, the US Third President Thomas Jefferson wanted to abolish fractional reserve banking and preserve metallic money. In fact, he opposed the renewal of the charter of the First Bank of the United States. Witnessing the severe dislocation caused by banks and their corrupt nature, President Andrew Jackson pronounced to a delegation of bankers discussing the re-charter of the Second Bank of the United States in 1832: “You are a den of vipers and thieves. I intend to rout you out, and by the eternal God, I will rout you out.” He abolished central banking in the United States and allowed the country to enjoy sustained prosperity. The re-establishment of central banking in 1913 with the Federal Reserve inflicted on the US its worst economic depression during 1929–1936, and has been since destabilizing the economy and falsifying prices and income distribution.Ron Paul (2009) considered “the creation of the Fed the most tragic blunder ever committed by Congress. The day it was passed, old America died and a new era began. A new institution was born that was to cause the unprecedented economic instability in the decades to come. The longer we delay a conversion to sound money and away from central banking, the worse our crises will grow and the more the government will expand at the expense of our liberties. Our wealth is drained, our productivity is sharply diminished. Our freedoms are eroded. We have been through nearly a hundred years of this same repeating pattern, so it is time to wise up and learn something. When the printing presses are available to the government and the banking cartel, they will use them rather than do the right thing.”
Maurice Allais wrote (1999): “In essence, the present creation of money, out of nothing, by the banking system is, I do not hesitate to say it in order to make people clearly realize what is at stake here, similar to the creation of money by counterfeiters, so rightly condemned by law. In concrete terms, it leads to the same results.” Bastiat (1877) deplored the redistributive injustice of paper inflation. It steals wealth from losers and showers it for free on the gainers. He wrote:
I must also inform you that this depreciation, which, with paper, might go on till it came to nothing, is effected by continually making dupes; and of these, poor people, simple persons, workmen and countrymen are the chief. […] Sharp men, brokers, and men of business, will not suffer by it; for it is their trade to watch the fluctuations of prices, to observe the cause, and even to speculate upon it. But little tradesmen, countrymen, and workmen will bear the whole weight of it. (Bastiat, [1849] 2011, p. 131)
Carroll (1850s) severely condemned the redistributive injustice of fictive money and credit, favorably quoting Daniel Webster: “that of all the contrivances for cheating mankind, none has been more effectual than that which deludes them with paper money. This is the most effectual of inventions to fertilize the rich man’s field with the sweat of the poor man’s brow.” (Carroll, [1856] 1972, p. 35) Carroll noted that “the truth is, an expanded and consequently cheap currency is the most costly and wasteful machinery a nation can possess; the history of the world shows it to be uniformly unprofitable or disastrous. … There was never a greater mistake in any science, and never one so fatal to the stability of property and the well-being of society.” (Carroll, [1858] 1972, p. 76) Carroll deplored the devastating effects of paper money. He stated that “the value of money is regulated to disorder, to the impairing of contracts, and to the confusion of all just ideas regarding the rights of property, as effectually by the powers exercised by the States in granting bank charters, with authority to issue bills of credit.” (Carroll, [1855] 1972, p. 6) He described the notion of “price without value”; namely, currency generated by bank lending pours forth only to drive up prices without creating additional value.Figure 1 showed that an item that cost £1 in 1945 would cost £38 in 2013.
In 1833, William Gouge noted: “Our American Bankers have found that for which the ancient alchemists sought in vain; they have found that which turns everything into gold — in their own pockets; and it is difficult to persuade them that a system which is so very beneficial to themselves, can be very injurious to the rest of the community.” (Gouge, 1933, p. 227) He regretted the evils caused by banks of issues. These institutions constantly altered the measures of value, caused uncertainty to trade, and conferred undeserved advantages on some men over others. He stated: “It has always been my opinion, that of all evils which can be inflicted on a free state, banking establishments are the most alarming. They are the vultures that prey upon the vitals of the Constitution, and rob the body politic of its life-blood.” (Gouge, 1833, p. 111)
Gouge stressed the redistributive evils of bank money.
It made a lottery of all private property. These Banks, moreover, give rise to many kinds of stock-jobbing, by which the simple-minded are injured and the crafty benefitted. …They see wealth passing continually out of the hands of those whose labor produced it, or whose economy saved it, into the hands of those who neither work nor save. The natural reward of industry then goes to the idle, and the natural punishment of idleness falls on the industrious. The reckless speculator, who has no capital of his own, but who operates extensively on the capital of other people, has much cause to be well pleased with this system. (Gouge, 1833, p. 31)
Gouge rejected the notion of over-production as pure nonsense as huge human needs in food, shelter, medication, etc., in every country remain unfulfilled; he attributed the business disruption to the disappearance of fictive money created by banks. Irving Fisher (1936) explained the Great Depression (1929-1936) by the evaporation of bank money. His reform plan (100 percent money) urged the abolition of fractional reserve banking. He rejected the notion of elastic money, which underlined the Federal Reserve Act in 1913. He noted that
the flexibility or elasticity of Bank medium is not an excellence, but a defect, and that “expansions” and “contractions” are not made to suit the wants of the community, but from a simple regard to the profits and safety of the Banks. The uncertainty of trade produced by these successive “expansions” and “contractions,” is but one of the evils of the present system. That the Banks cause credit dealings to be carried to an extent that is highly pernicious — that they cause credit to be given to men who are not entitled to it, and deprive others of credit to whom it would be useful. (Gouge, 1833, p. 136)
He rejected the notion that banks make money plentiful, saying,
Banks make money plenty. Nay, they make real money scarce. As Bank notes are circulated, gold and silver are driven away. It is contrary to the laws of nature that two bodies should fill the same space at the same time; and no fact is better established than that, where there are two kinds of currency authorized by law or sanctioned by custom, that which has the least value will displace the other. (Gouge, 1833, p. 45)
Gouge challenged the principle that paper was cheaper than specie. That paper money has some advantages must be admitted; but its abuses are also inveterate. Gouge rejected also government paper stating that: “Government issues of paper would be incentives to extravagance in public expenditures in even the best of times; would prevent the placing of the fiscal concerns of the country on a proper basis, and would cause various evils. Further than this, Government should have no more concern with Banking and brokerage than it has with baking and tailoring.” In terms of reforms, Gouge was ahead of both the 1933 Chicago Plan and Irving Fisher’s 100 Percent Money (1936). For Gouge, debt-money is an evil that has no remedy, except be abolished or extinguish itself through bankruptcy or when paper become worthless. He stated:
[N]o legislative enactments can afford an adequate remedy for the evils which flow from incorporated paper money Banks. The system is, to use the language of the lawyers, malum per se — or a thing which is evil in its nature. The very principle of its foundation is wrong. No immunities should, in a Republican Government, be granted to any, save those which are common to all. (Gouge, 1833, p. 52)
And, “’You may say what you will, paper is paper, and money is money.’” (Gouge, 1833, p. 232)
Gouge proposed prohibition of all incorporated paper money banks; that is, to eliminate their privileges of limited liability and note issue. In their place he would have banks subject to unlimited liability, lending only their own capital plus savings deposits (time deposits) and maintaining a hundred percent specie reserve. “With private Banks, and public Offices of Transfer and Deposit, we should have all that is good in the present system, without the evil.” (Gouge, 1833, p. 230) For Gouge, money is metallic:
The high estimation in which the precious metals have been held, in nearly all ages and all regions, is evidence that they must possess something more than merely ideal value. It is not from the mere vagaries of fancy, that they are equally prized by the Laplander and the Siamese. It was not from compliance with any preconceived theories of philosophers or statesmen, that they were, for many thousand years in all commercial countries, the exclusive circulating medium. Men chose gold and silver for the material for money, for reasons similar to those which induced them to choose wool, flax, silk, and cotton, for materials for clothing, and stone, brick, and timber, for materials for building. They found the precious metals had those specific qualities, which fitted them to be standards and measures of value, and to serve, when in the shape of coin, the purposes of a circulating medium…. (Gouge, 1833, p. 10).
No instance is on record of a nation’s having arrived at great wealth without the use of gold and silver money. Nor is there, on the other hand, any instance of a nation’s endeavoring to supplant this natural money, by the use of paper money, without involving itself in distress and embarrassment. (Gouge, 1833, p. 17)
Gouge was cognizant of the time dimension of reform:
[T]he sudden dissolution of the banking system, without suitable prepa-ration, would put an end to the collection of debts, destroy private credit, break up many productive establishments, throw most of the property of the industrious into the hands of speculators, and deprive laboring people of employment. …[T]he system can be got rid of, without difficulty, by prohibiting, after a certain day, the issue of small notes, and proceeding gradually to those of the highest denomination. (Gouge, 1833, p. 138)
All that it will be necessary for Congress to do, will, probably, be to declare that, after a certain day, nothing but gold and silver shall be received in payment of dues to Government, and that no corporation shall be an agent in the management of its fiscal concerns. The people will then begin to distinguish between cash and credit; and public opinion will operate with so much force on state governments, that they will, one by one, take the necessary measures for supplanting paper by metallic money. (Gouge, 1833, p. 234)
The obstacles to reform noted by Gouge would not be very different from those of today. Besides political and deep-vested financial groups, Gouge recognized a degree of ignorance of people about the nature of the paper system.
Their only misfortune was, being ignorant of the principles of currency, and having rulers as ignorant as themselves. Certain individuals who have never caught a glimpse of a more improved state of society, boldly affirm that it cannot exist: they acquiesce in established evils, and console themselves for their existence by remarking that they could not possibly be otherwise. (Gouge, 1833, p. 227)
Henry Ford once said, “It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” Holding similar views as Gouge and Carroll, the 1921 Nobel Prize winner in chemistry, Frederick Soddy (1934), condemned debt money as a form of legal swindling and counterfeiting and a violation of democracy. He accused it of sending millions of workers into unemployment and poverty and presenting a stumbling block to progress of technology, full employment, and the smooth distribution of the produce of industry. He urged abolition of debt-money and reconstitution of mints that would issue a state paper currency as a relief from taxation. Aware of hyperinflations in Germany, Austria, and many other countries, he recommended that state paper be regulated by a stable price index.
The money system condemned by Gouge, Carroll, and Walker was superior to the money system that has become deeply rooted since early 20th century. During their times labor, capital, and commodities markets were competitive with no customs barriers, no government-set prices and wages, no central bank, no labor unions, no formidable taxation, and oversized government.During the 19th century, labor markets recovered very quickly from depression caused by banking failure through a free market mechanism. In the depth of the Great Depression, with unemployment close to 25 percent, the US hiked up wage rates tremendously in the effort to stimulate spending. Not surprisingly, unemployment remained above 19 percent until the breakout of the war (1939–1944). With the war, unemployment fell to less than 1 percent. Simons (1947) lamented the erosion of competition, and the institutions that control capital and labor market. He was appalled by the use of government force in money area and money as policy tool, often referring to central bankers as “dictators” who inflicted great uncertainty and upheavals on the economy; he deplored the wide contraction and expansion of the money supply and the consequent alteration in the value of contracts which he called a perverse elasticity. He deemed that too much uncertainty was created needlessly by money policy. He strongly supported 100 percent money and abolition of both central banking and fractional reserve banking. Opposition to fractional reserve banking and its pillar central banking was not limited to the monetary system but also to the economic system it helped to shape in the form of too much government, too-powerful interest groups, and a totally rigid price and wage structure.Greece is an example of an economy saddled by oversized bureaucracy and deeply rooted rigidities that kept the economy in a depressed state during 2009–2015, with little scope for removing structural rigidities and downsizing government. Mises (1953) explained that rigidities and government support of monopolies of all kinds hindered recovery from depression. Massive quantitative easing in the US and the Eurozone illustrates clearly the belief of Mises, Simons, and many others on how deeply rigid the system has become. Mises argued that the best approach to unemployment was to remove legal restrictions on wage flexibility and let the labor markets clear on their own. Instead, governments force money expansion as the road to full-employment.
The principle of 100 percent reserve banking, (100 percent money) and the gold standard can be stated as follows. Banks are essential intermediaries in payments and investment; however, they should have no prerogative for money creation. Gold and silver are purely economic commodities and not an interest-based debt. Gold producers sell gold in the same manner as a farmer sells wheat. Gold is exchanged against wheat. As money, gold does not contract in the same fashion as a debt money, which contracts when borrowers pay it back or when issuers refuse to issue or when it goes into a general default. Gold does not expand at the stroke of a pen as debt-money does. Gold does not confer to any country a privilege status of a reserve currency. Under the gold standard, countries may not use their own currencies as a means of settlement and may have to settle balance of payments in gold if no other commodities are available for exports. Gold exerted the development of exports; nations exchanged commodities, and rarely settled in gold. With paper money, many countries neglected exports since they import with paper. Other countries, mainly developing countries, relied on borrowing, and in turn neglected their export sectors.
Suggested Reforms for Reintroducing 100 Percent Reserve Banking and a Domestic Gold Standard Restoring a gold standard following a suspension of gold convertibility is technically simple; it is purely a political decision. It requires relating changes in money (paper and demand deposits) to the flows of gold and foreign exchanges until the national currency reaches a stable rate vis-à-vis gold, at which point convertibility may be implemented on a permanent basis.The International Monetary Fund (IMF) adjustment programs imposed a strict ceiling or even reduction on the money supply in order to allow a country to reconstitute net foreign assets to a desired target. The IMF used the monetary approach to the balance of payments, which considered that the balance of payments reflected changes in domestic monetary aggregates. For instance, the German rentenmark was instantly pegged to gold in 1923, with no convertibility provision and almost no gold reserves, simply based on a full commitment to control the German money supply. Restoring a gold standard is exactly the same experience as restoring convertibility of a currency. After World War II, many European currencies, such as the French franc, were not convertible into foreign currencies at par as stipulated by the Bretton Woods system of fixed exchange rates. To reestablish convertibility, countries had to regain control of both money and fiscal policies and achieve macroeconomic stability. As long as the fiscal deficit was out of control and was being constantly monetized, countries could not attain convertibility.
Historical experiences of restoring the gold convertibility and gold standard are numerous. The basic principle was the same: strictly controlling banknotes and deposits emission. This principle was observed by the Bank of England in 1819 to pave the way for convertibility of its banknotes in 1821 following the suspension in 1797. In like manner, the US Treasury established gold convertibility of the greenbacks in 1879 through running fiscal surpluses that reduced paper money. As major industrial powers such as the United States, Germany, and France adopted gold standards during 1870–1900, the value of silver in relation to gold depreciated considerably. Numerous partner countries that were on a silver standard saw their currencies depreciate significantly, causing serious fiscal and external difficulties. Many silver standard countries had to introduce currency reforms consisting of achieving a fixed exchange rate of their currencies in relation to gold. These reforms were needed to establish stability of exchange rates and settle trade and capital operations in gold with gold standard countries (Kemmerer, 1916).
With the outbreak of war in 1914, many countries suspended the gold standard, meaning that their currencies were no longer convertible into gold; the currencies were floating in the exchange markets against each other. As soon as the war ended, countries were eager to restore the gold standard. An important feature of the return to a gold standard was the contrast between the doomed British experience and the successful French experience. The British experience restored gold at prewar parity in 1925 in the context of very high inflation. This rate did not reflect the very high degree of inflation since 1914 and was totally unrealistic. It necessitated a grave deflation that severely impaired the economy as well as external competitiveness. Mass unemployment developed, as wages could not be reduced. However, France was not as fast as the United Kingdom in restoring gold; it stabilized its economy until it reached a stable market rate of its currency in relation to gold that reflected past inflation as well as trade equilibrium. France restored a stable gold standard in 1928 at a highly devalued market rate, about one-fifth of the prewar parity, which enhanced external competitiveness without any reduction in nominal wages and was maintained with no difficulty thereafter.
Mises emphasized that a return to sound money, i.e., a gold standard, is technically simple; however, politically very difficult. His gold plan required an end to inflation by setting an insurmountable barrier to any further increase in paper and demand deposits; it required a safeguard against deflation. He proposed the establishment of a conversion agency, different from the central bank, which would be entrusted with exchange operations. The agency would have the monopoly to issue paper money against 100 percent gold and foreign exchange coverage. The banking system would be 100 percent reserve banking, with no discounting by the central bank. No privileges would be accorded to the agency, other than paper money issuance. It would not get a monopoly for dealing in gold or foreign exchange. The foreign exchange market would be perfectly free from any restrictions. Everybody would be free to buy or sell gold or foreign exchange. There would be no centralization of such transactions; any bank or dealer could settle foreign payments with foreign correspondents. Nobody would be forced to sell gold or foreign exchange to the agency or to buy gold or foreign exchange from it. Mises emphasized that the United States should restore the classical gold standard, which existed in the United States until 1933 with gold coins circulating freely, and not the gold-exchange standard. Gold should be in everybody’s cash holdings. Everybody should see gold coins changing hands, and everyone should be used to having gold coins in their pockets, receiving gold coins when they cash their paychecks, and spending gold coins when buying something from a store.
Rothbard (1962) proposed a gold standard with the dollar tied to gold permanently at a fixed weight, and redeemable in gold coin at that weight. The dollar should once again be defined as a unit of weight of gold. Rothbard urged the replacement of the name “dollar” by gold ounce or gold gram. Rothbard insisted that gold coins should circulate and be used in transactions. He emphasized that there seemed little point in advocating fundamental reforms while neglecting the causes that undermined the gold standard in the past. Besides abolishing the Federal Reserve, Rothbard wanted to eliminate, or at least dramatically reduce, inflation and business cycles. Consequently, he proposed 100 percent reserve banking, along the Chicago Plan (1933), Irving Fisher’s 100 Percent Money (1936), and Simons (1947) that would take away the ability of banks to create money and thus reduce leverage and inflationary and deflationary pressures. David Hume, Thomas Jefferson, Andrew Jackson, John Adams, W. Gouge, Charles H. Carroll, Amasa Walker, Isaiah W. Sylvester, Elgin Groseclose, and Ludwig von Mises all adhered to the 100 percent gold reserve tradition, i.e., paper and deposits are 100 percent covered by gold reserves. They considered the issuing of demand liabilities greater than reserves as a fraud.
Ron Paul (1985) asserted that Menger (1892) and Mises (1953) showed that money emerged by evolution from the market process. Namely, governments did not invent gold bullion as money. He proposed a new troy ounce gold coinage. Paul supported Mises’s Conversion Agency that would be responsible for issuing gold coins and bullion to the public and for exchanging gold and paper. Only the conversion agency should be allowed by law to legally exchange genuine coin for paper dollars at the par value. In Paul’s plan, a main step to restoring the gold monetary system is gold coinage; gold must be in the cash holdings of everyone. As with Mises, everybody must see gold coins changing hands; everybody must be used to having gold coins in their pockets, to receiving gold coins when they cash their paychecks, and spending gold coins when they go to buy goods in a store. In the critical importance of the gold coinage lies the key to establishing a new gold standard. In Paul’s gold standard plan, the coinage should be based on exact units of bullion weight. The coins should be denominated in troy ounces, half-ounces, and smaller sizes if feasible. The denomination of the coinage is the secret to success in the later stages of the political agenda.
Mises, Rothbard and Paul considered that a single country could go it alone and adopt the gold standard without waiting for the rest of the world to be under the gold standard.Soddy (1934) insisted that monetary reform is purely a national matter and should not require an international conference. The United Kingdom was the only gold standard country during 1816–1873. It introduced its gold legislation in 1816, without approval from another country; it rejected bimetallism proposed by the international monetary conferences of late 19th century in favor of its own gold standard. They rejected the idea of an international conference for restoring a gold standard, since in the past each country had gold money established by a sovereignty act and not by coordinating with partner countries. Mises (1944) wrote:
No international agreements or international planning is needed if a government wants to return to the gold standard. Every nation, whether rich or poor, powerful or feeble, can at any hour once again adopt the gold standard. The only condition required is the abandonment of an easy money policy and of the endeavors to combat imports by devaluation (p. 252).
In the same vein, Walker (1873) wrote:
If the principles we have previously laid down, and the practical results which follow, are such as we have stated, then no one nation needs to hesitate in making this experiment for fear that other nations may not follow their example; for the community which has the soundest currency will, other things being equal, have the most profitable industry and the most advantageous commerce. There need be no legal restriction whatever upon the issue of such a currency, and it matters not how voluminous it may be since it will be composed in fact of value money, will obey the laws of value, and, of course, will regulate itself. There would then be no expansions or contractions, except from the legitimate operations of trade; and the currency of the nation would be perfectly sound (p. 245).
One Hundred Percent Reserve Banking and a 100 Percent Convertible Gold Standard An essential reform, even before thinking about restoring the gold standard, is establishing 100 percent (or close to 100 percent) reserve banking or 100 percent money. The introduction of this reform has been thoroughly described by Soddy (1934), and Fisher (1936). Legislation has to change the banking into two components: (i) a 100 percent depository system, which issues no loans; and (ii) investment banking, which borrows or issues securities and bonds, and invests, lends or buys bonds and securities (Walker, 1873). This component cannot create money, i.e., issuing a loan, which has no money available, by simply crediting a borrower account and creating deposits. An investment bank operates like a development bankFor instance, the World Bank cannot lend without raising the funds prior to its lending by selling bonds. These funds are held at depository institutions. Certainly, it cannot create deposits in favor of its borrowers. or a mutual fund whose funds are held by a depository institution. Hence, starting from an implementation date, legislation has to require that a new loan issued by an investment bank would have to be fully covered by funds held in a separate depository institution. This decision will arrest the creation of new debt money; it will stabilize the money supply; and will enable the banking system to transit to a two-tier banking.To prevent a resurgence of fractional reserve banking, depository institutions issue no loans; they are payments institutions. Investment banks have no money creation role. The depository banks settle all their payments. Money holders would have to decide how much non-interest earning deposits they wish to keep, and how much interest-earning assets they acquire through the investment banking system. Simons stated that the best investment banking is the one that has no fixed money contracts at all:
What arrangements as to the financial structure would be conducive to lesser or minimum amplitude of industrial fluctuations? An approximate ideal condition is fairly obvious — and an unattainable. The danger of pervasive, synchronous, cumulative maladjustments would be minimized if there no fixed money contracts at all — if all property were held in residual equity or common stock form. With such a financial structure, no one would be in a position either to create effective money substitutes (whether for circulation or for hoarding) or to force enterprises into wholesale efforts of liquidation. (Simons, 1947, p. 165)
This reform enables the implementation of the McKinnon-Shaw financial deepening scheme. McKinnon and Shaw emphasized the importance of money deepening and a well-developed banking and financial sector. Large saving is pooled from small savers, large scale and efficient projects may be implemented, and risk is highly reduced. Investment banks borrow, or issue bonds, and stocks, and buy securities or extend loans to investment projects. Simons preferred that investment banks issue more equities than interest-bearing loans in mobilizing savings. Accordingly, the investment bank reduces its risk by linking the cost of its resources to the performance of its assets and to be able to raise long-term capital. Moreover, equity financing reduces the conflict between debtors and creditors and changes in value of debt due to changes in the price level.
The introduction of gold standard becomes an appendix to 100 percent reserve banking and 100 percent money, since a main obstacle to its existence has been removed, which is debt money. A gold standard with debt money would fail, since gold and debt money were like water and fire (Carroll, 1850s). A non-reserve currency country has nothing to lose by adopting a gold standard. It is presently in a pseudo-gold standard, since its foreign exchange can be converted instantly into gold at prevailing gold market prices. The gold standard cannot operate in any country with restrictions on the trade of gold. Gold restrictions were most futile and were imposed as a measure to force devalued paper on people as shown in France in 1720 and 1789–1795, the US after 1933, and the United Kingdom after 1931. A country has to establish a fully free gold market with no taxes on imports or exports of gold. The state assumes a role of quality control to prevent fraud. A free gold market establishes an equilibrium price free of distortions and contributes to a return to gold at true prices.
Peel’s Act in 1844 split the Bank of England into two departments: the Issue Department and the Banking Department. The issue department was in charge of issuing banknotes with 100 percent gold coverage. In like fashion, the central bank of a country envisaging 100 percent money with a gold standard will be re-organized into an issue department; the banking department becomes purely redundant in 100 percent money and may be eliminated. The issue department will issue national paper money only against foreign exchange and gold at floating market rates. The issue department has the strict monopoly of paper money. However, it has no monopoly in foreign exchange and gold markets. Banks, foreign exchange bureaus, and gold and silver dealers are entirely free in their trade of gold and foreign exchange within the regulatory framework. The issue department has no banking operations within or outside the country. It immediately turns its foreign exchange into gold at market rates and sells gold against national money at market rates.
A gold standard act would re-establish the mints and the gold and silver coins. The mints would be open to all the public, including domestic and foreign gold dealers, as well as to the issue department of the central bank. The mints would turn gold into coins and certify the quality of the coin at a simple fee for covering the cost of assaying and coining the gold metal. Nationals should be allowed to acquire gold coins minted locally or abroad. If residents export commodities, say, wheat, oil, and others, they may elect to import gold and transform the gold into coins. These coins should be allowed to circulate in the economy especially in settling large transactions. The purchase of gold coins should be facilitated through licensed banks and foreign exchange dealers. Monetary gold would be acquired through external trade, local mining if available, and diversion from non-money uses. The import of gold would be paid for by foreign exchange earned from exports of merchandise and services. Gold trade would be carried out at international prices in the same way as for all tradable commodities such as corn, crude oil, sugar, coffee, and others. The economy would have to export commodities in order to import gold or any other commodity. Gold would be bought and sold against national paper at the issue department or any appointed dealer at the market rate. Gold coins and bars may be deposited for safekeeping at depository institutions and used in payment operations. Depository institutions have to keep deposited gold in coins or bars and reconstitute them in coins or bars and never in paper money. Customers would convert their gold into national paper in separate operations at authorized banks and foreign exchange bureaus or directly at the issue department. During the transition period, gold would circulate alongside paper at floating rates in the same way as foreign currencies circulate alongside the paper. Traders may directly use their foreign currencies or convert them into paper to settle payments. Silver coins, to be issued by the mints, would circulate at a free rate as a commodity.
The issue department should monitor the exchange rate of the paper money in relation to gold only and not to foreign currencies; there should be no effort to economize on gold circulation or limit it only to bullion. The length of the transition is of little relevance, provided the issue department operates strictly as a conversion agency and the 100 percent money is in force. When paper is about to appreciate considerably in relation to gold, following a period of floating in relation to gold, a country would have reached the end of the transition period and would be ready to operate under a classical gold standard. The government may then fix the value of the paper in terms of gold. From this point of time onward, the issue department will buy and sell gold against paper at par. The paper has a denomination in units of accounts, and the gold coins and bars will continue to be denominated in weights. At par, paper will be as good as gold.
A country would have 100 percent coverage of any newly issued currency; that is, each new paper will have a full gold back up. Inversely, gold sold by the issue department entails a withdrawal from circulation of an equal amount of paper. The risk of a speculation against paper, once it is pegged to gold, is nil, since with 100 percent money, no money can be emitted as a debt. The paper has been strictly controlled and tightly linked to the transaction needs; there is no more redundancy of paper. However, there may be crop failure that necessitates considerable gold for imports, which may strain the gold holdings of the issue department or the foreign exchange dealers. In such contingency, the issue department may consider temporarily floating the currency until it reestablishes the previous parity again. We may observe that there should be a subsidiary metallic coin system in silver, copper, bronze, and nickel to supplement gold in the settlement of small transactions, as was the case with the UK system during 1816–1914. The subsidiary coinage is denominated not in weight but in decimals of units of account. To prevent inflation through subsidiary coinage, a number of paper money has to be drawn for each equivalent amount of decimal coins.
We should underscore that no initial condition is needed for the stock of the paper currency or the stock of gold. A country would not have to amass gold before it moves to a gold standard nor does it have to withdraw its paper currency from circulation through taxation and budget surpluses.A country can instantly peg its currency to gold at prevailing market rate, as the case of the German Rentenmark in 1923 with no convertibility provision. It reduces its currency when gold appreciates and expands when gold depreciates in relation to the fixed rate. The prior conditions would be to lift any restriction on gold as money and establish a totally free gold and silver market; establish a monopoly issue agency; and apply 100 percent reserve banking. The stock of gold acquired would be determined by the demand for gold; the higher the demand for gold, the more the country has to increase its exports and reduce its non-gold imports. The market would also determine the composition of its money in stocks of paper currency and gold and the convenience offered by each form of asset.
The Chicago Plan (1933) stressed 100 percent reserve money and equity-based banking without specific reference to gold. Why insist on re-introducing gold in a country when 100 percent reserve money would secure financial stability with paper money? We observe that all previous 100 percent money plans during the 18th and 19th centuries assumed a gold standard and aimed at securing gold convertibility. The authors of the Chicago Plan might have stressed a return to gold had they experienced a pure paper system such as prevailed after 1971. A removal of debt money is essential for stability under a paper or a gold system. Debt and money have to be split; money should not vary in relation to debt. Inconvertible paper is not natural money and did not emanate from market forces. As a result, the state has found paper money convenient to finance deficits. Paper representing gold may be coined as fully backed money; inconvertible paper is not, since it is often created through debt or fiscal deficit monetization. Moreover, gold is both a standard of value and an equivalent (i.e., exchanged commodity). Inconvertible paper has no intrinsic value and is not a standard of value. Hence, a country may not benefit by holding its foreign reserves in inconvertible paper. It will be safe to hold them in gold. A national paper pegged to gold has a known metal content and is stable money. It is no longer influenced by inconvertible and rapidly depreciating foreign currencies. A country will shelter its economy against the instability and uncertainties caused by reserve currencies countries. If not pegged to gold, the national paper will have an unstable exchange rate, and may suffer a degree of depreciation as reserve countries keep inflating their respective currencies. This will discourage investment and increases exchange rate risk and uncertainty.
Structural Reforms to Support 100 Percent Money: Fully Liberalized Labor, Capital, and Commodities Markets In almost every country, governments intervene in a multitude of sectors and areas of the economy. The more the government expands and intervenes, the more it needs resources, which it does by increasingly resorting to an inflation tax. Adam Smith, who demonstrated the fallacies of tariffs and bounties and warned against the expansion of the unproductive government sector, has detailed the dangers of government expansion and intervention. He confined the role of government to defense, justice, education, and public works. Among opponents to government intervention was Lysander Spooner (1886) who called for abolishing tariffs and monopolies and restoring free markets in capital, labor, and commodities. He stated:
[I]f a government is to “do equal and exact justice to all men,” it must do simply that, and nothing more. If it does more than that to any, that is, if it gives monopolies, privileges, exemptions, bounties, or favors to any, it can do so only by doing injustice to more or less to others. It can give to one only what it takes from others; for it has nothing of its own to give to anyone.(Spooner, 1886, p. 15)
Historically, therefore, the government had to force paper currency, make it a legal tender, to be able to levy inflation taxes and promote interest groups.
Paper money and fractional reserve banking have led to large government bureaucracies and powerful interest groups; the economy has reduced mechanisms for adjustment, except through inflation. Numerous writers have criticized the model of excessive intervention of the state in the economy. Mises (1949, 1953) stressed the necessity of unhampered markets and elimination of inflation as conditions for re-introducing a gold standard. He noted that government needed inflation to finance its expanding size. Simons (1947) deplored the devastating consequences of statism, and stressed that a monetary reform along the lines of 100 percent money has to be accompanied with abolishing monopolies and price rigidities. Hayek (1944) called it “the road to serfdom.” Anderson (1945), and a number of other writers showed the dangers of the present system of statism. The government keeps expanding in size.In his book, Our Enemy, the State, Albert Jay Nock (1935) showed the adverse consequences of an ever-bigger government in terms of economic decline, despotism, and social decline. F.A. Hayek (1944) deplored statism in many Western countries, which reduced people to serfdom. Failure of the state is called failure of the market. In spite of financial crises, economic decline and social inequities, this system is fully supported by politicians. Reserve currencies were able to finance their excessive statism by printing money. After 2008, reserve currency countries set interest rates at near zero with a view to running fiscal deficits and transferring part of the bailout cost to other countries. A non-reserve country has a strict external constraint. Admittedly, no Western country has the adoption of a gold standard on its radar, especially given wage and price rigidities, the dominance of statism, high spending, monetization of deficits, huge public and private debt, as well as the dominance of powerful financial groups. In many countries, the statist economic model has damaged exports, turned a previously rich agricultural economy into a food deficit country, and caused high external debt. With statism and rigid labor and control laws, a country will not be able to adopt a gold standard, or even, a restrictive money policy to tame inflation. It has to rely on inflation taxation to run large budget deficits.
A gold standard embedded in 100 percent reserve banking has been proposed by many writers since the 17th century because of the extensive damage caused by paper and fractional reserve banking. Although such a system has not existed in a recent past and there is no historical experience to prove its superiority, there are instead a great number of counterfactual cases regarding the disruptive consequences of inconvertible paper and debt money, by which leading industrial countries as well as developing countries are suffering economic stagnation, high unemployment, high inflation, high indebtedness, and continued financial instability. Very high income and wealth inequality prevails through redistribution caused by money printing, leverage and financial crises. The income distribution is no longer determined by the real contribution to the national output but by non-market advantages. In contrast, there is a substantive evidence that economic growth was rapid under the gold standard and benefited labor considerably in the form of substantial real wage increases with full-employment fully maintained in all gold standard countries (Farrer, 1898). Exchange rates were fixed for decades, and international trade was flourishing. However, the gold standard could not survive alongside fractional reserve banking. A system of 100 percent money, which abolishes debt money, does not allow money creation out of thin air.
Opponents of the gold standard have claimed that gold scarcity would prevent circulation of increasing volume of commodities, ignoring the role of clearing that clears almost all transactions in asset, commodities, international trade, etc., with almost no cash. Unlike the US Fed, which printed $4 trillion in money within 5 years to finance government expenditures, there is no mining company that could dig out as much gold within the same period. Banks, in emitting money, were guided by profit maximization and much less by commodity circulation. The redundancy of debt money evolved into a rampant inflation showing that too much paper was crippling the economy.Paradoxically, inconvertible paper creates money shortages. Cagan (1956) showed that real money was almost non-existent in hyperinflation countries. The US dollar has a purchasing power in 2016 that is less than 2 cents of what it had in 1914. Gold was used essentially as a standard; it rarely circulated as a means of payments as illustrated by the establishment of goldsmith houses, and the Bank of Venice, Bank of Amsterdam, Bank of Hamburg, and other similar banks that settled accounts without physical gold movements. By late 19th century, actual gold payments represented less than 2 percent of total payments in the United Kingdom. Be it for gold or paper, only the economy determines the actual real money in the economy via changes in prices. Moreover, there is a huge stock of gold buried deep in storage that could be released and used as money. Opponents also claim that gold impaired external competitiveness. In case of many countries, paper money inflation ruined the export sector as some countries relied on foreign debt to finance their external deficit, instead of exports. Moreover, domestic inflation impaired competitiveness. Improving external competitiveness via inflation and exchange rate depreciation amounts simply to a subsidy to exporters at the expense of importers and the fixed income groups; it is not a true improvement in competitiveness, which emanates from productivity gains and innovation. There is plenty of evidence that the gold standard improved competitiveness via substantial gains in productivity and a consequent drop in prices as witnessed during 1871–1914.
Conclusions We have recommended 100 percent (or realistically closer to 100 percent) reserve banking as the most important reform in restoring sound money and financial stability. This would also provide the foundation and a stepping stone to re-introducing a domestic gold standard in one or more countries that wished to do so. Sound monetary reform would help a country restore economic growth and social equity. As Gouge (1833) stated, fractional reserve banking is a malum per se, and has no remedy, except to be abolished and replaced by 100 percent reserve banking, in other words 100 percent money, as strongly advocated by the Chicago Plan (1933), Soddy (1934), and Irving Fisher (1936).
In the context of a cheap money policy by reserve currencies countries and consequent uncertainty, a non-reserve country might consider a gold standard to immunize its economy against fluctuations in exchange rates and prices. China has expressed such an interest at different times over the last 10 or so years. Besides 100 percent money, a country ought to encourage risk-sharing equity investment banking as suggested by Simons, thus alleviating the conflict between debtors and creditors and securing financial stability.
The inconvertible paper system has become highly unstable, as shown by the 2008 crisis, its aftermath as well as the turbulences that caused it. Controlling interest rates at near-zero bound will reduce savings, foster debt-financed consumption and misallocate resources away from their best physical investment opportunities in the real sector; increasing the level of debt, redistributing wealth with growing inequalities, fueling volatile exchange rates and asset prices, and all damaging growth, social equity, and international trade. By re-establishing 100 percent money, a country will have a most propitious money that will extricate an economy from inflation, restore fast growth, full employment, and enhance social justice, with its money and interest rates being market determined and not administered by the state.
Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 65–84
ABSTRACT: Central banks have embarked on a transition from relative secrecy to relative transparency over the last two decades. This has led researchers to investigate the ramifications of transparency on important economic outcomes. By and large, the results reported have been favorable, favorable with qualifications, or ambiguous. This paper examines the communications of officials from the Federal Reserve during 2007, the year between the end of the housing bubble and the beginning of the financial crisis. In contrast to previous findings, these communications are indicative of either deception, incompetence, or a combination of both.
KEYWORDS: Federal Reserve, transparency, monetary policy, policy objectives and coordination JEL CLASSIFICATION: E52, E58, E61, E65, Z18
“There are several reasons to believe that this concern about burst bubbles may be overstated.”– Fred Mishkin, Feb. 17, 2007
Introduction Central banks have become more “transparent” over the last quarter-century. By communicating their actions, intentions, and philosophy they give the appearance of public-spiritedness and justify their independence from the political process. By examining this greater transparency with regards to monetary policy, economists have found that it has led capital markets and interest rates to react more efficiently and be more efficient.The drive for increased transparency began in the 1990s. In 1994 the Federal Open Market Committee (FOMC) started announcing its target for the federal funds rate. In 1999, the FOMC began announcing its “bias” for future changes in monetary policy as well as issuing more details statements when it was not changing rates. A few years later it began announcing FOMC votes after each meeting. In 2005, the FOMC began releasing the minutes of its meeting prior to the subsequent FOMC meeting. In 2007, the Fed has increased the frequency and content of its publicly-released forecasts. Similar trends towards central bank transparency have occurred at the Bank of England, European Central Bank, the Norges Bank, Sveriges Riksbank (the central bank of Sweden) and the Reserve Bank of New Zealand. (Blinder et al., 2008, p. 3)
In contrast, the economic theory of regulation (Stigler, 1971) holds that regulators such as central banks will be “captured” and act in the private interests of the industries that they regulate. Evidence is presented here regarding the Federal Reserve’s role in regulation and financial oversight that supports this theory by showing that communications from the central bank have a tendency to support the Federal Reserve and the financial industry’s interests, rather than the public interest. The fact that the large banks were bailed out during the crisis confirms this conjecture about the nature of the relationship between the Federal Reserve and the financial industry.
This paper contends that central bank communications can indeed mislead market participants. Previous studies that rely on numerical market data have concluded that transparency has been generally beneficial. In contrast, public speeches by members of the FOMC on financial innovation and Federal Reserve oversight of financial institutions and financial products, such as mortgage-backed securities are examined here for their transparency. These communications are drawn from a critical period between the end of the housing bubble in 2006 and the financial crisis, which began in 2007. Rather than being transparent and helping markets equilibrate, these communications were effectively deceptive in an apparent attempt at maintain undo confidence in financial markets.
Central Bank Transparency The issue of central bank transparency or lack thereof is important under a discretionary monetary regime. For example, Koppl (2002) shows that the central bank is a “big player” and market participants must expend resources and bear risk because the central banker has discretion and disproportionate impact on market outcomes. Likewise, Goodfriend (1999) in examining the role of the regional Federal Reserve banks, concludes that market expectations could be fractured if decision making over monetary policy were centralized in the hands of a “dictator” and that centralized decision making could be more easily captured by special interests. Crowe and Meade (2008) and McGregor (2007) have analyzed how much transparency has really changed and whether to expect more or less transparency in the future.
Prior to 1990, monetary policy was largely shrouded in mystery. Under the gold standard and in the Bretton Woods system, monetary policy was less arbitrary than today because it had a relatively fixed anchor. Because money had no anchor after Bretton Woods, policy makers felt a need for secrecy and a fear that lack of secrecy would undermine markets. Those fears gradually receded and were replaced with the notion that better communications by central bankers would help to manage expectations in financial markets and lead to improved economic results.
The Federal Open Market Committee (FOMC) began to announce its federal funds rate target in February of 1994. In May of 1999, the FOMC began publishing statements regarding its “bias” towards future rate changes. In 2002, it began to release the votes of the FOMC immediately after meetings. The Fed has continued its transition to greater transparency and more timely communication of its monetary policy. Forward-looking policy guidance was added in 2003.The release of FOMC minutes was shortened to three weeks after each meeting in 2005. Numerical forecasts with an extended three-year time horizon were added in 2007. Meeting transcripts for an entire year are now publicly released with a five-year lag. The financial crisis that began in 2008 has led the Fed to extend its transparency further into the future, e.g. rates will remain low for the foreseeable future.
Blinder (2008) reports that the central banks of England, New Zealand, Norway, Sweden, elsewhere in Europe, and other nations have adopted the philosophy of greater transparency and in many cases explicit inflation-targeting regimes. According to Blinder (2008, p. 3), “the view that monetary policy is, at least in part, about managing expectations is by now standard fare both in academia and in central banking circles. It is no exaggeration to call this a revolution in thinking.”
There has been a great deal of research on this new paradigm of monetary policy and while better communication is generally lauded as a good thing, it is not yet considered a panacea. For example, there is the ultimate constraint that central banks will know more about their own views and actions than will the general public and financial markets. Therefore, there cannot be complete transparency. In addition, Bernanke (2004) admits that no system is known in which central banks can be completely self-constrained when changing conditions and surprises dictate deviations from previous central bank communications and inflation targets. Therefore central banks cannot provide 100 percent certainty about the information they share regarding the future.
The general appeal of transparency is that better communications by central banks help to manage or stabilize expectations and stable expectations help central bankers to implement more effective monetary policy, even though it may have less “influence” in the short run. Donald L. Kohn and Brian Sack (2004) contend that individuals place special authority on the communications of central banks based on the central banks’ records of forecasting. While empirical studies support this view, it is not surprising, given the large amount of resources allocated by central banks to forecasting and by market participants to analyzing central bank communications.
Blinder (2008) shows that there is an extensive empirical literature that examines the impact of central bank communications on measurable movements in interest rates and events in stock markets. The general conclusion of these studies is that such central bank communications can and do positively impact these markets, but not necessarily as completely as central banks wish.
This paper does not argue with this conclusion. Rather, it relies on these types of results: central bank communications do impact behavior in a relatively effective manner. Additionally, this paper builds on the suggestion in the literature that central bank communications could also be welfare reducing, a minority view. For example, Amato, Morris, and Shin (2002) contend that central bank communications could move markets away from fundamentals if market participants give too much weight to central bank communications relative to market-generated data.
Are Central Banks Captured? What are the implications of Amato, Morris, and Shin’s (2002) contrarian stance? Most of the literature on transparency implicitly or explicitly assumes central bankers are motivated by concern for the public interest. This literature produces a great deal of evidence that this is indeed the case. However, if we were to re-examine this literature from a private-interest approach we might even find that Amato, Morris and Shin (2002) was not the exception, but the rule. Perhaps the evidence that transparency facilitates such things as stabilization of interest rates and inflation expectation could also be viewed as in the interest of central banks and money center banks as well as the public interest.
George Stigler (1971) presents an economic theory of regulation that suggests that special interests have an economic incentive to have agencies regulate their industries to create a cartel-like environment that will produce economic rents for members of the industry. Stigler’s approach is closely aligned with the capture theory of regulation. This theory holds that interest groups with high stakes in both the form and the enforcement of a regulation or set of regulations will devote resources to capture the legislative process, commissions, and regulatory staffs. This allows the industry to control and benefit from the regulatory process. The outcomes are most often worse than if there were no regulation at all. Hamilton (2013) shows that when regulatory officials are not elected (as in the case of the central bank of the United States) and when democratically elected officials face insignificant competition, private-interest outcomes will dominate public-interest outcomes. More specifically Rothbard (1984) has demonstrated that the Federal Reserve System was intended as and acts as a cartelizing device for large banks’ interests. Broz (1997) argues that the Federal Reserve was a joint product consisting of a public good, i.e., a reduction in bank panics, and a private good, i.e., benefits to the large New York City banks, as suggested above.
An additional motivation for this research is an important paper by White (2005). He found that the Federal Reserve is highly influential in the business of publishing academic research in monetary economics. In his sample of the Journal of Monetary Economics and the Journal of Money, Credit and Banking, 80 percent and 75 percent of the articles had at least one coauthor with a Federal Reserve affiliation and 82 percent and 87 percent of the editorial board members had Federal Reserve affiliations. At the very least, this influence would tend to have a “crowding out” effect on research on alternative monetary regimes, such as the gold standard and free banking. White (2005, pp. 343–344) concludes that:
an academic economist who values the option to someday receive an offer from the Fed, either to become a staff economist, or a visiting scholar, faces a subtle disincentive to do regime-challenging research. To repeat Fettig’s (1993) characterization of Milton Friedman’s view: “if you want to advance in the field of monetary research… you would be disinclined to criticize the major employer in the field.”
Central Bank Deception? “Indeed, U.S. financial markets have proved to be notably robust during some significant recent shocks.”– Donald L. Kohn, Feb. 21, 2007
Thornton (2004) suggests that one should not listen to Federal Reserve chairman Alan Greenspan’s testimony and speeches. Delete it from your mind like spam emails. Watch what he has done and what he is doing, but deeply discount anything you read about his testimony. Note that Greenspan’s speeches and testimony as well other central bankers is often considered obfuscation rather than true deception.
Central banking is a confidence game. The Federal Reserve runs a monetary system where money has no traditional backing, such as gold or silver. It runs a banking system that has, until the housing bubble-financial crisis, had no reserves to back deposits, other than drawer money. The central bank certainly has its own tools to give us confidence in the system, such as the discount window, which serves as Federal Reserve role as a lender of last resort. Other institutions such as legal tender laws and deposit insurance also provide confidence by acting as security for the value of the dollar and insuring bank accounts against bank failure. Although central bankers would not accept the notion that central banking is a “confidence game,” they regularly speak of investors’ confidence, consumers’ confidence, policy expectations, and economic uncertainty.A confidence game (also known as a bunko, con, flimflam, hustle, scam, scheme, or swindle) is defined as an attempt to defraud a person or group by gaining their confidence. The victim is known as the mark, the trickster is called a confidence man, con man, or con artist, and any accomplices are known as shills. Confidence men exploit human characteristics such as greed, vanity, honesty, compassion, credulity, and naïveté. The common factor is that the mark relies on the good faith of the con artist.
The Federal Reserve seeks to maintain our confidence in its system and to encourage people to not take proper precautions against the negative effects of its policies. Printing up money and lowering the value of dollar-denominated assets while simultaneously providing benefits to special interest groups is a deception that is a major part of the confidence game.
The basic focus here will be on the Federal Reserve’s mission to instill confidence in us about the economy while simultaneously instilling confidence in us about the abilities of the Fed itself. The first mission is easy to see because Federal Reserve officials are almost always publicly bullish and hardly ever publicly bearish about the economy. According to the central bank, the economy always looks good, if not great. If this message fails to have its intended effect, the central bank will proclaim that the economy is better than it appears and that there are signs of recovery and economic growth. If there are some problems, please do not worry, the Federal Reserve says: it will come to the rescue with truckloads of money, lower interest rates, and easy credit. If things were to get worse, which they won’t, the Federal Reserve would be able to respond with monetary weapons of mass stimulation. Of course this perspective is consistent with the viewpoint of mainstream economists. They see the business cycle as caused by psychological problems, random technological shocks, or market failures. In fact, the business cycle can be attributed to the divide between interest rates set by the Federal Reserve and those indicated by market forces.
The evidence presented here comes from public speeches by leading officials of the Federal Reserve during the year 2007. This is the period between the ending of the housing bubble in 2006 and the onset of the financial crisis, which began in earnest in 2008. Predictably, their testimony and speeches are highly nuanced and hedged. The quotes taken from these communications typically represent concluding or summary remarks. Note that this evidence is qualitative in nature rather than quantitative and therefore not of the species used by mainstream economists.
Ben Bernanke
Let us begin at the beginning of 2007 with the chairman of the Fed, Ben Bernanke. The former economics professor from Princeton gave an address to the annual meeting of the American Economic Association. (Bernanke, 2007) Bernanke was the first chairman of the Fed from academia since Arthur Burns, and it was Burns who helped take us off the gold standard.
In addressing his fellow mainstream academic economists, Bernanke was unusually bold in describing the Federal Reserve’s access to and ability to use data concerning financial markets. This knowledge and expertise includes the market for derivatives and securitized assets. He describes the Federal Reserve as a type of superhero for financial markets. In discussing the Federal Reserve’s role as chief regulator of financial markets he makes powerful claims concerning the Federal Reserve’s ability to identify risks, anticipate financial crises, and effectively respond to any financial challenge.
Many large banking organizations are sophisticated participants in financial markets, including the markets for derivatives and securitized assets. In monitoring and analyzing the activities of these banks, the Fed obtains valuable information about trends and current developments in these markets. Together with the knowledge it obtains through its monetary policy and payments activity, information the Fed gains through its supervisory activities gives the Fed an exceptionally broad and deep understanding of developments in financial markets and financial institutions.
In its capacity as a bank supervisor, the Fed can obtain detailed information from these institutions about their operations and risk-management practices and can take action as needed to address risks and deficiencies. The Fed is also either the direct or umbrella supervisor of several large commercial banks that are critical to the payments system through their clearing and settlement activities. (Bernanke, 2007)
In other words, according to the Federal Reserve, it knows everything about financial markets. In truth, the banks and the Federal Reserve apparently had no idea about the looming dangers concerning derivatives, securitized assets, and risk management practices. But it gets worse:
In my view, however, the greatest external benefits of the Fed’s supervisory activities are those related to the institution’s role in preventing and managing financial crises.See Thornton (2010). https://mises.org/daily/4177/The-Federal-Reserve-as-a-Confidence-Game-What-They-Were-Saying-in-2007#_ftn1.
In other words, the Federal Reserve can prevent most crises and manage the ones that do occur. Given that we are more than seven years into this serious economic downturn, that banks are even bigger and more susceptible to systemic risk, and that the national debt and the Fed’s balance sheet have exploded upward in size, his statement is clearly in doubt.
Finally, the wide scope of the Fed’s activities in financial markets—including not only bank supervision and its roles in the payments system but also the interaction with primary dealers and the monitoring of capital markets associated with the making of monetary policy—has given the Fed a uniquely broad expertise in evaluating and responding to emerging financial strains. (Bernanke, 2007)
In other words, the Federal Reserve is an experienced, forward-looking preventer of financial crises. This is a strong claim given Bernanke’s own abysmal record of forecasting near-term events during and after the housing bubble. As financial strains did emerge, it would be hard to judge Bernanke’s evaluation and response as even marginally satisfactory unless one takes the perspective of the large banks and financial institutions.
Bernanke is infamous on the Internet because of the YouTube video that chronicles his rosy view of the developing crisis from 2005 to 2007. He denied in 2005 that there was a housing bubble. Bernanke in 2006 denied that housing prices could decrease substantially. He said that if they were to fall it would not affect the real economy and employment. He first denied and then tried to calm fears about the subprime-mortgage market. He stated in 2007 that he expected reasonable growth and strength in the economy, and that the problem in the subprime market (which had then become apparent) would not impact the overall mortgage market or the economy in general. In mid-2007 he declared the global economy strong and predicted a quick return to normal growth in the United States. Remember, Austrians were writing about the housing bubble, its cause, and the probable outcomes as early as 2003.See the compilation by MarcellusCMarcellus, “Ben Bernanke Was Wrong,” at https://www.youtube.com/watch?v=9QpD64GUoXw.
Possibly the worst of Bernanke’s statements occurred in 2006, near the zenith of the housing bubble and at a time when all the exotic mortgage manipulations were in their “prime.” This was the era of the subprime mortgage, the interest-only mortgage, the no-documentation loan, and the heyday of mortgage-backed securities. The new Federal Reserve chairman admitted the possibility of “slower growth in house prices,” but confidently declared that if this did happen he would just lower interest rates.
Bernanke also stated in 2006 that he believed that the mortgage market was more stable than in the past. He noted in particular that “our examiners tell us that lending standards are generally sound and are not comparable to the standards that contributed to broad problems in the banking industry two decades ago. In particular, real estate appraisal practices have improved.”
Bernanke is considered a top mainstream economist with the best credentials and extensive service in academia and government. The chairman of the Federal Reserve has enormous resources at his disposal including a virtually unlimited budget, thousands of economists and consultants, and every piece of economic data, including detailed information concerning every major financial firm. With those resources at his disposal he consistently issued wrong answers over an extended period of time. The plausible explanations for this pattern of misinformation include; 1) Modern mainstream economics is inadequate with respect to using monetary policy to control macroeconomic outcomes, 2) Monetary policy is something beyond the capabilities of bureaucratic management, or that 3) Bernanke was issuing statements that were in the private interests of either the Federal Reserve, the banking and nonbanking financial industries, or both. These three possibilities are not mutually exclusive.
Fred Mishkin
Less than two weeks after Bernanke’s address to the American Economic Association, fellow academic Fred Mishkin, a governor of the Federal Reserve Board, took the stage at the Forecaster’s Club of New York. (Mishkin, 2007) Mishkin is a leading mainstream economist and expert on money and banking, and the author of the best-selling college textbook on money and banking. Mishkin addressed the group on the topic of enterprise risk management and mortgage lending.
He begins,
Over the past ten years, we have seen extraordinary run-ups in house prices … but … it is extremely hard to say whether they are above their fundamental value.… Nevertheless, when asset prices increase explosively, concern always arises that a bubble may be developing and that its bursting might lead to a sharp fall in prices that could severely damage the economy.…
The issue here is the same one that applies to how central banks should respond to potential bubbles in asset prices in general: Because subsequent collapses of these asset prices might be highly damaging to the economy … should the monetary authority try to prick, or at least slow the growth of, developing bubbles?
I view the answer as no. (Mishkin, 2007)
In other words, if the Federal Reserve is not worried enough to change policy and address bubbles, you should not be worried either. He continues:
There is no question that asset price bubbles have potential negative effects on the economy. The departure of asset prices from fundamentals can lead to inappropriate investments that decrease the efficiency of the economy. (Mishkin, 2007)
In other words, there are some potential problems with bubbles. But Mishkin has a theory that says there can be no such thing as significant bubbles.
If the central bank has no informational advantage, and if it knows that a bubble has developed, the market will know this too, and the bubble will burst. Thus, any bubble that could be identified with certainty by the central bank would be unlikely ever to develop much further. (Mishkin, 2007)
He then tells his listeners that in the unlikely event of a housing bubble, it really would not be a problem for several reasons:
Asset price crashes can sometimes lead to severe episodes of financial instability.… Yet there are several reasons to believe that this concern about burst bubbles may be overstated.
To begin with, the bursting of asset price bubbles often does not lead to financial instability.…
There are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability. House prices are far less volatile than stock prices, outright declines after a run-up are not the norm, and declines that do occur are typically relatively small.… Hence, declines in home prices are far less likely to cause losses to financial institutions, default rates on residential mortgages typically are low, and recovery rates on foreclosures are high. Not surprisingly, declines in home prices generally have not led to financial instability. The financial instability that many countries experienced in the 1990s, including Japan, was caused by bad loans that resulted from declines in commercial property prices and not declines in home prices. (Mishkin, 2007)
Everything he just said turned out to be completely untrue. As the leading expert on these subjects, he should have known that all of the statements in this quote were either not true or were at least far from certain. He clearly appears to be using this communication to quell rising fear and to instill confidence and it all turned out to be not true. But he continues to dig his hole deeper and his deception wider:
My discussion so far indicates that central banks should not put a special emphasis on prices of houses or other assets in the conduct of monetary policy. This does not mean that central banks should stand by idly when such prices climb steeply.…
Large run-ups in prices of assets such as houses present serious challenges to central bankers. I have argued that central banks should not give a special role to house prices in the conduct of monetary policy but should respond to them only to the extent that they have foreseeable effects on inflation and employment. Nevertheless, central banks can take measures to prepare for possible sharp reversals in the prices of homes or other assets to ensure that they will not do serious harm to the economy. (Mishkin, 2007)
In other words, the Federal Reserve understands bubbles, but it is not going to stop a possible housing bubble. In fact, if prices did start to decline noticeably and present any danger to employment or to raise the specter of deflation, Mishkin says the Federal Reserve is prepared to protect us from the bursting of the bubble and prevent housing prices from falling. Mishkin was in effect issuing a blanket insurance policy on housing prices.
Donald Kohn
Federal Reserve vice chairman Donald L. Kohn significantly downplayed the possibility of a crisis, but said:
In such a world [of financial crisis], it would be imprudent to rule out sharp movements in asset prices and deterioration in market liquidity that would test the resiliency of market infrastructure and financial institutions.
While these factors have stimulated interest in both crisis deterrence and crisis management, the development of financial markets has also increased the resiliency of the financial system. Indeed, U.S. financial markets have proved to be notably robust during some significant recent shocks. (Kohn, 2007)
He is in effect telling his listeners—mostly high-level employees in banking, finance and regulatory agencies—that financial markets are stable in the face of shocks, but despite this stability the Federal Reserve is working further to deter economic crisis and learning and doing more to be ready to manage future crises.
The Federal Reserve, in its roles as a central bank, a bank supervisor, and a participant in the payments system, has been working in various ways and with other supervisors to deter financial crises. As the central bank, we strive to foster economic stability. As a bank supervisor, we are working with others to improve risk management and market discipline. And in the payments and settlement area, we have been active in managing our risk and encouraging others to manage theirs. (Kohn, 2007)
In other words, the Federal Reserve will deter any crisis and is working with other regulators to prevent financial crises, to provide economic stability, improved risk management, and market discipline.
The first line of defense against financial crises is to try to prevent them. A number of our current efforts to encourage sound risk-taking practices and to enhance market discipline are a continuation of the response to the banking and thrift institution crises of the 1980s and early 1990s.…
Identifying risk and encouraging management responses are also at the heart of our efforts to encourage enterprise wide risk-management practices at financial firms. Essential to those practices is the stress testing of portfolios for extreme, or “tail,” events. Stress testing per se is not new, but it has become much more important. The evolution of financial markets and instruments and the increased importance of market liquidity for managing risks have made risk managers in both the public and private sectors acutely aware of the need to ensure that financial firms’ risk-measurement and management systems are taking sufficient account of stresses that might not have been threatening ten or twenty years ago. (Kohn, 2007)
In other words, the Federal Reserve’s number-one job is to prevent “extreme” events. Kohn is essentially telling his audience that the Federal Reserve is aware of black swans and that the Federal Reserve tests financial firms so that if such an event were to take place financial markets could withstand extreme changes in the economy.
A second core reform that emerged from past crises was the need to limit the moral hazard of the safety net extended to insured depository institutions—a safety net that is required to help maintain financial stability. Moral hazard refers to the heightened incentive to take risk that can be created by an insurance system. Private insurance companies attempt to control moral hazard by, for example, charging risk-based premiums and imposing deductibles. In the public sector, things are often more complicated. (Kohn, 2007)
Well, he did get that one right. Things are more complicated in the public sector. The Federal Reserve’s bureaucratic approach does need the element of deposit insurance, provided by the FDIC, to instill confidence in the system of fractional-reserve banking. However, the Federal Reserve’s own record of bailouts over the period of the so-called Great Moderation created a moral hazard for financial firms that ended up overwhelming the deposit insurance system. And now for the pièce de résistance: “The systemic-risk exception has never been invoked, and efforts are currently underway to lower the chances that it ever will be.” (Kohn, 2007)
This record of resisting the systemic-risk exception has now been shattered. What does that tell about the status of moral hazard in financial markets and what might transpire in the next crisis?
Randall Kroszner
Fed governor Randall S. Kroszner was the Federal Reserve’s number-one official in terms of regulation of financial markets. He was the point man in preventing things like systemic risk, but he considered all the new financial “innovation” and “engineering” to be a good thing:
Credit markets have been evolving very rapidly in recent years. New instruments for transferring credit risk have been introduced and loan markets have become more liquid.… Taken together, these changes have transformed the process through which credit demands are met and credit risks are allocated and managed.… I believe these developments generally have enhanced the efficiency and the stability of the credit markets and the broader financial system by making credit markets more transparent and liquid, by creating new instruments for unbundling and managing credit risks, and by dispersing credit risks more broadly.…
The new instruments, markets, and participants I just described have brought some important benefits to credit markets. I will touch on three of these benefits: enhanced liquidity and transparency, the availability of new tools for managing credit risk, and a greater dispersion of credit risk. (Kroszner, 2007a)
What he then goes on to discuss are “recent developments” such as credit default swaps (CDS), of which the “fastest growing and most liquid” are credit-derivative indexes involving such things as packages of subprime residential mortgages. He says that “among the more complex credit derivatives, the credit index tranches stand out as an important development.”
He believes that, historically, secondary markets were illiquid and nontransparent because banks held their own loans and that this was a problem. Now because of these new financial vehicles liquidity has improved and transparency has improved. This promotes better risk management, as risk is measured and priced better because market participants have better tools to manage risk. The result has been a “wider dispersion of risk.”
On its face, a wider dispersion of credit risk would seem to enhance the stability of the financial system by reducing the likelihood that credit defaults will weaken any one financial institution or class of financial institutions. (Kroszner, 2007a)
According to Kroszner, yes, there are some concerns here, but most of these concerns are “based on questionable assumptions.” Yes, there is risk, but it is the risk that has been out there all along; now we can trade this risk among ourselves. There is “nothing fundamentally new to investors … credit derivative indexes simply replicate the sort of credit exposures that have always existed.” Plus, remember that this risk is greatly diminished because lenders require borrowers to put up collateral.
What Kroszner seems to have failed to realize is that by allowing institutions to disperse their risk, the regulators encouraged and allowed for a huge increase in the aggregate amount of risk. When banks kept their own loans on their own books, they were careful to make prudent loans, but with nearly free money available from the Federal Reserve, they wanted to make more loans, and the only way to do that is to make riskier loans. They did not want to hold the risky loans, so they “dispersed” them.
Kroszner told his audience that the market already experienced a surprise in May of 2005, but that since that time much energy has been expended by market participants and the Federal Reserve to improve risk management.
We do not have to worry, Kroszner tells us, because Gerald Corrigan is in charge of making sure nothing goes wrong. Corrigan—a former president of the New York Federal Reserve and a managing director in the Office of the Chairman of Goldman Sachs—has been in charge of a private-sector group that controls “counterparty risk management policy” for the financial industry.
Cooperative initiatives, such as [this one led by Corrigan] can contribute greatly to ensuring that those challenges are met successfully by identifying effective risk-management practices and by stimulating collective action when it is necessary.… The recent success of such initiatives strengthens my confidence that future innovations in the market will serve to enhance market efficiency and stability, notwithstanding the challenges that inevitably accompany change. (Kroszner, 2007a)
Checking ahead, we find Kroszner still bullish later that same year.
Looking further ahead, the current stance of monetary policy should help the economy get through the rough patch during the next year, with growth then likely to return to its longer-run sustainable rate. As conditions in mortgage markets gradually normalize, home sales should pick up, and homebuilders are likely to make progress in reducing their inventory overhang. With the drag from the housing sector waning, the growth of employment and income should pick up and support somewhat larger increases in consumer spending. And as long as demand from domestic consumers and our export partners expand, increases in business investment would be expected to broadly keep pace with the rise in consumption. (Kroszner, 2007b)
Over the next year, the Dow would lose 6,000 points; by 2010 the amount of unemployment increased by seven million. Consumer confidence had hit a 27-year low, and sales of new homes hit the lowest level in a half a century—the lowest level in recorded history!
Conclusion We can see that the Federal Reserve plays a confidence game. Its officials’ public pronouncements, while heavily nuanced and hedged, uniformly present the American people and the leading figures in banking and finance with a rosy scenario of the economy, the future, and the ability of the Federal Reserve to manage the market. Ben Bernanke and his successor, Janet Yellen have continued to spin a positive story of economic recovery dating back to the spring of 2008.
These are the people who said that there was no housing bubble, that there was no danger of financial crisis, and that a financial crisis would not impact the real economy. These are the same people who said they needed a multitrillion-dollar bailout of the financial industry, or else we would get severe trouble in the economy. They got their bailout, and we got the severe trouble anyway. Is it not time to bring this game, this confidence game, to an end for the sake of economic stability?
However, all this evidence does not rule out the other explanations for their behavior. They could be just incompetent; they could genuinely think they are acting in the public interest, or it might not be humanly possible to run such a monetary system and they were just hoping that unwarranted confidence could save all of us from a genuine disaster.
In December, the Fed hiked its target for the federal funds rate, which is the interest rate banks charge each other for overnight loans of reserves. Since 2008 the Fed’s target for the Fed Funds Rate had been a range of 0 percent – 0.25 percent (or what is referred to as zero to 25 “basis points”). But last month they moved that target range up to 0.25 – 0.50 percent. Ending a seven-year period of effectively zero percent interest rates.
From our vantage point, we already see carnage in the financial markets, with the worst opening week in US history. This of course lines up neatly with standard Austrian business cycle theory, which says that the central bank can give an appearance of prosperity for a while with cheap credit, but that this only sets the economy up for a crash once rates begin rising.
However, there is something new in the present cycle. The Fed is trying to raise rates while simultaneously maintaining its bloated balance sheet. It is attempting to pull off a magic trick whereby it can keep all of the “benefits” of its earlier rounds of monetary expansion (i.e., “quantitative easing” or “QE”) while removing the artificial stimulus of ultra-low interest rates. As we’ll see, this attempt will not end well, for the Fed officials or for the rest of us. In the meantime, Ben Bernanke will look on with concern, writing the occasional blog post and perhaps giving a speech about poor Janet Yellen’s tough predicament.
Austrian Business Cycle TheoryOne of the seminal contributions of Ludwig von Mises was what he called the circulation credit theory of the trade cycle. In our times, we simply call it Austrian business cycle theory, sometimes abbreviated as ABCT. The Misesian theory was subsequently elaborated by Friedrich Hayek, and it was partly for this work that Hayek won the Nobel Prize in 1974.
In the Mises/Hayek view, interest rates are market prices that perform a definite social function. They communicate vital information about consumer preferences regarding the timing of consumption. Entrepreneurs must decide which projects to start, and they can be of varying length. Intuitively, a high interest rate is a signal that consumers are “impatient,” meaning that entrepreneurs should not tie resources up in long projects unless there are large gains to be had in output from the delay. On the other hand, a low interest rate reduces the penalty on longer investments, and thus acts as a green light to tie capital up in lengthy projects.
So long as the interest rate is set by genuine market forces, it gives the correct guidance to entrepreneurs. If consumers are willing to defer immediate gratification, they save large amounts of their income, and this pushes down interest rates. The high savings frees up real resources from current consumption — things like restaurants and movie theaters — and allows more factories and oil wells to be developed.
However, if the interest rate drops not because of genuine saving, but instead because the central bank electronically buys assets with money created “out of thin air,” then entrepreneurs are given a false signal. They go ahead and take out loans at the artificially cheap rate, but now society embarks on an unsustainable trajectory. It is physically impossible for all of the entrepreneurs to complete the long-term projects they begin.
In the beginning, the unsustainable expansion appears prosperous. Every industry is growing, trying to bid away workers and other resources from each other. Wages and commodity prices shoot up; unemployment and spare capacity drop. The economy is humming, and the citizens are happy.
Yet it all must come crashing down. In a typical cycle, price inflation eventually rises to the level that the banks become nervous. They halt their credit expansion, allowing interest rates to start rising to a more correct level. The tightening in the credit markets causes pain initially for the most leveraged operations, but gradually more and more businesses are in trouble. A wave of layoffs ensues, with large numbers of entrepreneurs suddenly realizing they were too ambitious. The painful “bust,” or recession, sets in.
This Time Is Different (Sort of)Since the financial crisis of 2008, the stock market’s surges have coincided with rounds of QE, and the market has faltered whenever the expansion came to a temporary halt. The sharp sell-off in August 2015 occurred when investors thought the first rate hike was imminent (it had been scheduled for September 2015). That particular hike was postponed, but after it went into effect in December, we soon saw the market tank to 2014 levels.
As we would expect in times of Fed tightening, the official monetary base has fallen sharply in recent months, but this doesn’t mean that the Fed is selling off assets (as it would in a textbook tightening cycle). Indeed the Fed’s assets have been constant since the end of the so-called taper in late 2014.
This is unusual since the monetary base and the Fed’s total assets typically move in tandem. Yet since late 2014, there have been three major drops in the monetary base that occurred while the Fed was dutifully rolling over its holdings of mortgage-backed securities and Treasuries, keeping its total assets at a steady level.
The explanation is that the Fed has been testing out new techniques to temporarily suck reserves out of the banking system, while not reducing its total asset holdings.
Meanwhile, the Fed in December bumped up the interest rate that it pays to commercial banks for keeping their reserves parked at the Fed. I like to describe this policy as the Fed paying banks to not make loans to their customers.
What Does It All Mean?So why is the Fed trying to tighten the money supply without selling off assets as it has done in the past? It boils down to this: In order to bail out the commercial and investment banks — at least the ones who were in good standing with DC officials —as well as greasing the wheels for the federal government to run trillion-dollar deficits, the Federal Reserve in late 2008 began buying trillions of dollars worth of Treasury debt and mortgage-backed securities (MBS). This flooded the banking system with trillions of dollars of reserves, and went hand in hand with a collapse of short-term interest rates to basically zero percent.
Now, the Fed wants to begin raising rates (albeit modestly), but it doesn’t want to sell off its Treasury or MBS holdings, for fear that this would cause a spike in Uncle Sam’s borrowing costs and/or crash the housing sector. So the Fed has increased the amount that it is paying commercial banks to keep their reserves with the Fed (rather than lending them out to customers), and — for those institutions that are not legally eligible for such a policy — the Fed is effectively paying to borrow the reserves itself. By adjusting the interest rate the Fed pays on such transactions, the Fed can move the floor on all interest rates up. No institution would lend to a private sector party at less than it can get from the Fed, since the Fed can create dollars at will and is thus the safest place to park or lend reserves.
We thus have the worst of both worlds. We still get the economic effects of “tighter monetary policy,” because the price of credit is rising as it would in a normal Fed tightening. Yet we don’t get the benefit of a smaller Fed footprint and a return of assets to the private sector. Instead, the US taxpayer is ultimately paying subsidies to lending institutions to induce them to charge more for loans, while the big banks and Treasury still benefit from the effective bailout they’ve been getting for years.
It Can’t LastWill the Fed be able to keep the game going? In a word, no. We’ve already seen that even the tiniest of interest rate hikes has gone hand in hand with a huge drop in the markets. Furthermore, the Fed’s subsidies to the banks are now on the order of $11 billion annually, but if they want to raise the fed funds rate to, say, 2 percent, then the annual payment would swell to more than $40 billion. That is “real money” in the sense that the Fed’s excess earnings would otherwise be remitted to the Treasury. Therefore, for a given level of federal spending and tax receipts, increased payments to the bankers implies an increased federal budget deficit.
Janet Yellen and her colleagues are stuck with a giant asset bubble that her predecessor inflated. If they begin another round of asset purchases, they might postpone the crash, but only by making the subsequent reckoning that much more painful.
You don’t make the country richer by printing money out of thin air, especially when you then give it to the government and Wall Street. The Fed’s magic trick of raising interest rates without selling assets can’t evade that basic reality.
It seems like every other news story about the International Monetary Fund (IMF) reflects (at least in passing on the Fund's uneven treatment of developed and developing countries. Established at the Bretton Woods conference to oversee the system of fixed exchange rates prevailing in 1944, the Fund’s mission has gradually expanded to promoting economic growth, macro-economic stability, and poverty reduction.
Yet no one seems convinced anymore that the Fund can actually accomplish these goals. To the contrary, many now argue the IMF is a highly politicized organization, biased in its choice of whom to help, how, and how much. For instance, critics argue that Christine Lagarde (current managing director of the IMF) is keen on denying African countries agricultural subsidies as part of the IMF loans conditionality, even though she supports the same measures — labelled ”economic incentives”— when it comes to the EU Common Agricultural Policy and the French farmers.
While critics often perpetuate many economic fallacies themselves — such as “beneficial subsidies,” or the better-known “exploitation” of developing countries by their developed counterparts — they are not entirely mistaken in their misgivings about the Fund. There is something inherent in what the IMF does that perpetuates conflict among and within national economies. This has to do with the monetary-policy principles on which the Fund was established.
How the IMF Spreads the “Wealth”The IMF’s funds for loans are drawn from the expanded money supplies of its member countries on the basis of a contribution quota, and then redistributed to countries in need of financial or foreign exchange stabilization. The list of borrowers ranges from France in 1947 and Argentina (just before its 2001 crisis) to Ireland, Portugal, Ukraine, Colombia, Greece, and many others.
These loans promote an artificial and temporary type of global economic growth, because they do not have a neutral impact on the world economy. IMF loans endow some countries with additional purchasing power, thus allowing them to increase their command of resources and their wealth to the detriment of other countries. The latter’s resources and overall wealth are diminished by the depreciation of the monetary unit purported by every disbursement of the new money.
This global, inter-country redistribution of wealth is central to the conflicting relationships which arise around the allocation of IMF packages. Mises explained this to his students at FEE in the 1960s when he noted that the central problem is over who gets the money:
Everybody, every country, would say the same thing: “The quantity we got is too small for us.” The rich countries will say, “As the per head quota of money in our country is greater than it is in the poor countries, we must get a greater part.” The poor country will say, “No, on the contrary. Because they have already a greater part of money per head quota than we have, we must get the additional quantity of money.”
But, Mises observed, it’s impossible to distribute the money in a neutral way:
one can never increase the quantity … in such a way that it does not further the economic conditions of one group at the expense of other groups. This is, for instance, something that wasn’t realized in this great error — I don’t find a nice word to describe it — in starting the International Monetary Fund.
The IMF, Inequality, and Central BanksThese conflicts are underlined by an even less acknowledged conflict at the national level — also predicated on the redistribution of wealth — which arises from the inflationary policies of national central banks. National central banks often cooperate with each other to, as Jörg Guido Hülsmann summarized,
to coordinate central-bank policies, i.e. … to increase their note issues in concert, thus avoiding the embarrassment of the falling exchange rates that inevitably result from unilateral inflation.
However, when this coordination fails, IMF loans can be used to buy one’s currency off foreign exchange markets and temporarily halt its collapse. Here too, instead of macroeconomic stability, what IMF loans really accomplish is maintaining the inflationary monetary policies which have brought countries to this predicament in the first place. The primary social consequences of inflationary policies are the redistribution of wealth from the last receivers of the new money toward the first receivers. Thus, the perpetuation of this institutional framework is a fertile ground for growing economic inequality, a hot issue nowadays, often over-estimated, but always blamed on the free market.
Mises Institute: What prompted you to write In Defense of Deflation?
Philipp Bagus: One reason is that there was simply no complete treatment of deflation. The other reason is that the fear of deflation has brought disastrous consequences for our economies. This is so because the alleged threat of deflation is used to justify the production of new money. Central bankers argue today that if they do not engage in quantitative easing and other unconventional policies, our economies will slide into a recession and a price deflation. And, implicitly, price deflation is portrayed as something horrible. It is so widely regarded as horrible, in fact, that anti-deflationists do not even think it necessary to prove their claims and analyze the phenomenon systematically. Therefore, I thought it useful to analyze deflation.
MI: You note in your book that deflation is a neglected topic in economics textbooks. Why do you think this is, and what is the most misunderstood aspect of deflation?
PB: One reason is that we have lived after World War II in a world of continuous price inflation. Therefore, textbooks dedicate much time to price inflation but not to price deflation. Deflation simply hasn’t been a common experience in recent decades. And again, there remains the prevailing idea that deflation is self-evidently bad.
The most misunderstood aspect of deflation is probably that price deflation is not a general economic problem. Falling prices merely lead to redistribution. Sellers lose and buyers win.
But, we are all buyers (of goods and services) and sellers (of goods and labor services). Companies also buy factors of production and sell products. So price deflation per se is not harmful to all, but only to those whose selling prices fall faster than their buying prices. Yet, the selling prices of some are the buying prices of the other side of the exchange. So when there are people who lose, then there are necessarily people who win. The selling prices fall slower than the buying prices.
It is also true that debtors lose in a price deflation. But the purchasing power that debtors lose, creditors win. And if a company goes bankrupt due to its nominal fixed debt, the creditor takes over the assets and may continue production, if the business is in principle viable and only went down due to its debt. This change in ownership does not disturb the productive potential of the economy (i.e., factories and machines do not disappear). Thus, price deflation is no general economic problem, but it leads to a redistribution.
Price deflation that is caused by the government may, of course, be considered to be harmful on moral grounds. This is not the case for price deflation that occurs on a free market or is a market reaction to government intervention.
MI: What are the policy implications of this? How does this mixture of winners and losers cause so much fear of deflation among policymakers?
PB: The policy implication is that one should not listen to people who argue that you need inflationary monetary policy to prevent price deflation at all costs because deflation is the end of the world.
Inflation will itself cause a redistribution in favor of the first receivers of the new money, it will distort relative prices, benefit debtors, prop up malinvestments, and potentially finance even new distortions and bubbles. It is completely understandable that those who benefit from inflation are spreading myths about the evils of deflation.
Who benefits from continued inflation? Well, the political and business elites. The biggest debtor in our economies is the state. Also many business elites are highly indebted. They would lose out in a scenario with price deflation. Therefore, they portray it as a general problem, even though credits would benefit from deflation. And as a policy remedy, the anti-deflationists argue in favor of the production of new money of which they, the government, the financial industry, and other business elites, will be the first recipients. In other words, these elites benefit from the creation of new money — which they can spend before prices adjust upward — at the expense of those who only receive the money after price inflation has already occurred.
MI: So why do so many economists blame deflation for the depressions of the past?
PB: Many economists are empiricists. So they look at history and come up with conclusions. They see that during the Great Depression a very strong economic downturn was accompanied by deflation. Then they think that it was the deflation that caused the downturn or made it stronger.
Keynesians also think that a recession occurs due to a collapse in aggregate demand. They do not understand that people produce in order to demand. So there can be no general overproduction. If not everything produced is demanded, the structure of supply must be adapted to the demand. And here price deflation or monetary deflation may speed up the readjustment of the structure of production by liquidating malinvestment and shifting resources faster into projects that produce goods and services which consumers demand more urgently.
MI: Can we point to deflationary periods where there was an increase in the standard of living?
PB: Of course. During the nineteenth century in many countries we observed falling prices caused by strong economic growth. In the book, I analyze in detail the United States from 1865 to 1896. During this period the US experienced thirty years of falling prices and a strong increase in the standard of living at the same time. In fact, the natural result of economic growth is that prices tend to fall and the population enjoys the increase in production in form of lower prices. Something we observe today in the technology sector.
MI: In your book, you quote influential economist Brad DeLong who observed that declines in prices once seemed to be extremely unlikely. But now it seems more likely. Why do you think that is? In other words, why are inflation numbers nowadays coming in so far below those 2 percent targets set by central banks?
PB: There has been a deleveraging by the financial sector. The credit contraction exerts a downward pressure on prices. But there is also economic growth, not only in developing countries but also in Western economies where entrepreneurs after the crisis adapted the structure of production.
During the period 1980s and 1990s, the desirability of the “independence from politics” of central banks became almost an article of faith among mainstream macroeconomists and those operating in financial markets. This development was driven by two factors: academic research on central banking; and the personality cults that grew up around the two Fed Chairmen during this period, Paul Volcker and Alan Greenspan.
In the decade leading up to the financial crisis, the intellectual climate was such that anyone suggesting that the Fed have its independence curtailed or even abrogated by Congress would have been considered beyond the pale of rational, let alone scholarly, discussion. However, as the painful and protracted recovery from the Great Recession has dragged on, the Fed’s independence of “politics,” i.e., of legislative oversight and constraint, has begun to be challenged even by economists and financial pundits.
Few of the recent proposals to curb the Fed’s independence mentioned envision fundamental institutional reform of the way in which base money is supplied under our current fiat-dollar regime.
One such reform would involve wresting control of the money supply away from the unelected technocrats at the Fed and returning it to Congress and the Treasury. In fact this reform was put forward during the controversy over raising the debt ceiling in 2013.
It is important to note that this blueprint for monetary reform closely approximates — in its fundamentals if not in its aim or sophistication — the monetary and fiscal framework that Milton Friedman proposed in 1948. The monetary component of the proposal focused on eliminating “both the private creation or destruction of money and the discretionary control of the quantity of money by central-bank authority.” The first goal would be attained by implementing Henry Simon’s “Chicago Plan” for 100 percent reserve banking. Friedman maintained that the second objective could be achieved by eliminating the issue of interest-bearing government securities to the public, thereby restricting the financing of government spending to taxation and money creation. Thus, as Friedman pointed out: “Deficits or surpluses in the government budget would be reflected dollar for dollar in changes in the quantity of money; and, conversely, the quantity of money would change only as a result of deficits or surpluses.”
A common objection to such a proposal is that if money were under the control of the Treasury, monetary policy would become a political football and inflation would run rampant. But how much more inflationary would monetary policy become than it is right now? The unaccountable bureaucrats at the Fed have fastened on the US economy a regime of zero interest rates, quantitative easing, and the targeting of a real variable (the unemployment rate) using nominal variables. The latter is a reversion to stone-age Keynesianism. Indeed, current Fed policy has enabled a fiscal policy of high deficits and rapidly mounting national debt, anyway.
An Austrian View of Money, Taxation, and SpendingLet us grant for the sake of argument that congressional control of monetary policy alters the mix of financing government spending toward less taxation and more deficits financed by money creation. From the point of view of Austrian public finance theory, the method of governmental “revenue extraction” does not matter nearly as much as the total amount extracted. For all government spending drains resources from productive uses in the private economy and squanders them on the wasteful spending of politicians and bureaucrats on their favored projects and constituencies. Government spending is either consumption spending that directly satisfies the preferences of members of the political establishment or it is investment in waste assets because it is not based on the profit and capital-value calculations that guide the decisions of private entrepreneurs and capitalists. It is in effect a redistribution of income and resources from the productive to the unproductive, from the “taxpayers” to the “tax-consumers.”
The total amount of government spending is therefore what Murray Rothbard called “government depredation on the private product.” For Austrian economists, then, the method of financing government depredation — whether it be taxation, borrowing from the public, or money creation — is of secondary importance. Thus, at a given level of government spending, siphoning off resources from the private economy via deficits financed by money creation is no worse than extracting them through taxation. Indeed inflationary finance may even be preferable to taxation because the threat of physical coercion implicit in taxation has a detrimental effect on the direct utility of private individuals that goes beyond the expropriation of their income.
Needless to say, from the point of view of consumer welfare and economic efficiency, a smaller government budget financed by money creation is preferable to a larger budget that is in balance. Obviously, legislative control of the fiat money supply is far from the ideal monetary system, and my sole purpose here is to suggest a politically feasible solution to the urgent problem of arbitrary power exercised by a clique of Federal bureaucrats.
The desideratum of the Austrian political economist with classical-liberal or libertarian leanings involves the complete separation of government and money through the establishment of a commodity money like gold (or silver), the supply of which is determined exclusively by market forces. Nonetheless, there is great merit in replacing the opaque and pseudo-scientific control of “the money supply process” by entrenched Fed employees and officials with overtly political control of money by elected officials and partisan administration appointees. There are a number of benefits of stripping the Fed of its quasi-independent status and transforming it into a handmaiden of the Treasury, as the American Monetary Institute (AMI) and early Friedmanite reform programs call for.
How It Would WorkFirst, money would be created in a transparent manner that is understandable to the public at large. The Treasury would simply send an administrative order to the Fed to credit its checking account with the sum of money needed to pay the government’s bills that are not covered by tax revenues. Now, formally, this order may be called a “Treasury bond,” but it would not be a bond in the economic sense because it would not be exchanged in financial markets. Nor would the “interest” that the Treasury may pay on these pseudo-bonds really be interest because it would not be determined by supply and demand on financial markets. Rather it would be a payment to reimburse the administrative costs of the Fed and its amount would be completely controlled by the Treasury. It thus becomes evident to the public that every increase in the money supply engineered by the Treasury benefits the specific individuals and firms receiving government checks. The new money is being created from nothing to purchase military aircraft from Boeing, to subsidize agribusiness giant Monsanto, to bail out General Motors, etc.
This contrasts with the arcane process by which money is now created, which involves the Treasury issuing debt that is purchased by private entities, mainly banks and other financial institutions, and then eventually repurchased by the Fed via open market operations. In this way the Fed circuitously “monetizes the debt” and expands the money supply while distorting interest rates in the bargain. Invisible to the layperson is the fact that twenty or so privileged Wall Street (and foreign) banks and financial institutions — so-called “primary dealers” — that sell bonds to the Fed profit immensely from the money creation process. Also benefiting from the newly created reserves are the commercial banks’ business clients who borrow the money at reduced interest rates and spend it to appropriate extra resources before prices have begun to rise.
Furthermore, under this plan, the Fed would no longer function as a discretionary lender (bailer-outer) of last resort, a role that infects the entire financial system with pandemic moral hazard. No longer would the Fed be able to surreptitiously, arbitrarily, and without democratic oversight or accountability bail out all kinds of financial institutions in the United States as well as foreign countries. First of all there would be no need to bail out pure depository institutions because all such institutions would hold 100 percent reserves. But, second, even if purely financial (non-money-issuing) institutions were in danger of failing, the decisions to bail them out would be made by an openly partisan Treasury under the watchful eye of the congressional opposition and in full view of the public. With the Fed neutered and unable to leap to their rescue at the first sign of distress and with their appeals for bailouts subject to full scrutiny by a skeptical congress and public, financial institutions would run their affairs much more prudently.
“Our greatest enemy today, in short, is the economic illiteracy and confusion on the part of those who insist on “planning,” “stabilizing,” and straitjacketing the economy and who have the political power to do it.” So wrote Henry Hazlitt in 1946, words that sadly retain their relevancy today. The consequences of this pervasive fallacy takes many forms. Ryan McMaken this week highlighted how soaring university tuition is fueled largely by a government fueled boom in student loans, while Paul-Martin Foss highlighted the alarming signals coming from international shipping. Around the world, people are coming to realize what Austrians have long warned, that the increasingly absurd policies of central banks offer no hope for true, sustainable economic growth. Sadly there is a firmer grasp of economics to be found in a Harry Potter novel, than the halls of the Federal Reserve.
Mises Weekends this week focuses on the true foundations for economic prosperity: innovation and entrepreneurship. At last week’s AERC, Hunter Hastings — a leading business and marketing consultant — discussed how technology breakthroughs and smart machines can power a new age of individualism.
And in case you missed any of them, here are this week’s featured Mises Daily articles and some of our most popular articles at Mises Wire:
Keynes in 1939: The Coming War Will Solve Our Unemployment Program by Carmen Elena DorobățAnd So It Begins… Negative Interest Rates Trickle Down in Japan by Paul-Martin FossRothbard: Essentials of Money and Inflation by Murray N. RothbardThe Fed's Firepower by Jonathan NewmanEconomists as Modern Astrologers by Ryan McMakenCash Banned, Freedom Gone by Thorsten PolleitDumb and Dumber – From Negative Interest to Helicopter Money by Paul-Martin FossThe Fed Can't Save Us by Robert MurphyMises: Politics and Liberty by Ludwig von MisesThe Real Meaning of Competition by Peter KleinWhat Harry Potter Can Teach the Federal Reserve by Tho BishopMill Power Is Trump's Card by Joseph SalernoDon’t Confuse the Cost of College with the Cost of Education by Ryan McMakenLiberty Defined by Ron PaulWhat Would Trump Economics Mean for America? by Mark ThorntonThe Skyscraper Index Meets the Supertanker Index by Paul-Martin Foss30 Years of Mises University by Ryan McMakenThree Lessons Learned from Tesla’s Success by Mateusz Machaj"Free Stuff" Isn't All That It's Cracked Up to Be by Louis RouanetHazlitt, 1946: Inflation, Deflation, Confusion by Henry Hazlitt
Some politicians want to ban cash, arguing that cash is helping criminals. The first steps in that direction are the withdrawal of big denomination notes and the limits imposed on cash payments.
Proponents of a ban on cash claim that this will help fight criminal transactions — involved in money laundering, terrorism, and tax evasion. These promises of salvation are used to get the general public to agree to a society without cash. But there is no convincing proof for the claim that the world without cash will be a better one. Even if undesirable behavior is indeed financed by cash, you still need to answer the question: will the undesirable behavior disappear without cash? Or will those who commit the undesirable acts take to new ways and means to reach their goal?
Take the example of the 500 euro note. If we do away with it, won't those who wish to use cash pay with five 100 euro notes instead? Or ten 50 euro notes? And what about the costs imposed on the large majority of respectable people, if you put a ban on their cash? Using the same logic, should we ban alcohol, because some can't handle it properly?
It’s Really about Central BanksThe plan to restrict the use of cash, or to abolish it step by step, has nothing to do with the fight against crime. The real reason is that states (and their central banks) want to introduce negative interest rates.
Although central banks have long pursued inflationary policies that devalue the debt owed by governments, negative interest rates offer a new and powerful tool to do this. But, to make negative interest rates work well, you have to get rid of physical cash.
Otherwise, if you apply negative rates on bank deposits, customers in the short or long run will try to avoid the costs that negative rates impose on their bank deposits. So, depositors will, in many cases, hoard cash. To block this last escape route, proponents of the ban on cash want to do away with it.
The Natural Rate of InterestIncidentally, some reputable economists are supporting the plan, claiming that the “natural rate” has become a negative rate. Because of that, central banks were forced to push interest rates below zero, being the only way to foster growth and employment. The assertion that the balanced interest rate has become negative doesn't stand up to a critical examination though.
[RELATED: The “Natural Interest Rate” Is Always Positive and Cannot Be Negative]
It is inherently impossible that the balanced interest rate is negative. Market rates, which entail the balanced rate, can fall below zero, but not the balanced rate itself. The policy of negative rates is no cure for the economy but causes massive economic problems.
Competition and Property RightsBanning cash is infringing on the freedom of citizens on a massive scale. In withdrawing cash, the citizen is bereft of choice for his payments. After all, the state has the monopoly on the production of money. There is no competition on cash. Thus, nobody but the state can satisfy the demand for money by citizens.
If the state bans cash, all transactions must be executed electronically. For the state to see who buys what when and who travels when where is then only a small step away. The citizen thus becomes completely transparent and his financial privacy is being lost. Even the prospect that a citizen can be spied upon at any time is an infringement on his right of freedom.
Cash helps to protect the citizen from an unfettered intrusiveness by the state. If the state increases taxes too much, citizens at least have the option to avoid the tribulation by paying in cash. The knowledge that citizens can do so, makes states hold back a little.
States will give up any restraint once cash has been banned. The justified concern isn't at all rendered obsolete by the cases of Sweden and Denmark, where the cashless society is said to function to its perfection. The citizens of those countries can still use foreign cash if they want.
The plan to ban cash — step by step — is a sign of the fundamental ailment of our time: the state is destroying more and more of the freedom of citizens and businesses, once it has turned into a territorial monopolist and highest judge of all conflicts.
The fight to keep cash may bring something good though: it will shed light on the need to take the power away from the state as we know it, by applying the same principles of law on its actions as on those of each and every citizen. That way, the state’s monopoly on producing cash would come to an end and the citizen wouldn't need to worry that he may be deprived of his cash against his will.
Recorded during the Authors Forum at the 2016 Austrian Economics Research Conference, Leonidas Zelmanovitz (Liberty Fund), discusses his recent book, The Ontology and Function of Money: The Philosophical Fundamentals of Monetary Institutions (Lexington Books, 2015). Includes an introduction by Mark Thornton.
In the view of John Tamny — an editor at Forbes and RealClearMarkets — economics as it is usually studied and taught in universities is unnecessarily complicated. The basic truths of economics are simple and require no difficult mathematics to understand. Readers will be reminded of Hazlitt’s great Economics in One Lesson.
Entrepreneurs vs. BureaucratsThe book is animated by a controlling vision. A successful economy depends on innovative entrepreneurs who are willing to take large risks in return for the chance at great profits. It is essential to prosperity not to hamper the efforts of these entrepreneurs through governmental efforts to tax and regulate the economy. Tamny illustrates his thesis with many stories about famous persons, as the subtitle of the book suggests.
The government, Tamny emphasizes, produces nothing on its own. It operates by taking resources away from the productive. To the objection that the government may itself use money it takes in taxes for purposes beneficial to the economy, Tamny answers that people successful in business are highly likely to be better judges of what is beneficial than bureaucrats in the government. If the bureaucrats were better able to discern profit-making opportunities, they themselves would be entrepreneurs. High level bureaucrats may earn substantial salaries, but the wealth of those in business is far greater. “If you’re so smart, why are you a bureaucrat?”
To this, one can imagine someone objecting: Even if it is right that successful entrepreneurs will raise economic productivity, does this not bring with it a great danger? What about inequality? What if the successful entrepreneurs do so well that they accumulate vastly more wealth than others? Thomas Piketty has notoriously made much of this point; but Tamny has an effective and simple answer to it. Great accumulations of wealth are desirable: the rich will invest their money, and everyone will benefit. “When the rich ‘hoard’ their wealth, it is loaned to those who need money for cars, clothes, and college tuition, not to mention the next generation of Bill Gateses, full of ideas but in need of the capital that will abound if some of society’s richest keep their wealth intact so it can pass to future generations.”
If high investment is the key to prosperity, the capital gains tax is especially to be deplored. “Investors who might risk their capital in the private sector know they might lose it all, and they face a 20 percent tax on whatever return they do get on their investment. Those same investors have the option of buying government bonds, and, though the returns are small, they’re reliable and, in the case of municipal bonds, tax-free. ... Our tax code ... puts entrepreneurs at an enormous disadvantage when they compete with the government for investors.”
Taxation is of course not the only way the government hampers the free market. Attempts by government to regulate the economy face exactly the problem that Tamny finds with taxation. Antitrust laws, for example, purport to prevent companies from gaining monopoly control of important commodities; but are not those on the scene better qualified than government “experts” to assess whether market conditions make mergers desirable? Once more, it is entrepreneurs, not government officials, who are skilled at anticipating future demand. “Mergers are ultimately about survival. Companies must adjust to an uncertain future business climate, and restraining the ability of larger businesses to act in the best interests of shareholders is counter-productive. Antitrust regulation does not foster competition so much as it reduces successful companies to sitting ducks.”
“Capitalist Societies Can Rebound from Anything”We have so far omitted a key part of Tamny’s argument. Skilled entrepreneurs succeed, but many in business fail. The market operates by sorting out of the successful from the failures by the test of profitability. Given this fact, it is as essential that the failures be allowed to fail as it is that those who succeed be allowed to keep their profits. Attempts to prop up failures disable the market.
This vital point can be used to answer a common objection to free trade. Many people object to free trade because, in some cases, foreign competition drives domestic companies out of business, causing unemployment. To the response that expanded trade creates jobs elsewhere in the economy, the reply oft en given is, what about the workers who do lose their jobs? They are often unable to secure new jobs as good as those they had previously. The fact that others are better off is small solace to them.
Tamny’s account of the way the free market works makes it impossible to accept the objection just given. “In a free economy, capital migrates to talented entrepreneurs eager to pursue profitable opportunities. Innovations like the automobile, computer, and online retail services destroy jobs, but the process leads to better, higher-paying jobs ... to create jobs in abundance, we must allow the free marketplace to regularly annihilate them.” Tamny acknowledges that “the progress of job creation through job destruction does not make losing your jobless agonizing. ... Yet getting laid off is not cause for despair. Good often comes from losing your job.” Workers, like capitalists, need to be alert to new opportunities.
In a manner showing great insight, Tamny applies the point about falling businesses to the financial crisis of 2008. According to Ben Bernanke, Timothy Geithner, and many others, only the massive bailouts of financial institutions in response to the collapse of the housing market saved the economy from disaster. Tamny reverses this contention. It was essential to the proper working of the market to allow the businesses that had acted recklessly to fail. Had this been done, the economy could have quickly readjusted. “Capitalist societies can rebound from anything. In particular, they can bounce back from bank failures that do not exterminate human capital or destroy their infrastructure. An interfering government is the only barrier to any society’s revival, and that is why the global economy cratered amid all the government intervention in 2008.”
Gold, Money, and the StateSo far there has been little reason to dissent from the author’s principal arguments. In monetary theory though, he makes what seems to me an incorrect claim; but fortunately, his main policy prescription can be restated in a better way. Tamny rightly calls for sound money. He rejects as misguided inflationary efforts to reduce our “unfavorable” balance of trade. As he points out, a trade deficit is not at all to be feared. “All trade balances. Trade ‘deficits’ with producers from near and far away are the rewards for everyone’s productivity.”
So far, so good; but he errs when he compares the dollar to a measuring rod that must not change. “Just as the foot is never long or short, money should be neither strong nor weak. The foot is a standardized tool to measure actual things, and money should have the same constancy.” What is his argument for this view? As he points out, people want money, not for its own sake, but in order to purchase goods and services. (We set aside a few exceptions.) He thinks that from this fact, if the government follows the proper policy, the value of money can be kept constant. Relative prices of goods and services will change, to reflect changes in their supply and demand. Money can then serve as a measuring rod, to enable people to assess these changes in relative prices. It does not follow, though, that because money is demanded as a means to get other things, there is no independent demand for money at all. In the free market, money is a commodity whose price can change.
Even if Tamny is wrong on this point, though, his main message can be salvaged. It is entirely desirable that the monetary commodity be one unlikely to be subject to substantial fluctuations in price. The gold standard abundantly meets this requirement, and this gives Tamny all that he can reasonably want. To speak of measuring rods merely darkens counsel, as Mises long ago pointed out. “Although it is usual to speak of money as a measure of value and prices, the notion is entirely fallacious. So long as the subjective theory of value is accepted, this question of measurement cannot arise.” (Mises, Theory of Money and Credit, chapter 2.)
The book’s many insights far exceed in importance this disagreement about money as a measure of value. Popular Economics is an outstanding book that, if read widely, will greatly improve public understanding of basic economic truths.
If you thought negative interest rates were as bad as it could get with central banks, you might be in for a surprise. Central banks have been so spectacularly unsuccessful with their accommodative monetary policies that they are discussing pulling out all the stops to get the results they want. They fail to realize that the reason prices aren’t rising is because they really want and need to fall. Bad debts weren’t liquidated during the last financial crisis, the debtors were merely bailed out. Overpriced assets weren’t allowed to be reduced in price. Central banks pumped trillions of dollars into the economy to attempt to paper over the recession. Market forces want to drive prices down, while central banks attempt to prop them up. So what to do when central banks aren’t getting their way?
Central bankers may very well recommend price controls in an attempt to “jolt the economy out of its doldrums.” Of course, economies don’t go into doldrums and they can’t be jolted out of them. Recessions are not something endemic to the economy but are rather the result of central bank monetary intervention. Because central banks refuse to acknowledge their culpability for causing recessions, their methods for responding to recessions end up being more of the same thing that caused them in the first place: monetary easing. And now that those methods are proving ineffective, more drastic measures might be on the way. Remember that the last time all-out wage and price controls were implemented in the United States was in the early 1970s, also a time of great monetary turmoil. In fact, the price controls were instituted by President Nixon at the same time as he closed the gold window in 1971.
As Ludwig von Mises pointed out many decades ago, once you begin to institute price controls, you inevitably lead to socialism.
It must add to the first decree concerning only the price of milk a second decree fixing the prices of the factors of production necessary for the production of milk at such a low rate that the marginal producers of milk will no longer suffer losses and will therefore abstain from restricting output. But then the same story repeats itself on a remoter plane. The supply of the factors of production required for the production of milk drops, and again the government is back where it started. If it does not want to admit defeat and to abstain from any meddling with prices, it must push further and fix the prices of those factors of production which are needed for the production of the factors necessary for the production of milk. Thus the government is forced to go further and further, fixing step by step the prices of all consumers’ goods and of all factors of production — both human, i.e., labor, and material — and to order every entrepreneur and every worker to continue work at these prices and wages.
That is why no one should be surprised that the governments of Japan, Europe, and the United States might resort to price controls to try to achieve what monetary policy could not. It follows logically, after all, since central bankers are in the price-setting and price control game to begin with. The interest rates that central bankers target or set are themselves prices, prices of money being loaned overnight or of money being deposited with the central bank. The aim of targeting or setting those interest rates is to influence interest rates and prices in the broader economy. So if that limited price-fixing doesn’t work, governments will expand their efforts to fix even more prices. It may not come directly, at least at first, but rather through some sort of incentivization. Pressure may be brought to bear to raise wages, using tax policy as either a carrot or a stick. The aim and the effect, though, will be to move prices to where the government thinks they ought to be, not what the market can actually bear.
If price controls are in fact enacted, it will make it all the more obvious that economic planning on the parts of central banks and governments must be firmly opposed. It will separate the wheat from the chaff, those who actually support economic freedom from those who are willing to rationalize central planning. Anyone who claims to stand for free markets, free trade, and limited government but who attempts to defend the existence or importance of the Federal Reserve or central banking is a liar. Either you support free markets and freedom of pricing or you support central bank price-fixing and creeping socialism. There is no third way or middle road — socialism and the free market are mutually incompatible. A little bit of socialism in the form of price-fixing is like a little bit of gangrene, if left unchecked it will eventually infect and kill the whole. Now that governments and central banks may endorse further price controls as a remedy, the monetary policy facade has been torn away to reveal the reality that it is just another tool that leads to intensified central planning. Will enough people rise to the occasion to oppose further transgressions against monetary and economic freedom, or will they shrug their shoulders as our society continues to slouch toward socialism?
Quarterly Journal of Austrian Economics 18, no. 4 (Winter 2015): 578–583
Based on his doctoral thesis directed by Jörg Guido Hülsmann (who also wrote the foreword to the book), German economist Eduard Braun's Finance Behind the Veil of Money aims to show how money affects our financial decisions. The reader will notice that Braun approaches this goal from a different angle of most Austrian-school economists. Instead of looking at how money and credit affect interest rates and propagate an Austrian business cycle, Braun focuses on the “subsistence fund.” Largely jettisoned from modern Austrian business cycle theory, in a way Finance Behind the Veil of Money picks up where Richard Strigl left off with his Capital and Production (1934).
In expounding an updated theory of the definition and role of the subsistence fund, Braun rewards the reader for the time dedicated to reading the book. This time is not insubstantial. At 342 pages, the book is neither concise nor easy reading. It is heavy, dense, technical and littered with citations. The publisher’s exclusive use of endnotes makes the going tougher yet, as the reader constantly finds himself flipping pages to find out to whom Braun is attributing a concept, to what era the idea belongs or, indeed, since Braun uncovers the changing thoughts of several authors over their lifetimes, to what specific work of an author he is referring.
Janet Yellen was forced to wave a white flag this week, admitting what was long obvious — the Federal Reserve overestimated the strength of the global economy and will not be able to go through with its planned four rate hikes in 2016. As David Stockman noted in his take down of the FOMC announcement, “Listening to even a small portion of Simple Janet’s incoherent babble makes very clear that the nation’s central bank is well and truly impaled on its own petard.” Meanwhile, Ryan McMaken notes that diminishing foreign government holdings of US debt creates another issue for the Fed, possibly requiring the central bank to resume monetarizing public debt.
In the Fed’s desperation to hold off the pain that will come from the eventual popping of our current easy-money fueled bubbles, will Yellen start listening to the advice of her predecessor Ben Bernanke and embrace the absurdity of negative interest rates? We are already seeing the consequences of such policy play out in Switzerland and Germany and Japan.
At least the sight of Brazilians taking to the streets demanding Less Marx, More Mises can offer hope in our battle against the folly of “public policy.” As the ideas of Mises, Rothbard and the Austrian school continue to spread around the world, the closer we come to being able to achieve prosperity, freedom, and peace.
On the newest episode of Mises Weekends, Jeff joins Dennis Tubbergen of Everything Financial Radio to dive deeper into the bizarre world of negative interest rates.
And in case you missed any of them, here are this week’s featured Mises Daily articles and some of our most popular articles at Mises Wire:
We Are Headed Toward a Cashless Society? by Thomas DiLorenzoDemagoguery vs. Data on Employment in America by Tyler WattsWe Need the Pain that Comes with More Saving by C. Jay EngelIncluding the Ocean Floor, the Feds Own Much More Land than You Think by Mark BrandlyTo Oppose Free Trade Is To Embrace Violence by Ryan McMakenSwitzerland: Negative Interest Rates Result in Rising Mortgage Rates by Paul-Martin FossHillary Clinton Wins the Federal Reserve Primary by Tho BishopThe "We've Created Millions of Jobs" Myth by Ryan McMakenHope in Brazil as Millions March Against Rouseff by Tho BishopRothbard: The Progressive Movement by Murray RothbardThe Rage Against Wall Street Isn't Just Anti-Capitalism by Ryan McMakenFed Waves White Flag: "Foresees Fewer Rate Hikes" by Ryan McMakenMises: The Fight Against Error by Ludwig von Mises"Who Will Pay for It?" is the Wrong Question To Ask Politicians by Matthew McCaffreyImpaled On Its Own Petard — The Fed’s Folly Festers Further by David StockmanForeign Regimes Dumping US Debt — Will the Fed Just Monetize the Debt Instead? by Ryan McMakenFree Trade, and the US as "an Antiquated and Unnatural Construct" by Ryan McMakenMarc Faber: Some Misallocation Is Worse than Others by Ryan McMakenAgainst Public Policy by Jeff DeistGerman Response to Negative Interest Rates: Safe Deposit Boxes by Paul-Martin FossA New Italian Translation of Human ActionMateusz Machaj on the Taylor RuleSalerno Reviews Grant's The Forgotten Depression
The endgame of monetary side manipulations is upon us. Since 2008, central banks have done what they thought was needed to bring the markets back from the pain they experienced during the crash. The problem, of course, is that these Keynesians and Monetarists placed the high level of stock markets as the goal of “policy” and confused booming asset levels with economic growth.
The enemy of prosperity, in the eyes of global economic policymakers, is the desire of the consumer to save and businesses to refrain — even in the short term — from investment. As such, their “solution” was the very poison that has infected the Western world over the decades: more credit, lower costs of money, more push for “consumer demand.”
The Current Orthodoxy Is FailingBut “easy” monetary policy has merely led to debt-ridden economies and a bubble that is increasingly being exposed as a complete farce. January saw a market pullback tease that reminded investors that what was pushed up artificially can’t be sustained forever. Monetary policy, even if it goes to negative interest rate territory with a vengeance, isn’t going to be the miracle drug needed to provide a better economic foundation. Austrians have long known this. The mainstream is just starting to publicly admit it.
The Savings-Glut MythHowever, the right lessons are not being learned by either the economic policymakers or the financial pundits. In fact, the most dangerous economic fallacies still underlie their entire financial worldview. For instance, there is the ever-constant theme that there is a “glut of savings” and that low consumer demand is the chief villain that stands opposed to economic stabilization. Martin Wolf, writes in The Financial Times:
that the global economy is slowing durably. The OECD now forecasts growth of global output in 2016 “to be no higher than in 2015, itself the slowest pace in the past five years”. Behind this is a simple reality: the global savings glut — the tendency for desired savings to rise more than desired investment — is growing and so the “chronic demand deficiency syndrome” is worsening.
The proper economic way of thinking does not blame the economic pain on savings, nor does it desire an artificial, government-driven, attempt to coax people into consuming and “investing.” In fact, the economic reality of the situation is that savers are to be praised, not admonished; and that the refraining from consumption is the very means by which malinvestment can be most swiftly liquidated.
For the Austrian-school thinkers, the collapsing of the bubble that results from people “hoarding” their money and refusing to purchase over-priced “assets” is the precondition for future economic growth. This is because it is the bubble, not the bust, that is the problem. The bubble is the time of malinvestment and mismatch between consumer time preferences and resource allocation that results from the artificial expansion of the supply of money. It is the falsification of interest rates that encourages investment into areas that the economy is not prepared to handle. And while in the near term the bubble appears as prosperity and good times, it is actually the very seeds of destruction being sown. It is this piece of the boom-bust cycle that is destructive and impoverishing. The bust is merely the needed adjustment that gives society the wonderful opportunity to “start over” and do it right this time. Unfortunately, we never actually get to do things right, because the economic bureaucrats in our unfree-market system fear the bust more than the boom. They have it all backward!
How Saving Heals the Problems Caused by BubblesSo then, the so-called “global savings glut,” has the economic role of encouraging the readjustment of capital asset prices back toward their proper levels. The refusal to participate in the bubble, it is true, is harmful for the overvalued stock market levels worldwide. But what the mainstream does not understand is that overvalued stock market levels is a result of the underlying rot in the system itself. The pain to be experienced in a collapse will surely shock an entire generation of unprepared retirees, especially those relying on pension levels which are tied closely to stock market performance in the near to medium term.
But if the economy is ever going to slough off generations of central bank-induced malinvestment, if the economy is ever going to shift to a proper and sustainable foundation of capital accumulation, if future generations are going to live in a truly prosperous world, the pain is unavoidable. Propping up the markets and encouraging misguided consumption and malinvestments will be the death blow to western civilization. Only near-term pain can allow long-term growth. Economic savings are the cure, and to be welcomed with open arms.
In this article, Claudio Grass, Managing Director at Global Gold Switzerland, talks to economist and Mises Institute Senior Fellow Thomas DiLorenzo. This exclusive interview covers central bank monetary policies, Keynesian economics, the economic“recovery,“ political correctness, and much more.
Claudio Grass: Thomas, it is an honor to have this opportunity to talk to you. I am also pleased to announce that you will be delivering the keynote speech at the BFI Inner Circle Wealth Forum in Florida on April the 18th and 19th. Let’s get started! Given the limited impact of loose monetary policy thus far, where do you think we are headed on the central bank front? Do you think it is likely that the Fed moves interest rates into negative territory, like many central banks across the globe have already done? What would the implications of such a step be?
Tom DiLorenzo: On the central bank front, we are headed where Japan has been over the past twenty years or so: more and more easy money in a quixotic quest to push interest rates into negative territory, a truly crazy idea. The craziness of this stems from the fact that the entire academic economics profession abandoned Keynesianism in the 1970s. Its failure to explain stagflation was considered to be the final nail in the Keynesian coffin. Franco Modigliani’s presidential address to the American Economic Association in the late '70s was a remarkable white-flag-of-surrender speech by one of the prominent Keynesians. He confessed that Keynesian “stabilization policy” had been a failure. Then, like a bad horror movie, Keynesianism reared its ugly head fifteen or twenty years later as though it had never been discredited. Thus we now have the crazed policy of negative interest rates based on the thoroughly-discredited idea that only “aggregate demand” matters, and if we can just have the central bank push interest rates low enough, people will spend more and businesses will invest more, and all will be good. After the crash of 2008, caused by these same Fed policies, I recall the old Keynesian propagandist/economist Alice Rivlin on TV advising everyone to go out and spend wildly on anything. “It doesn't matter what you spend it on,” she said, “just spend it.”
In reality, what this new policy — which is the same as the old policy — does is induce businesses to invest more on durable goods like cars and houses, which is why there are new bubbles in these markets, at least in some regions. The price-per-square-foot of Las Vegas real estate, for example, is now higher than it was just before the crash of 2008. There’s also a student debt bubble and a stock market bubble, in my opinion, thanks to the Fed’s single-minded and very simple policy of print, print, and print some more. Rather than reducing some of the wild and reckless speculation on Wall Street, the government bailouts of the speculators created a “moral hazard problem” that will encourage even more reckless speculation. If the speculative investments pay off, they keep the profits; when they go bust, they can count on another round of “too-big-to-fail” bailouts.
CG: The only way it seems feasible to move interest rates substantially into negative territory would be to either ban or at least massively restrict the use of cash. In our view, there is a clear “war on cash” being promoted in the media. Do you have any thoughts on the issue and are we headed toward a cashless society?
TD: Yes, there is a war on cash being promoted by the Fed, in particular, and the government, in general (and its lapdog supporters in the media). The main reason for this is that if people can hold cash, it makes it more difficult for the Fed to centrally plan the economy. Also, Keynesianism has always been at war with savings since its principle tenet is that savings are bad, consumption is good (there you have all of Keynesianism in a nutshell). This began with the silly theory of the “paradox of thrift” that said that savings is harmful to the economy; therefore, the more we save now, the poorer we will all become, and the less able we will be to save (and consume) in the future. The Keynesian central planning authorities at the Fed and elsewhere would like to see a cashless society because keeping cash can be a form of savings instead of consumption. I think we are headed toward a cashless society unless the public wakes up and begins to protest this.
CG: What do you think the implications of a cashless society are when we combine this with other legislation like the PATRIOT Act? Do you think we are headed toward a totalitarian state in the US, where private property rights will no longer be protected?
TD: An important reason why the state would like to see a cashless society is that it would make it easier to seize our wealth electronically. It would be a modern-day version of FDR’s confiscation of privately-held gold in the 1930s. The state will make more and more use of “threats of terrorism” to seize financial assets. It is already talking about expanding the definition of “terrorist threat” to include critics of government like myself. The American state already confiscates financial assets under the protection of various guises such as the PATRIOT Act. I first realized this years ago when I paid for a new car with a personal check that bounced. The car dealer informed me that the IRS had, without my knowledge, taken 20 percent of the funds that I had transferred from a mutual fund to my bank account in order to buy the car. The IRS told me that it was doing this to deter terrorism, and that I could count it toward next year’s tax bill.
Property rights in the US have been under assault for a very long time and the assault is proceeding at an accelerated rate with such monstrosities as “Obamacare,” which forces Americans to buy government-prescribed “health insurance,” and all the Soviet-style regulation and regimentation of financial markets in the wake of the government-created Great Recession of 2008.
CG: We believe that history doesn’t repeat itself, but rather rhymes (Mark Twain). Do you think there are historical parallels to be found in US history to the current situation (economic socialism, restrictions on private gun ownership, etc.)?
TD: I don't know if history rhymes, but there are some things that are true of all governments at all times. One thing is a deep distrust, resentment, or even hatred of Adam Smith’s “invisible hand”: the idea that individuals, in pursuing their self-interest in the free market, coincidentally benefit the rest of society in most instances without any “czar” or central planning authority involved. Peaceful, voluntary trade leaves little room for politicians to plan everyone’s life and make themselves rich and famous through plunder. Thus, they are eternal enemies of free enterprise in particular, and freedom in general, with very few modern-day exceptions, such as former Congressman Ron Paul. So despite hundreds of years of miserable failures of socialism and government “planning” of every other kind, governments ignore this history because it is in their self-interest to do so.
With regard to gun ownership, all governments have promoted, to some degree, the idea that only the government’s police and military should have guns. This policy has been less successful in America than in any other country, thank God. The main reason for the Second Amendment’s right to bear arms in the US Constitution, according to the “father of the Constitution” James Madison, was so that an armed population could defend itself from a future government that wanted to enslave them.
CG: Why do you believe the economic recovery has been so weak? What impact do you think this will have on precious metals and other assets with real value?
TD: The recovery has been so weak because of (1) Fed policy and (2) most other government policies. The bright side to any recession is that businesses are finally forced to liquidate bad investments and do everything they can to become more profitable. The Fed delayed and interfered with this process by continuing the same easy-money policies that caused the recession in the first place. This resulted in significantly more bad investments and the creation of another bubble economy. Much of the rest of government policy has created tremendous uncertainty, what economist Robert Higgs calls “regime uncertainty.” Businesses still have only a vague idea of what Obamacare will cost them, for example. A high degree of uncertainty makes it difficult, if not impossible, to plan for the future so many businesses simply stay where they are until the government steps back. This is what happened after FDR’s death. There were no longer constant threats of new taxes, regulations, or confiscations of gold and other assets, and so capital investment finally began to increase after being negative throughout the 1930s. In this atmosphere, which I don’t see as changing very significantly, the smart investors will include more gold and precious metals in their portfolios.
CG: You often talk about the dangers of political correctness (PC) in your articles. We believe that under the guise of PC, free speech as we know it is being limited and PC is being used to try to implement a sort of “thought control.” Would you share your views on the topic?
TD: Most Americans do not realize that the academic elite at most universities are what are known as “cultural Marxists.” After the worldwide collapse of socialism in the late ‘80s and early ‘90s, the academic Marxists redefined themselves. They largely abandoned the old “class struggle” rhetoric involving the capitalist and worker “classes” and replaced them with an oppressor and an oppressed class. The oppressed includes women, minorities, LGBT, and several other mascot categories. The oppressor class consists of white heterosexual males who are not ideological Marxists like them. Another branch of the Marxist Left decided to continue promoting socialism under the guise of “saving the planet.” I call these people “watermelons” — green on the outside, red on the inside.
The cultural Marxists have adopted the advice of the philosopher Herbert Marcuse, who is really the “godfather” of cultural Marxism. He preached that free speech is really a tool of oppression because it leads to critiques of “utopia,” by which he meant communism. This is where all the vicious crackdowns on campus free speech come from: the cultural Marxists will say that they are doing the morally-correct thing to censor speech by conservatives or libertarians, for such speech may be critical of their ideology. They are totalitarian-minded, fascist thought control police and dominate almost all university administrations in the US. It is creating a real dumbing down of American youth, for much of their university education is now indoctrinated in left-wing platitudes rather than the development of critical thinking. The big exceptions, however, are the students who stick to studying business, economics, engineering, math, etc., and largely ignore the PC circus.
CG: Now to the presidential election in the US. Who do you think will be the likely winner of this race? It is believed that if Trump wins the election that the US will move toward a more isolationist foreign and economic policy. What are your thoughts on Trump?
TD: Right now my money is on Donald Trump being the next president. If that happens, there will be a less “isolationist” foreign policy, for Trump does not want to risk starting World War III, unlike all of the “neoconservatives” who run both of the main political parties. That is why he is so hated and despised by the Republican Party establishment. He would like to do more business with countries like Russia rather than start a nuclear war with the Russians. They, on the other hand, want to see endless military aggression in the Middle East and elsewhere. This is why they will do everything possible to defeat Trump, including putting all of their Big Money behind Hillary Clinton or whomever the Democrat Party nominee is. If I were Donald Trump I would also double or triple my personal security detail.
As for economic policy, Trump could hardly be worse than Obama or his predecessor. He has said that he hates taxes and does everything in his power to minimize his own tax burden, which is certainly a good instinct. Since he’s a billionaire, he can’t be bought off on any policy, which is really the main reason why the GOP oligarchs hate him with a red-hot passion. But if he wins and becomes a politician, there is always the chance that he will succumb to a more interventionist economic policy so that the media will say nicer things about him. Vanity seems to be one of the man’s hallmarks.
This weekend, Americans move forward their clocks for daylight saving time, one of the more absurd (outdated) examples of insane government control. Notes James Alexander Webb, the government mandated spring forward is simply another example of “disrespect for the principle of simply leaving people alone.” Unfortunately the principle of lassiez-faire is one too often ignored in today’s world. The consequences of our government’s rigged society are all around us, be it the increasing reliance on food stamps, a far reaching tax system, or the gratuitous examples of well-connected elites enriching themselves from state intervention.
This all begs the question of whether it is democracy itself that may be to blame? That’s the subject of the next episode of Mises Weekends. This week we feature a past talk given by Hans-Hermann Hoppe highlighting some of the key points he makes in his book Democracy: The God That Failed. Hoppe’s lecture not only shows how democratic elections often lead to bad results, but illustrates how political democracy is often incompatible with human liberty.
And in case you missed any of them, hereW are this week’s featured Mises Daily articles and some of our most popular articles at Mises Wire:
Free Trade Is the Path to Prosperity by Georgi VuldzhevBernie vs. Ron Paul: There's No Comparison by Lew RockwellHumans Are Hard-Wired to Value Some People Over Others by Andrew SyriosFreedom vs. Justice: Are They in Conflict? by David GordonDaylight Saving Time: A Government Annoyance by James Alexander WebbAnatomy of a Bank Run by Murray N. RothbardMyth: Half of Americans Don't Pay Federal Taxes by Ryan McMakenNegative Rates May Be Ineffective and Dangerous by Joseph SalernoThanks, Bush and Obama: 1 in 7 Americans Were on Food Stamps in 2015 by Ryan McMakenFormer ECB Chief Economist Disses Negative Interest Rates and Praises Deflation by Joseph SalernoBernie, It’s Government That "Rigs" The Economy by Tho BishopMises: The Meaning of Lassiez Faire by Ludwig von MisesThe Undeserving Rich by Jeff DeistDowntrend in Money-Supply Growth Poses a Threat to Bubble Activities by Frank ShostakThe European Central Bank Finally Throws in the Kitchen Sink by Ryan McMakenThe Problem with "Expressive Voting" by Gary GallesInvesting Responsibly in an Irresponsible World by Doug FrenchWe Need to Talk about Frank (Fetter) by Matt McCaffreyA "Libertarian" Argument for the Welfare State by David GordonRothbard: The Genius and the Man, and How to Approach His Work by Joseph Salerno and Tom WoodsMoney, Bank Credit, and Economic Cycles Now Available in Japanese
The Federal Reserve is a key component of the American Transfer State. Under the guise of “macroeconomic management,” it redistributes vast amounts of wealth on an ongoing basis through inflation. The victims of these transfers are ordinary Americans. The beneficiaries are the government and its elite cronies.
The Fed masks the nature of this surreptitious taxation and corporate welfare by performing a simple shell game that is just complicated enough to confound the general public.
First, let’s imagine the government performing this kind of inflationary transfer without the shell game.
Imagine Uncle Sam sitting at a desk, representing the Federal government. His right hand is the Treasury. It has the government’s main bank account, represented by a ledger on the desk. Uncle Sam also has revenue collecting powers, represented by a gun resting on the desk, which he uses to extort taxes from the public. Whenever he confiscates money, the cash balances of the public decline, and Uncle Sam’s ledger increases by the same amount.
Now let’s say Uncle Sam wants to raise $200 million for current expenditures: bureaucrat salaries, weapons purchases, welfare payments, etc. The problem is, the public has a limited tolerance for overt taxation. So, at a certain point, if Uncle Sam simply gestures to his gun again to levy the funds, he might face a tax revolt.
So let’s say instead of using his taxing power, Uncle Sam uses his fiat money power: his ability, based on the government’s monopoly control over the money supply, to inflate (defined here as monetary expansion). As the God of the Bible could say “let there be light” (in Latin, fiat lux) and it was so, the modern omnipotent State can say “let there be money” (fiat money or fiat pecunia) and it is so. With his right hand, Uncle Sam adds $200 million to his Treasury bank balance by simply writing it on his ledger. Voilà, he now has $200 million, simply because he says so. He can then transfer the new money to his workers, contractors, and dependents.
It would seem the public wasn’t taxed at all. Uncle Sam’s balance increased, but the cash balances of the populace did not diminish. So no skin off the backs of the people, right? Does anybody lose when the government gains in this magical way? When you think about it, somebody must lose. After all, it’s not really magic.
The true wealth of society — what actually sustains human life and makes it more comfortable and delightful — is the stuff we buy with money; not money itself. It’s the food, clothing, housing, smartphones, mountain bikes, and other consumers’ goods. It’s also the farmland, factories, robots, raw materials, labor and other producers’ goods used to make those consumers’ goods. I covered this point in detail in a lecture I gave which is on YouTube, and in my essay based on that talk, “How Inflation Drinks Your Milkshake.”
Creating new money does not create any additional stuff to go around. So if creating money got the government more stuff, that means others sharing the same world of scarcity must have less stuff. It’s a zero-sum game; a win-lose situation. If the government wins something through inflation, somebody has to lose. So who loses?
Well what if the government did not have the money needed to hire the bureaucrats? Then that labor would have had to enter the private market. And what if the government couldn’t afford its weapons purchases? Then that capital would have been liquidated, even scrapped, and would have also been reallocated to the private market. So the losers include the private market actors that would have acquired the labor and resources, had they not been outbid by the government’s inflation-enhanced purchasing power.
But the government paymasters are not the only one who gained from the inflation. The bureaucrats and contractors themselves did too, because their wages and selling prices were bid up higher than otherwise. And then since the government suppliers also have more money to spend, their own workers and suppliers benefit similarly.
Does that mean that as the new money filters through the economy’s supply chains, everybody’s selling prices get bid up? Yes, that’s an alternative definition of “inflation”: the general rise in prices caused by monetary expansion. But does that make everybody better off? That is impossible, because again, that would mean more stuff had been created, when it wasn’t.
The new money reaches some people early and some people late. By the time the new money reaches the late receivers, bidding up their selling prices, it has already bid up the prices of the things they buy to an even greater extent. So the late receivers get poorer, while the early receivers get richer. (In economics, these are called “Cantillon effects.” For more about this process, see my inflation essay mentioned above.)
And the earliest receivers always include the government and its partners, while the late receivers are usually workers and small business owners who don’t have such lofty connections. So these “commoners” are effectively taxed for the benefit of the government-connected elite. But, since the taxation was effected through inflation, the public doesn’t realize that. They know they are poorer, but not why. They never saw a tax bill or had to cut a check. They just see their wages and revenue fail to keep pace with the rising costs of living and costs of doing business. And as a result, they see their ability to get actual stuff diminish. But they don’t see the government’s role in it.
Instead of obnoxiously demanding that the public hand over its wealth, the government just quietly siphons it away. This way it avoids public outrage and resistance, and so is able to maximize the loot. As Jean Baptiste Colbert (finance minister to King Louis XIV of France) put it, “The art of taxation consists in so plucking the goose as to get the most feathers with the least hissing.” With inflation, the geese hardly hiss, because they think they are simply molting, and are unaware they are even being plucked.
Yet, it is in the hands of central bankers that the art of taxation truly nears perfection. The inflation tax is sneaky, but by itself it’s not quite sneaky enough. Even with inflation’s quiet method of wealth transfer, the jig would eventually be up if the government simply kept adding to its own account. Even if people don’t realize how they are losing, they can see that the government is simultaneously gaining, which would be suspicious. That correlation needs to be blurred somehow, else the more astute geese will start honking. That’s where Uncle Sam’s shell game comes in.
Let’s say instead of the Treasury creating the $200 million, it borrows it from an investment bank, like Goldman Sachs. Let’s see if, working together, Uncle Sam and Goldman can inflate, and both come out richer with a stroke of a pen, at the expense of the public, without it being clear that they did.
To borrow the funds, Uncle Sam’s Treasury right hand writes on a piece of paper: “IOU $200 million.” That represents a bond issue. Goldman lends the government money by purchasing the bonds. $200 million transfers from Goldman’s ledger to Uncle Sam’s. And in return, Uncle Sam gives Goldman a transferable IOU which gives the holder the right to collect $200 million from Uncle Sam later, plus interest. Then, the Uncle Sam transfers the newly borrowed $200 million to his bureaucrats, contractors, and dependents. And now the Treasury owes Goldman $200 million plus interest.
But that’s where Uncle Sam’s left hand finally comes into play (shell games usually require two hands). His left hand is the Federal Reserve. In the US government’s real-life arrangement, it is the Fed, not the Treasury, that has the power to create new money.
Now the Fed goes shopping for government debt. Lo and behold, it finds that Goldman Sachs is selling $200 million in Treasury bonds. Let’s say the Fed then pays $205 million for the bonds, giving Goldman a tidy profit. But of course the Fed has its own peculiar way of paying. Uncle Sam just reaches over with his Federal Reserve left hand and credits Goldman’s account $205 million by simply writing it directly on the investment bank’s ledger. Keep your eye on the ball! That money was conjured out of thin air. That is where the inflation occurs in the slightly more elaborate process. “Fiat pecunia!” says Fed Chair “Hermione” Yellen. For all its technocratic jargon, this sleight-of-hand is pretty much the only “magic” trick the Fed knows.
Now let’s review. Who benefits? Goldman Sachs has $5 million in profit. And Uncle Sam was able to pay off his crew. At what cost? Well, the Federal Reserve has $200 million in Treasury IOUs. But that only means the Treasury owes the Fed $200 million plus interest. In other words, Uncle Sam’s right hand owes his left hand some money. But it’s all Uncle Sam; it’s all the same government. As Boston University economist Laurence Kotlikoff has pointed out:
Yes, the Treasury pays interest and principal to the Fed on the bonds, but the Fed hands that interest and principal back to the Treasury as profits earned by a government corporation, namely the Fed.
Uncle Sam gave up nothing. There are no costs for the government or its buddies. They are simply enriched. And again, inflation cannot enrich early receivers of new money without commensurately impoverishing the late receivers. The monetary expansion simply aggrandized the government, its bureaucrats, its contractors, and (now) its banking buddies at the expense of the general public, just as it did in the simpler example.
But that is not clear to most observers, because they get distracted and confused by the Treasury/Fed/private bank shell game that Uncle Sam plays. The thinking goes: “Well, the Treasury isn’t getting something out of nothing, because it’s just borrowing, which means it’ll have to pay it back. And Goldman Sachs is getting new money, but that’s not for nothing either, because it’s selling a bond; it makes sense that they would accrue a profit. And the Fed is doing the money creation, but that’s not going directly to government spending. It’s just compensating Goldman Sachs for its investment. Also, I heard on CNBC that the Fed’s open market operations stabilize the price level and minimize unemployment. Anyway, it’s all very complicated and technical. But they’re the experts, and I’m sure they’re just looking out for us.”
It’s all a con, and a cheap one at that. Unfortunately, sometimes the most successful con artists are the ones who keep it simple.