Mal-Investments Small And Large

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In yesterday’s article I emphasised that it is profit that is beneficial, not revenue. I’ve just read an excellent article (H/T Sean Corrigan) by Jerry L. Jordan, past president of the Federal Reserve Bank of Cleveland. He makes the same point, with particular reference to government “investment” and national accounting. He opens with an analogy to warm the hearts of American readers:

It is tempting to think that the Soviets perfected negative-value-added investment — the stuff produced is worth less than the value of the resources to produce it. However, most families have experienced this first hand. It usually surfaces with an entrepreneurial adolescent deciding it would be a good idea to sell lemonade at the curbside to passers-by Parents, wanting to encourage the idea that working and making money is a good idea, drive around to buy the lemon, sugar, designer bottled water, cups, spoons, napkins, a sign or two, and probably a paper table cloth. Aside from time and gas, the outing adds up to something north of $10. At the opening of business the next day, the kids find business is slow to non-existent at $1 per cup. So, they start to learn about market demand and find that business becomes so brisk at only 10 cents per cup that they are sold out by noon, having served 70 cups of lemonade and hauled in $7. The excited lunch-time conversation is about expanding the business. A stand across the street to catch traffic going the opposite direction; maybe one around the corner for the cross-street traffic. The kids see growing revenue; the “investors” see mounting losses. There is a strand of economics, we’ll call it the K-brand, that sees all this as worthwhile. They add together the $10 spent by the parents to back the venture and the $7 spent by the customers and conclude that an additional $17 of spending is clearly a good thing. Surely, the neighbourhood economy has been stimulated. To the family it is a loss, chalked up as a form of consumption. If this were a business enterprise it would be a write-off. In classical economics it is a “mal-investment.”

But of course the government “invests” on a much larger scale:

To K-brand economics, such “investing” is better done by the government because there never has to be a write-down for bad ideas. So, Japan spent a couple of decades “investing” in airports few people fly to, highways few people drive on and bullet trains that not enough people ride on. All the expenditures were recorded as investment and were additions to national output, never recognizing that the value of what was produced is less than the value of the resources needed to produce it — negative-value-added. Surely it is clear that Japan was made poorer by lots of bad “investments.” The U.S. recorded a great amount of “residential investment spending” in the central valleys of California that added to national output, only to have the houses bulldozed because there were no buyers. Subsequently, the home-builders incurred losses, reducing business income, thus shrinking national output. Nevertheless, the national accounts will never be revised to reflect that the “investment spending” of a few years earlier was all “mal-investment” and should have been recorded as a form of business consumption. Such “investment” actually made us poorer. The irony of this example is the expenditures incurred to bulldoze the vacant houses is recorded as “stimulus” to the economy. Thanks for that to K-brand economics. They now want California to “invest” in a Japanese-style bullet train that is negative-value-added economics.

I recommend the whole article.

A Challenge for 2012 – Part Two

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A challenge for 2012 – part one was to read The Theory of Money and Credit by Mises on its 100th year anniversary. The 1934 preface was sadly so pertinent to today that we reproduced it as an enticement to read the whole book. My second challenge for 2012 is to read a book written 86 years later by Jesús Huerta de Soto in its English translation called Money, Bank Credit, and Economic Cycles, which can be downloaded here. Like The Theory of Money and Credit in its day, this book is the most comprehensive economic text on money, capital theory, business cycles and entrepreneurship written by a modern Austrian. Here is the preface to the second English edition, written by Huerta de Soto in November 2008. I am happy to present the second English edition of Money, Bank Credit, and Economic Cycles. Its appearance is particularly timely, given that the severe financial crisis and resulting worldwide economic recession I have been forecasting, since the first edition of this book came out ten years ago, are now unleashing their fury. The policy of artificial credit expansion central banks have permitted and orchestrated over the last fifteen years could not have ended in any other way. The expansionary cycle which has now come to a close began gathering momentum when the American economy emerged from its last recession (fleeting and repressed though it was) in 2001 and the Federal Reserve reembarked on the major artificial expansion of credit and investment initiated in 1992. This credit expansion was not backed by a parallel increase in voluntary household saving. For many years, the money supply in the form of bank notes and deposits has grown at an average rate of over 10 percent per year (which means that every seven years the total volume of money circulating in the world has doubled). The media of exchange originating from this severe fiduciary inflation have been placed on the market by the banking system as newlycreated loans granted at very low (and even negative in real terms) interest rates. The above fueled a speculative bubble in the shape of a substantial rise in the prices of capital goods, real-estate assets and the securities which represent them, and are exchanged on the stock market, where indexes soared. Curiously, like in the “roaring” years prior to the Great Depression of 1929, the shock of monetary growth has not significantly influenced the prices of the subset of consumer goods and services (approximately only one third of all goods). The last decade, like the 1920s, has seen a remarkable increase in productivity as a result of the introduction on a massive scale of new technologies and significant entrepreneurial innovations which, were it not for the injection of money and credit, would have given rise to a healthy and sustained reduction in the unit price of consumer goods and services. Moreover, the full incorporation of the economies of China and India into the globalized market has boosted the real productivity of consumer goods and services even further. The absence of a healthy “deflation” in the prices of consumer goods in a stage of such considerable growth in productivity as that of recent years provides the main evidence that the monetary shock has seriously disturbed the economic process. I analyze this phenomenon in detail in chapter 6, section 9. As I explain in the book, artificial credit expansion and the (fiduciary) inflation of media of exchange offer no short cut to stable and sustained economic development, no way of avoiding the necessary sacrifice and discipline behind all high rates of voluntary saving. (In fact, particularly in the United States, voluntary saving has not only failed to increase in recent years, but at times has even fallen to a negative rate.) Indeed, the artificial expansion of credit and money is never more than a short-term solution, and that at best. In fact, today there is no doubt about the recessionary quality the monetary shock always has in the long run: newly-created loans (of money citizens have not first saved) immediately provide entrepreneurs with purchasing power they use in overly ambitious investment projects (in recent years, especially in the building sector and real estate development). In other words, entrepreneurs act as if citizens had increased their saving, when they have not actually done so. Widespread discoordination in the economic system results: the financial bubble (“irrational exuberance”) exerts a harmful effect on the real economy, and sooner or later the process reverses in the form of an economic recession, which marks the beginning of the painful and necessary readjustment. This readjustment invariably requires the reconversion of every real productive structure inflation has distorted. The specific triggers of the end of the euphoric monetary “binge” and the beginning of the recessionary “hangover” are many, and they can vary from one cycle to another. In the current circumstances, the most obvious triggers have been the rise in the price of raw materials, particularly oil, the subprime mortgage crisis in the United States, and finally, the failure of important banking institutions when it became clear in the market that the value of their liabilities exceeded that of their assets (mortgage loans granted). At present, numerous self-interested voices are demanding further reductions in interest rates and new injections of money which permit those who desire it to complete their investment projects without suffering losses. Nevertheless, this escape forward would only temporarily postpone problems at the cost of making them far more serious later. The crisis has hit because the profits of capital-goods companies (especially in the building sector and in real-estate development) have disappeared due to the entrepreneurial errors provoked by cheap credit, and because the prices of consumer goods have begun to perform relatively less poorly than those of capital goods. At this point, a painful, inevitable readjustment begins, and in addition to a decrease in production and an increase in unemployment, we are now still seeing a harmful rise in the prices of consumer goods (stagflation). The most rigorous economic analysis and the coolest, most balanced interpretation of recent economic and financial events support the conclusion that central banks (which are true financial central-planning agencies) cannot possibly succeed in finding the most advantageous monetary policy at every moment. This is exactly what became clear in the case of the failed attempts to plan the former Soviet economy from above. To put it another way, the theorem of the economic impossibility of socialism, which the Austrian economists Ludwig von Mises and Friedrich A. Hayek discovered, is fully applicable to central banks in general, and to the Federal Reserve—(at one time) Alan Greenspan and (currently) Ben Bernanke—in particular. According to this theorem, it is impossible to organize society, in terms of economics, based on coercive commands issued by a planning agency, since such a body can never obtain the information it needs to infuse its commands with a coordinating nature. Indeed, nothing is more dangerous than to indulge in the “fatal conceit”—to use Hayek’s useful expression—of believing oneself omniscient or at least wise and powerful enough to be able to keep the most suitable monetary policy fine tuned at all times. Hence, rather than soften the most violent ups and downs of the economic cycle, the Federal Reserve and, to some lesser extent, the European Central Bank, have most likely been their main architects and the culprits in their worsening. Therefore, the dilemma facing Ben Bernanke and his Federal Reserve Board, as well as the other central banks (beginning with the European Central Bank), is not at all comfortable. For years they have shirked their monetary responsibility, and now they find themselves in a blind alley. They can either allow the recessionary process to begin now, and with it the healthy and painful readjustment, or they can escape forward toward a “hair of the dog” cure. With the latter, the chances of even more severe stagflation in the not-too-distant future increase exponentially. (This was precisely the error committed following the stock market crash of 1987, an error which led to the inflation at the end of the 1980s and concluded with the sharp recession of 1990–1992.) Furthermore, the reintroduction of a cheap-credit policy at this stage could only hinder the necessary liquidation of unprofitable investments and company reconversion. It could even wind up prolonging the recession indefinitely, as has occurred in Japan in recent years: though all possible interventions have been tried, the Japanese economy has ceased to respond to any monietarist stimulus involving credit expansion or Keynesian methods. It is in this context of “financial schizophrenia” that we must interpret the latest “shots in the dark” fired by the monetary authorities (who have two totally contradictory responsibilities: both to control inflation and to inject all the liquidity necessary into the financial system to prevent its collapse). Thus, one day the Federal Reserve rescues Bear Stearns, AIG, Fannie Mae, and Freddie Mac or Citigroup, and the next it allows Lehman Brothers to fail, under the amply justified pretext of “teaching a lesson” and refusing to fuel moral hazard. Then, in light of the way events were unfolding, a 700-billion-dollar plan to purchase the euphemistically named “toxic” or “illiquid” (i.e., worthless) assets from the banking system was approved. If the plan is financed by taxes (and not more inflation), it will mean a heavy tax burden on households, precisely when they are least able to bear it. Finally, in view of doubts about whether such a plan could have any effect, the choice was made to inject public money directly into banks, and even to “guarantee” the total amount of their deposits, decreasing interest rates to almost zero percent. In comparison, the economies of the European Union are in a somewhat less poor state (if we do not consider the expansionary effect of the policy of deliberately depreciating the dollar, and the relatively greater European rigidities, particularly in the labor market, which tend to make recessions in Europe longer and more painful). The expansionary policy of the European Central Bank, though not free of grave errors, has been somewhat less irresponsible than that of the Federal Reserve. Furthermore, fulfillment of the convergence criteria involved at the time a healthy and significant rehabilitation of the chief European economies. Only the countries on the periphery, like Ireland and particularly Spain, were immersed in considerable credit expansion from the time they initiated their processes of convergence. The case of Spain is paradigmatic. The Spanish economy underwent an economic boom which, in part, was due to real causes (liberalizing structural reforms which originated with José María Aznar’s administration in 1996). Nevertheless, the boom was also largely fueled by an artificial expansion of money and credit, which grew at a rate nearly three times that of the corresponding rates in France and Germany. Spanish economic agents essentially interpreted the decrease in interest rates which resulted from the convergence process in the easy-money terms traditional in Spain: a greater availability of easy money and mass requests for loans from Spanish banks (mainly to finance realestate speculation), loans which these banks have granted by creating the money ex nihilo while European central bankers looked on unperturbed. When faced with the rise in prices, the European Central Bank has remained faithful to its mandate and has tried to maintain interest rates as long as possible, despite the difficulties of those members of the Monetary Union which, like Spain, are now discovering that much of their investment in real estate was in error and are heading for a lengthy and painful reorganization of their real economy. Under these circumstances, the most appropriate policy would be to liberalize the economy at all levels (especially in the labor market) to permit the rapid reallocation of productive factors (particularly labor) to profitable sectors. Likewise, it is essential to reduce public spending and taxes, in order to increase the available income of heavily-indebted economic agents who need to repay their loans as soon as possible. Economic agents in general and companies in particular can only rehabilitate their finances by cutting costs (especially labor costs) and paying off loans. Essential to this aim are a very flexible labor market and a much more austere public sector. These factors are fundamental if the market is to reveal as quickly as possible the real value of the investment goods produced in error and thus lay the foundation for a healthy, sustained economic recovery in a future which, for the good of all, I hope is not long in coming. We must not forget that a central feature of the recent period of artificial expansion was a gradual corruption, on the American continent as well as in Europe, of the traditional principles of accounting as practiced globally for centuries. To be specific, acceptance of the International Accounting Standards (IAS) and their incorporation into law in different countries (in Spain via the new General Accounting Plan, in effect as of January 1, 2008) have meant the abandonment of the traditional principle of prudence and its replacement by the principle of fair value in the assessment of the value of balance sheet assets, particularly financial assets. In this abandonment of the traditional principle of prudence, a highly influential role has been played by brokerages, investment banks (which are now on their way to extinction), and in general, all parties interested in “inflating” book values in order to bring them closer to supposedly more “objective” stockmarket values, which in the past rose continually in an economic process of financial euphoria. In fact, during the years of the “speculative bubble,” this process was characterized by a feedback loop: rising stock-market values were immediately entered into the books, and then such accounting entries were sought as justification for further artificial increases in the prices of financial assets listed on the stock market. In this wild race to abandon traditional accounting principles and replace them with others more “in line with the times,” it became common to evaluate companies based on unorthodox suppositions and purely subjective criteria which in the new standards replace the only truly objective criterion (that of historical cost). Now, the collapse of financial markets and economic agents’ widespread loss of faith in banks and their accounting practices have revealed the serious error involved in yielding to the IAS and their abandonment of traditional accounting principles based on prudence, the error of indulging in the vices of creative, fair-value accounting. It is in this context that we must view the recent measures taken in the United States and the European Union to “soften” (i.e., to partially reverse) the impact of fair-value accounting for financial institutions. This is a step in the right direction, but it falls short and is taken for the wrong reasons. Indeed, those in charge at financial institutions are attempting to “shut the barn door when the horse is bolting”; that is, when the dramatic fall in the value of “toxic” or “illiquid” assets has endangered the solvency of their institutions. However, these people were delighted with the new IAS during the preceding years of “irrational exuberance,” in which increasing and excessive values in the stock and financial markets graced their balance sheets with staggering figures corresponding to their own profits and net worth, figures which in turn encouraged them to run risks (or better, uncertainties) with practically no thought of danger. Hence, we see that the IAS act in a pro-cyclic manner by heightening volatility and erroneously biasing business management: in times of prosperity, they create a false “wealth effect” which prompts people to take disproportionate risks; when, from one day to the next, the errors committed come to light, the loss in the value of assets immediately decapitalizes companies, which are obliged to sell assets and attempt to recapitalize at the worst moment, i.e., when assets are worth the least and financial markets dry up. Clearly, accounting principles which, like those of the IAS, have proven so disturbing must be abandoned as soon as possible, and all of the accounting reforms recently enacted, specifically the Spanish one, which came into effect January 1, 2008, must be reversed. This is so not only because these reforms mean a dead end in a period of financial crisis and recession, but especially because it is vital that in periods of prosperity we stick to the principle of prudence in valuation, a principle which has shaped all accounting systems from the time of Luca Pacioli at the beginning of the fifteenth century to the adoption of the false idol of the IAS. In short, the greatest error of the accounting reform recently introduced worldwide is that it scraps centuries of accounting experience and business management when it replaces the prudence principle, as the highest ranking among all traditional accounting principles, with the “fair value” principle, which is simply the introduction of the volatile market value for an entire set of assets, particularly financial assets. This Copernican turn is extremely harmful and threatens the very foundations of the market economy for several reasons. First, to violate the traditional principle of prudence and require that accounting entries reflect market values is to provoke, depending upon the conditions of the economic cycle, an inflation of book values with surpluses which have not materialized and which, in many cases, may never materialize. The artificial “wealth effect” this can produce, especially during the boom phase of each economic cycle, leads to the allocation of paper (or merely temporary) profits, the acceptance of disproportionate risks, and in short, the commission of systematic entrepreneurial errors and the consumption of the nation’s capital, to the detriment of its healthy productive structure and its capacity for long-term growth. Second, I must emphasize that the purpose of accounting is not to reflect supposed “real” values (which in any case are subjective and which are determined and vary daily in the corresponding markets) under the pretext of attaining a (poorly understood) “accounting transparency.” Instead, the purpose of accounting is to permit the prudent management of each company and to prevent capital consumption, by applying strict standards of accounting conservatism (based on the prudence principle and the recording of either historical cost or market value, whichever is less), standards which ensure at all times that distributable profits come from a safe surplus which can be distributed without in any way endangering the future viability and capitalization of the company. Third, we must bear in mind that in the market there are no equilibrium prices a third party can objectively determine. Quite the opposite is true; market values arise from subjective assessments and fluctuate sharply, and hence their use in accounting eliminates much of the clarity, certainty, and information balance sheets contained in the past. Today, balance sheets have become largely unintelligible and useless to economic agents. Furthermore, the volatility inherent in market values, particularly over the economic cycle, robs accounting based on the “new principles” of much of its potential as a guide for action for company managers and leads them to systematically commit major errors in management, errors which have been on the verge of provoking the severest financial crisis to ravage the world since 1929. In chapter 9 of this book (pages 789–803), I design a process of transition toward the only world financial order which, being fully compatible with the free-enterprise system, can eliminate the financial crises and economic recessions which cyclically affect the world’s economies. The proposal the book contains for international financial reform has acquired extreme relevance at the present time (November 2008), in which the disconcerted governments of Europe and America have organized a world conference to reform the international monetary system in order to avoid in the future such severe financial and banking crises as the one that currently grips the entire western world. As is explained in detail over the nine chapters of this book, any future reform will fail as miserably as past reforms unless it strikes at the very root of the present problems and rests on the following principles: (1) the reestablishment of a 100-percent reserve requirement on all bank demand deposits and equivalents; (2) the elimination of central banks as lenders of last resort (which will be unnecessary if the preceding principle is applied, and harmful if they continue to act as financial central-planning agencies); and (3) the privatization of the current, monopolistic, and fiduciary state-issued money and its replacement with a classic pure gold standard. This radical, definitive reform would essentially mark the culmination of the 1989 fall of the Berlin Wall and real socialism, since the reform would mean the application of the same principles of liberalization and private property to the only sphere, that of finance and banking, which has until now remained mired in central planning (by “central” banks), extreme interventionism (the fixing of interest rates, the tangled web of government regulations), and state monopoly (legal tender laws which require the acceptance of the current, state-issued fiduciary money), circumstances with very negative and dramatic consequences, as we have seen. I should point out that the transition process designed in the last chapter of this book could also permit from the outset the bailing out of the current banking system, thus preventing its rapid collapse, and with it the sudden monetary squeeze which would be inevitable if, in an environment of widespread broken trust among depositors, a significant volume of bank deposits were to disappear. This short-term goal, which at present, western governments are desperately striving for with the most varied plans (the massive purchases of “toxic” bank assets, the ad hominem guarantee of all deposits, or simply the partial or total nationalization of the private banking system), could be reached much faster and more effectively, and in a manner much less harmful to the market economy, if the first step in the proposed reform (pages 791–98) were immediately taken: to back the total amount of current bank deposits (demand deposits and equivalents) with cash, bills to be turned over to banks, which from then on would maintain a 100-percent reserve with respect to deposits. As illustrated in chart IX-2 of chapter 9, which shows the consolidated balance sheet for the banking system following this step, the issuance of these banknotes would in no way be inflationary (since the new money would be “sterilized,” so to speak, by its purpose as backing to satisfy any sudden deposit withdrawals). Furthermore, this step would free up all banking assets (“toxic” or not) which currently appear as backing for demand deposits (and equivalents) on the balance sheets of private banks. On the assumption that the transition to the new financial system would take place under “normal” circumstances, and not in the midst of a financial crisis as acute as the current one, I proposed in chapter 9 that the “freed” assets be transferred to a set of mutual funds created ad hoc and managed by the banking system, and that the shares in these funds be exchanged for outstanding treasury bonds and for the implicit liabilities connected with the public social-security system (pp. 796–97). Nevertheless, in the current climate of severe financial and economic crisis, we have another alternative: apart from canceling “toxic” assets with these funds, we could devote a portion of the rest, if desired, to enabling savers (not depositors, since their deposits would already be backed 100 percent) to recover a large part of the value lost in their investments (particularly in loans to commercial banks, investment banks, and holding companies). These measures would immediately restore confidence and would leave a significant remainder to be exchanged, once and for all and at no cost, for a sizeable portion of the national debt, our initial aim. In any case, an important warning must be given: naturally, and I must never tire of repeating it, the solution proposed is only valid in the context of an irrevocable decision to reestablish a free-banking system subject to a 100-percent reserve requirement on demand deposits. Any of the reforms noted above, if adopted in the absence of a prior, firm conviction and decision to change the international financial and banking system as indicated, would be simply disastrous: a private banking system which continued to operate with a fractional reserve (orchestrated by the corresponding central banks), would generate, in a cascading effect, and based on the cash created to back deposits, an inflationary expansion like none other in history, one which would eventually finish off our entire economic system. The above considerations are crucially important and reveal how very relevant this treatise has now become in light of the critical state of the international financial system (though I would definitely have preferred to write the preface to this new edition under very different economic circumstances). Nevertheless, while it is tragic that we have arrived at the current situation, it is even more tragic, if possible, that there exists a widespread lack of understanding regarding the causes of the phenomena that plague us, and especially an atmosphere of confusion and uncertainty prevalent among experts, analysts, and most economic theorists. In this area at least, I can hope the successive editions of this book which are being published all over the world may contribute to the theoretical training of readers, to the intellectual rearmament of new generations, and eventually, to the sorely needed institutional redesign of the entire monetary and financial system of current market economies. If this hope is fulfilled, I will not only view the effort made as worthwhile, but will also deem it a great honor to have contributed, even in a very small way, to movement in the right direction. Jesús Huerta de Soto Madrid November 13, 2008

A Challenge For 2012 – Part One

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Dear Reader, It has been 100 years since the publication of Ludwig von Mises’s The Theory of Money and Credit. I post here the 1934 preface written by Mises that is sadly so relevant to the events of today. If you haven’t yet found time to read this masterwork, I hope this excerpt piques your interest.  It is a foundational text of economics, particularly of the branch that has become known as the Austrian School. Please take note: Mises just thought he was expounding economic orthodoxy very much as a mainstream economist – oh how the profession has regressed in these last 100 years!

PREFACE TO THE ENGLISH EDITION

The outward guise assumed by the questions with which banking and currency policy is concerned changes from month to month and from year to year. Amid this flux, the theoretical apparatus which enables us to deal with these questions remains unaltered. In fact, the value of economics lies in its enabling us to recognize the true significance of problems, divested of their accidental trimmings. No very deep knowledge of economics is usually needed for grasping the immediate effects of a measure; but the task of economics is to foretell the remoter effects, and so to allow us to avoid such acts as attempt to remedy a present ill by sowing the seeds of a much greater ill for the future. Ten years have elapsed since the second German edition of the present book was published. During this period the external appearance of the currency and banking problems of the world has completely altered. But closer examination reveals that the same fundamental issues are being contested now as then. Then, England was on the way to raising the gold-value of the pound once more to its pre-war level. It was overlooked that prices and wages had adapted themselves to the lower value and that the re-establishment of the pound at the pre-war parity was bound to lead to a fall in prices which would make the position of the entrepreneur more difficult and so increase the disproportion between actual wages and the wages that would have been paid in a free market. Of course, there were some reasons for attempting to re-establish the old parity, even despite the indubitable drawbacks of such a proceeding. The decision should have been made after due consideration of the pros and cons of such a policy. The fact that the step was taken without the public having been sufficiently informed beforehand of its inevitable drawbacks, extraordinarily strengthened the opposition to the gold standard. And yet the evils that were complained of were not due to the resumption of the gold standard, as such, but solely to the gold value of the pound having been stabilized at a higher level than corresponded to the level of prices and wages in the United Kingdom. From 1926 to 1929 the attention of the world was chiefly focused upon the question of American prosperity. As in all previous booms brought about by expansion of credit, it was then believed that the prosperity would last forever, and the warnings of the economists were disregarded. The turn of the tide in 1929 and the subsequent severe economic crisis were not a surprise for economists; they had foreseen them, even if they had not been able to predict the exact date of their occurrence. The remarkable thing in the present situation is not the fact that we have just passed through a period of credit expansion that has been followed by a period of depression, but the way in which governments have been and are reacting to these circumstances. The universal endeavor has been made, in the midst of the general fall of prices, to ward off the fall in money wages, and to employ public resources on the one hand to bolster up undertakings that would otherwise have succumbed to the crisis, and on the other hand to give an artificial stimulus to economic life by public works schemes. This has had the consequence of eliminating just those forces which in previous times of depression have eventually effected the adjustment of prices and wages to the existing circumstances and so paved the way for recovery. The unwelcome truth has been ignored that stabilization of wages must mean increasing unemployment and the perpetuation of the disproportion between prices and costs and between outputs and sales which is the symptom of a crisis. This attitude was dictated by purely political considerations. Governments did not want to cause unrest among the masses of their wage-earning subjects. They did not dare to oppose the doctrine that regards high wages as the most important economic ideal and believes that trade-union policy and government intervention can maintain the level of wages during a period of falling prices. And governments have therefore done everything to lessen or remove entirely the pressure exerted by circumstances upon the level of wages. In order to prevent the underbidding of trade-union wages, they have given unemployment benefits to the growing masses of those out of work and they have prevented the central banks from raising the rate of interest and restricting credit and so giving free play to the purging process of the crisis. When governments do not feel strong enough to procure by taxation or borrowing the resources to meet what they regard as irreducible expenditure, or, alternatively, so to restrict their expenditure that they are able to make do with the revenue that they have, recourse on their part to the issue of inconvertible notes and a consequent fall in the value of money are something that has occurred more than once in European and American history. But the motive for recent experiments in depreciation has been by no means fiscal. The gold content of the monetary unit has been reduced in order to maintain the domestic wage level and price level, and in order to secure advantages for home industry against its competitors in international trade. Demands for such action are no new thing either in Europe or in America. But in all previous cases, with a few significant exceptions, those who have made these demands have not had the power to secure their fulfilment. In this case, however, Great Britain began by abandoning the old gold content of the pound. Instead of preserving its gold value by employing the customary and never-failing remedy of raising the bank rate, the government and parliament of the United Kingdom, with bank rate at four and one-half percent, preferred to stop the redemption of notes at the old legal parity and so to cause a considerable fall in the value of sterling. The object was to prevent a further fall of prices in England and above all, apparently, to avoid a situation in which reductions of wages would be necessary. The example of Great Britain was followed by other countries, notably by the United States. President Roosevelt reduced the gold content of the dollar because he wished to prevent a fall in wages and to restore the price level of the prosperous period between 1926 and 1929. In central Europe, the first country to follow Great Britain’s example was the Republic of Czechoslovakia. In the years immediately after the war, Czechoslovakia, for reasons of prestige, had heedlessly followed a policy which aimed at raising the value of the krone, and she did not come to a halt until she was forced to recognize that increasing the value of her currency meant hindering the exportation of her products, facilitating the importation of foreign products, and seriously imperiling the solvency of all those enterprises that had procured a more or less considerable portion of their working capital by way of bank credit. During the first few weeks of the present year, however, the gold parity of the krone was reduced in order to lighten the burden of the debtor enterprises, and in order to prevent a fall of wages and prices and so to encourage exportation and restrict importation. Today, in every country in the world, no question is so eagerly debated as that of whether the purchasing power of the monetary unit shall be maintained or reduced. It is true that the universal assertion is that all that is wanted is the reduction of purchasing power to its previous level, or even the prevention of a rise above its present level. But if this is all that is wanted, it is very difficult to see why the 1926-29 level should always be aimed at, and not, say, that of 1913. If it should be thought that index numbers offer us an instrument for providing currency policy with a solid foundation and making it independent of the changing economic programs of governments and political parties, perhaps I may be permitted to refer to what I have said in the present work on the impossibility of singling out any particular method of calculating index numbers as the sole scientifically correct one and calling all the others scientifically wrong. There are many ways of calculating purchasing power by means of index numbers, and every single one of them is right, from certain tenable points of view; but every single one of them is also wrong, from just as many equally tenable points of view. Since each method of calculation will yield results that are different from those of every other method, and since each result, if it is made the basis of prac tical measures, will further certain interests and injure others, it is obvious that each group of persons will declare for those methods that will best serve its own interests. At the very moment when the manipulation of purchasing power is declared to be a legitimate concern of currency policy, the question of the level at which this purchasing power is to be fixed will attain the highest political significance. Under the gold standard, the determination of the value of money is dependent upon the profitability of gold production. To some, this may appear a disadvantage; and it is certain that it introduces an incalculable factor into economic activity. Nevertheless, it does not lay the prices of commodities open to violent and sudden changes from the monetary side. The biggest variations in the value of money that we have experienced during the last century have originated not in the circumstances of gold production, but in the policies of governments and banks-of-issue. Dependence of the value of money on the production of gold does at least mean its independence of the politics of the hour The dissociation of the currencies from a definitive and unchangeable gold parity has made the value of money a plaything of politics. Today we see considerations of the value of money driving all other considerations into the background in both domestic and international economic policy. We are not very far now from a state of affairs in which “economic policy” is primarily understood to mean the question of influencing the purchasing power of money. Are we to maintain the present gold content of the currency unit, or are we to go over to a lower gold content? That is the question that forms the principal issue nowadays in the economic policies of all European and American countries. Perhaps we are already in the midst of a race to reduce the gold content of the currency unit with the object of obtaining transitory advantages (which, moreover, are based on self-deception) in the commercial war which the nations of the civilized world have been waging for decades with increasing acrimony, and with disastrous effects upon the welfare of their subjects. It is an unsatisfactory designation of this state of affairs to call it an emancipation from gold. None of the countries that have “abandoned the gold standard” during the last few years has been able to affect the significance of gold as a medium of exchange either at home or in the world at large. What has occurred has not been a departure from gold, but a departure from the old legal gold parity of the currency unit and, above all, a reduction of the burden of the debtor at the cost of the creditor, even though the principal aim of the measures may have been to secure the greatest possible stability of nominal wages, and sometimes of prices also. Besides the countries that have debased the gold value of their currencies for the reasons described, there is another group of countries that refuse to acknowledge the depreciation of their money in terms of gold that has followed upon an excessive expansion of the domestic note circulation, and maintain the fiction that their currency units still possess their legal gold value, or at least a gold value in excess of its real level. In order to support this fiction they have issued foreign-exchange regulations which usually require exporters to sell foreign exchange at its legal gold value, that is, at a considerable loss. The fact that the amount of foreign money that is sold to the central banks in such circumstances is greatly diminished can hardly require further elucidation. In this way a “shortage of foreign exchange” (‘Devisennot’) arises in these countries. Foreign exchange is in fact unobtainable at the prescribed price, and the central bank is debarred from recourse to the illicit market in which foreign exchange is dealt in at its proper price because it refuses to pay this price. This “shortage” is then made the excuse for talk about transfer difficulties and for prohibitions of interest and amortization payments to foreign countries. And this has practically brought international credit to a standstill. Interest and amortization are paid on old debts either very unsatisfactorily or not at all, and, as might be expected, new international credit transactions hardly continue to be a subject of serious consideration. We are no longer far removed from a situation in which it will be impossible to lend money abroad because the principle has gradually become accepted that any government is justified in forbidding debt payments to foreign countries at any time on grounds of “foreign-exchange policy.” The real meaning of this foreign-exchange policy is exhaustively discussed in the present book. Here let it merely be pointed out that this policy has much more seriously injured international economic relations during the last three years than protectionism did during the whole of the preceding fifty or sixty years, the measures that were taken during the world war included. This throttling of international credit can hardly be remedied otherwise than by setting aside the principle that it lies within the discretion of every government, by invoking the shortage of foreign exchange that has been caused by its own actions, to stop paying interest to foreign countries and also to prohibit interest and amortization payments on the part of its subjects. The only way in which this can be achieved will be by removing international credit transactions from the influence of national legislatures and creating a special international code for it, guaranteed and really enforced by the League of Nations. Unless these conditions are created, the granting of new international credit will hardly be possible. Since all nations have an equal interest in the restoration of international credit, it may probably be expected that attempts will be made in this direction during the next few years, provided that Europe does not sink any lower through war and revolution. But the monetary system that will constitute the foundation of such future agreements must necessarily be one that is based upon gold. Gold is not an ideal basis for a monetary system. Like all human creations, the gold standard is not free from shortcomings; but in the existing circumstances there is no other way of emancipating the monetary system from the changing influences of party politics and government interference, either in the present or, so far as can be foreseen, in the future. And no monetary system that is not free from these influences will be able to form the basis of credit transactions. Those who blame the gold standard should not forget that it was the gold standard that enabled the civilization of the nineteenth century to spread beyond the old capitalistic countries of Western Europe, and made the wealth of these countries available for the development of the rest of the world. The savings of the few advanced capitalistic countries of a small part of Europe have called into being the modern productive equipment of the whole world. If the debtor countries refuse to pay their existing debts, they certainly ameliorate their immediate situation. But it is very questionable whether they do not at the same time greatly damage their future prospects. It consequently seems misleading in discussions of the currency question to talk of an opposition between the interests of creditor and debtor nations, of those which are well supplied with capital and those which are ill supplied. It is the interests of the poorer countries, who are dependent upon the importation of foreign capital for developing their productive resources, that make the throttling of international credit seem so extremely dangerous. The dislocation of the monetary and credit system that is nowadays going on everywhere is not due—the fact cannot be repeated too often—to any inadequacy of the gold standard. The thing for which the monetary system of our time is chiefly blamed, the fall in prices during the last five years, is not the fault of the gold standard, but the inevitable and ineluctable consequence of the expansion of credit, which was bound to lead eventually to a collapse. And the thing which is chiefly advocated as a remedy is nothing but another expansion of credit, such as certainly might lead to a transitory boom, but would be bound to end in a correspondingly severer crisis. The difficulties of the monetary and credit system are only a part of the great economic difficulties under which the world is at present suffering. It is not only the monetary and credit system that is out of gear, but the whole economic system. For years past, the economic policy of all countries has been in conflict with the principles on which the nineteenth century built up the welfare of the nations. International division of labour is now regarded as an evil, and there is a demand for a return to the autarky of remote antiquity. Every importation of foreign goods is heralded as a misfortune, to be averted at all costs. With prodigious ardour, mighty political parties proclaim the gospel that peace on earth is undesirable and that war alone means progress. They do not content themselves with describing war as a reasonable form of international intercourse, but recommend the employment of force of arms for the suppression of opponents even in the solution of questions of domestic politics. Whereas liberal economic policy took pains to avoid putting obstacles in the way of developments that allotted every branch of production to the locality in which it secured the greatest productivity to labour, nowadays the endeavour to establish enterprises in places where the conditions of production are unfavourable is regarded as a patriotic action that deserves government support. To demand of the monetary and credit system that it should do away with the consequences of such perverse economic policy, is to demand something that is a little unfair. All proposals that aim to do away with the consequences of perverse economic and financial policy, merely by reforming the monetary and banking system, are fundamentally misconceived. Money is nothing but a medium of exchange and it completely fulfils its function when the exchange of goods and services is carried on more easily with its help than would be possible by means of barter. Attempts to carry out economic reforms from the monetary side can never amount to anything but an artificial stimulation of economic activity by an expansion of the circulation, and this, as must constantly be emphasized, must necessarily lead to crisis and depression. Recurring economic crises are nothing but the consequence of attempts, despite all the teachings of experience and all the warnings of the economists, to stimulate economic activity by means of additional credit. This point of view is sometimes called the “orthodox” because it is related to the doctrines of the Classical economists who are Great Britain’s imperishable glory; and it is contrasted with the “modern” point of view which is expressed in doctrines that correspond to the ideas of the Mercantilists of the sixteenth and seventeenth centuries. I cannot believe that there is really anything to be ashamed of in orthodoxy. The important thing is not whether a doctrine is orthodox or the latest fashion, but whether it is true or false. And although the conclusion to which my investigations lead, that expansion of credit cannot form a substitute for capital, may well be a conclusion that some may find uncomfortable, yet I do not believe that any logical disproof of it can be brought forward. LUDWIG VON MISES Vienna June 1934

Opponents Of Gold, Get On Your Mark

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A good article from Brian Domitrovic on Forbes.com:

Let’s face it – we’ve seen what arbitrary government control and central bank manipulation can do. Namely, what the Federal Reserve has done since 2008. This is to scare everyone away from the currency such that there’s no investment, with inflation hedges (such as gold) shooting the moon, all the while stiffing the small defaulter and bailing out the biggest of the big. This kind of anti-democratic monopolism is exactly what the gold standard forestalls, and The True Gold Standard explains why, among much else, in less than a hundred tidy pages. Here’s another exquisite recommendation from the book: given gold, government bonds can’t count as bank reserves. This will do two things. First, dry up the market for government debt, an unqualified good in our age of trillion-dollar deficits. And second, release bank assets to be at the service of the real economy.

Bandits With Begging Bowls

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A recent CNBC article by Catherine Boyle has some classic quotes from Sean Corrigan:

The euro zone’s banks, seen by many as the source of the region’s debt crisis, will ultimately be bailed out by “vested interests,” Sean Corrigan, chief investment strategist, Diapason Commodities Management, said. “There may be one or two forced to merge or to fall by the wayside, but all the vested interests will come back together,” he said. “We don’t allow for the market or competitive forces to come to their full severity, and when these guys act like bandits in the good times and come with begging bowls in the bad, we criticize capitalism.”

On the euro zone deal:

“They have averted a collapse this way, but they themselves don’t know what they have put in place,” Corrigan said of the EU leaders. “There’s this idea that it will conduct some little bit of magic, that these guys in the financial markets, who we hate, have been conducting and this will simply make Italy’s debt lower and Greece competitive. Yet nobody knows what the details are.”

On policy closer to home:

“Whether or not you believe the government should be setting banking policy rather than bankers, the issue is that the government didn’t take any executive control,” Corrigan said. “If that’s going to happen, there should be a clear program of forcibly putting the bank back in the hands of the market in a set time. I don’t see that happening in Britain.”

Sean of course had more to say that didn’t make it into the article, but even so, it’s great to see our message relayed in the mainstream press.

The Iinflationist View Of History

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This chapter from Human Action is spot on for today:

Part 4, Chapter XVII. INDIRECT EXCHANGE

18. The Inflationist View of History

A very popular doctrine maintains that progressive lowering of the monetary unit’s purchasing power played a decisive role in historical evolution. It is asserted that mankind would not have reached its present state of well-being if the supply of money had not increased to a greater extent than the demand for money. The resulting fall in purchasing power, it is said, was a necessary condition of economic progress. The intensification of the division of labor and the continuous growth of capital accumulation, which have centupled the productivity of labor, could ensue only in a world of progressive price rises. Inflation creates prosperity and wealth; deflation distress and economic decay.[25] A survey of political literature and of the ideas that guided for centuries the monetary and credit policies of the nations reveals that this opinion is almost generally accepted. In spite of all warnings on the part of economists it is still today the core of the layman’s economic philosophy. It is no less the essence of the teachings of Lord Keynes and his disciples in both hemispheres. The popularity of inflationism is in great part due to deep-rooted hatred of creditors. Inflation is considered just because it favors debtors at the expense of creditors. However, the inflationist view of history which we have to deal with in this section is only loosely related to this anticreditor argument. Its assertion that “expansionism” is the driving force of economic progress and that “restrictionism” is the worst of all evils is mainly based on other arguments. It is obvious that the problems raised by the inflationist doctrine cannot be solved by a recourse to the teachings of historical experience. It is beyond doubt that the history or prices shows, by and large, a continuous, although sometimes for short periods interrupted, upward trend. It is of course impossible to establish this fact otherwise than by historical understanding. Catallactic precision cannot be applied to historical problems. The endeavors of some historians and statisticians to trace back the changes in the purchasing power of the precious metals for centuries, and to measure them, are futile. It has been shown already that all attempts to measure economic magnitudes are based on entirely fallacious assumptions and display ignorance of the fundamental principles both of economics and of history. But what history by means of its specific methods can tell us in this field is enough to justify the assertion that the purchasing power of money has for centuries shown a tendency to fall. With regard to this point all people agree. But this is not the problem to be elucidated. The question is whether the fall in purchasing power was or was not an indispensable factor in the evolution which led from the poverty of ages gone by to the more satisfactory conditions of modern Western capitalism. This question must be answered without reference to the historical experience, which can be and always is interpreted in different ways, and to which supporters and adversaries of every theory and of every explanation of history refer as a proof of their mutually contradictory and incompatible statements. What is needed is a clarification of the effects of changes in purchasing power on the division of labor, the accumulation of capital, and technological improvement. In dealing with this problem one cannot satisfy oneself with the refutation of the arguments advanced by the inflationists in support of their thesis. The absurdity of these arguments is so manifest that their refutation and exposure is easy indeed. From its very beginnings economics has shown again and again that assertions concerning the alleged blessings of an abundance of money and the alleged disasters of a scarcity of money are the outcome of crass errors in reasoning. The endeavors of the apostles of inflationism and expansionism to refute the correctness of the economists’ teachings have failed utterly. The only relevant question is this: Is it possible or not to lower the rate of interest lastingly by means of credit expansion? This problem will tb treated exhaustively in the chapter dealing with the interconnection between the money relation and the rate of interest. There it will be shown what the consequences of booms created by credit expansion must be. But we must ask ourselves at this point of our inquiries whether it is not possible that there are other reasons which could be advanced in favor of the inflationary interpretation of history. Is it not possible that the champions of inflation have neglected to resort to some valid arguments which could support their stand? It is certainly necessary to approach the issue from every possible avenue. Let us think of a world in which the quantity of money is rigid. At an early stage of history the inhabitants of this world have produced the whole quantity of the commodity employed for the monetary service which can possibly be produced. A further increase in the quantity of money is out of the question. Fiduciary media are unknown. All money-substitutes–the subsidiary coins included–are money-certificates. On these assumptions the intensification of the division of labor, the evolution from the economic self-sufficiency of households, villages, districts, and countries to the world-embracing market system of the nineteenth century, the progressive accumulation of capital, and the improvement of technological methods of production would have resulted in a continuous trend toward falling prices. Would such a rise in the purchasing power of the monetary unit have stopped the evolution of capitalism? The average businessman will answer this question in the affirmative. Living and acting in an environment in which a slow but continuous fall in the monetary unit’s purchasing power is deemed normal, necessary, and beneficial, he simply cannot comprehend a different state of affairs. He associates the notions of rising prices and profits on the one hand and of falling prices and losses on the other. The fact that there are bear operations too and that great fortunes have been made by bears does not shake his dogmatism. These are, he says, merely speculative transactions of people eager to profit from the fall in the prices of goods already produced and available. Creative innovations, new investments, and the application of improved technological methods require the inducement brought about by the expectation of price rises. Economic progress is possible only in a world of rising prices. This opinion is untenable. In a world of a rising purchasing power of the monetary unit everybody’s mode of thinking would have adjusted itself to this state of affairs, just as in our actual world it has adjusted itself to a falling purchasing power of the monetary unit. Today everybody is prepared to consider a rise in his nominal or monetary income as an improvement of his material well-being. People’s attention is directed more toward the rise in nominal wage rates and the money equivalent of wealth than to the increase in the supply of commodities. In a world of rising purchasing power for the monetary unit they would concern themselves more with the fall in living costs. This would bring into clearer relief the fact that economic progress consists primarily in making the amenities of life more easily accessible. In the conduct of business, reflections concerning the secular trend of prices do not bother any role whatever. Entrepreneurs and investors do not bother about secular trends. What guides their actions is their opinion about the movement of prices in the coming weeks, months. or at most years. They do not heed the general movement of all prices. What matters for them is the existence of discrepancies between the prices of the complementary factors of production and the anticipated prices of the products. No businessman embarks upon a definite production project because he believes that the prices, i.e., the prices of all goods and services, will rise. He engages himself if he believes that he can profit from a difference between the prices of goods of various orders. In a world with a secular tendency toward falling prices, such opportunities for earning profit will appear in the same way in which they appear in a world with a secular trend toward rising prices. The expectation of a general progressive upward movement of all prices does not bring about intensified production and improvement in well-being. It results in the “flight to real values,” in the crack-up boom and the complete breakdown of the monetary system. If the opinion that the prices of all commodities will drop becomes general, the short-term market rate of interest is lowered by the amount of the negative price premium.[26] Thus the entrepreneur employing borrowed funds is secured against the consequences of such a drop in prices to the same extent to which, under conditions of rising prices, the lender is secured through the price premium against the consequences of falling purchasing power. A secular tendency toward a rise in the monetary unit’s purchasing power would require rules of thumb on the part of businessmen and investors other than those developed under the secular tendency toward a fall in its purchasing power. But it would certainly not influence substantially the course of economic affairs. It would not remove the urge of people to improve their material well-being as far as possible by an appropriate arrangement of production. It would not deprive the economic system of the factors making for material improvement, namely, the striving of enterprising promoters after profit and the readiness of the public to buy those commodities which are apt to provide them the greatest satisfaction at the lowest costs. Such observations are certainly not a plea for a policy of deflation. They imply merely a refutation of the ineradicable inflationist fables. They unmask the illusiveness of Lord Keynes’s doctrine that the source of poverty and distress, of depression of trade, and of unemployment is to be seen in a “contractionist pressure.” It is not true that “a deflationary pressure … would have … prevented the development of modern industry.” It is not true that credit expansion brings about the “miracle … of turning a stone into bread.”[27] Economics recommends neither inflationary not deflationary policy. It does not urge the governments to tamper with the market’s choice of a medium of exchange. It establishes only the following truths: 1. By committing itself to an inflationary or deflationary policy a government does not promote the public welfare, the commonweal, or the interests of the whole nation. It merely favors one or several groups of the population at the expense of other groups. 2. It is impossible to know in advance which group will be favored by a definite inflationary or deflationary measure and to what extent. These effects depend on the whole complex of the market data involved. They also depend largely on the speed of the inflationary or deflationary movements and may be completely reversed with the progress of these movements. 3. At any rate, a monetary expansion results in misinvestment of capital and overconsumption. It leaves the nation as a whole poorer, not richer. These problems are dealt with in Chapter XX. 4. Continued inflation must finally end in the crack-up boom, the complete breakdown of the currency system. 5. Deflationary policy is costly for the treasury and unpopular with the masses. But inflationary policy is a boon for the treasury and very popular with the ignorant. Practically, the danger of deflation is but slight and the danger of inflation tremendous.

[25]. Cf. the critical study of Marianne von Herzfeld, “Die Geschichte als Funktion der Geldbewegung,” Archiv fuer Sozialwissenschaft, LVI, 654-686, and the writings quoted in this study. [26]. Cf. below, pp. 541-545. [27]. Quoted from: International Clearing Union, Text of a Paper Containing Proposals by British Experts for an International Clearing Union, April 8, 1943 (published by British Information Services, an Agency of the British Government), p. 12.

The Circular Flow Of Income Fallacy

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At the Tory Party Conference, the Prime Minister said:

The only way out of a debt crisis is to pay off your debts. That’s why households are paying down their credit card bills and store card bills. It means banks getting their books in order. And it means governments all over the world  – cutting spending and living within their means.

This contrasts with a recent Globe and Mail editorial by Martin Wolf:

What Mr. Cameron recommends is even nigh on impossible. Why is that? Is it not common sense that if one has borrowed too much, one must pay it back? Alas, what makes sense for individuals does not make sense for an economy, because one person’s spending is another person’s income. Consider a closed economy. Income and spending must match. If the private sector decided to spend less than its income, to pay down debt and if the government also decided to stop borrowing, aggregate incomes would fall until they could no longer achieve what they wanted. All they would obtain, by following Mr. Cameron’s advice, is a race to the economic bottom.

This is the gigantic cul-de-sac of the “Circular Flow of Income” that every 1st year economics undergraduate is taught in their opening macro class. Whilst it is true that one man’s spending is another man’s income, this truism says nothing about how that money is spent or whether it is conducive to prosperity. The aggregation makes the circular flow nothing more than a tautological statement.  I previously explored some of the negative routes that economists have embarked upon in this blog post from September 2009. Wolf is one of the FT’s most mainstream high-profile writers. Before Keynes he would have been considered a consumptionist crank of the sort that used to come to fore every few decades or so to be thoroughly discredited by any non-muddleheaded economist of the day. Now he and his type are in the majority. If your household had outgoings of £2,000 per month and income of £1,800, you have to either consume your saved capital, or borrow some else’s to the tune of £200 per month.  If there is no one to borrow from, or the amount you have borrowed is making it very burdensome for you to make any repayments (or even to cover the interest costs), then you need to cut back on your outgoings. Now if you cut back on your outgoings so you now spend £1,700 per month on a £1,800 per month income, it is happy days for you as you are accumulating £100 of capital per month. You are profitable. In this example, substitute you for a company and you can see how a company reliant upon debt can become a profitable contributor to society. Now with a sovereign government, the same logical of living within your means must also apply. Restoration of profitability is the only sure-fire way of establishing long-term recovery in the economy.  The aggregate expenditures of all being the aggregate income of all is in fact a red herring. What matters is the degree of profitability within the aggregate measures in all aspects of the economy, from the Sovereign State, through the corporations, to the humble household. This implies a deflating down of the credit-induced bubble. This is liquidation. This will mean creditors who have lent money unwisely to walking dead businesses, zombie governments and bozo corporations will not get all their money back. This means there will be some pain. The alternative proposed by Wolf and much of the economics profession is to inflate the debt away. This means that all the prudent and wise people who have saved to provide for themselves will see their savings eroded, and will be forced to live on less. Meanwhile, those who unwisely lent to households, corporations and governments who could never fulfill their promises will in nominal terms be spared any default on their debt. Morally, I prefer liquidation, just as I prefer a restoration of profitability to the current approach of maintaining the aggregate incomes and expenditures of all at unsustainable levels without regard to profit. Creating and perpetuating illusions is not for any sane politician or economist, only muddle-heads like Wolf.

Gingrich Adopts Gold Standard Model

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American Principles Project:

Washington, D.C.–Republican presidential candidate and former House Speaker Newt Gingrich called for “hard money with a very limited Federal Reserve” at the Republican presidential debate in New Hampshire on Tuesday. Gingrich is the third candidate to take this position. Herman Cain endorsed the gold standard at the American Principles Project Palmetto Freedom Forum in South Carolina last month and Ron Paul, who has been steadily advocating it for much of his career, raised it at last night’s debate.

If one of them disposes of Obama, this will be at the heart of any Republican agenda. When will our senior politicians start to entertain a move to honest money?

The Magicians At The Bank Of England (with close support from No 10 & 11 Downing Street)

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Who made this very sound statement two years ago in relation to QE I?

The last resort of desperate governments when all other policies have failed

Answer: George Osborne, our Chancellor.

Sometime soon it will have to stop because in the end printing money leads to inflation.

Answer: our Prime Minister. Both of these statements were made in 2009 when the first round of QE unfolded. If people are spending less, it follows that the money unit is being used less. Indeed corporate balance sheets are paying down debt and chalking up healthy cash balances. Coupled with this, in a fractional reserve system, when money gets repaid and not relent, as we know, it came from nothing, and it goes back to nothing. Personal savings are at their highest for many years as households do the same, pay off debt and replenish cash balances. Bank reserves are the highest they have been for a long time in relation to overall bank balance sheet size. God help us if people do start to spend again in the fashion of old as there will be the mother of all inflations. By the way, many empirical studies, most notably by Friedman, show us that the demand for money is very stable. As we have discussed here before, regime policy uncertainty will cause people to hold precautionary balances, but only for a short period of time. With the first round of QE of £200bn and now the second of £75bn we have nearly added 15% to the money supply. They way out for the Bank of England is to massively raise interest rates as part of a very tight money policy. Either way, this is bad news for us. Hoping a mild inflation will reduce our real debts over time is a very dangerous game. As soon as the inflation genie is out of the bottle, and we all realise that our money is depreciating, we will spend it, retailers will reprice to take into account the new demand, and prices will soar. They are hoping not only for a mild inflation, but also for those in receipt of the new money, the people who have had their gilts bought with the new money, to then go and spend it and get those “animal spirits” working again. So the bankers once again win. More expensive houses, more fast cars and boats, with their bonuses for organizing the buying of the gilts. The banks get the new money deposited with them and can then shore up their balance sheets even further, as I suspect they are still concerned about all the wonky property loans and dodgy sovereign debt they need to wipe off their books. Thus, giving effectively £75bn of money out of the ether to the banks will not have the desired effect of increasing lending or spending (besides the bankers’ toys already mentioned). We all just have our purchasing power diminished while that of the banking system is raised. They get the new wealth effect, not you! As most of these institutions are replete with failed corporate executives, still in the same jobs, who will more than likely repeat the same mistakes, who are regulated by the same people in differently named organizations, we have once more a recipe for disaster. As we always say on this site, the creditors get fleeced . A pensioner buying an annuity today with a £300k pension would have got £22,500 pa and now will get £18,500, should the yields go down to where they want it. The ongoing war on the poor is relentless.  Pensioners just have to swallow a 30% pay cut. Forget looters in Tottenham, we will have geriatrics in the streets of green and leafy middle class suburbia smashing the place up if they are not careful. They will suffer for the mistakes of past governments who in partnership with the banks created the mother of all credit booms, which has led to the largest misallocation of resources since the 30s. As blame for the artificial boom does not lie with the Conservative Party, but with the Blair and Brown money regimes, I can’t fathom why the current government keeps trying to repeat the policy mistakes of the previous one, especially when they condemned this approach to money policy back in 2009. One further thing, if they do pull yields down on gilts, this may well make borrowing costs marginally cheaper, but lets face it: if 50 basis points means you live or die in business, you are kidding yourself that you have a viable business anyway. Likewise, if you are a home owner who is so close to the wire that a fraction of a interest rate move wipes you out, then you are a renter of a home, not an owner. The quicker you default, then better for you and your family. Release your burden, rent, and feed your family. No one will be saying at your funeral “he was a great man, he honoured his mortgage. Even though he never should have taken it out because he could not afford it, he was advised by the bank to do so.  What’s more, they were so kind that they gave him a mortgage worth more than the house, so he could buy his furniture.  Failing to feed his kids and getting divorced did not trouble this honorable man; for the rest of his life he toiled for the bank.” Embrace default and let’s get this correction over and done with, so we can carry on and rebuild our lives in peace.

Daniel Hannan On Our Money-Printing Masters

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As we feared, the wise men at the Bank of England have decided that what our ailing economy needs is another dose of QE. I was about to blog the event, but it’s hard to match the eloquence of Daniel Hannan’s latest post:

According to the BBC, the Bank of England has decided to ‘inject a further £75 billion into the economy’. Who knew it was that easy? I mean, why not inject £500 billion? Or a trillion? According to the BBC’s logic, it would surely make us the wealthiest nation on Earth. I can’t believe I’m having to write this, but nothing new will be manufactured, invented or developed as the result of this monetary splurge, no services offered, no businesses founded. Rather, the money already in circulation – the money in your bank account, in your purse, under your mattress – will be worth less. The government, in other words, is helping itself to your savings – and, in doing so, is damaging productivity, disincentivising work and weakening the competitiveness of the British economy.

These themes will be familiar to regular Cobden Centre readers, as will his conclusion:

It’s a paradox. If I were to print counterfeit £20 notes and buy goods with them, I’d be perpetrating a fraud: I’d be buying something of real value with something I had magicked out of thin air. Yet when a central bank does the same thing, the half-educated economists who dominate our universities and television stations nod approvingly and mumble cliches about ‘boosting demand’. You can’t keep boosting demand without producing anything, for Heaven’s sake. That’s what got us into this mess.

We’ll post more on this latest act of folly in due course, but in the meantime Steve Baker has posted a warning straight from Human Action: