Those who sold will most [...]]]> The consolidation of gold’s bull phase from October 2008 to the peak last September was a classic three-leg correction: an initial slide, rally, and final sell-off. Silver followed a similar but more violent pattern. The psychology was there too, with the final sell-off convincing many investors the game was finally over.

Those who sold will most probably be kicking themselves. Consolidations that break established trends, such as 200-day moving averages, shake out weak holders who will buy again higher up when they are more confident. The big traders in the futures market know this: your losses are simply their gains. And as a result both gold and silver are on a far sounder footing with these weak holders out of the way. It is lethal for your savings to play this game. Instead it is more sensible to understand what is happening in simple economic terms. To do this you must turn your normal thinking upside down, and realise that what is happening to precious metals prices is only a reflection of what is actually happening to paper money.

Put simply, governments all over the world are debasing their paper monies at an accelerating rate. Printing euros to rescue the banks has been in the headlines, but this process has only just begun. America, which has to be the focus of monetary attention, is committed to zero interest rates for the next three years, which is unprecedented. The result is that the price of gold has been left behind by exceptional monetary events. You can see this clearly in the chart below.

This chart shows US dollar True Money Supply (cash, instant deposits and checking accounts plus a few other minor cash balances) expressed in official gold reserves held at the US Treasury. This has soared over the years, and we can expect it to accelerate further from December’s figure of $31,600 per ounce of gold. Meanwhile, the percentage of TMS actually backed by gold stood at 4.8% at the year-end, and this is shown by the blue line.

The chart clearly shows that while gold has risen dramatically over the last decade in nominal dollar terms, adjusted for the extra money in the system it has only risen 150%. Amazingly, the price of gold measured in these TMS terms has only risen to where it was in late 1991, when the nominal price was $360. Gold’s valuation is therefore still at exceptionally low levels.

The sense of perspective charts like this imparts is vital for understanding the dangers from the tsunami of paper money and debt. Conventional portfolio managers have missed this point entirely, being hampered by the legacies of portfolio management theory and Keynesian economics. But there is a growing band of private individuals around the world who do get it and are accumulating physical gold and silver. They are beginning to understand that paper money is falling rather than gold and silver rising.

The message is if you think like an investor, you will probably lose your investment. Be aware of what is happening to paper money and you probably won’t.

This article was previously published at GoldMoney.com.

Here is my point, and every clear-thinking person already knows it: That economic growth, and thus [...]]]> The economic policy debate is dominated by wishful thinking and fallacies of the most dangerous kind, propagated no less by the high and mighty in the policy bureaucracy and the alleged experts in the media.

Here is my point, and every clear-thinking person already knows it: That economic growth, and thus recovery from the crisis, will come about through the actions of governments is complete and utter nonsense. It is an illusion to assume that running budget deficits and printing lots of money and manipulating prices will make the economy better. Nevertheless, this fantasy is being reflexively regurgitated ad nauseam in countless reports and ‘analyses’ in the media so that nobody really bothers thinking about it anymore. A large part of the public seems to have been numbed into passively accepting it as the truth.

Since 2007, various governments have been engaged in Keynesian deficit spending and Monetarist money printing of unprecedented proportions. If the stupid ‘theories’ behind these policies had any merit, the world economy would be booming right now. It isn’t. Go figure!

Thank you, government, for all the growth!

Earlier this week the Wall Street Journal Europe had this to report about the Eurozone debt crisis:

“Some analysts also say the [fiscal consolidation] pact biases the euro zone toward recession. Not only does it limit governments’ ability to use budgetary policy to avert an economic downturn, but the long-term requirement to lower government debt would make it harder for nations with high debts, such as Italy, to grow their way out of their problems.”

[In fairness to the WSJE, the authors of the article may not share these views. But the ‘analysts’ who hold these views certainly exist, we know who they are, and they are actually quite numerous.]

So, here we have it. Public spending and deficits help the economy grow faster. By allowing our governments to constantly spend money they don’t have we all get more prosperous. — But how does that work? What is the evidence for this? Countries with massive government spending, big deficits and lots of debt are hardly booming, are they? In fact, these are the basket case economies. Is their problem maybe that they have not run large enough deficits in the past to stimulate their economies more?

The following statement is so absurd that it deserves repeating:

“The long-term requirement to lower government debt would make it harder for nations with high debts, such as Italy, to grow their way out of their problems.”

Italy has a debt problem. But if Italy was only allowed/encouraged/enabled to run even larger deficits, the deficits would then create growth, and this growth would automatically raise tax receipts and this would pay for the extra debt-load taken on to create the growth. Wonderful. Government deficits are obviously self-financing. They create growth that then pays off the debt, and not only the new debt but also the old debt, because only then would you “grow out of your problem”. The only question is how these governments could have piled up all this debt in the first place if their deficit spending was self-funding?

The idiocy behind these ideas knows no bounds, and the newspapers are full of such hogwash. That is why it is so refreshing when you occasionally get a chance to speak to sensible people.

The other day, I was discussing the economic crisis during a cab ride with the taxi driver. “I don’t get this,” he volunteered on the topic of the government saving us, without much prompting on my part, “so the government hires someone at £70,000 a year and is collecting £30,000 in taxes from him. Who pays the difference? How does that help the economy?”

To give credit to my cabdriver it has to be said that he probably has not undergone the extensive economic education that our economic experts have benefitted from. He had not had his common sense sapped out him by learning about magical multipliers, doing economic equations, and running complex econometric regression analyses. He is a practicing capitalist who is independent, has kept an independent mind, and who knows a thing or two about balancing the books, serving the paying public and running a business.

“Of course,” our economic experts will say, “this is all so very different, once you transport it into the complexity of the modern economy.”

No, it isn’t.

Fiscal death trap

Let’s look at a large and complex economy. The US economy is by far the largest in the world. The US Treasury and the US Federal Reserve hardly ever come under criticism from the Keynesian commentariat. Why? Because the US is conducting one gigantic Keynesian ‘stimulus’ experiment that is positively Krugmanesque in its dimensions. For years on end, the US government has been spending money like a drunken sailor, and the Fed is widely known, correctly me thinks, as a passionate QEer. In short, there is a lot of pro-growth policy going on in Washington.

Here is a very rough back-of-the envelope calculation: Economic growth in the US was 1.6% for the year 2011, when measured quarter over quarter (i.e. Q4/2011 versus Q4/2010). In a roughly $15 trillion p.a. economy that means an extra $240 billion in goods and services were produced by US companies and US individuals in 2011 compared to 2010. That is the extra growth, the extra economic activity.

Over the same time, the US government ran a budget deficit of $1,500 billion, and the Fed printed money to the tune of $600 billion, a growth-rate in the monetary base of almost 30 percent.

The US government is running 10% of GDP deficits to ‘stimulate’ 1.6% of growth. This is not only absurd it is certainly not self-financing. Debt is accumulating much faster than the economy is growing.

Is this how the ‘analysts’ imagine a country “grows its way out of problems”? Is this what Italy, Spain and Greece should do? (As an aside, as a percent of GDP, the Greek deficit and the US deficit are almost identical.)

The reality is that the US government is piling ever more problems onto its economy with these policies. The U.S. government is a hindrance to wealth and prosperity.

And for those who still believe the old folklore that it was exactly this type of policy that got us out of the Great Depression, consider this quote from FDR’s Treasury of the Secretary, Henry Morgenthau, spoken in the early 1940s:

“We have tried spending money. We are spending more than we have ever spent before and it does not work. . . . After eight years of this administration we have just as much unemployment as when we started . . . and an enormous debt to boot!”

Without the recent binge-spending the official statistics may well have shown an economic contraction in 2011. So what? At least that would have provided a realistic picture of what is going on on the ground in the US economy rather than provide some pathetic charade that is supposed to fool the public into believing we are in a recovery.

If the state stepped out of the way and allowed the liquidation of the accumulated imbalances, and allowed the private sector to get on with rebuilding the economy, we would already be in better shape. Present policies pile more debt on an already debt-laden economy; they obstruct the cleansing of the economy of misallocated capital and fictitious ‘wealth’, and introduce new misallocations of resources.

Aggregate demand, baby, aggregate demand!

All this nonsense is conducted in the name of “aggregate demand”. This concept itself is a coarse trivialization of economic reality. The economy is not about aggregate demand but always about specific demand, and the specific activities that are needed to satisfy that demand.

The economy is a tool. It is a tool for all of us who participate in it to improve our provision with material things by mixing our labour with that of countless other people in an extensive division-of-labour economy and with the accumulated capital stock in that economy. We get wealthier by combining our efforts with others in precisely the way that produces exactly the goods we want at the prices we are willing to pay for them, and we earn the income to afford these goods by participating in their production. If that sounds complex, it does because it is.

For this process to work, it requires an undisturbed market and free price formation (and that includes interest rates!), and it needs entrepreneurs and capitalists who constantly look out for new opportunities to combine capital and labour in new ways. Everything about this is specific.

But to those who keep babbling on about “aggregate demand” such complexities count for nothing. The economy can, in their view, be conveniently squeezed into a number of statistical aggregates, which can then be manipulated by government intervention. In a way, they consider the economy to be like a receptacle that can contain and should contain a certain amount of ‘economic activity’ at each moment in time, and if some ‘activity’ drops out of that bucket (because the private sector, at least momentarily, discontinues this activity) then the difference has to be made up by government activity of some sort.

In this concept, one activity is as good as any other. The drop in activity in the housing market (because a bubble, which had been inflated by state fiat money, finally burst) can be offset with the activity of the government building another road or spending more money on a war. It all neatly goes into GDP statistics – whether it is what people really want or not. It is the aggregate that matters.

Bad advice

In the meantime, over at the IMF, the Keynesian policy road show continues. The joy of constant debt accumulation and monetary debasement must be spread to every corner of the global economy. Asian growth, so says the IMF, has been resilient but with the international bureaucracy and the central banks already working hard at intensifying and prolonging the crisis, it is only a question of time until Asia will wobble, too. What, then? – More pro-growth policy of course:

“In the event of a further slowdown in the global economy, our sense is that most economies in Asia have room for a strong policy response,” said Anoop Singh, director of the IMF’s Asia and Pacific Department.

China and many export-dependent economies in the region could loosen fiscal policy, while Japan’s central bank could boost its asset purchases, he said, adding that efforts to trim external surpluses would reduce exposure to outside risks and support global growth.”

Thanks, Anoop, great advice. More debt and more paper money – prosperity through government policy knows no limits!

The IMF should, of course, be dissolved immediately. As a friend of mine, who worked for that institution for a number of years, observed: “The IMF only serves one group of people: those who work for it.”

And if you want to discuss the economy, you better do it with a London cabdriver than with anyone from the IMF.

In the meantime, the debasement of paper money continues.

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 [...]]]> 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 passersby

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 nonexistent 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 neighborhood 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 homebuilders 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.

Our political masters follow the lead of the economists. Recently we heard [...]]]> At times of recession, like we have today, a range of dodgy economic ideas that have been refuted several times over during the last 200 years are recycled with fresh enthusiasm, requiring us to refute them once again.

Chimera 1: prosperity through stealing and spending

Our political masters follow the lead of the economists. Recently we heard this statement from our Culture Secretary, the Rt Hon. Jeremy Hunt MP,

There are people who say that doing a project like this is a massive Keynesian boost to the economy. That is definitely the case, in terms of money being spent.

The message is clear: if we spend money, we will end up getting wealthier. That’s nice and simple then. What are we waiting for? If £39bn of spending is going to create more than £39bn of wealth, we should not be shy! Why not spend £339bn? In fact, choose any number!

It is remarkable that an educated man like Hunt cannot see that if we extract £39bn in taxes from the private sector and give it to the Olympic development people to spend, we have just moved money that people would otherwise have spent on goods and services they actually want, and directed it instead to the government’s preferred expenditure? The net gain is zero, at best.

This was clear enough to Jean-Baptiste Say in 1803, when he wrote A Treatise on Political Economy:

But this advantage is to be derived from real production alone, and not from a forced circulation of products; for a value once created is not augmented in its passage from one hand to another, nor by being seized and expended by the government, instead of by an individual. The man, that lives upon the productions of other people, originates no demand for those productions; he merely puts himself in the place of the producer, to the great injury of production, as we shall presently see.

Say had a great letter exchange with his English contemporary Malthus. Like Hunt today, Malthus believed public expenditure was essential to keeping the economy going. He argued that the payroll of the state — in modern terms, the army of teachers, nurses, civil servants, and quango staff — should be maintained across the economy, for the benefit of all.

Say pointed out that if no extractions were made from the private sector, the public labour force would soon get redeployed.  If the tax collector did not collect, no-one would struggle to find better ways to spend their money!

In his letters to Mr Malthus, Say reminds us that spending is only half of the equation.  Value must be traded for value, and production must precede consumption:

When I advance that produce opens a vent for produce; that the means of industry, whatever they may be, when unshackled, always apply themselves to the objects most necessary to nations, and that these necessary objects create at once new populations and new enjoyments for those populations, all appearances are not against me. Let us only look back two hundred years and suppose that a trader had carried a rich cargo to the places where New York and Philadelphia now stand; could he have sold it? Let us suppose even, that he had succeeded in founding there an agricultural or manufacturing establishment; could he have there sold a single article of his produce? No, undoubtedly. He must have consumed them himself. Why do we now see the contrary? Why is the merchandize carried to, or made at Philadelphia or New York, sure to be sold at the current price? It seems to me evident that it is because the cultivators, the traders, and now even the manufacturers of New York, Philadelphia, and the adjacent provinces, create, or send there, some productions, by means of which they purchase what is brought to them from other quarters.

We produce in order to support our own demand for goods and services. We can’t produce just anything.  We must be focused on producing things our fellow citizens want. This happens naturally in an unhampered market economy. If we consume without producing, we will eventually burn through all our capital and have no ability to demand anything further in the future.  Spending alone is never the solution. The key is prior production.

So much for the Rt Hon. Jeremy Hunt’s plan to boost wealth by stealing and spending.

Chimera 2: prosperity through printing and spending

A more senior political master, the Chancellor, acquiesces to his Governor of the Bank of England: they will make more money units, freshly minted digital ones, specifically to create a Keynesian stimulus! The letter from the Governor to the Chancellor laying this proposition out concludes

the Committee judged that it was necessary to inject further monetary stimulus into the economy.

I have spent 22 years in devotion to satisfying consumer demands, and thus creating wealth. It is done as follows:

• As an entrepreneur you look for the most urgent needs of consumers.
• You work out how to fulfill those needs.
• Painfully, at the beginning of your enterprise, sometimes to pay more to your staff, you go without wages yourself and refrain from consumption — in short you save.
• Thus you deploy your savings or borrow the savings of others to take command over the various factors of production — land, labour and capital — and mix them into better and more capital-intensive combinations to provide the goods and services that the customers want.
• More capital deployed in the right intensity creates more productivity, allowing cheaper goods and services.
• This takes place over time.

More money units may create the illusion of wealth, leading to temporary euphoria, but when reality bites, you rapidly go back to square one, perhaps having made some unwise decisions along the way.

We are currently experiencing a money deflation, which the authorities are attempting to counteract by putting more money units in circulation. All stops have been pulled to prevent prices from falling into line with what consumers want.  The money printers are obsessed with aggregate spending, when they should be concerned about profits.

If you had a company with £1m of capital invested in the capital structure, with revenues of £10m p.a. and profits of £250k and by dumping low-margin, loss-making work, you could move to a £1m capital intensive enterprise with £8m revenues and £500k of profit, would this not be better? The capital deployed would now be generating twice as much. I often give this analogy to people who have consumption spending fetishes, showing that it is not the top line, but the bottom line that we should all focus on.

Another analogy I give is of the salesman who reports to you that he has sold £1m of kit and does not mention at what net margin.  How does he compare to the one who says he has sold £1m of kit at 10% net margin? It will almost be apodictic that the latter will have sold for more profit while the former, not concentrating on the bottom line and not even mentioning it, will have sold for less profit. Profit (in cash terms) is the only thing that matters at the end of the year.

Crudely put, the mass of Keynesians relate GDP, which measures largely the consumption side of the economy (ignoring the larger production side), as the revenue of goods and services sold for money in a particular period (usually a year). There are many problems with this, but for now note that a lowering of prices means a lowering of GDP.  If prices fall thanks to productivity improvements we have the basis for a recovery, but GDP-obsessed planners will instead see disaster.

Attempts to prop up GDP by printing more money units will not increase real wealth, but they will cause further distortions to an economy that’s already out-of-sync with consumer preferences, and stoke new asset bubbles.   The injections of cash will not address any of the causes of monetary deflation.

Over the last two decades, credit has been created to the extent that our money supply has tripled and asset prices have soared. These prices need to come down. When they come down, people will start to pick up bargains and start spending again. Companies will then invest to satisfy the renewed demand.

No politician will allow this painful adjustment to happen.  They are in thrall to the circular flow of income fallacy.

What would Say say?

Say pointed out, as we have seen in the examples above, that it is production that allows you to trade for other goods and services. Production and consumption can’t be out of sync in an unhampered free market. Why do we have recessions like today’s, with shops and factories with too much to sell and too little demand? The only answer can only be that prices are too high.  These goods and services, and indeed the factors of production that create these goods and services, are offered for too much money.  Prices need to come down.

Prices were a subject of lively debate in the letters between Say and Malthus. Malthus, wedded to the erroneous Labour Theory of Value, alleged that if prices fell too low, wages would not be paid and the problem would get worse as labour would become idle, there would be less spending, and we would spiral into the abyss. This is what virtually all economists tell us today.

Here’s what Say had to say, in 1821:

Give me some just ideas on the price of things?

If you wish to form just ideas on this subject you must never confound the nominal price with the real price of things.

What do you call the nominal price of things?

The price we pay for a thing in money or in coin.

What do you call its real price?

The value we have given to obtain the money with which we purchase this thing.

Give me an example.

A potter is in want of a loaf of bread, which sells for a shilling: he is obliged, in order to obtain it, to sell a vase which is worth a shilling. If the price of the loaf should rise to two shillings; and if the potter is obliged to sell two vases in order to obtain these two shillings, which he must pay for the loaf, the dearness of the bread is real. If the potter can obtain these two shillings by the sale of a single vase, the dearness of the bread is only nominal. He has in both cases exchanged only one vase against one loaf, whatever may have been the denomination of the intermediate value. It is the value of the money which is depreciated, that of the bread has remained the same.

Is it not a real dearness to a man whose income arises from lands which are let, or from a capital lent at interest, when the loaf has risen from one to two shillings?

No: that which is real is the depreciation which has taken place in the value of the merchandise in which his income is stipulated to be paid: that is, in the fall of the money. He who pays the income, by acquiring at less expense this merchandise, gains in this case what the other loses.

You have said that if, when I am obliged to give two shillings to buy a loaf, I am able to obtain these two shillings, on the same terms that I before obtained one, the loaf has not become dearer; but if to obtain two shillings, that is, the price of one loaf, I am obliged to give two vases instead of one, then the bread will have really become dearer?

No; not if the vases as well as the money have fallen to half their value.

How can I tell whether they have fallen to half their value or not?

They have fallen if they can be obtained for half the expenses of production: that is, if means have been found to create, at the same charge of production (which consists as we know of the workmanship, interest of capital and profit) two vases instead of one.

It is then the lowering the charges of production which causes the real fall in the price of products?

Just so. Then whatever may be the value with which a product is purchased, this product, which has fallen one half, is obtained for one half less expense of production.

Explain that by an example.

If, by means of a knitting frame, I can make a pair of stockings for three shillings, instead of expending six shillings on them, he who grows wheat can obtain a pair of stockings for one half the quantity of wheat which he had before been accustomed to give for them. That is, if he was before obliged to sell thirty-six pounds of wheat in order to obtain a pair of stockings, he would now sell but eighteen. But the eighteen pounds have required on his part only one half the expenses of production which the thirty-six pounds would have required.

It is the same whatever is the production with which we are occupied. It may be said, that when an article really falls in price, not only those who produce it, but every body else, obtains it at the price of the reduced charge of production.

You have said besides that the riches of society is composed of the sum total of the values which it possesses: it appears to me to follow, that the fall of a product, stockings for example, by diminishing the sum of the values belonging to society, diminishes the mass of its riches.

The sum of the riches of society does not fall on that account. Two pairs of stockings are produced instead of one; and two pairs at three shillings are worth as much as one pair at six shillings. The income of society remains the same, for the maker gains as much on two pairs at three shillings, as he did on one pair at six shillings.

But, when the income remains the same, and the products fall, the society is really enriched. If the same fall takes place on all products at once, which is not absolutely impossible, society by obtaining all the objects of its consumption at half price, without having lost any part of its income, would really be twice as rich as before, and could buy twice as many things.

This does not generally happen, but it has happened to a great number of products, which have fallen from the price they were formerly at, some a tenth, some a fourth, a half, three-fourths, as silver, and even in a greater proportion as silks, and probably many other articles.

To what cause is that to be attributed?

To many causes: but principally to the progress of intelligence and industry. It is to their progress that we owe, both the discovery of countries in which there is a greater abundance of products, and also a means of transporting them less hazardous and more economical. To that progress also we are indebted for processes more simple and more expeditious, the use of machinery, and in general a better adaptation of the productive faculties of nature.

Are there any products which have really become dearer?

There are some, but very few, and only those the demand for which has increased in consequence of the progress of civilization, without the means of production having increased in the same proportion. Such as butchers’ meat and poultry, and almost all the useful animals which are raised at less expense in less civilized countries.

Are there not variations in value which are not the consequence of the charges of production?

The errors, the fears or the passions of men, or unforeseen events, cause disorder and confusion in values which are merely relative: that is, when any merchandise rises or falls with respect to others, in consequence of circumstances foreign to its production. Late frosts increase the price of the last years wines, whatever may have been the charges of their production.

Does such a dearness increase the national wealth?

No: for in exchanging another product for one which has become dearer, one must give more to receive less: he who buys, loses on his merchandise, precisely as much as the seller gains on his goods.

When the wine doubles its price, he, who, to purchase a piece of wine is obliged to sell six bushels of wheat instead of three, which should have purchased a piece of wine is poorer by all that the wine merchant is richer.

Thus these kinds of variation, which sometimes overturn private fortunes, do not affect the general riches

The key thing to note is that a rise in productivity means the same goods are produced at a lower cost, and profits go up, allowing more demand to be expressed in the economy.  Productivity rises can be facilitated by allowing taxpayers to retain more of their wealth.  Adding more money units simply creates asset bubbles.

Over the next few days I will post copies of some of the best refutations of Keynes’s supposed refutation of Say’s Law. The wisdom of the older economists is in short supply, and we will do our bit to promote that wisdom.

Those who have eyes to see and ears to hear will have noticed the accelerating trend towards interventionist policies and assertive state action all around us. This is not a conspiracy theory circulating on the internet. It is [...]]]> “All within the state, nothing outside the state, nothing against the state.” Benito Mussolini

Those who have eyes to see and ears to hear will have noticed the accelerating trend towards interventionist policies and assertive state action all around us. This is not a conspiracy theory circulating on the internet. It is a phenomenon that is now so blatantly obvious that it makes the headlines in the highbrow pro-establishment media: The Economist and the Financial Times are talking openly about the trend towards “repression” and “national capitalism” as if it was simply the latest fashion in crisis management. A century ago, Randolph Bourne pointed out that “war is the health of the state”. It turns out that so is economic crisis.

Politicians, bureaucrats and many of their claqueurs in the media have drawn conclusions that are conveniently in their own interests: to them the crisis is evidence that things cannot be left to the markets, to consumers, to greedy bankers, and the spontaneous interaction of the public. If the state does not regulate and control everything, chaos ensues. We need more government. More control. More regulation. More oversight.  Politicians and bureaucrats need more power.

Conveniently, the public believes it was greedy bankers and ‘unfettered capitalism’ that brought us down. But cheap credit through state fiat money and the systematic subsidization of the housing market are not features of the free market but of politics. The present mess is the result of decades of institutionalized monetary debasement and the accumulation of public debt. These policies have left us with bankrupt welfare states and overstretched banks, yet none of this has diminished the enthusiasm of politicians and bureaucrats to give us more of their medicine.

Let’s not forget that it was politicians and their central bankers, with the intellectual support of ambitious but misguided economists, who got rid of the gold standard. They considered the gold standard an inconvenient monetary straitjacket that was best replaced with a system of limitless fiat money under central bank control. Limitless money allowed unrestricted bank credit creation and state deficit spending. Once that system was in place, it was politicians who accumulated all that public debt and issued the deluge of unfunded and unkeepable promises that pit large sections of society against one another. And it is the central bankers who happily funded this gigantic debt bubble for decades with cheap credit.

After 40 years of fiat money the world is in a deep and deepening financial crisis. Excess levels of debt, weak and overstretched banks and distorted asset markets – all of this marks the inevitable endgame of a system based on persistent monetary debasement. But politicians and central bankers are merrily undeterred. “Nothing that cannot be papered over with more paper money!”

Authoritarianism needs ever more authorities

So the problem is not with the policy establishment but with us, the masses. We need to be controlled better. Mr. Martin Wheatley, inaugural head of the UK’s new Financial Conduct Authority, told the Financial Times last week that his agency will “step into the footprints of investors – who cannot be counted on making rational choices.” Apparently, we, the consumers and savers, cannot be trusted with our own money. We need someone to tell us what we should or should not buy. But don’t worry. Mr. Wheatley assures us that his interventions into our financial affairs are based on the latest insights of science, namely the latest research in “behavioural economics.”

Part and parcel of this trend is the global fight against cash. Authorities want to monitor and record ALL your transactions. They don’t want you to use cash. Ever more countries restrict the amount of cash you can take across borders (noticed the signs at airports?), and in Italy and Spain, proposals are being discussed to limit the amount of cash citizens can use for individual transactions. “Cash has been a problem for a long time” the UK’s top taxman, Dave Hartnett, told The Daily Telegraph last week. Hartnett wants the citizenry to stop giving cash to their cleaners, gardeners, and to small tradesmen and other potential tax cheats and economic criminals so that they can no longer avoid paying taxes. Hartnett’s vision of Britain is a society of snoops and denunciators. “Households have a duty to ensure that other people do not evade paying their share of tax. The people who are worried about it should use our whistle-blowing line to tell us. We are getting better and better at finding people who receive cash.” Nice touch. A tinge of the former GDR’s Stasi culture for the British way of life?

The beauty of a big state is apparent to Mr. Hartnett: “Tax provides the funding to run the country.” Really? No, I don’t think so. It is rather Mr. Wheatley’s irrational savers and Mr. Hartnett’s tax-avoiding cleaners, gardeners and shopkeepers who are running whatever is still functioning in this country, the productive, independent middle class, who are able to and do look after themselves and their children, but who are also forced to fund the largely parasitic class of self-deluded authoritarians with their wasteful government projects.

Decent citizens don’t use cash. Cash is used by tax-cheats, terrorists, drug-dealers and child pornographers. Once this is established it will be a short step to severely restricting or even banning the withdrawal of cash from bank accounts. As all banks will soon anyway be mere branches of the ever-expanding central bank, which prints the money to keep the nominally private banks alive, all transactions will then be just electronic bookkeeping adjustments at the state central bank. All financial transactions will then be entirely transparent to the authorities. “Irrational” behaviour can be identified early and – eliminated.

Whatever you may think of Julian Assange’s Wikileaks, it is deeply troubling how quickly and easily this organization was crippled by Visa and Mastercard cutting it off from its donors. This gives you a taste for where we are going.

Fiat money and central banking are incompatible with free banking, with a system in which banks are independent capitalist enterprises. But more than that, fiat money and central banking are incompatible with capitalism and a free society. Central banking is central planning.

Hey, who is boss?

The bureaucracy is annoyed. The public is not giving it enough credit for its excellent management of the economy. The public is still pessimistic and concerned about banks and the overall direction of the equity market. Okay. So the government just stops them from acting on that pessimism. Show them who is boss:

In France, Spain and Belgium the government has ruled that shares of financial companies cannot be shorted. In Italy you are banned from shorting any stocks. Shorts on stock indices are banned in Italy, France, Belgium and Spain. Is this arbitrary? Of course it is. But the real measure of power is if you can use it arbitrarily. Make it clear to people what you, the government, likes or dislikes. Then you ban what you don’t like.

Government is not voluntary association, contractual cooperation and trade. “Government is essentially the negation of liberty” (Ludwig von Mises). “Everything a government does rests on the use of force. No law actually is a law unless it is backed by the threat of force.” (George Reisman). And a government that is digging itself an every deeper economic hole will, in its growing desperation, apply force ever more readily. Count on it.

But what does the sovereign do, the democratic masses? Well, they obey. Like obedient sheep they stand patiently in line at airports in the UK, the USA, and elsewhere, calmly watching their six-year olds being padded down by security personnel. And they happily pay their Starbucks Coffee and the pack of cigarettes (as long as we are still allowed to smoke somewhere) at Tescos with their debit cards, or buy everything on the internet, leaving for whatever they do a perfect paper trail, a seamless record kept forever. “It is so convenient. And I have nothing to hide.”

And, naturally: “the government is here to help, so why not cooperate with the government? After all it is still a democratic state.” Every four to five years each of us has an opportunity to cast a vote of infinitesimally small importance to decide which of two gangs will get almost unlimited power over the ever growing state apparatus, and this, it seems, is to many sufficient compensation for handing over control of their lives and property to others. Stimmviehvolk is how an incredibly prescient Friedrich Nietzsche described them more than a hundred years ago: voting cattle.

Prosperity through money printing

The persistent debasement of money in the modern state fiat money system is an obstacle to the smooth operation of the market, the production of wealth and the growth in prosperity. It keeps the middle class in bondage as its efforts to save and gain financial independence are constantly undermined by the official policy of inflationism. But the central planners and central bankers and their apologists among journalists and economists tell us that it is exactly the other way round: “Prosperity through monetary debasement” is Big Brother’s slogan, and he has spokespeople with outstanding academic credentials to explain this absurdity to the masses. In November 2010, MIT and Princeton man Ben Bernanke, the U.S. government’s money-printer-in-chief, wrote this in the Washington Post when explaining to the less educated why creating $600 billion out of thin air and massaging yields on government debt down was a clever policy:

Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

Well, that was 14 months ago. As it turns out, manipulating the economy by artificially lowering rates (lowering rates not by saving but by simply printing money) has not started a virtuous circle. Such manipulations come with nasty unintended consequences, and after a few decades of such a policy the accumulated unintended consequences far outweigh whatever short–lived growth blip money debasement may have manufactured otherwise. None of this has anything to do with healthy growth and a functioning free market economy.

But it is important that those in positions of authority do not admit that they are clueless. They never make mistakes. Their policy is never wrong. They simply need to do more of the same – and then even more. As I write this, the Fed is, of course, preparing another round of quantitative easing, and so is the Bank of England. And the ‘economists’ on Wall Street and the City of London cheer them on.

The debasement of paper money certainly continues.

My second challenge for 2012 is to read a book written 86 [...]]]> 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