Economic Myths #15 – Unemployment

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One of the key indicators of the economic “performance” of any given country is its rate of unemployment. Low rates of unemployment are understood as a sign of prosperity while high rates are taken as a sign of recession and stagnation. Indeed, during the Great Depression, unemployment reached as high as 25% in the United States. Politicians are particularly keen to monitor the rate of unemployment as low unemployment lends credence to the economic policies of those in power while high unemployment stocks the arsenal of those in the opposition. Given also that entire economic dogmas such as the so-called trade-off between full employment and inflation, not to mention the generation-long post-war Keynesian consensus are, at least, part rooted in the concept of unemployment, one would expect unemployment to be a unique and important category in economic theory.

This short essay will not explore in detail the government induced causes or aggravations of unemployment such as the minimum wage and excessive regulations heaped upon the shoulders of employers. Such topics have been examined countless times over by many economists, “Austrian” or otherwise. Rather, what we wish to concentrate on here is the validity of the very term “unemployment” itself and to determine whether it is really a useful concept in shaping so-called “economic policy” or whether it is really redundant and meaningless.

In the first place, as “Austrians” we must be highly suspicious of any concept that is an aggregation and is not explicitly linked to any notion of individual human action. All voluntary actions are, as we know, the result of the best choice of ends available with scarce means. A man who has several million pounds stashed in his bank account may be content to spend all of his time in leisure and would be “unemployed”. Yet aside from any moral wrangling over the worth of such a lifestyle we would hardly view this as a problem. But what about those lesser privileged folk – the ones who are not working but nevertheless have the outward appearance of needing an income from some kind of employment? Shouldn’t we classify these people as “unemployed” and doesn’t this state of unemployment indicate an egregious case of market failure?

The question turns on whether employment at the terms of the available opportunities is worthwhile for the individual person. If there are jobs available yet he refuses to accept them then it indicates that he is not satisfied with the terms of those opportunities. Perhaps it is the wrong industry, it is in wrong the place, or – most likely – the wage offered isn’t high enough for him. He therefore chooses to abstain and holds out for a better opportunity to appear in the future. From the point of view of individual satisfaction with the scarce means available, the outcome of seeming “unemployment” is therefore optimal. Indeed, labour, like anything else, is a resource that is available for an individual to use. Not all resources are deployed 100% of the time as it would be wasteful to do so. Everyone, for example, owns possessions that are not being used at the current moment – food in the fridge, clothes in the wardrobe, books and DVDs on the shelf, etc. Clearly it would be wasteful – nay, ridiculous – to try and use all of these “unemployed” resources at once. They are more valuable being kept in abeyance ready for utilisation when an opportune moment appears, i.e. when the person believes that use of them would yield more benefit than leaving them idle. More widely, there are always buildings to let, oil in the ground, trees that are left standing, water in lakes and reservoirs, and so on. All of these resources remain idle because an opportunity valuable enough for deploying them has not yet arisen. Indeed, consistent requirement for all resources to be utilised would mean that shops should be empty of all goods as they have already been purchased and consumed, and ultimately everything in the world should be consumed right now. To put it at its most basic, a person actively searching for the right job is not, in his mind, unemployed in the sense of carrying out a wasteful activity.

The inability to see labour as a resource that is deployed at the choosing of the individual labourer leads to many related fallacies and reveals the dangers of looking only at surface phenomena and appearance. An individual does not view employment as an end itself – work for work’s sake. Rather, all employment is action aimed at diverting scarce means available to their most highly valued ends. Employment per se is not a goal or achievement. No one would dig a hole in the ground and fill it up again unless the act of doing so led to a valuable end. Governments and people succumb to the illusion of economic activity brought about by “employment” and the apparent lack of it by “unemployment”, with any focus on providing “full employment” never stopping to ask whether the activity in which employment will be created is worthwhile or is wasteful. The most grievous example of this this is, of course, the forced lowering of interest rates to provoke an artificial investment boom. There will be lots of employment, everyone will be engaged in lots of activity and wages will be rising rapidly. But it is clear that everyone’s endeavours are ultimately wasteful and lie on a doomed path. So-called full employment policies are therefore nothing more than a surface coating to prevent social unrest, to make people feel as though they are doing something worthwhile and to put money into their hands that they can spend. To the extent that these actions create no new wealth, however, they should properly be regarded as welfare and not as employment. The wheels may be turning but the carriage goes nowhere and it is simply expending fuel on motionless activity. Far more difficult would be for governments to concentrate on policies that promote full production instead of full employment as this would, of course, require a dramatic reduction in the size and scope of government power and interference.

We submit, therefore, that unemployment is a meaningless concept at least when applied to the unfettered free market. It may have some relevance in economies where governments impede the ability of the supply of labour to meet demand through minimum wages and the like. Apart from shutting out a good number of low-productive persons from the labour market entirely, such interferences ultimately distort people’s views as to which terms of employment are achievable – they hold out for high wages because there is the illusion that that is what their labour is worth. They do not realise, however, that supply is unwilling to meet demand at that inflated level and hence their search for employment is in vain. All of this, however, is simply a particular application of price theory. If the price of any good is fixed too high it will remain unemployed. There is, therefore, no special concept of unemployment applying only to labour that attracts a different body of theory. Furthermore, the whole question of “nominal rigidity” or so-called “sticky wages” is beside the point when it comes to economic theory. If the demand for a particular good – in this case, labour – should drop it is entirely open for the particular labourers to express incredulity at this fact and to stubbornly hold out for wages that will never meet a willing demand. This is not, however, evidence of the market’s “failure to clear”. It is simply that the supply curve remains stuck to the left. There is an misconception that the market is “efficient” because it “values” everything correctly – a doctrine that underpins so-called “efficient market hypothesis”. But the “efficiency” of the market – the  nexus of voluntary exchanges between individual people – comes from its superior ability to channel goods to where they are most highly valued; it has nothing to do with whether a good should be valued or whether any particular valuation is correct. A good could be utterly useless but if a significant enough people chase a small supply it will command a relatively high price. The market will place this ware in the hands of those who value it the most, but the source of that value is the human mind and this valuation can be and often is erroneous. If people remain unemployed, holding out for unrealistically high wages, the fault lies in their incorrect assessment of the value of their labour, not in any market’s failure. Needless to say, however, the causes of these erroneous valuations are government interferences. It is because government creates such macroeconomic calamity that price bubbles and collapses occur and so-called “sticky prices” are a phenomenon associated with post-boom deflations. Having become accustomed to high wages, it is natural for workers to become frustrated and resistant when supply for these wages suddenly dries up and they not only have to face the prospect of lower wages but also a mass shift out of the capital goods industries – where they may have developed significant, specialist skills in the meantime – to consumer goods industries. In a genuine free market it is highly unlikely that workers would be faced with these problems. However, none of this really has much to do with economic theory, the purpose of which is to expound the formal characteristics of human action rather than the substance of those actions. Rather, sticky wages is more a topic for psychology, the field of human action that studies why people make the valuations that they do.

We conclude, therefore, by emphasising that there is no special category of “unemployment” as it applies solely to labour. Any “unemployment” of labour is explained either as the willing choice of the individual worker to withhold his labour from the market (and thus, to him, the best possible outcome), or as the result of government price fixing which is merely a particular instance of the economic effects of that wider category of interference.

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“Austrian” Business Cycle Theory and the Rate of Interest

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In an earlier essay, the present author explained “Austrian” Business Cycle Theory (ABCT) as an analogy to basic price theory, namely the specific law that a price ceiling for a specific good will lead to a shortage of that good. Here we will build on this analogy with an elaboration of what is meant by “the interest rate” with an additional emphasis that stresses the mismatch between the rate of saving and the rate of investing.

The reason for this new elaboration is that ABCT typically concentrates on “the rate of interest”, explaining the business cycle as an effect of “the market rate” of interest falling below “the natural rate”. This has opened “Austrians” up for criticism because any adherence to the pure time preference theory of interest runs into the problem of there being many “natural” rates for different capital goods and so we never know precisely which rate it is that is being undercut by credit expansion1. Moreover we might as well also point out that different borrowers pay a multiplicity of interest rates and that is dependent upon their specific contract so there is no, single “uniform” rate paid by every borrower.

What will be demonstrated here is that, while ABCT’s emphasis on interest rates is valid and is necessary to explain why particularly lengthier, roundabout projects will be engaged in, the most important aspect is that credit expansion simply permits borrowers to access funds for durations that lenders are not willing to lend for and it is this lack of harmony – made clear by our analogy to the results of price fixing – that is the key to unlocking the business cycle.

Robinson Crusoe Economics

In the situation where we have a lone human being (who, for argument’s sake, we shall call John), the fact of scarcity results in the necessity for John to choose which ends he will pursue and which he will discard. There are costs and benefits related to everything he does – such are the logical implications of the action axiom – but exchange of these costs and benefits is unilateral. If John decides to pick apples instead of picking oranges, the benefit he derives from picking apples comes at the cost of picking oranges. He cannot pursue both ends – he therefore exchanges picking oranges for picking apples, albeit unilaterally and in his own mind. This is the nature of basic, simple choices between presently available goods and services.

If John wishes to increase his consumption by investing in capital goods he must also make an exchange, but an exchange of a different nature. At any one moment John will have an array of resources available to him. His basic choice over these resources is whether to consume them now or to invest them to yield consumer goods in the future. It is plainly clear that John cannot do both at the same time – he cannot consume resources and invest them. If he wishes to invest the resources in a capital project that will yield consumer goods in one year’s time then he must be prepared to abstain from the consumption of the resources that he will invest in that project for one year’s time. If the period of investment will be two years then he must be prepared to abstain from consumption for two years, and so on. The precise length of time for which he will abstain from consumption and engage in investment is determined by his relative weighting of the value of time against the value of the quantity of consumer goods yielded – if the quantity of future consumer goods is more valuable to him than the waiting time then he will invest, wait and then enjoy the larger quantity of consumer goods when the investment project reaches its completion; if time is more valuable to him than the additional quantity of future goods then he will not invest but consume the lower available quantity of goods now. The result of such a valuation is summarised simply by the term “time preference”.

Is it possible for John, in his lonely world, to experience the unilateral equivalent of boom and bust? Will he experience a sudden spurt of investment followed by a downturn in his investment activity? The answer is yes, he could, because his capacity to keep on investing is connected solely to his willingness to carry on with the abstinence from consumption of the resources that are required for the investment project to come to fruition. If, half way through his investment project, he changes his mind and his desire for consumption increases so that he must divert resources away from the investment project then he will experience something of a bust – the project must now be liquidated as it has been starved of resources for completion. The viability of the investment project is wholly dependent upon his willingness to abstain from consumption and invest those resources that he could have consumed. The investment therefore turns out to be a malinvestment, unconnected to his consumption/waiting preferences as they are now revealed to be.

Bilateral Exchange

In an economy of more than one person, exchange of a simple good is now bilateral rather than unilateral but it is still based upon the same principles. We make a choice of what to receive in exchange and what to give in exchange. Normally, of course, we give money in exchange rather than a concrete good but we can think of the real cost as being other goods that the money could have bought. If, for example, I only have enough money to buy an apple or an orange and I choose to buy the apple, the cost of me buying the apple is the orange which I could have bought had I not purchased the apple. We can say that I exchanged the orange for the apple, even though the actual physical exchange involved not the orange but, rather, the money that could have been used to purchase it. It is clear, moreover, that I cannot have both the apple and the orange at the same time – or both the apple and the money used to buy it at the same time. I must choose between them because of the eternal condition of scarcity. Only an increase in wealth can alleviate this so that a person is in a position to be able to afford both an apple and an orange.

The market price of a good is the price at which the quantity of the good demanded is equal to the quantity supplied – in other words, it is the price where the number of willing buyers is equal to the number of willing sellers, the level where those who wish to give up in exchange equals the number of those who wish to receive. There is, therefore, not only a harmony of interests at the market price but also the market price regulates the amount of consumption of a certain good that is sustainable by the current level of wealth. Attempts at price controls interfere drastically with this harmony. Artificially lowering the price of, say apples, may, on paper, make it appear as though one now has enough money to buy both an apple and an orange rather than just an apple. The problem, however, is that at the new, sub-market price for apples, the number of willing buyers exceeds the number of willing sellers; the shrunk supply will be bought rapidly by the swollen demand and, therefore, shortages will ensue and there will be no apples left anywhere. This much is standard economic theory. What we can note, however, is that price controls are solely an attempt to allow people to have their cake and eat it – that, whereas at the market price, they could only afford an apple or an orange, the fixed, low price attempts to give them the ability to afford both the apple and the orange at the same time but without any corresponding increase in wealth. On our Robinson Crusoe island we noted that John could not enjoy apples and oranges at the same time because his wealth was insufficient to do this. Any attempt to do so would be at variance with reality and he would end up having to choose between them anyway. Exactly the same law operates in bilateral exchange. Simply trying to forcibly change the prices that emerge in bilateral exchange cannot defy reality and the whole scheme collapses precisely because the objective of providing more and cheaper goods cannot be sustained – you cannot have more of something without increasing wealth. People will find that all of the apples are gone and all that will be left is oranges so they are in the same position as before with only one fruit being available to them, except now without a choice of one or the other. Sustainable trade cannot exist under terms where the suppliers are not willing to offer goods for sale to the demanders.

A further feature of general buying and selling that we might note for our comparison with lending and borrowing that we shall explore in a moment is that every buyer pays the same price as every other buyer and every seller sells for the same price as every other seller. One buyer’s dollars are as good as any other’s and one seller’s good is interchangeable with another’s. In other words, except in cases where there is favouritism or prejudice for the individual personalities, there is insufficient qualitative difference between the different buyers and sellers to make an impact upon price.

Bilateral Investment

On our Robinson Crusoe island we noted that if John wished to increase his consumption in the future he had to abstain from the consumption of resources today in order to use them in investment projects that will yield consumer goods in the future. John’s level of investment was precisely correlated with the amount that he refused to consume and channelled into his project.

In the complex economy, where the abstinence (or saving) on the one hand and the investment on the other is carried out by different people the transaction is effected through the market for lending and borrowing. The market for money loans is actually little different from the sale and purchase of ordinary goods, except that what is being traded and at which prices is a little more difficult to understand. Specifically, what is being traded is not a hard good such as an apple or an orange; rather, it is the purchasing power over resources. A lender, in making a loan to a borrower, transfers his purchasing power over resources today in exchange for the borrower transferring an (at least nominally) higher purchasing power over resources at a point in the future. The market price for these loans – that is, the rate of interest that the borrower pays – is the price at which all willing lenders would be able to lend to all willing borrowers.

There are several key aspects of this market that must be highlighted. First, all loans contracts are for a specific duration which, for argument’s sake, we will say is three years. The lender here must be prepared to sacrifice his purchasing power over resources for three years. During this time, the borrower will use the resources purchased for his investment and will arrange himself to be in a position to transfer back purchasing power in three years’ time. More specifically, what this means is that the lender gives up his power to consume the resources that his purchasing power would afford him and transfers them to a person who wishes to invest them for a three year period that will yield consumer goods at the end of that period, thus earning him an income and the wherewithal to transfer back the purchasing power to the lender. This is the fuel of sustainable growth because the lender relinquishes consumption for exactly the same period as the borrower engages in investment. The basic theory is therefore nothing different from John on the Robinson Crusoe island. Just as John had to abstain from consumption for the duration of his investment project, so too must the lender be prepared to do the same so that the borrower’s project can be completed.

One notable difference of this market when compared to the market for simple, present goods, is that the rate of interest paid by different borrowers will be different rather than uniform for all borrowers. This is because the business of lending money contains an entrepreneurial element. The borrower is making a business decision that his investment will accrue enough income to enable him to pay back the capital and the interest. The lender, wishing to maximise the chance that he will receive his money back, shares this entrepreneurial burden and hence adjusts the rate of interest he charges to different borrowers. The riskiest borrowers – those whose entrepreneurial efforts appear the least likely to succeed – will pay higher rates of interest than the less risky borrowers. There are two possible ways of analysing this. Either we can say that there exists a single market for money loans which, all else being equal, every borrower would pay the same “core” interest rate determined by supply and demand for loanable funds with the difference between the actual rates constituting an entrepreneurial profit and loss element for the lender. Or, we could suggest that the qualitative difference between borrowers creates distinct markets for different categories of lending that attract different rates. In the markets for lending that contain the least risky borrowers the supply of loanable funds will be relatively high so interest charges will be low; in the markets with the most risky borrowers, however, supply will be relatively lower to demand resulting in higher interest charges to these borrowers. We shall use both analyses below although we will conclude with a preference for the latter – that of distinct markets that attract different rates. However, the most important fact that we need to concentrate on is that, whichever analysis we use, all lenders are prepared to fund all borrowers’ enterprises for the duration of their projects under whatever interest rate is agreed and hence these projects can be fully funded to completion.

The fact that the exchange between borrowers and lenders is facilitated by an intermediary – usually a bank – makes little difference to this situation. The bank simply borrows from the lender (or “saver”) at a certain rate and lends to the borrower at a slightly higher rate, the difference between the rates compensating the bank for its efforts in channelling the savings of ordinary people into the profitable projects of borrowers. The key aspect, again, is that there are real funds that can fuel all projects through to their completion under the terms agreed.

Credit Expansion

In order to understand the effects of credit expansion, let us first of all posit the case where a direct lender creates a mismatch with a borrower. Let’s say that a lender is prepared to lend for three years whereas the borrower thinks (erroneously) that he is borrowing for five years. The borrower’s project takes five years to complete and he needs purchasing power over resources for five years as his project will not earn an income to transfer back that purchasing power before five years is up. If, after three years, the lender, wishing to take back his purchasing power for present consumption, calls in the loan the borrower will have a shock. His project is only 3/5ths complete. Only two options are possible. Either the lender must change his priorities and save for the full duration of the investment project; or the borrower must liquidate the investment in order to pay back the lender2. If the latter option is necessary then we have a mini boom-bust between these two individuals; the investment is revealed to be a malinvestment as the borrower was not willing to lend purchasing power over resources for a time sufficient to complete the investment project. In order to create a sustainable investment project the lender must be prepared to advance purchasing power to the borrower for the full duration of the project. If he is not then the project cannot continue.

Now let us examine what happens when an intermediary bank engages in credit expansion and brings about effectively the same thing. The borrower is now a depositor of the bank and the borrower borrows from the bank rather than directly from the lender. Above we cited two possible analyses of the loan market – either there is a “core” rate of interest governed by supply and demand for loanable funds with individual variations in loan contracts representing the entrepreneurial risk that the lender takes; or, there are distinct markets for different types of loan, each of which attracts a different rate. We will use both analyses here.

On the eve of the credit expansion all willing lenders will have lent, through the bank, to all willing borrowers at whatever terms in the individual contracts. The willing lenders will be prepared to lend the funds for exactly the duration of the loans of the willing borrowers. Let us call these fulfilled borrowers Group A. When the bank expands credit, however, it gives the impression to unfulfilled borrowers – let’s call them Group B – that the supply of loanable funds has expanded. Under the first analysis, if the supply of funds expands then the “core” interest rate will reduce as the fresh funds have to find new, willing borrowers as those who were prepared to pay the highest charges have already been loaned to. This brings down the total amount of interest (“core” interest +/- the entrepreneurial charge) that Group B borrowers pay. Before credit expansion a core interest charge of (for example) 10% plus an entrepreneurial element of 5% would have given a Group B borrower a total interest charge of 15%, which may have been too high for him to take out a loan. Now, however, if the effects of credit expansion reduce the “core” interest charge to 5% leaving the entrepreneurial element unchanged then the total rate payable will be 10%, at which rate he may become a willing borrower. Hence the number of willing borrowers begins to expand. Under the second analysis, where there are distinct markets for different loans to different categories of borrower, expanding the volume of credit will expand the number of markets to which funds can be lent. As all of the Group A markets are fully lent to the new funds must seek out new, unfulfilled markets in Group B. This has the effect of bringing down the individual interest rates in these markets. Before credit expansion, the interest rate in these markets was infinitely high as supply in these markets was zero. Now, credit expansion has created supply that moves into these markets and depresses the interest rate to a level at it may reach demand. Hence loans will start to be made in these new markets.

To the present author, the second analysis seems preferential for visualising clearly the reconciliation between ABCT with the multiplicity of interest rates that are paid by borrowers. Indeed, while separating out the “core” rate from the entrepreneurial rate may be easy to conceptualise to a degree3, the idea of lowering rates is less straightforward to perceive when we think of the market as a unified whole. Conceiving them as separate rates in distinct markets which are individually depressed by credit expansion removes this conceptual difficulty4.

Under both analyses however, we can see that increased credit expansion leads to loans at rates that are lower than those that would be paid on the unhampered market. It is important to realise, though, that the contracted interest rates paid by borrowers in Group B – the new borrowers – may actually be higher than the rates paid by Group A. What we may observe is new borrowers in Group B paying what appear to be increasingly higher rates rather than increasingly lower rates. But the crucial point for ABCT is that the rates paid by Group B are lower than those that they would pay on the unhampered market. Such rates do not have to be lower than Groups A’s and thus it is still true to say that, overall, credit expansion has lowered interest rates.

How is it, though, that Group B borrowers, if they may pay higher rates than Group A borrowers, channel these funds into longer, more roundabout investment projects? Wouldn’t the interest rates have to be lower than Group A’s in order to accomplish this? The comparison to Group A’s rate is not relevant, however. It is still the case that extending loans to Group B will cause an overall lengthening of the structure of production as funds that previously were earmarked for consumption will now be channelled into investment5.

However, whatever the duration of a loan and whatever terms on which is it advanced the cardinal fact remains as follows: lenders are not prepared to devote real resources towards the investment projects of the borrowers for the entirety of their duration. Just as in the same way as price controls in our example above tried to give people the ability to have their cake and eat it – afford both one apple and one orange at the same time even though the level of wealth could not sustain these purchases – and just as in the same way that John on the Robinson Crusoe island not consume his resources and invest them at the same time, so too is credit expansion a societal wide attempt to indulge in both consumption and investment simultaneously. The borrower thinks his new money allows him to purchase resources for investment whereas the lender, not having relinquished his purchasing power, thinks that he can still use his original money for consumption. What happens in practice, of course, is that the credit expansion forcibly transfers purchasing power from the lender to the borrower. The increased money supply causes an increase in the prices of capital goods and a relatively weaker increase in the prices of consumer goods. The lender still loses out, therefore, as he must now pay higher prices for the things that he wished to consume – in just the same way as he would lose out from price controls when he sees that the shelves are empty. As the cycle gets underway, higher doses of credit expansion are necessary to maintain purchasing power in the hands of the borrowers as prices rise sharply and inflation premiums begin to be written into loan contracts. Once the inflation gets out of control and the credit expansion is halted or reduced funds are cut off to the borrowers in Group B as they must now rely upon the genuine saving of lenders. But lenders are not prepared to lend real purchasing power under the terms that these borrowers are willing to pay. Thus, starved of resources to complete their projects, Group B borrowers must liquidate their half-finished investments which are now revealed, after the true consumption/saving preference of lenders becomes apparent, to be malinvestments. The bust phase of the cycle therefore sets in.

Conclusion

What we have seen from this analysis, therefore, is that while the “Austrian” claim that “credit” expansion lowers “the interest rate” leading to the business cycle can be elaborated and defended to account for multiple rates paid by multiple borrowers, the primary fact is that lenders are not prepared to lend purchasing power over resources to the borrowers for the duration of their investments. It is this lack of harmony in the use of resources which is the key to understanding the start of the boom and the eventual collapse and this should be the focus of anyone wishing to understand and expound “Austrian” Business Cycle Theory.

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1See, for example, the relatively well known Hayek-Sraffa debate. “Austrian” economist Robert P Murphy has stated that “Austrians”, or at least those who ascribe to the pure time preference theory of interest, are yet to provide a sufficient answer to Sraffa’s objections. Robert P Murphy, Multiple Interest Rates and Austrian Business Cycle Theory, unpublished.

2We are, of course, ignoring the real-world possibility of refinancing.

3Although the length of time may itself be an element that is accounted for in risk.

4It is also the case that, even if all else was equal, there would not be one “core” interest rate in the loan market anyway as different lending periods would also attract different rates. Again, the second analysis overcomes this problem as different time periods would constitute individual markets.

5From a simple cost account point of view, the longer a particular business enterprise takes to come to fruition the harder it becomes to fund interest charges on the borrowing that has funded it. An uncompounded interest charge of 10% on a loan of $1m for a project that will last one year will result in a total repayment of $1.1m, something that might be manageable. If the same loan at the same rate was made for ten years, however, the borrower will to pay twice the capital – $2m – back at the maturity date; a cripplingly high cost for even the most profitable of projects. If the interest rate is reduced to 2%, however, the ten-year borrower would only pay back a total of $1.2m, which would be more manageable.

Fractional Reserve Banking – The Ethics and Economics

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Fractional reserve banking is a prime topic for study on the part of libertarians on the one hand and of “Austrian” economists on the other. For not only is the practice, in the way it is carried out today, deeply unethical it also creates macroeconomic instability and is one of the causes of economic crises such as that which we are enduring currently. This essay will explore in particular the ethical and economic consequences of the legal framework imposed by government fiat that breathes life into this practice, concluding that it is government that is at the heart of its unethical nature and causes the endurance of its bad effects.

What is Fractional Reserve Banking?

A bank engages in fractional reserve banking if it retains as reserves only a fraction of its liabilities that can be redeemed on demand – most often, this means money that is held in current or “checking” accounts where you are entitled to withdraw your money at a moment’s notice. If customers have deposited in the bank £10 million of cash and the bank’s reserve requirement (or its internal practice, depending upon the regulatory regime) is 10% then the amount of cash held by the bank for withdrawal by those customers is a mere £1 million. This may be easier to visualise when deposited money consisted not of paper but of gold and other precious metals. When you deposited your gold in a bank, you were issued with a paper warehouse ticket stating the amount of your deposit (say, 10oz) and the fact that you were entitled to withdraw it on demand. If your bank engaged in the practice of fractional reserve banking then only a portion of this gold would actually be in the bank ready for you to withdraw. Incidentally, these warehouse tickets were the origin of paper money – a £10 banknote issued by the Bank of England still states “I promise to pay the bearer on demand the sum of £10”, £10 originally meaning 10 pounds in weight of sterling silver. Indeed, all of the monetary denominations such as pounds, dollars, francs and marks were originally fixed weights of precious metal. These days, of course, the note is backed by no commodity whatsoever and statements of account at banks merely indicate a promise to pay the sum stated in paper money which has, to all intents and purposes, replaced metals such as gold and silver.

The obvious question, then, is where on Earth has this money gone? If it is not in the bank then where is it? And more importantly, why is it not in the bank? Have the bankers taken your money and used it to purchase luxury consumption goods, hoping that you will never come back for it? Not quite; the answer is that the bank has loaned the money to borrowers, usually for the long term to people who wish to take out a mortgage, for example, in spite of the fact that all of the bank’s liabilities are payable on demand. In this practice of “borrowing short to lend long” the bank takes a gamble that two conditions will be met. First, that it will only ever need the fraction of deposits kept as reserves in order to meet the number of withdrawals by its depositors that are likely to be required at any one time; and second, that a sufficient number of the borrowers will pay back the money that has been lent out. The primary motivation for this is, of course, to earn interest on the sums lent. This is why most banks do not charge their depositors a fee for their services – they are using your money deposited to earn an income from other people.

Fractional Reserve Banking – Fraudulent or Legitimate?

The question of whether fractional reserve banking is fraudulent is a matter for debate in libertarian circles. Could not, for example, two persons agree to engage in the practice? If I know, for example, that my bank will only keep a fraction of the money as reserves and I know it is at risk of the bank’s insolvency then is there any breach of the non-aggression principle?

The answer to this question lies in the consequences of the terms upon which such an arrangement could be made and the also in the legal and regulatory context. There are two basic possibilities; either one’s deposit of money in a bank is a bailment, in which case the bank acts as a custodian of your money (like a warehouse or storage facility); or, the deposit takes the form of a loan to the bank and the bank is simply your debtor. In the former case, you retain proprietary title to the money and it is ring fenced from the bank’s own assets. If the bank goes bust then its creditors cannot get their hands on your money. Your bank statement is not a statement of account but, rather, an inventory of property deposited in the bank for safekeeping. In this scenario, but for one important qualification that we will mention below, the statement of account (or the warehouse ticket for gold deposits) is defined as the cash on deposit – in other words, it is the same thing. That is why people accepted paper tickets in trade when they were titles to gold. These transactions are not payments of money at all; they are transfers of the bank’s obligation to redeem cash on demand from one person to another. Because the obligation to pay is a full, proprietary title the transfer of this obligation is as good as the cash itself. Under this banking arrangement, fractional reserve banking would be fraudulent. If the bank loans out the money to a third party then it is required to grant full proprietary title over the money to the third party debtor in exchange for a promise to pay back the sum lent once the maturity date of the loan is reached. But the bank cannot legally divest itself of a title that is not in its possession. In essence the bank would be selling property which it does not own. It is exactly the same as me purporting to sell your house or your car to someone else and pocketing the cash – or a storage warehouse loaning out the furniture that you have deposited there for safekeeping. In practice, what happens is that the bank creates two simultaneous titles to the cash on deposit – one for you as the original depositor and one for the borrower. Both of you are under the delusion that you have exclusive title to the cash on deposit whereas in reality it could be claimed by the other person. In the second case, however, where the deposit takes the form of a loan to the bank, if this is agreed and understood by both parties in a genuinely free legal and regulatory environment then all well and good – there is certainly no breach of the non-aggression principle for libertarians to complain about. If the bank goes bust with it goes any claim to your money. However, one important aspect is that what is now in the depositor’s possession – a mere promise that you will receive payment in cash on demand rather than a full, proprietary title to cash – is a markedly different good from cash or a proprietary title to cash. Hence, we are now talking about two different goods – money on the one hand and a loan agreement on the other, something that is below the quality of money as the most marketable commodity. While it therefore may be a perfectly legal arrangement and people may be able to trade these loan agreements in exchange for goods and services (as we do today when we make electronic transfers) we would expect a loan agreement to trade at a discount compared to real money. Should this be doubted, even under full reserve banking the paper ticket to warehouse deposited gold was regarded as a distinct commodity by the trading public; when gold coins were stamped with a dollar value equal to the dollar value of a paper ticket, even though redemption of that paper ticket would guarantee payment of the same dollar value in coin, Gresham’s law came into effect and the paper tickets were traded while the coin was hoarded1. Under a system with genuine market pricing, therefore, we would expect warehouse receipts to gold to trade at a discount compared to real gold. If this is so then clearly loan agreements – far less secure than 100% warehouse receipts – would trade at a discount even lower than this.

All of this would be fine from a libertarian point of view and nobody can stop anyone else from accepting loan agreements freely in exchange for goods and services if that is what they want. The problem with today’s banking system, however, is that there is no genuine choice between these two arrangements. The fact that in today’s world “everybody” uses fractional reserve banks and “everybody” generally accepts mere loan agreements in settlement of debt without a premium does not mean that this arrangement has the full, unbridled consent of the public. First, legal tender laws force the public to accept as payment the government’s own monopoly brand of money and are unable to consider alternative media of exchange. Second, under the guise of “anti-money laundering” (in other words to try and stop drug traders, “terrorists” and other underground operations that are of the government’s own creation) the legal and regulatory regime has all but abolished cash transactions of any significant quantity, thus forcing people to direct their financial needs through banking institutions. Third, government schemes such as the Financial Services Compensation Scheme in the UK or Federal Deposit Insurance in the US (which basically means that the taxpayer is forced to foot the bill if the bank loses your money) provide a positive incentive to use these banking institutions and prevent either the hoarding of cash by the public or any “maverick” banker from splintering away and establishing a full reserve bank2. Fourth, these institutions have been completely cartelised under the aegis of the central bank, meaning that the only institution available for people to use for their banking amounts to little more than a single, fractional reserve bank splintered off into different brand names such as HSBC or Barclays in order to give the illusion of competition in the banking industry. Indeed, the force of government, either in the form of direct enforcement of fractional reserve banking or by forcing the taxpayer to bail out the consequences, has always been required to sustain the practice for any extended period of time as genuine competition between freely standing banks has always restricted their ability to issue large quantities of unbacked notes. The precise effectiveness of this point is debated between “Austrians”. The Mises-Rothbard orthodoxy emphasises that competing banks will swiftly call upon each other for redemption in the event that one bank takes possession of another’s notes. For example, if I deposited gold at Bank A and received for it a paper ticket stating that I had gold deposited in Bank A, I could use this paper ticket to buy goods and services from, say, a grocer. But if the grocer banks at Bank B, he will deposit my note from Bank A with Bank B, but Bank B will call upon Bank A to redeem its note in gold. Hence Bank A would be restricted from over issuing unbacked notes as whenever they fell into the hands of the customers of other banks those other banks would call upon Bank A for redemption in gold. Mises, moreover, also emphasised that the bank’s reputation with its own customers for being able to meet redemption on demand was a decisive limit upon the expansion of unbacked notes3. However, when all banks are issuing the same notes everywhere, with all gold deposited centrally in a monolithic bank (or no gold at all, as under our current regime) then this clearly isn’t possible and all banks would be able to expand together in concert. Later writers, however, have pointed out the importance of interbank lending in neutralising the effectiveness of banking competition, with banks that have over-issued notes borrowing from banks that are under-issued in order to meet redemption demands. In other words banks will not necessarily call upon each other for redemption and will seek instead to earn an interest profit through mutual lending4. However, all we need to conclude here is that people today do not have a genuine choice as to whether they should meet their financial needs through fractional reserve banks. We can, though, still see the difference between payments in cash and other methods of payment in certain limited circumstances. Debit and credit card payments are inherently less secure than hard cash and the risk to the merchant is that the card issuing bank will not honour the transaction after the customer has left with the goods – in just the same way as a deposit bank may be unable to honour a paper ticket to warehouse deposited gold. Acquiring banks and card issuers therefore levy a charge upon merchants in order to guarantee – or at least improve – the security of the transactions and some merchants pass this charge on explicitly to their customers as an additional fee. This results in two prices – a lower price for payment by cash and a higher price for payment by card. It is reasonable to assume also, therefore, that given a genuine choice people would also regard hard cash and deposits in fractional reserve banks as distinct goods of different value. Finally, if the lack of genuine consent of the public in using fractional reserve banks should be doubted, then try asking any banker whether he would be prepared to look his customers in the eye and tell them their money is not really in the bank. The experience of the present author suggests that this is enough to close a debate on the matter with bank employees who actually know how the system operates.

All of this suggests that people do not wish their banking arrangements to be managed with fractional reserves, given a genuine choice. Indeed the entire backbone of Mises’ thesis in The Theory of Money and Credit is that money and what he called “fiduciary media” (notes issued unbacked by gold) are distinct concepts and where people trade fiduciary media at a par with money or backed notes they only do so because they believe that they are not fiduciary media and are, instead, fully backed notes with redemption on demand all but certain. Something to pull the wool over the public’s eyes is needed in order to achieve this. In our world today it is the force of government sustaining fractional reserve banking and compelling people to use it which is the illegal and immoral element. This should be the focus of libertarians in their moral opposition to its practice.

Fractional Reserve Banking and Economic Instability

In addition to the moral element concerning fractional reserve banking, the practice in the way it is carried out today is also economically destabilising. As we know from “Austrian” Business Cycle Theory, the creation of credit that is not supported by any real saving forces the economy onto a path of malinvestment that must collapse once the credit creation stops. Fractional reserve banking is the primary method through which this credit creation occurs. Nevertheless, once again this issue is intricately connected to the legal and regulatory framework in which fractional reserve banking operates and it is this factor that will be emphasised in the treatment below.

Let us posit a first scenario where banking consists of deposits of gold and precious metal in exchange for paper warehouse certificates, certificates that are a legal title to money and do not represent merely a loan to the bank that would permit the latter to do with the gold whatever it likes. If, therefore, A deposited 100oz of gold in a bank the bank would issue a 100oz paper ticket to A and the gold would remain locked up in the bank’s vault ready for A to come and collect at a point in the future when he deems fit. In this instance 100z of gold in the economy has been replaced by a warehouse ticket to 100oz deposited in the bank When this ticket is used and accepted in trade it is “as good as gold” and people will trade the paper as though it was gold, although, as we noted earlier, with the possibility that it may trade at a minor discount compared to the real thing. At this point, the money supply has not altered; rather 100z of money proper has been replaced by a 100z “money substitute”. In this environment, if the bank engaged in fractional reserve banking it would print new paper tickets which represent full, legal titles to gold without any corresponding increase in gold on deposit in its vault – in other words, pure fiduciary media, in Mises’ terminology. Let’s say that the bank lends an unbacked 100oz ticket to a borrower, B. There is now, therefore, 100oz of gold deposited in the bank but 200oz of paper tickets that can be exchanged in trade. The supply of equally homogenous money substitutes that are deemed to be as good as money and are traded as money has therefore doubled. This method of fractional reserve banking (which, we might recall, is also the fraudulent one) will therefore cause economic instability and lead to the business cycle as it has channelled a new supply of money unsupported by real saving through the loan market. The new supply will lower the interest rate on money and will incentivise borrowers to invest in longer term investment projects than are sustainable under the pool of available savings5.

Let us now examine a second scenario where banking does not consist of deposits of gold and precious metal in exchange for paper warehouse certificates but, rather, gold is deposited on loan to the bank that is redeemable on demand. The money is legally the bank’s to do with whatever it likes but the lender may call for redemption at any time, taking the risk that the bank may not have sufficient reserves to meet the redemption. Furthermore let us assume that this arrangement is entirely voluntary and agreed to, with no government impetus or the force of law compelling its use. If A therefore makes such a loan of 100oz to the bank he will receive a paper ticket or a statement of account stating that he has loaned money to the bank that is redeemable on demand. A may be able to trade these “loan agreements” either in paper ticket form or electronically – either way it doesn’t really matter as both would be a transfer between individuals of the bank’s obligation to pay. 100oz of gold has been deposited in the bank and a 100oz loan agreement has been released into the economy. If the bank now engages in fractional reserve banking and makes a loan of 100oz to B by creating out of thin air another paper ticket (that in and of itself constitutes only a loan agreement and not a proprietary title to hard money), we now have 100oz of gold still in the bank but 200oz of paper loan agreements to gold issued in the economy. On the face of it, it would again appear as though the money supply has expanded through credit creation. Wouldn’t this lead to economic instability and ultimately to the business cycle? However, this is unlikely to be the case. For the crucial aspect in starting the business cycle is that the interest rate on money is lowered through people’s inability to perceive money that represents genuine savings and money that has been created out of thin air. In this case, however, it is possible to distinguish between money proper and mere loan agreements to money that are redeemable on demand. An expansion of the latter does not lead to an expansion of the former. While the “interest rate” on the loan agreements may fall as a result of the their expansion, so too would their discount compared to money proper as the increasing abundance of these loan agreements makes the security of redemption less likely. The effect of the increased discount would be raise production costs to borrowers which would offset the reduction of interest rate and prevent the business cycle from occurring.

Let us now fast forward to the situation that we have today. Now, the paper ticket itself has replaced gold as the item that is deposited and as we stated above everyone is either forced or cajoled into using fractional reserve banks under the aegis of a single, central bank. The expansion occurs through the increasing of deposit balances on account – i.e. the numbers on your bank statement. If you deposit £100 worth of Bank of England notes in your account you can transfer the bank’s obligation to pay electronically. If the bank then creates a loan out of thin air by creating another deposit account, both you and the borrower then have the ability to spend these digits in the economy. But, unlike the difference between money proper and mere “loan agreements” that was plainly obvious in the second scenario we explored, here, nobody knows which of the digits being spent represents genuine savings and which have been conjured out of thin air. Hence, the interest rate on money will fall, longer term investment projects will be stimulated and the business cycle begins with its “boom” phase.

It could be alleged that the inherent instability of this arrangement could be countered with the “prudence” of the banker – the idea that an expert fractional reserve banker will be able to loan wisely to only those borrowers who are most trustworthy and will keep on hand enough reserves to meet redemption requirements. This is beside the point. Apart from the fact that it is the least prudent bankers and borrowers who post the highest profits during the boom phase, leaving any conservatives way behind, the fundamental problem for economic stability is that no inter-temporal transaction has occurred – in other words there has been no a trade of present goods for future goods. In normal saving and lending, in order to make loan to the borrower for, say, one year the lender must save for a year. The lender in this instance has given up consumption for one year and freed real resources in the economy to the borrower so that the latter may use these resources in an investment that will come to fruition at the maturity date of the loan in one year’s time, allowing the borrower to pay back the loan to the lender so that the lender can then purchase consumption goods that have come into existence as a result of the borrower’s year-long investment. This is what makes real, sustainable economic growth possible – the harmony of temporal interests over goods between those with short time horizons and those with long. With fractional reserve banking, however, no such harmony exists. The lender – that is, the depositor – does not want to relinquish consumption for a year. He maintains his cash balance in a demand deposit account because he wishes to call upon those funds for current consumption and not consumption in one year. He may, of course, leave the funds in his deposit account for a year but the crucial point is that at the outset this is not certain – he wants to be able to call on consumption goods at a moment’s notice when the time arises. The borrower, however, wants goods that he can invest for a yearlong production process, tying up those goods for that duration until the project comes to fruition. He cannot accept goods that someone else will want back in a shorter time. It is clear that both individuals cannot have their way and that one or the other must ultimately triumph because the same resources cannot be simultaneously consumed and invested. During the boom phase when credit expansion rises, it is the borrower who wins as his increased purchasing power allows him to purchase the resources and invest them in capital goods – hence there is, during the boom phase, a marked price inflation of capital goods as these borrowers take advantage of their newly found purchasing power and a relatively weaker price inflation of consumer goods as the latter become more scarce relative to the demands of consumers. Once the credit expansion stops and starves the borrower of fresh purchasing power, however, it is the lender’s preferences that rule the roost. Either the lender must be prepared to start saving and thus provide the resources to complete the borrower’s investment projects; or, if he is not so prepared and maintains a preference for consumption, then the borrower’s investments must be liquidated. Hence, in the bust phase we experience a heavy price deflation of capital goods as they are hastily sold off and a weaker, relative price deflation in consumer goods buoyed up by the fact that these goods are still in demand.

Conclusion

What we can see from all of this is that the destabilising effects of fractional reserve banking on the one hand and its illegal and immoral aspect on the other are two sides of the same coin. The fact that people do not know which units of currency in existence represent real, genuine savings and which have been conjured out of thin air as fiduciary media is the essence of both the fraudulent  and destabilising nature of fractional reserve banking. The government in bed with a monolithic banking system pulls the wool over everyone’s eyes for their own enrichment at the expense of wasteful malinvestments during booms, followed by unemployment, misery and taxpayer funded bailouts during busts. It is high time that the public realised the true nature of their fractional reserve banking system and anyone who cares for liberty is right to emphasise its odious nature.

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1As Ron Paul has suggested, it was this that resulted in a withdrawal of gold coin from circulation and its concentration as deposits in banks that made it easier for governments to confiscate them. It is for this reason that both Paul and, earlier, Mises urge the need for gold coins to be used physically in transactions. See Ron Paul, “The Political Agenda for the Real Gold Standard”, Ch. 7 in Llewellyn H Rockewell, Jr. (ed.), The Gold Standard – Perspectives in the Austrian School; and Ludwig von Mises, The Theory of Money and Credit, Part Four, Chapter III, “The Return to Sound Money”.

2We can also suggest that, as per Ron Paul’s analysis cited in note 1 above, that as electronic transfers and paper notes bear the same legal value, Gresham’s law comes into effect and the paper notes are stashed away in banks while electronic digits are traded.

3Ludwig von Mises, Human Action, The Scholar’s Edition, p. 436.

4See, for example, Nikolay Gertchev, “The Inter-bank Market in the Perspective of Fractional Reserve Banking”, Ch. 10 in Jörg Guido Hülsmann (ed.), Theory of Money and Fiduciary Media – Essays in Celebration of the Centennial.

5This expansion of credit is not likely to last for very long in a competitive banking environment that lacks deposit accounts. Not only, of course, could overexpansion call for redemption of the overissued notes in specie, but soon the economy would clearly be awash with paper tickets which reveal that something is amiss. Central banking, abolishing competition, would be needed to sustain the expansion of note issue and electronic transfers between deposit accounts would be needed to hide the expansion from plain sight. Ironically, therefore, monetary expansion or “printing money” these days involves a contraction and not an increase of circulating paper notes. As a note of historical interest, Peel’s famous Bank Charter Act of 1844 failed to control economic instability because, following the otherwise insightful Currency School of thought that was prevalent at the time, it concentrated only on banknotes and overlooked the role of deposit accounts in expanding the money supply.

Economic Myths #6 – Price Stability

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One of the so-called mandates that our economic lords and masters have arrogated for themselves is that of maintaining so-called price stability, a constant purchasing power of the monetary unit in our wallets. At first blush, price stability sounds rather appealing – not only does it “bless” us with the apparition of certainty but might we not also be “protected” by the potential of higher prices in the future, so we never have to curtail the amount that we can buy and enjoy? If so we can therefore assure ourselves that our cost of living will be sustained and manageable, relieved of the horror that the essential consumables may some day be out of our reach.

Unfortunately this ambition is not only disastrous for a complex economy but is also antithetical to the nature of human action in the first place. The whole purpose of economising action is to attempt to achieve more for less – to direct the scarce resources available to their most highly valued ends and to gain the highest possible outputs with the lowest possible inputs. In short, economic progress means that we are gradually able to attain more and more for the same amount of labour; or, to put it another way, we could attain the same quantity of goods for a lower amount of labour. Any consistent attempt to stabilise the prices in the economy would not only target the goods that we buy with our money but also the goods that we sell – and that for most of us means our labour! But if we cannot sell our labour for any more and if we cannot buy our wares for any less then it means that we will simply be locked into a repetitive cycle of working, buying, consuming and working again for the same prices for the whole of our lives with no improvement in the standard of living whatsoever. Instead of economic progress bringing goods at cheaper prices to the lowest earners, everyone will now have to attempt to be a high earner – i.e. by putting in more labour – in order to accomplish any increase in their wellbeing.

Of course, real price stability never does and never can work in this way for it is impossible for a centralised authority to monitor and regulate all the many millions of individual prices and exchanges that occur every day in the economy. Rather they target the mythical pseudo-concept of the general “price level”, usually concocted by taking a selective index of goods, an index that can be altered conveniently in order to paint the data in the fashion desired. Individual prices within the index, however, may still fluctuate relative to each other even though the absolute price average may appear constant – a fact that may not mean a great deal to the bureaucrat but is of great importance to the individuals who wish to purchase those particular goods. Furthermore, because of the belief that a dose of price inflation is good for a growing economy, “stability” usually tends to be defined as including some measure of price inflation such as the Bank of England’s 2% inflation target. We are apparently “stable” when the government is robbing your pay packet of some of its purchasing power, it seems.

Such a policy is not restricted to existing as a mere moderate tempering of an otherwise healthy and growing economy. Rather, it can have disastrous and deleterious effects upon the entire system. The outcome of a genuinely growing economy with sound capital investment should be a gradual, secular price deflation where goods and services become cheaper over time. If central banks attempt to counter this in order to achieve stability it must lower interest rates and print more money in order to devalue the monetary unit relative to goods in order to prevent prices from falling. However such an act is what induces the ill-fated business cycle; prices may appear stable but the relative prices of capital goods will begin to rise and those of consumption goods to fall as the new money gets sucked into ultimately unsustainable investment projects. This is precisely what happened in the 1920s when a high degree of productivity was countered by a voluminous expansion of credit that masked price rises, giving the illusion of price stability and suckering promoters of the scheme (such as Irving Fisher) into believing that they were living in a new era of permanent prosperity. The same was also true of the run up to the tech boom collapse at the turn of the century and the housing market collapse of 2008; these had been preceded by a period of low interest rates and apparently low price inflation – alleged hallmarks of an successful economy – that camouflaged the underlying distortions, leaving mainstream economists scratching their heads in confusion as to what went wrong.

Far from creating certainty and consistency, achieving “price stability” is one of the very worst horrors of a centralised, bureaucratically managed economy. Let us leave prices – which, after all, are supposed to result from the underlying supply and demand according to individual preferences – to the free market so that we can create a genuinely stable and lasting economic prosperity.

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Money – the Root of all (Government) Evil?

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In addressing the evil and parasitic nature of the state, libertarians focus on many of the state’s specific characteristics in order to demonstrate its destructive effects upon civilisation – whether it is nationalised industries, market interference, the minimum wage, anti-discrimination and egalitarian pursuits, the business cycle, or whatever, there is a treasure trove of libertarian literature available that explains and elaborates the deleterious effects of these particular state endeavours. However, a less addressed question is which of these areas, if any, are the most important? Which of them amount to mere nuisances that can be circumvented or otherwise put up with and which, if any, of them amount to a significant transfer of wealth and power to the state with seemingly permanent effects? Furthermore, is there any one issue that libertarians should stress above all others if we are to deliver a real and significant puncture to the state’s ever-inflating balloon?

One prime candidate for this title is war and international conflict. With war comes every glittering prize that the state could ever dream of – mass mobilisation of labour and industry towards a common purpose dictated by the state; control of all markets; mass propaganda; control of communications; suspension of free speech and possibly of habeas corpus; and not to mention the bogeyman of the supposed enemy to which to channel the attention and hatred of the average citizen. Indeed Murray Rothbard, relatively in his career, recognised that while libertarians had some very profound things to say about the state’s mismanagement of, for example, the post office, focussing on war was the real key to unravelling the state’s power and oppression of the population.

Nevertheless, while a permanent and lasting degree of state power and control is enabled by war there is another contender for the top spot. That is the government’s control of money and, specifically, the ability to create an endless supply of paper money distributed to itself and its favoured outlets, as opposed to the rigour and discipline imposed by a “hard money” standard such as gold. Ultimately it is the state’s ability to fund itself that is at the root of all of its other absorption of power and control – even war.

In order to demonstrate this let us look at what the situation would be if government was constrained by a denationalised, “hard” money such as gold. In the first place, government would be wholly reliant upon the tax receipts of its individual citizens for funding and would be unable to resort to extensive deficit spending or inflation. The plainness and visibility of that confiscation places a much lower limit upon the state’s coffers. Put simply, when too much money is taken out of your hands physically you are likely to revolt much sooner. Indeed, in the past, war itself was an expensive operation and battling kings often struggled to raise funds to maintain campaigns. Strategic brilliance was often not accomplished by an all-out destruction of the enemy but, rather, by out-manoeuvring your opponent and preserving for as long as possible expensively-trained soldiers and equipment. In many cases funding had to come from external sources. The genesis of the aristocracy was in those who were rewarded with titles to the conquered land in return for funding the war – in other words the ruler had to parcel out parts of the new territory to those who had helped him grab it. Indeed even the English parliament itself and the Magna Carta­ – famed as the genesis for two cardinal principles of liberty, no taxation without consent and no trial without due process – resulted in part from the reliance of the king upon his relationship with the barons for support and funding. Hard money therefore not only physically restricts the amount the state can spend but has been the indirect cause of the enshrinement of restrictions upon the state’s despotic power.

In more recent times, however, the ability to provide funding from a non-stop printing press has permitted the state to expand its activities without having to account for them through tax receipts. People do not see the money disappearing from their pay packets or from their bank accounts; all they see is the prices they have to pay for goods and services rising and squeezing their purchasing power, a fact that can be easily blamed on greedy businessmen and shareholders. It is possible for a libertarian to be sympathetic with the view that as long as you know how much the government is taking from you then it has a reasonable degree of tolerability. But when government resorts to the smoke and mirrors trick of robbing not the money in your hand but, rather, its purchasing power then it must be opposed emphatically. In comparison to earlier conflicts, the wars of the twentieth century were so prolonged and destructive precisely because government could resort to the printing press. Had they relied solely upon tax receipts “war-weariness” would have set in much sooner among the population and they would have demanded a swift end to hostilities. Hence all of the overreaching effects of the state’s engagement in war flows directly from its ability to control the supply of money. If we wish to end the consequences of war upon the state’s metastasised growth then we need to attack the root of its ability to fund it.

It is true, of course, that there may be something of a chicken and egg story when it comes to war and paper money. Does paper money cause government to engage in war or does war cause government to print paper money? Either way, however, even if government was previously respectful of a hard money standard which it does not abandon until the outbreak of a war, it is this power of printing paper money in and of itself that fuels the extent of its belligerence. And in any case, the ease with which government can suddenly suspend a hard money standard only comes about because they have arrogated to themselves monopolistic control of the operation of money issuance. It would be much harder for government to print un-backed notes and force their acceptance when others are issuing notes fully redeemable in gold. Whatever comes first, however, either the paper money or the war and the growth of the state power, if you wish to prevent the flood then you must turn off the taps.

In more peaceful times hard money also disciplines the citizenry into realising that government is not the fountain of all wealth. The state has grown so much under democracy because, apart from the veneer of legitimacy that popular elections lend to the state, politicians are able to bribe the electorate with endless goodies that they do not believe that they have to pay for. The resulting borrowing and inflation – now reaching an eye-watering level in the West – which does not touch the citizen directly gives the impression of government as an endless stock of resources, the only difficult task being to elect someone who will give them to you rather than worrying about the more trifling matters of production and enterprise. Indeed, public discourse rarely seems to acknowledge the fact of scarcity, usually focussing on single issues and concluding with an explosion of outrage about how government isn’t “doing more” to combat the alleged societal ill. The more difficult question of the expense that we would endure, what should be given up as a result and which goods cannot be brought into being because of the new expenditure diverted to cure the problem complained of is overlooked. To the citizen there is always more money, more resources and more of everything that government can acquire from somewhere other than himself. However, in exactly the same way as a hard money standard would induce “war-weariness” in belligerent times so too would it induce “state-weariness” in peaceful times. People would soon tire of having their pay packets robbed to fund goods for other people; and people would soon realise that many of the things they would otherwise want from government for free simply cannot be afforded and must be worked for by themselves.

Let us turn next to the whole problem of the business cycle. Although panics existed before the advent of modern central banking many of these occurred precisely because hard money rules were casually abandoned, with issuing institutions expanding the volume of credit beyond the stock of monetary gold and government happily stepping in and relieving them of the obligation to redeem their notes in specie. But whatever the characteristics of pre-central banking business cycles it is undeniable that they reached a depth, severity and prolongation in the twentieth century that was not seen before. There are two reasons for this. First, government’s enhanced control over the supply of money induces a more serious degree of malinvestment than would otherwise be the case where the supply of money is checked by the stock of redeemable gold. In both of the biggest collapses of the last one hundred years – 1929 and 2008 – credit expansion ran for the best part of a decade or more. The longer the false signals towards entrepreneurs are continued the more they will borrow and invest in unsustainable capital projects and the further those projects go the more difficult they will be to unwind. When the bust finally comes, therefore, the situation is far more serious than it otherwise would have been. This brings about the second factor – that it lends credibility to the argument that the government should step in and “do something” to combat the malaise. The reason why the Great Depression endured for years (and why we are still enduring the current one) is not because of the initial collapse – it is because government did everything it could to maintain the existing structure of production, wages and prices. Fittingly enough President Hoover often invoked the language of war in describing the threat of the downturn and the culmination of this in the New Deal – the complete cartelisation of industry and agriculture into a fascistic economy – was achieved by the resurrection of World War One era departments and programmes. It is supremely ironic that government-caused depressions give rise to ever more invasive government intrusions, an irony that turns truly into tragedy when we consider that what followed the Great Depression was the carnage and destruction of World War II. With the current belligerence of the US in provoking tension with Russia and China another war is something that cannot be ruled out as a result of the present crisis; and we all know how destructive war is to freedom.

What we can see therefore is that government control of money is a prime contender for the top spot of issues that libertarians should consider as the most serious when combatting threats to liberty. If this should be doubted then one has to question why the mystery of central banking and its ability to pull the monetary strings from a shady, secretive outlet has been a political non-issue for decades. Politicians only bring into debate the relatively “easy” problems that do not upset the apple cart. While they are keen to oust their immediate, political opponents they never provide the public with any serious choice that would restrict the power and growth of government as a whole. At least democracy – another cause of government growth and legitimacy – gets praised and lauded from time to time, if only ever to justify the government’s military crusades against foreign tyrants. But before the last few years central banking and monopoly issuance of money was hardly even mentioned – not even to give it a blessing. It seems as though government is fine with brainwashing its citizens into embracing the justice of elections by voting but it is far too scared to even make them aware of its power over money. Although this is now beginning to change and there is a greater enquiry into and scrutiny of the US Federal Reserve (not least because of ex-Congressman Ron Paul’s emphasis of the issue) the acceptance of and absence of discussion of these evil institutions has pervaded for too long. This is where government would be truly and irredeemably hurt. It could enact as many reams of invasive and destructive legislation as it liked, yet they would be of zero threat if government was starved of funding to enforce them.

It is appropriate to end with the words of Ludwig von Mises who recognised everything we have been saying here in his first major treatise on the subject of money:

Defense of the individual’s liberty against the encroachment of tyrannical governments is the essential theme of the history of Western civilization. The characteristic feature of the Occident is its peoples’ pursuit of liberty, a concern unknown to Orientals. All the marvellous achievements of Western civilization are fruits grown on the tree of liberty.

It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights. The demand for constitutional guarantees and for bills of rights was a reaction against arbitrary rule and the non-observance of old customs by kings. The postulate of sound money was first brought up as a response to the princely practice of debasing the coinage. It was later carefully elaborated and perfected in the age which—through the experience of the American continental currency, the paper money of the French Revolution and the British restriction period—had learned what a government can do to a nation’s currency system.

[…]

Thus the sound-money principle has two aspects. It is affirmative in approving the market’s choice of a commonly used medium of exchange. It is negative in obstructing the government’s propensity to meddle with the currency system.

The sound-money principle was derived not so much from the Classical economists’ analysis of the market phenomena as from their interpretation of historical experience. It was an experience that could be perceived by a much larger public than the narrow circles of those conversant with economic theory. Hence the sound-money idea became one of the most popular points of the liberal program. Friends and foes of liberalism considered it one of the essential postulates of a liberal policy1.

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1 Ludwig von Mises, The Theory of Money and Credit, p 414.

 

Economic Myths #3 – We Need More Jobs!

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During the economic malaise one of the most frequently watched figures in the economy is the number of jobs that are either created or destroyed. Government makes “job creation” a central plank of its economic policy to put people back to work and the impression that more people are being hired and fewer are being fired buoys their hubristic impression that we must be on the road to recovery.

Unfortunately this obsession with jobs is another example of the error of looking at an isolated aspect of economic achievement rather than at the entire picture – much like trying to boost consumption in order to further growth which we explored in myth #2. Jobs (or work, or labour) are simply what we have to do in order to achieve our valuable ends with the scarce resources available. It is the toil and suffering that we have to undertake in order to get to what we want because we do not live in the Garden of Eden. Our ideal situation is to have everything we want without having to have any jobs at all and economic growth fuelled by greater capital investment permits us to have more and more of what we desire for less effort. Our focus, therefore, is not on jobs per se but, rather, on what these jobs produce – the outcome of our labour and not that labour itself.

The most oft-cited example of useless job creation is government paying people to dig holes in the ground and then fill them up again. The unemployment figures would go down; the stock market would probably rally; the currency would strengthen. And yet these “jobs” have produced absolutely nothing whatsoever. All of the time and effort put into administering and fuelling them simply depleted the world of resources rather than added to it. In the real world, what this looks like is government providing artificial stimulus or subsidies to industries that are not otherwise economically viable; government “job creation” programmes; and not to mention, of course, the endless ream of bureaucrats that the government employs directly. Creating artificial jobs that do nothing funded by a government payroll simply papers over the cracks of an unsound economy. Yes, more people feel better as they have dollars in their hands and are probably not worrying about where the next meal will come from; but all that has happened is that those who were already working are now being forced to subsidise those whose employment creates no productivity.

A related fallacy is that if somebody somewhere is carrying out some kind of economic activity and the more of that activity there is then, so it is concluded, the better the economy is doing. To the central planners it doesn’t matter whether there is a housing boom, a construction boom, a tech boom or a stock market boom as long as there is lots of stuff going on, regardless of whether people actually want the products that are churned out by those enterprises. It is for this reason why we have the business cycle in the first place. Obsessed by creating some kind of “output” the artificial stimulus of credit expansion pushes the economy onto a path which, while brimming with activity, is ultimately not in harmony with the desires of consumers.

Job quality is more important than job quantity. The correct focus of any economic policy should be to ensure that we are labouring to direct the scarce resources available to the ends that we desire – and not simply on wasting those resources by doing some kind of fundamentally useless activity just to make government look good. “Full production” and not “full employment” should be our mantle.

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Economic Myths #2 – Consumption Boosts Growth

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The belief that economic growth is boosted by consumption is based upon such a simple misunderstanding that a realisation of the truth will cause one to question why such a simple fact evaded you in the first place.

The confusion is based on a conflation of the desire to consume on the one hand with the act of consumption on the other. It is true that all economic growth, and all economic activity, is motivated by the desire to achieve consumption – in other words, to devote scarce resources in order to satisfy our most highly valued ends. Without any desire to consume or to satisfy any ends there would never be any economic activity whatsoever. The act of consumption, however, does not in and of itself fuel any economic growth. For consumption is the result of growth – i.e. of increased production – and not the initiator. Consumption is what we reward ourselves with once we have achieved growth and not that which we do in order to begin it. Stated in its simplest way you cannot consume a good unless it has first been produced.

At any one moment in time there is an array of produced goods available to us. Each of us faces a basic choice as to what to do with these goods – consume them now, or turn them into productive capital goods that will yield a greater output of consumption goods in the future. If we choose the first path – consumption – all we do is reduce the number of goods available to us and we are left with less. We may have achieved immediate satisfaction but we now have fewer resources left with which to produce more in the future. If I burn a log of wood to keep warm I cannot then use it as building material later. Rather it is gone forever and I will now have to labour in order to search for fresh building materials if I am to make good this loss. A farmer who decides to eat the seeds for crops in the spring will then have nothing to sow and come harvest time will have barren and empty fields rather than lush acres full of wheat. Beyond the point of providing nourishment and sustenance to the human body the act of consuming of these goods will not provide any growth. Consumption, for the most part, is the destruction of what we have. Growth is the transformation of what we have into something that will produce more for us in the future. If we choose the second option – that of turning our goods into productive resources – rather than destroying the resources available to us we will invest them in productive enterprises that raises the yield of consumer goods in the future.

The key to promoting growth, therefore, is not to encourage the act of consumption which equates with an act of destruction. Rather it is to encourage production and a direction of a greater proportion of our resources available today towards saving and investment so that we may consume more in the future. This is particularly important following a bust that results from a boom or bubble inflated by credit expansion. With so many malinvestments left starved of resources the best thing we can do to minimise the pain is to increase the proportion of saving and investing so that at least some of the doomed projects may realise a degree of viability. Instead our economic lords and masters do the precise opposite and encourage us to borrow, spend and consume which only exacerbates the losses experienced by those projects that were started in the boom. Growth must begin with saving, sound investment and production which is then rewarded by greater consumption. Consumption will never lead to growth and it is important for Austro-libertarians to point out this grave fallacy.

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