“Capitalism – A Treatise on Economics” by George Reisman – A Review

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It is not often that the present author is moved to review any particular publication by a specific author, let alone one that was published nearly twenty years ago. However, Capitalism by George Reisman, at more than one thousand pages long, is the first major treatise that is at least related to the “Austrian” tradition since the publication of Murray N Rothbard’s Man, Economy and State in 1962.

Although Reisman is a contemporary of Rothbard and a fellow student of Ludwig von Mises, Reisman’s approach to economics is markedly different from either. Indeed, armed solely with knowledge of his pedigree one might be forgiven for wondering why more attention has not been directed towards to Reisman’s work from within “Austrian” circles. It is only after having read this treatise that one can see why. Although Reisman claims that Mises is his primary intellectual influence, there is very little of this treatise that could be regarded as distinctly Misesian. Rather, Reisman’s direct influences are the classical economists (especially Smith, Ricardo and J S Mill, upon whom he relies for support to an extent far beyond his reliance upon Mises) and Ayn Rand. Reisman specifically rejects the categorisation of economics as the science of human action, and prefers, instead, to regard it as “the science that studies the production of wealth under the division of labour”. He therefore willingly abandons any analysis of individual values, means, ends, and choices, and restores economic theory to the study of holistic aggregates; indeed we might say that his definition of economics, which views wealth as an entity possessing some kind of objectively determinable magnitude, demands such a restriction. Reisman positions the businessman, rather than the consumer, as the centre of the economic system, stating that consumers (as a whole) are largely dependent upon businessmen (as a whole) rather than vice versa. While, according to Reisman, consumers provide the direction of economic activity (i.e. the precise direction of resources to fulfilling specific industries), businessmen and capitalists are responsible for its extent, i.e. the limits of saving and capital investment. In other words, it is the decisions of capitalists that determine the extent of “economic progress” (a term Reisman prefers to “economic growth”) rather than those of consumers. A corollary of this is that production and producers are reinstated as the keystones of economic activity rather than consumption and consumers (there is at least an implication in parts of the treatise that production is good and proper whereas consumption is bad and wasteful, although this is much muted compared to the same in Reisman’s classical influences). Furthermore, it is clear that Reisman does not regard his approach to economics as a wertfrei science and, instead, believes his economic theory to be a rigorous promoter and defender of the capitalist system – an attitude that cannot be avoided by his definition of economics as the study of the accumulation of wealth under the division of labour, a division that he says is only possible under private ownership of the means of production. Thus, in Reisman’s world, a discussion of economics is a discussion of capitalism which, presumably, explains the book’s title.

What can we say about Reisman’s approach? Without beating about the bush we must state at the outset that Reisman, who is thoroughly acquainted with “Austrian” economics, has jettisoned a tremendous degree of sound theoretical understanding from the science. Although Reisman, who self-identifies as an “Austro-classical” economist, endeavours to restore to economics many of the (in his opinion) sound doctrines of the classical economists that were allegedly rejected following the discovery of the law of marginal utility and the backlash against Marxism, we must conclude that the result is something of a retrogression rather than a synthesis of two, hitherto quite disparate, schools of thought. In Reisman’s world, the achievement of all ends and their associated costs never advance deeper than the objective measurement of exchanges for money. He never advances any exposition of individual ends and subjective costs (indeed, he explicitly rejects the doctrine of opportunity cost). Hence the entire purpose of the economic system as serving the needs of individuals and the types of decisions that individuals must make in order to achieve these ends is missing, subsumed by the supposedly limitless need of man as a whole to accumulate “wealth” in perpetuity. In other words, Reisman’s restoration of the primacy of the production of “wealth” overlooks the fact that all production is ultimately aimed at providing for consumers and that it is the ends of consumers to which the economic system is geared. It is perfectly consistent to state, as does the wertfrei “Austrian” school, that the purpose of all economic endeavour is to provide for consumption while on the other hand remaining firm that the means of achieving this consumption can only be served by increased production. Therefore, while we can hold that the desire for consumption is the ultimate cause of economic progress, we can also state that production is the proximate cause. Thus, while Reisman’s categorisation of economic theories under the headings of either “productionism” or “consumptionism” – the former of which involves the promotion and encouragement of increased production as the means towards economic progress, the latter the promotion and encouragement of increased consumption – provides an instant and convincing cognitive aid, it obscures the clarity afforded by this insight of the “Austrian” school.

Furthermore, Reisman’s repositioning of the capitalist/businessman as the driver of economic progress relies upon capitalists providing the bulk of investment funds, i.e. that it is the consumption/saving decisions primarily of businessmen that determines the extent of economic progress. He argues that the wages of labourers do not provide a significant source of investment funds and are usually consumed either immediately or are saved in order to purchase durable consumer goods such as housing or automobiles. Any investment saving that labourers do happen to undertake is likely to be wholly disinvested at retirement, thus netting out the saving of younger generations. However, there is no reason for Reisman to think that this this must be the case. It is just as possible for investment funds to come from the savings of everyday individuals that are then lent to businessmen for them to deploy in their enterprises via a conduit such as bank savings accounts (and such a view would greatly undermine any opinion that capitalism keeps the masses in servitude as wage labour). The distinctive role of the businessman is that he provides entrepreneurial talent in order to generate economic progress by directing those saved funds to where they are most urgently desired by consumers. Yet Reisman’s treatise lacks any extensive theory of entrepreneurship and only passively recognises the need for superior decision-making in order to fulfil the ends of consumers. This lacuna in Reisman’s theory means that in order to position the businessman as the driver of economic progress he has to paint him as the primary provider of investment funds. This contrasts greatly with Reisman’s mentor, Mises, who makes entrepreneurship a hallmark of Human Action, thus giving us an insight into the economic significance of the businessman that extends far beyond the fact that he simply didn’t consume his wealth. (Some of Reisman’s views on what determines an individual’s consumption/investment preferences, which inform his theory here, are also incorrect and we will explore these below). In any case, however, Reisman seems to support his theory through a blurring of economic categories, such as labourers, consumers, capitalists, etc. (something which, irritatingly, is done all too frequently). In reality, all individual people in the economy participate in different categories at different times – a man is clearly a labourer when he goes to work, a consumer when he spends his wages in the shops, and a saver when he buys a corporate bond. However, when we are discussing, for the purposes of conceptual clarity, the roles of individuals in these economic categories, we isolate those specific roles from other categories and thus we always talk of labourers qua labourers and consumers qua consumers, etc. So even if it may happen be true that the particular people who are businessmen are responsible for the greater part of saving and investment, businessmen are consumers too and considering them as consumers qua consumers it is their decision to refuse to consume their wealth today in favour of accumulating greater wealth for consumption tomorrow that provides the source of investment funds. It is therefore true to state that it is the choices of consumers who determine both the direction and extent of economic progress. Moreover, as Mises also recognises, any consumer who is currently a wage earner can transform himself into a businessman, entrepreneur or capitalist by saving and investing his wages (while, equally and oppositely of course, any businessman who decides to consume his fortune may end up as a wage earner).

Finally, it is one thing to state that the preoccupation of the economic activity of any one (or even most) individuals may be with the accumulation and augmentation of their own wealth. But it does not follow from this that the science of economics itself concerns the accumulation of wealth. Animals preoccupy themselves with the need to attain food and shelter but this does not mean that the focus of zoology is with the achievement of these things.

Examining Reisman’s treatise on its own, non-wertfrei terms as a rigorous defence of the capitalist system, much of its earlier part is a detailed offence against the fallacies of socialism, collectivism, interventionism and environmentalism (and later, Keynesianism and inflationism). These devastating, if often heavy handed, critiques are likely to be viewed as by Austro-libertarians as Reisman’s greatest achievement in this work, even if some of it was previously published as The Government Against the Economy. A specific and lengthy chapter is possibly the most passionate assault against the ecology movement, a chapter that could easily be expanded and published as a separate treatise (Reisman’s stress of the anti-human zeal of environmentalism resonates with that of environmentalists, such as former Greenpeace Canada President Patrick Moore, who have become disillusioned with the movement). Reisman’s explanation of various forms of government intervention, such as price fixing, with reference to specific notable examples such as the oil recession of the 1970s, in which he traces out all of the effects (and effects of alternatives to) government meddling have rarely been matched. Yet much of the remainder of Reisman’s exposition does not in fact read as a promotion or a defence of the capitalist system; rather it is more akin to an aggregative, accountancy-laden explanation of what the capitalist system does, much like a description of some giant machine that swallows up inputs measured in numbers and churns out some kind of output, also measured in numbers. Reisman categorises an endeavour as productive according to its ability to earn money voluntarily through exchange. Hence all government functions, relying upon taxation, must necessarily be classified as consumption and not production. In other words, government can never produce and must always be a leech on the genuinely productive, capitalist system. Moreover, his excellent critique of socialism recognises that socialism must entail tyranny and a replacement of the ends sought by individuals with the ends sought by leaders. However, Reisman’s aggregative, accountancy approach never builds upon this insight. In the depths of the latter half of the treatise one almost forgets any connection between these accounting entries and how the capitalist economy serves the needs of individual people. One of Reisman’s stated aims in the treatise is to show how a proper understanding of the capitalist system should prevent one from feeling any kind of “alienation” from or subjugation by the capitalist system – something which Reisman comes closest to achieving through his analysis of the division of labour. Yet in the main it would appear that the Mises-Rothbard approach of detailing the economy as a network of bilateral, voluntary exchanges between individual people striving to meet their own needs through voluntary co-operation (and how these disparate and often conflicting goals and purposes nevertheless mesh into a harmonious, productive society) is much more conducive to achieving this than is Reisman’s aggregative, accountancy method. While it is true that the ability of capitalism to manifestly increase the standard of living and the degree of material wealth lends it a tremendous amount of moral weight, we can suggest here without too much elaboration that any rigorous defence of capitalism and, moreover, freedom can proceed only by focussing on the primacy of the needs of each individual person, not all of which can be measured or attained though objectively viewable exchanges for money. This omission in Reisman’s work also weakens the distinctly economic flavour of this treatise, as individual choices, desires, wants, decisions and actions do not seem to matter.

Turning now to some of Reisman’s theoretical contributions to the science of economics, there are two that stand out in particular. The first is his attempted demolition of the “conceptual framework” of the Marxist exploitation theory by asserting the primacy of profit rather than of wages. In Reisman’s view, critics of Marxism, including Böhm-Bawerk, have accepted the categorisation, originating with Adam Smith, of profits paid to capitalists as deductions from wages, and have sought explanations in order to justify this deduction. Reisman, however, asserts that wages, paid to labourers, are, in fact, a deduction from profits. If profits are calculated by subtracting business costs from business revenue, it is clear that if a person undertakes an enterprise to achieve, say, 100 units of revenue then every monetary outlay he expends in order to achieve that 100 units of revenue must count as a deduction from it. The fewer costs he has the more profit he is left with. Thus it is profits that represent the primary economic income, not wages. It is conceivable for the economic system to have profits but not wages in the event that every individual person operated as a sole trader and employed no other individuals. If, however, a businessman hires labourers to assist in his enterprise, the wages he must pay to these workers for their assistance are deducted from the ultimate sales revenues. Therefore, according to Reisman, wages only appear in the economic system on account of the help that other people provide to a businessman’s enterprise, and their help stakes a claim on his revenue. Thus it is wages that are deducted from profits, not vice-versa.

Whatever the merits of this view we must conclude that, to the dyed-in-the-wool Marxist, it is likely to be beside the point. The source of contention in the exploitation theory is that the businessman doesn’t do anything and simply leeches off the productivity of the worker; in other words by hiring labourers the businessman simply abdicates any participation in the act of production yet still gains an income. Reisman himself provides the answer to this by pointing out that labour is not the only source of productivity in a division-of-labour society and that it is, in fact, decision making, risk-taking, management and oversight that are also essential – in other words, entrepreneurship. And yet, as we noted, any extensive treatment of entrepreneurship is precisely what is missing from Reisman’s theory. Therefore, it must be submitted that an understanding of entrepreneurial profit and loss and the insulation of the labourer from business risk coupled with the time preference theory of interest provides a more effective demolition of Marxism than the primacy of profit theory which, if correct, provides only additional ammunition for it.

This brings us to Reisman’s next theoretical contribution which is his net-consumption/net-investment theory of aggregate profits, profits which he tries to explain in an environment of an unchanging supply and flow of money. The attempt to explain profit in terms of physical goods is relatively straightforward. Goods, of course, can increase or decrease and thus there can be absolutely more (profits) or fewer (losses) of them across society as a whole. We can also understand clearly, across the time structure of production, how the consumption of a smaller quantity of physical goods can be foregone today in order to produce a larger quantity of goods tomorrow. This is not so when it comes to accounting for profits and losses in terms of money which is assumed to be fixed in supply and flow. For every transfer of money that represents a credit to ones businessman’s income must show up as a corresponding debit to another businessman’s costs. Hence, while some individual businesses would earn profits and others would suffer losses, all profits and losses across the economy as a whole would net out and hence any question of aggregate profit would be impossible. The only method of solving this conundrum is to somehow, on the societal balance sheet, create a credit entry to income/equity without a corresponding debit entry to costs. It is the explanation of how this is possible that Reisman sets out to achieve.

The first element of aggregate profits – “net consumption” – derives from the fact that business revenues from consumption spending by labourers (and, as we noted, Reisman categorises all spending by labourers as consumption spending) shows up also as a business cost in the form of wage payments. Therefore, revenue and cost cancel each other out on the societal income statement. Similarly, business to business spending will be counted as both an equal and opposite revenue and cost and will net to zero. However, “the payment of dividends by corporations, the draw of funds by partners and proprietors from their firms, and the payment of interest by business firms” (which Reisman regards as “transfers”) to business owners, which provide the latter with a source of consumption spending, does not show up as a business cost yet does, once spent, show up as a business revenue. Thus the rate of profit is determined solely by the desire of the capitalists to consume. This element of profit has, Reisman claims, the ability of providing continued aggregate profits in an environment of unchanging money. For example, if the volume of spending is 1000 units of money each period, business costs could be 900 while business revenues could be 1000 and profits 100 in each and every period. (Reisman uses similar reasoning to explain how the rate of profit is increased by taxation as all taxation is consumption spending). The second element, “net investment”, derives from the fact that business spending on assets to produce business revenue are capitalised as assets and only later depreciated incrementally as a business cost. Thus, in an environment where the volume of spending is the same, business revenue exceeds business cost. For example, if 100 units of money are expended on capital assets, 800 units are spent on business costs, and there are 1000 units of business revenue, profits would be 200 as the 100 units spend on capital assets are not charged as a cost. Reisman believes that net investment provides a finite outlet for aggregate profit because, eventually, depreciation charges from assets previously capitalised will equal the value of new assets capitalised. For example, if 100 units of monetary spending on assets per year are capitalised and then depreciated at an uncompounded, annual rate of 10%, depreciation charges will be 10 units in year one, 20 units in year two, 30 units in year three, and so on until, in year 10, depreciation charges will exactly equal the 100 units of additional investment and so net-investment will provide no source of aggregate profit in that year. Thus, Reisman believes, only net consumption is capable of providing continuous, aggregate profits period after period. Net consumption and net investment are, however, joined at the hip. Reduced net consumption provides increasing funds for net investment to be capitalised on the balance sheet and charged as business costs only at increasingly remote points in the future.

What can we say about this theory? It should not be surprising to “Austrians” that Reisman’s theory is based upon net-consumption and net-investment as it those elements that are determined by the “Austrian” theory of time preference, which affects the rate of interest. (What Reisman refers to as “profit” is what most “Austrians” would refer to as “interest” – Reisman offers no explicit distinction between entrepreneurial profit and loss on the one hand and what “Austrians” would regard as interest on the other). Yet Reisman regards his theory as standing in opposition to the time preference theory and, moreover, the older productivity theory of interest. However, Reisman’s approach, characterised as simply a description of accountancy practices and the summation of money flows, does not challenge the time preference theory at all. The primary question of profit and interest that is answered by this latter theory is why do businessmen not impute the full value of the final product to the factors of production. In other words, why, even after businessmen are compensated for their managerial or oversight activities as a factor of production, is there always a further residual surplus that is not eliminated by competitive bidding amongst entrepreneurs? Why is there, to use Reisman’s terminology, a “going rate of profit” at all? The net-consumption/net-investment theory, while explaining that rises in net consumption will increase the rate of profit while reductions in them will lower it, only really explains how, from an accounting point of view, profits are possible. Reisman offers no extended treatment of the motivations of capitalists in paying (and of labourers in accepting) a sum lower than the total of business revenues and thus it is difficult to regard this as a distinctly economic theory. A more convincing explanation of his theory would detail how, with decreasing time preference, more funds are advanced to factors of production yielding revenue in the future, thus diminishing net consumption and the rate of profit, while these expenditures will be capitalised at increasingly higher amounts, depending on the time period when they come to fruition, relative to the ultimate business revenue that is earned. Thus Reisman’s accountancy-laden approach would, in this way, be fully reconciled with the “Austrian” approach to profit, or, rather, to what “Austrians” would call interest.

When Reisman does address the motivations that determine net-consumption and net-investment he does so erroneously. Reisman defines time preference as the determinant of “the proportions in which people devote their income and wealth to present consumption versus provision for the future.” It is Reisman’s link between this posited desire to provide for the future and net-investment that causes him to declare that net investment can provide only a limited contribution to net profit. To quote: “As capital and savings accumulate relative to income, the need and desire of people to increase their accumulated capital and savings still further relative to their income diminishes, while their desire to consume their income correspondingly increases”. In other words, the more saving and capital people possess the more they have provided for the future and thus productive expenditure will fall and consumption will rise, choking off net investment in the form of further additions to the asset side of the balance sheet. Thus depreciation charges begin to equalise new investments and aggregate profits from net-investment begin to fall. This view, however, is mistaken. Time preference has nothing to do with the desire of people to provide for the future. The need to provide for the future is always a present end just like any other and could be achieved by plain saving rather than investment. Time preference, rather, is the rate at which individuals prefer a larger quantity of goods available at some point in the future ahead of a smaller quantity of goods available today. It is perfectly possible for people to continue to invest sums of capital that will not produce consumer goods for well after they are deceased. Indeed, this is precisely why people have inheritances to bequeath. Many of the buildings, factories and infrastructure we have today were created not in our own lifetimes but were handed down to us from past generations. And it is further possible that capital accumulation and technological progress, which Reisman himself stresses enhances the ability to produce capital goods, will enable the production of capital goods that last further and further into the future. People would not even need to create capital goods that last so long with the purpose that they do so – in other words they could be perfectly limited in their own time horizons and yet still produce capital goods that yield a product well after the elapse of this time horizon. Let’s say, for example, that the current rate of time preference means that the produce from all assets appearing after thirty years hence is fully discounted to zero. In other words, only what the assets can produce in the next thirty years is valuable to present persons. If a capital good was created that could yield produce for sixty years, after the elapse of each year, another year’s discounted produce would be capitalised as this year is drawn into the thirty year time horizon. Therefore, such assets will provide a continued source of credits to business equity (and, thus, profits) without corresponding business costs. This is precisely the case with some of the most valuable patches of urban land which, for all intents and purposes, will go on producing well beyond the lifetimes and time horizons of any living person. Thus there is no reason for net-investment to be so limited in its contribution to aggregate profits in the environment of unchanging money. Moreover, we can see in this way how accumulating, aggregate profits that are capitalised for longer and longer periods is the hallmark of an economically progressing society – one where more and more capital is invested for longer – while the opposite, aggregate losses, represents retrogression through capital consumption.

Finally, as we noted above, there is no reason to discount saving by labourers a source of investment funds. This would divert spending from business revenue as the funds would be lent to businesses who would then spend it on “productive expenditure”. Without any corresponding business revenue the rate of profit would fall. (Thus we can see why increased funds that are made available for lending must be made at increasingly lower rates of interest).

There are one or two further disagreements we can cite here. First, “Austrian” business cycle theory, the jewel in the crown of “Austrianism”, is never explained at length and instead takes its place in a wider treatment of the effects of inflation. Second, his treatment of neoclassical price theory is too aggregative and does not explain how individual bidders and suppliers bring about a harmony between the quantity demanded and the quantity supplied. Third, as in his critique of the time preference theory of interest, Reisman often perceives differences or disagreements where there are none, such as that alleged between his productivity theory of wages and the marginal productivity theory of wages, the latter of which he describes incorrectly. And finally, in spite of having been the translator of Mises’ Epistemological Problems of Economics, Reisman has little to say concerning method – something which perhaps descends from his rejection of economics as the science of human action, which underpins Mises’ methodological dualism that divides economics from the natural sciences.

Overall, therefore, the question of whether Reisman’s approach to economics has successfully synthesised the “Austrian” and classical schools, and, moreover provided a progressive outlook for the science of economics must, regrettably, be answered in the negative. Rather, Reisman’s positive economic theory in this treatise comes across more as a restatement and re-polishing of classical economics (with some corrections to that school of thought), peppered with insights from neoclassicism and the “Austrian” school. Reisman’s rejection of the primacy of human action as the subject matter of economics has been at the expense of not only losing a great deal of theoretical understanding in the wertfrei science that this affords, but also weakening any positive promotion for capitalism and freedom.

Nevertheless, while this review has been mainly been critical of Reisman’s positive economic theory, we must end by celebrating the fact that our author has, in this treatise, many great things to say concerning socialism, environmentalism, interventionism, inflationism, Keynesianism and all other manner of false doctrines rejected by “Austrians” and libertarians alike. What Reisman has put to paper here are among the finest critical analyses of these areas ever written and, even if one cannot agree with Reisman’s specific, economic outlook, these contributions alone place Reisman in the top rank of economists whose work should be studied avidly.

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Against the Welfare State – and Bank Bailouts

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The welfare state is undoubtedly one of the elements of government opposed by libertarians, not only due to its inherent injustice and economic destructiveness, but also because of its ability to provide fuel and sustenance to the growth of the metastasising state

If we are launch a critique of the welfare state we must first attempt to define it and to distinguish it from other categories of government activity. Such a task is not an immediately clear cut one as, fundamentally, all government expenditure sustains the welfare of its beneficiaries. If the government launches an invasion of a foreign country, spending on military grade weaponry, aircraft and whatever else will very much contribute to the “welfare” of armaments manufacturers yet we wouldn’t ordinarily classify this as part of the welfare state. Similarly, if the government decides to build a new road or railway line we wouldn’t usually describe this as providing “welfare” to the construction workers who undertake the leg work (although certain “job creation” schemes that simply pay people to carry out pointless work could be classified as welfare).

Whether or not a particular government outlay is classified as part of the welfare state is therefore defined more by its purpose rather than by its effect. The purpose of a foreign war is usually to gain control of valuable resources (even if it is veneered with an alternative justification such as spreading freedom and democracy). The purpose of building a road or railway is to “improve” the country’s transportation and communication networks. None of these projects is designed to provide some kind of comfortable lifestyle to those who undertake them (and, ignoring the possibility of benefiting favoured lobbyists and donors, to the extent that a government has a particular purpose in mind and wishes to achieve it efficiently it will have a desire to remunerate its suppliers as little as possible rather than as highly).

Welfare spending, on the other hand, is markedly different. Its purpose is always couched in the language of providing some kind of “help”, “care”, or “assistance” to the citizenry, as if the government is a giant nanny who appears with an equally giant milk bottle whenever one’s own teat runs dry. Given this, then, we can attempt to define the welfare state as that portion of government activity which is devoted to the sustenance of either the existing lifestyle of a particular citizen or to a lifestyle that is thought to be the minimum that is equitable in terms of wealth and income. The welfare state therefore provides a cushion or relief from events that may intercede in that lifestyle so, for example, if you get sick, the government will provide you with either free or subsidised healthcare; if you lose your job you will be entitled to unemployment benefit; and if you have baby the government will give you some money so that you are able to take care of it and give it an “adequate” upbringing. Granted, this definition if the welfare state is not precise and it will overlap with many other types of expenditure – few government outlays have a single purpose, even if some of these purposes are not made public – but we can be satisfied that it is reasonably accurate.

In spite of the fact that the welfare state is a moral issue and that its proponents believe that its existence is justified by the fact that the able should take care of the less able (“from each according to his means to each according to his needs”) it is arguable that the strength of its cause derives more from a misunderstanding of economics and that an amelioration of these misunderstandings is likely to weaken the foundations of the welfare state most effectively. Rather, therefore, than elaborating on the fact that the welfare state is, in a genuine free market, a morally unjustifiable confiscation and redistribution of property from its owners to non-owners respectively, let us concentrate mainly on a proper realisation of the economic effects of the welfare state in order to find the source of its undoing.

The type of welfare spending that we will focus on specifically is the bailout of the banks. This selection may appear surprising as surely most supporters of the welfare state are flat out opposed to bailing out the banks? And yet if we look closely, the qualities of bankers’ bailouts fits our definition of welfare spending all but perfectly. The financial services industry was accustomed to its business of expanding credit during the boom years and ploughing them into ultimately unsustainable malinvestments; its practitioners were richly rewarded for doing so and could afford big houses, expensive cars, private schools for their children, exotic foreign holidays, and so on. Metaphorically, they became accustomed to a lifestyle of gambling and partying fuelled by the punch bowl of monetary expansion. Following the inevitable crash that revealed the extent of the malinvestments and the huge losses that would ensue, the bailout of the banks was designed precisely to prevent the liquidation of this crumbling economic structure so that the banks could keep on making loans, keep on making profits from those loans, and so their top employees would not lose the lifestyle to which they had become accustomed. It was meant to refill the punch bowl and to keep the music playing so that the party would never end. The difference, therefore, between bankers’ bailouts and what we typically regard as the welfare state is simply a matter of degree, not of kind. They each provide a taxpayer funded cushion for their respective beneficiaries that insulates their lifestyles from the effects of either their own choices or from events that are beyond their control. Indeed, the collapse of the financial services industry as we know it would also have seriously curtailed the ability of governments to retain their accustomed lifestyle of borrowing and spending. To that extent, therefore, the bank bailouts were an exercise in self-preservation. The only perceived difference between bank bailouts and the welfare state is that the beneficiaries of the former were “rich” and not “poor”, which, it must be understood, is itself a misrepresentation. Many of those affected by a collapse of the financial services sector would not necessarily have been multi-millionaires as any insolvencies and downsizing is likely to have hit those lower down the pecking order first such as local branch managers and tellers before it hit those in the penthouse offices.

We have outlined this description of bank bailouts because every single argument that welfare statists use to oppose them are, in fact, the very same arguments that apply to their conception of the welfare state. We will therefore take each of these arguments in turn and show just how both bank bailouts and the welfare state, which are both a form of welfare spending, are economically destructive.

The first argument against the bank bailouts used by its opponents is that it creates moral hazard. In other words, if the banks can privatise their gains yet socialise their losses it provides an incentive to carry on and, indeed, augment the very destructive activity that was the source of the problem in the first place. All of this is true and we can have no quarrel with it. Yet it applies equally to the welfare state as well. Proponents of the welfare state imagine that if the government throws money at all of the events that manifest themselves as pitfalls in one’s own lifestyle then these pitfalls will simply go away. However if the government simply pays for a problem when it occurs then it creates as much of a moral hazard as the bank bailouts because all you have done is simply lowered the cost to individuals of bearing these pitfalls – and lowered cost leads to a swelled demand. If you pay people when they get sick, there will be more sickness; if you pay people when they are unemployed there will be more unemployment; if you pay people when they have children people will produce more children that need a roof and need feeding. The welfare state is not the solution to the problems it seeks to resolve; it is, rather, a fertiliser for their growth and proliferation, just as bank bailouts are a fertiliser for the growth of credit expansion, malinvestment and repeated boom and bust cycles.

The second argument against bank bailouts, related to the one we just outlined, is that it shoves the cost of the bad decisions of the bankers onto the shoulders of everybody else. Yet isn’t this precisely what the welfare state does? Welfare statists imagine that nearly every unfortunate circumstance in which people find themselves is not the product of their own making and that they are therefore blameless and should be (patronisingly) pitied – in short, that people do not bear any responsibility for their own circumstances. However, this is not the case with many of the issues that the welfare state attempts to address. As was argued in a previous essay on universal healthcare, the majority of medical ailments from which people suffer are not the unfortunate result of a random, illness lottery but are, rather, directly related to their environment and lifestyle – particularly diet, exercise and consumption of alcohol, tobacco and narcotics. If, therefore, people choose to pursue a lifestyle of eating gluttonously, exercising little and smoking and drinking heavily with this resulting in sickness, then if the government picks up the tab this simply forces the cost of these bad decisions onto everyone else. People, in most cases, choose to have children, or at least to engage in the intercourse that results in children – it isn’t a random, spontaneous event that appears out of nowhere to inflict itself upon people’s lifestyles. To the extent, therefore, that people cannot afford to raise these children properly and the government intervenes then the cost of other people’s bad decisions is again shovelled onto the shoulders of everybody else. But even those aspects of the welfare state that are not necessarily the fault of the individuals concerned – such as unemployment – is usually the result of government anyway. Low employability is caused not only by inadequate state education, but also government interference in the labour market such as minimum wages and excessive regulations that cause the cost of employment to exceed that of the productivity of the lowest skilled workers. Why, therefore, do welfare statists propose a government solution to what is a government created problem? Why not just get rid of the government created problem?

The third argument against bank bailouts is that they perpetuate what we might call a crony “corp-tocracy” where taxpayers’ money is siphoned off into the hands of the government’s favoured millionaire chums. Yet this is precisely the result of the welfare state also. Although the nominal beneficiaries of the welfare state are individual people, someone has to be paid in order to carry out the work of the welfare state. Not only does a welfare state require the creation and sustenance of a vast, leeching bureaucracy to administer it all but particular parts of the welfare state have to be contracted out to individual specialists. For example, public housing schemes need to find construction companies, hospitals need to find doctors and they need to purchase medicines from drug companies. The interests of these suppliers to the welfare state is to ensure that their compensation for carrying out their tasks is as high as possible; indeed, one of the reasons why the welfare state is such a burgeoning expense is because the disconnect between the consumer that pays and the supplier that is paid results in spiralling costs for the services of the latter, with the result that the majority of welfare spending goes not to the individual people but straight into the bank accounts of large corporations and contractors. Moreover, the welfare state is not usually a fixed pool of services that are provided by the government, but includes also private organisations and charities that lobby the government for money in order to solve the particular societal “problems” and grievances that they happen to have identified. Much of this money is simply wasted, as suggested by the recent collapse of Kids Company, a UK children’s charity, around a week after it received a £3 million grant from the government. Indeed, in the UK – when the chief executives of high profile charities are paid six figure salaries and they have been chastised for “aggressive” funding raising strategies that were recently attributed, at least in part, to the death of a pensioner – the substantive difference between a charity on the one hand and a corporation on the other is becoming increasingly questioned.

The fourth argument against bank bailouts is that they distort the economy, shovelling excess funding into the financial services sector and expanding their profits at the expense of other industries. Again, nothing about this is untrue and, indeed, as “Austrian” economists we would make an even more detailed case about how the resulting credit expansion distorts the consumption/investment ratio in order to result in unsustainable malinvestments across the entire economy. Yet the welfare state distorts the economy also, only in a more incremental and pacing manner. In the first place, the increased incentive caused by the welfare state to exacerbate the very problems it is supposed to solve, such as sickness and unemployment, reduces the capacity of the labour market and thus shrinks the extent of the division of labour that would otherwise have been possible. Second, the burgeoning cost of the welfare state caused by an artificially inflated demand for welfare requires more and more resources to be confiscated by the government in order to fund it. Thus, the areas of the economy that are devoted to providing welfare are swollen at the expense of other areas of the economy which must correspondingly shrink. Third, this is compounded by the fact that a large, government pot of gold encourages rent seeking behaviour, which in the case of welfare means (as we stated above) large numbers of special interest groups lobby the government each with a claim that they have identified some societal affliction that is ripe for resolution by government spending. Governments are eager to attract this kind of attention for more government spending means not only more power and prestige but also provides another outlet with which to bribe citizens with their own money when making election “promises”. The result of this, again, is that the total portion of the economy that is devoted to welfare spending is artificially inflated compared to what consumers would otherwise prefer.

The final argument against bank bailouts that we will consider is that they create a feeling of bitterness and resentment in the general population, a fissure of hate, contempt and distrust between the bankers and the people whom they supposedly serve. Again, all of this is true. However, it applies just as readily to the welfare state. Its proponents usually justify the imposition of the welfare state by stating that it is morally good for us to care and look after one another as if we are all one big family. This may be true enough, but the welfare state does not create that situation. In order to become a morally better person I have to choose to care and to look after my fellow man – I have to decide to do it voluntarily. I am looked upon with admiration because in spite of all of the personal luxuries I could have spent my money on, I willingly deprived myself of them and was happy to give the money to a person in need. The welfare state, however, does not give me any choice in this regard – it just forces me to do it regardless of what I want. The action, therefore, is not as the result of any personal sympathy or empathy for the plight of the less fortunate, nor of any aspiration to moral heights. Instead, the void left by an absence of sympathy and empathy is likely to be filled by bitterness and resentment as my hard earned money has just been confiscated from me to go to people who I believe may not deserve it, particularly if it goes to some cause that I may disagree qualifies for welfare spending (such as breast enhancement surgery on the NHS or unemployment benefits to those who are just workshy). The welfare state therefore creates the opposite of any charitable feeling whatsoever and destroys any notion of brotherhood or family. When this is coupled with the welfare state’s encouragement of the afflictions it seeks to solve then the result is a society with a lower, rather than higher, moral standing. This is exacerbated by the interdependent relationship between bank bailouts on the one hand and the welfare state on the other. Bank bailouts mean that the banks take the money of the taxpaying public and plough it into assets so that the income of anyone who owns these assets – i.e. the bankers themselves – is swollen while the incomes of those who do not stagnates. The resulting price inflation lifts the affordability of assets such as houses and basic necessities, such as food, out of the grasp of those on low incomes. The consequence is another artificially swollen demand for welfare to give ordinary people somewhere to live and something to eat. Thus, the poorest in society demand increased taxes on the rich – i.e. the very bankers who were bailed out – in order to fund increased welfare spending. The result, therefore, is a toing and froing of mutual theft, a circle of robbery where bankers demand taxpayers’ money to continue their casino operations, after which everyone else demands some of it back to ameliorate the resulting effects. Far from being a moral and harmonious society all we end up with is hating each other and trying to grab whatever we can out of each other’s pockets.

What we can see from this brief comparison of the welfare state to bank bailouts, therefore, is that there is very little qualitative difference between the two and that the arguments that are used to oppose bank bailouts apply just as easily to the welfare state. The amelioration of welfare demand is achieved not through the redistribution of a fixed pool wealth but through the raising of real incomes by increasing the productive output per person. In order to achieve this we need to eliminate both the bank bailouts and the welfare state so that we can return to a genuine economy where everyone serves each other rather than engages in mutual plunder. The rich would have to earn their wealth by directing and increasing the productive capacity of the economy to best meet the needs of the consumer; the poor earn their money by providing the labour to bring about this direction, with their wages being able to buy more and more goods as a result of the increased output. Not only would this create a more prosperous society where poverty has truly been consigned to the history books, but the vanquishing of hatred, resentment and antagonism would create a morally superior one too.

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Negative Interest Rates

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Since the 2008 financial crisis, the policy of central banks to forcibly push down interest rates, followed by the rapid expansion of their balance sheets in order to attempt to “stimulate” economic growth has, to say the least, been something of an abysmal failure. Unemployment is still high, economic growth barely makes it any higher than a rounding error and real wage rates continue to stagnate as they have done for the past ten years or more. Benefitting only Wall Street, the new money has pushed stock markets to record highs and bond yields to record lows, so much so that owning these assets over the past five years has been the closest one can get to a sure bet. Main Street, however, having had to deal with the reality of the fact that the debt-fuelled consumption mania is no longer sustainable and that real savings to grow businesses are in short supply, continues to languish in what seems like a completely separate realm from the casino operations of the financial markets. With positive interest rates now as low as they can possibly go and with little to show for it, it is no surprise that the prospect of negative interest rates in order to force everyone to spend their way into a recovery is now a real one. Indeed, it is already very much a reality in Switzerland and Denmark.

The proposal for negative interest rates rests on a typical Keynesian plea that the government and central banks did not act “drastically enough” in attempting to defibrillate the economy back to growth. Contrary to understanding the lack of any meaningful recovery as a failure of their policies, they instead turn around and say “if it is this bad now then imagine how terrible it would have been had we done nothing at all!” The patient is therefore prescribed ever greater doses of bad medicine in spite of the fact that it is the medicine that is killing him. (Has it not also been said often that the definition of insanity is to repeat an act continuously with the expectation of a different outcome?) Indeed, the economy is so saturated with debt that only paying people to get deeper into it has any prospect expanding the volume of spending.

Negative interest rates are, of course, a praxeological absurdity and could not come about through anything except government force. It is tantamount to placing a premium on future goods as opposed to present goods, so that the prospect of receiving £100 today is less valuable than receiving £100 in a year’s time. Practically, what this means is that, if you deposit £100 in the bank today with an interest rate of -5%, you will have only £95 in one year’s time. You are, therefore, quite literally paying the bank to borrow your money, a proposition absurd to anyone except a tenured professor of economics. Since when, to invert a popular proverb, has a bird in the bush been worth two in the hand? The idea, of course, is that you will be so keen to avoid the interest charges that you will cease to be an “evil” saver and rush out to spend all of your money as soon as you can. Thus the magical Keynesian multiplier will burst into life, restoring us to the land of milk and honey. What’s more, they hope that it will encourage a flurry of borrowing as all the excess reserves piling up in bank vaults (or, rather, on their computer screens) are now lent out to those eager to be paid to hold cash. Traditionally, of course, banks earn their revenue by paying depositors a lower interest rate than they charge to borrowers. With negative interest rates it seems as though the situation will reverse: the bank will make its money by charging its depositors more than it has to pay its borrowers.

Such a ridiculous idea does, of course, run into the unfortunate fact that every unit of money has to be in someone’s cash balance and if all cash balances attract a negative interest rate there can only be an incentive to borrow if the rate on your deposit account is less than the terms of the loan – in other words, you have to pay less to hold the cash than you get paid for taking out the loan. Further, if someone can only get rid of their cash by passing it onto someone else and that latter person can then only do the same then the logical end of the proposal is hyperinflation. That aside, however, what will be the likely effects of the introduction of such a policy?

The first likelihood is that, with bank deposits now charging an interest levy, holding hard cash under the mattress becomes an attractive alternative. In both inflationary and deflationary environments it will lose less and gain more than a bank deposit. Indeed, at first blush, libertarians should welcome this possibility. After all, it is free deposit banking that has resulted in people willingly stashing all of their cash in fractional reserve banks, enabling them to pyramid loan upon loan on top of them and thus causing the disastrous business cycle. When money consisted of gold or silver stored in full reserve banks it was natural for banks to levy a charge for this storage service. People could either choose to accept the charge in return for the safekeeping of their assets, or prefer to keep the cash in their own storage provisions at no cost. Viewed this way, negative interest rates give the appearance of a return to something more akin to cash handling as it would be in a libertarian world. Unfortunately, of course, the negative interest rate is an arbitrary figure and does not represent the true value of storage services to holders of deposit accounts, and having been accustomed to the provision of such services for free anyway a mass withdrawal will be the most likely response. Indeed, it would not be unsurprising if something akin to Gresham’s Law emerged where, legally, bank deposits and cash notes trade at par but where undervalued cash becomes hoarded and people keep only a minimum amount of overvalued bank deposits with which to use for their exchanges. Such an outcome would, of course, utterly defeat the purpose of negative interest rates which is to swell the volume of spending through electronic exchange. In other words, the point at which negative interest rates begin a flight into cash will mark the true limits of monetary policy in creating a spending splurge.

Needless to say, of course, the likely government response is to restrict cash holding with a view to eliminating cash altogether in order to concentrate as much money as possible in commercial bank deposits. Such an end has, in and of itself, been a cherished aim of government, as it permits oversight of and control over every single financial transaction. Under the guise of “combating terrorism” such restrictions have already been tightened recently in France, where, from September of this year, cash payments in excess of €1000 will be illegal. Similar restrictions have appeared, in the last few years, in Spain, Italy, Russia and Mexico. Where cash remains less restricted, any attempts to convert deposits into cash may be met with refusal and obstinacy, as a Swiss pension fund discovered recently when it attempted to switch its deposits to paper notes stored in a vault. Indeed all of this harkens back to the era when banks overinflated on a monetary base of redeemable gold. Back then, redemption in gold was restricted to concentrate people’s cash holdings in paper notes. Now, redemption in paper notes is restricted to concentrate cash holdings in deposits.

The likely reaction to this is that, with deposits and fixed income securities losing value in both nominal and real terms, people will abandon these assets in pursuit of safer stores of value – probably gold and silver. In other words, shorn of the ability to withdraw hard cash, people will keep on deposit only the amount they need to meet their current expenditures while the rest of their savings will be ploughed into harder assets. A flight out of debt instruments would trigger a deleveraging and usually, in such circumstances, the safe home for such funds would be cash. But if cash will also be subject to a negative interest rate and with no ability to withdraw paper notes, then movement of the money into gold would cause the gold price to rise. We would therefore have the peculiar effect of increasing asset prices during an era of deflation. Such are the ways in which monetary policy can turn the world upside down.

The likely effects of a negative interest policy as outlined here demonstrate the limits of a monetary policy that attempts to kick the economy back into gear through spending. You can print all of the money that you like; you can lower interest rates as far as they will go; you can make it impossible for people to withdraw their cash; but like the proverbial horse to water, you cannot force people to borrow and spend. In short, you cannot cheat the market with increasingly absurd tricks that would have baffled even the monetary charlatans of yesterday. Only liquidation of the existing debt and a return to sound money with interest rates determined by the supply of and demand for saved funds will create a proper, sustainable recovery on the path to prosperity.

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Austro-Libertarianism – Three Next Steps

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Austro-libertarianism undoubtedly has a long history of scholarship of which it can proudly exemplify as not only providing a coherent body of truthful insights into the way in which the world really works, but also provides a foundation for a just and prosperous society.

However, far from resting on any laurels (and I doubt any scholar in this tradition would ever believe that we are at the stage where we can do such a thing), this essay will suggest three areas of development to which scholars in the Austro-libertarian tradition may wish to focus their research.

Pure Praxeology

The first area is to reconceive “Austrian” economics as a pure (or at least “purer” theory) of praxeology. Although “Austrian” economics is noted for deriving its laws from the theory of individual human action, economics traditionally – not least because concepts such as exchange, production, prices, money, and so on are the complex phenomena that we wish to study and understand the nature of – concentrates only on action above the level of the bilateral exchange of wares for a money income. Our economic categorisations and concepts therefore rest on that limitation. “Austrian” treatises, although they begin quite properly by explaining how economic theory is derived from the action axiom (together also with extremely useful chapters on unilateral or “Robinson Crusoe” exchange), soon begin to espouse their theories in terms of these more aggregative concepts, only occasionally returning to individual action in order to emphasise a particular point1.

A simple example to illustrate this point is the economist’s approach to the classification of goods. A “consumer good” is one that is purchased by a consumer for money without any further sale for money expected. Bread, for example, is treated as a consumer good because it generally goes through no further monetary exchange prior to being consumed. At the individual level, however, the bread may only be a capital good in making, say, a sandwich. Labour is combined with the bread and other goods – say cheese and tomatoes – in order to produce the final consumer good of a cheese and tomato sandwich. We can say the same thing about cutlery and crockery, paper and ink and so on. All of these goods are used at the level below that of exchange for money by individuals to produce further goods. “Land”, on the other hand, is treated as the natural resources which are a gift to all humans, not just an individual human being. However, a good produced by another human being may, to the individual who happens to stumble upon it, comprise “land” in the sense that it is a free gift to him and that he has not had to exert any productive effort in order to bring it into the condition in which he finds it. If, for example, I find an abandoned car in perfect working order and (assuming there are no competing ownership claims), even though the car is a produced good, as far as my action and my computation of costs and benefits towards that action goes, the car is a gift of nature and is in exactly the same condition as, say, a tree that has grown naturally.

It is easy to see why any loss of the connection to individual action can quickly lead economists in the “Austrian” tradition and their fellow travellers down wrong paths. Murray N Rothbard provides an extensive critique of W H Hutt’s aggregative concept of “consumer sovereignty” – the idea that all consumers are sovereign over producers and that the latter exist only for the benefit of the former and not for themselves2. The market place is where everybody seeks to benefit himself through voluntary exchange, and there is not, in fact, a distinct class of labourers, of producers and of consumers with one being “sovereign” over the other. Rather, everybody at differing points of the day (even from minute to minute) participates in a different economic category – a man is a labourer when he goes to work; he is a consumer when he stops by at the shop on his way home; he is a capitalist if he purchases some shares for his pension, and so on. Questions of “sovereignty” – the boundaries of rule – concern only the political arena. Concentration on the basis of economic law in individual human action would have avoided any fallacy and prevented a resort to parcel phenomena into homogenous, collective blocks. However, Rothbard hardly escapes the same danger to which Hutt succumbed, building his entire theory of production using the economic fiction of the Evenly Rotating Economy (ERE), an economy in which all economic activity is repeated and known. Thus, entrepreneurial profit and loss is eliminated. This model allows (or, perhaps, forces) Rothbard to conclude that capital goods earn no net rents and that all rents are paid back to the original factors of production – land and labour – a theme that is oft repeated throughout his entire treatise. It is submitted here, however, that regardless of how such an approach may be helpful in illustrating the complexity of the structure of production, any firm or even implied conclusions drawn from it are likely to be grossly misleading and can only lead to error. The most dangerous false step from this presentation is to assume that the ownership of land – as an original factor – provides essentially free income to those who happen to hold it. Needless to say Rothbard takes great pains to rebut this conclusion, but his attempt could be condensed, with a slight modification, to a single paragraph:

As the only income to ground land that is not profit or interest, we are left with the original gains to the first finder of land. But, here again, there is capitalization and not a pure gain. Pioneering—finding new land, i.e., new natural resources—is a business like any other. Investing in it takes capital, labor, and entrepreneurial ability. The expected rents of finding and using are taken into account when the investments and expenses of exploration and shaping into use are made. Therefore, these gains are also capitalized backward in the original investment, and the tendency will be for them too to be the usual interest return on the investment. Deviations from this return will constitute entrepreneurial profits and losses. Therefore, we conclude that there is practically nothing unique about incomes from ground land and that all net income in the productive system goes to wages, to interest, and to profit3.

The correct position, therefore, is that “things” do not “earn” anything. All actions, whether they involve the dispensation of labour, land or capital goods, require the sacrifice of one state of affairs (“costs”) in the pursuit of another state of affairs. It is hoped that the ends brought about are more valuable than the ends given up. The creation of this value if the action is successful (or its destruction if it is not) is the product of entrepreneurial judgment. All income from any action is therefore paid out to cover costs, interest or entrepreneurial profit and loss. All net rents in the economy accrue only to this latter element – successful entrepreneurial judgment with the means at one’s disposal, whether this is your labour, land that you own, or a capital good that you hold. All of these things that can be bought or sold for more or less money than is sufficient to cover their costs plus interest. It is only by remaining firmly anchored to action at the individual level that this realisation can remain in focus4.

Coupled with this endeavour of better preserving the link between the complex phenomena in the economy with individual action is a greater emphasis on “Austrian” methodology not as a separate topic but one to be espoused during the course of the treatise. The reason for this is that a “vulgar” conception of “Austrianism” would state that all economic theory and all of the laws of economics are deduced logically from the action axiom and one or two subsidiary axioms. Truths derived empirically have little or no place in “Austrian” economics. This is not, however, altogether true. Only the core theory concerning the action axiom and its immediately related categories, in addition to some of the more fundamental laws (such as the law of marginal utility) are deduced logically. However, there is a great body of “Austrian” economic law that requires the ascertainment of empirical facts. We cannot, for example, derive economic laws of bilateral exchange without ascertaining the existence of more than one human being, an endeavour which any individual cannot simply deduce. We cannot have an “Austrian” approach to the economic effects of taxation unless one group of persons had, in fact, attempted to tax another group. We cannot have an “Austrian” business cycle theory without first assuming the existence of banks, the practice of fractional reserve banking, a loan market and even money itself must be presupposed. Although the regression theorem, for instance, is a valid praxeological law5, it would only exist if we first of all knew that money existed and that people had chosen to use a good as a general medium of exchange. Now it is true, of course, that these laws would remain valid and true even if the substantive human choices upon which they rely had not been made. If we imagined a world without money, for example, and pondered its existence merely as a hypothetical we could still derive “Austrian” laws concerning it without it ever actually existing. The actual phenomena in existence simply direct our interest to them as those are the areas that matter in our lives and hence are the things we wish to study and understand. No doubt it is also quite impossible to try and “imagine” alternative institutions and choices that have never existed and to apply to them the core “Austrian” theory, especially as our own experience of real concepts such as money, exchange, prices, banking and so on often provides an illustrative tool to our theoretical insights. However, it is more accurate to speak of the entire endeavour of “Austrian” economics not solely as a body of economic law that is deduced logically, but as the application of the core theory, deduced from the action axiom, to the substantive institutional choices that humans have made, the existence of which is verified empirically6. More prominent highlighting of the “Austrian” method and the source of each parcel of knowledge during the course of a treatise would aid greatly any misunderstanding in this regard.

Ethics

The second area of fertile development in “Austro-libertarianism” is the necessity to sever or more sharply delineate the relationship, often casually assumed not only in political philosophy but also in the opinions of lay persons, between legal norms and moral norms. That is, the question of what should be legal – in other words, those norms which may be enforced by the imposition of violence – should be separated from the question of what is good, worthy or preferable. It is submitted that this is one of the greatest barriers to a proper understanding of the role of violence in interpersonal morality, and has been dealt with in detail by the present author here, here and here. Many people happily recognise the illegitimacy of the legal (violent) enforcement against themselves of norms that other people value as moral ends which, as the hapless victims of this enforcement, they themselves do not (or at the very least, they would complain about it). But, because of the prevalence of the legitimising effect of democracy and the blurring of any distinct line between the governors and the governed, most would not think twice to advocacy of the legal (violent) enforcement of ends that they deem good against other people. Indeed, the criterion for what should be legally enforced boils down to little more than what most people think should be legally enforced. Libertarians need to create an understanding that the proper role of violent enforcement is restricted to preserving the physical integrity of each individual’s person and property – and as moral agency requires such integrity in order for a person to choose and act, such an insight is crucial for any proper understanding of interpersonal morality. The examination of whether something is bad, unpleasant or a vice must be separated from the question of whether its prevention should be enforced legally; and, equally and oppositely, the examination of that which should be peacefully permitted by the law should be separated from the question of whether such acts are good and noble things. In addition to aiding moral and political philosophy, this would be of a benefit to libertarianism specifically as it would render inert the perceived support for all of those bad and unpleasant things – drugs, prostitution, gambling, blackmail, and so on – which are non-violent but are nevertheless not necessarily things that we would wish to see in our society7.

Inflation

The final area for development in Austro-libertarianism, this time in the field of economic history and anthropology, is to engage in a rigorous study of the effects of inflation and inflationism throughout history. “Austrian” scholars have certainly charted well the purely economic effects but, in the opinion of the present author, an exhaustive study of the social, cultural, political, and aesthetic effects of inflation is yet to be written, at least in the “Austrian” tradition. As Henry Hazlitt notes:

[Inflation]…discourages all prudence and thrift. It encourages squandering, gambling, reckless waste of all kinds. It often makes it more profitable to speculate than to produce. It tears apart the whole fabric of stable economic relationships. Its inexcusable injustices drive men toward desperate remedies. It plants the seeds of fascism and communism. It leads men to demand totalitarian controls. It ends invariably in bitter disillusion and collapse8.

Apart from the wide “macro” effects of inflation – not least of which include the birth of odious ideological movements and regimes and their ability to fund wars and conflict – also of interest is how inflation effects us at the individual level. For example, how many of our day-to-day products that we enjoy today are the result of genuine development by a capitalist economy and how many are simply substitutes developed in an era of inflation to enable people to attempt to salvage some of their previous standard of living? Products such as instant coffee, condensed milk; synthetic clothing; plastic bottles; and so on. How many genuine labour saving products were developed not because people genuinely wanted to save time but because inflation had either reduced their income to such a degree that time came at a premium or because inflation had induced impatience and a present-oriented fervour? Indeed the latter may have had distinct ramifications beyond the economic – the birth of adolescence as a distinct demographic; the sexualisation of society; the preference for entertainment ahead of learning; the attraction to style rather than to substance; the prominence of sound bites and “tweets” rather than in-depth analysis; the emphasis on youth and adaptability to an ever changing world rather than on age and accumulated wisdom. All of these things have significant consequences for which inflation much at least be partly responsible. Further, how much does inflation distort our views of reality and of what is possible? Inflation, as Hazlitt noted, makes speculation rather than production profitable – the image of productivity and wealth creation rather than the very thing itself. It makes big or easy wins more attractive than patient investment in a lifelong endeavour. But at the extreme we might say that we have attempted to replace reality itself with dreamed ideals. Government, has taken over and replaced real money (gold and silver) with a fake paper counterfeit. Having replaced reality with one form of fakery, we expect government to be able to legislate to replace reality with our pseudo visions, to carry out the miracle of transforming stones into bread. Thomas Nast’s cartoon, Milk Tickets for Babies in Place of Milk (below), concerning the inflation during the American Civil War, perhaps captures the foundation of this mindset in artistic form. The cartoon contains representations of reality that are passed off, for example, by Acts of Congress as reality itself. As English professor Paul A Cantor explains:

Nast’s illustration brilliantly captures [the confusion of] things with representations of things. Like Magritte [in the painting The Treachery of Images], Nast reminds us that a picture of a cow is not actually a cow, but he is not making a merely aesthetic statement. He is drawing a more serious analogy between the duplicity involved in artistic representation and the duplicity involved in the government printing money and forcibly establishing it as legal tender, an analogy embodied in the parallel “This is a Cow By Act of the Artist” and “This is Money by the Act of Congress”9.

Given that “Austrians” lead in the way in a providing a genuine understanding of the definition and effects of inflation it would be appropriate for an historian versed in “Austrian” theory to undertake a full study along the lines that we have suggested here.

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1It is also the case that most “Austrian” scholars writing today received their initial education in the mainstream economics tradition and only later “turned” to “Austrianism”. Thus one senses a tendency, if not a persistency, to lapse into the comfort of aggregative and pseudo-concepts, at best obscuring the essential connection to individual human action, and at worst completely losing it and ending up in the rhetoric of collectivist and societal-oriented action.

2Murray N Rothbard, Man, Economy and State with Power & Market, p. 631-6

3Ibid., p.530, emphasis added.

4The present author is not enthusiastic about the excessive use of equilibrium constructs and they should, at the most, be used as a tool in order to distinguish one concept from another, an endeavour that would be impossible without such a construct. Nevertheless, it is possible that a dynamic equilibrium – a fiction in which there is change and entrepreneurial profit and loss but where all forecasts of the particular entrepreneur in the model are correct – together with a focus on the costs of land acquisition and of the dispensation of labour would have created a better illustration than the ERE. But whatever model is used, it is submitted that the illustration of every stage of production, whether it is with land, labour or capital, necessitates the elements of costs, interest and entrepreneurial judgment and that, contra to Rothbard’s assertion that the mental construction of the ERE is necessary in explaining the structure of production, a much clearer grasp of reality can be and, indeed, is attained without omitting any of the crucial elements.

5Although this is disputed. See Gary North, The Regression Theorem as Conjectural History, Ch. 7 in Jörg Guido Hülsmann (ed.), The Theory of Money and Fiduciary Media – Essays in Celelbration of the Centennial.

6If anyone should doubt this and remain steadfastly wedded to the idea that “all” of “Austrian” economics is deduced logically this then he should attempt to present an “Austrian” treatise written in formal logic.

7The present author has dealt with the so-called “thick” or “thin” libertarian debate here.

8Henry Hazlitt, Economics in One Lesson, p.157.

9Paul A Cantor, Hyperinflation and Hyperreality: Thomas Mann in Light of Austrian Economics, The Review of Austrian Economics, Vol. 7, No. 1 (1994), 3-29.

Economic Myths #12 – The Deflation Danger

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Politicians and mainstream economists have been warning us again lately of the so-called “deflation danger” – the idea that falling prices is calamitous for economic growth and that a perpetual and ceaseless price inflation is needed in order to bring us back to prosperity. With price deflation, so these sages tell us, lower prices today cause people to expect prices to be lower tomorrow so that, as a result, they put off their purchases until a later date, which causes prices to fall further and further. Hence we end up in an endless downward spiral of depression and impoverishment. Inflating prices, however, cause people to buy today so that they may insulate themselves from future price rises, thus bringing about economic growth and an increase in the standard of living. This fresh round of deflation warnings comes in the wake of the news that prices in the Eurozone were 0.2% lower than at the same time the previous year – something of an hilarious travesty when, regardless of the merits of the deflation thesis, this figure amounts to little more than a rounding error.

In basic economic theory, a price will fall as a response to the fact that demand is insufficient to meet supply at the current price. For some reason – say, as a result of the revelation of malinvestments – the demand curve for a particular asset or good shifts sharply to the left, meaning that prices now have to fall in order for the inventory to be sold to a willing level of demand. It will eventually settle at such a level. Indeed, all of the talk of “illiquid” and “toxic” assets on the balance sheet of banks following the 2008 financial crisis resulted from the unwillingness to find these lower prices and to, instead, retain assets at the old, inflated prices. Any asset, however, is surprisingly liquid when you offer a low enough price for it. However, the deflation thesis rests on the proposition that the initial fall in price, based on some exogenous factor, will then in and of itself cause a further shift in the demand curve to the left so that prices have to fall further. And then that this second price fall will cause yet another shift in the demand curve and prices will fall even further. Hence the thesis requires repeated, fresh rounds of shifting demand curves which are caused by nothing other than a previous shift in the demand curve.

However, there is no reason to suggest that prices falling as a result of a genuine, external change in valuation will, in and of themselves, cause further price falls. Indeed, every businessman will tell you that if you lower prices people will buy more and if you raise them people will buy less – precisely the opposite of the deflation thesis. More importantly, however, even if such price falls did result, there is no further reason to suggest that it would cause economic calamity. First, goods are, at the end of the day, evaluated for the ends that they meet. The fulfilment of these ends, as a result of the logic of human action, cannot be put off indefinitely and each individual will have to consume at some point. A person may simply be waiting for prices to bottom out before he purchases but there must come a time where he believes this to be. Taken to its logical extreme, the deflation thesis suggests that falling prices will cause people to simply stop acting altogether – that they cease seeking the fulfilment of ends through means. This will never happen so long as they remain human. Indeed, price deflation in entire industries – particularly in personal technology, such as computers and mobile phones – has not caused the collapse of this sector precisely because the value of owning a more expensive computer today is greater than that of waiting for a less expensive one in, say, three years. In other words, even if a person knows that a computer may cost £1000 today but only half as much in three years, he will still spend £1000 today if the benefit to be derived from the computer today is more valuable than saving £500 and waiting three years for that benefit. Second, viewed from the point of view of the satisfaction of each individual’s ends, there is no reason to suggest that artificially inflating prices, thus causing a person to buy sooner, will cause a greater fulfilment of that person’s ends compared to an economy where there is no deliberate price inflation. From that individual’s point of view, the earlier purchase may be wasteful compared to the later purchase he would have made had prices not been forcibly inflated. Third, even though the opposite of “catastrophic” deflation – namely, hyperinflation – in and of itself causes shifts in the demand curve to the right that accelerate the price rises, the motivation for this is not so much the rising prices as the realisation, on the part of the public, that the currency is worthless. Hence, a hyperinflation always ends in a flight to other currencies and stores of value. Indeed, following the recent Zimbabwean hyperinflation, the government there has gone as far as to recognise no fewer than nine foreign currencies as legal tender. No such realisation exists during falling prices and, funnily enough, people do not seem to be eager to flee to inflating currencies during a deflation! Fourth, there is no reason to suggest that falling prices will dampen business prospects. Nominal revenue will, of course, fall during a general price deflation. However, the success of a business – measured by its profit – depends not only upon the height of its revenue but also upon the height of its costs and these too are falling. Businesses would only put off purchasing and investing if revenue was predicted to remain constant while costs were predicted to fall, or fall further. If, however, falling revenue is met by falling costs then there still exists a profit motive, with every incentive to invest and trade today. Fifth, much of the deflation fear comes from the monetarist analysis of the Great Depression where, indeed, there was a monetary contraction1. However, the stagnation during that era was not due to the deflation per se but because of the widespread attempt to keep wages and prices high in spite of the monetary contraction. Had prices been allowed to fall then recovery would have been much swifter.

The real reason for the deflation scare is, of course, because perpetual inflation serves to protect the vested interests of the state and its corporate cronies and banker elites. The characteristic of any deflation is that the purchasing power of the monetary unit becomes stronger; all else being equal, therefore, assets that are merely quoted in the unit of currency and promise to pay no amount of fixed currency – such as shares, houses, precious metals, and so on – will fall in value. However, assets that are denominated in the unit of currency and promise to pay a fixed number of dollars, euros or whatever – such as bonds and debt instruments – will not lose value. Governments and banks, having benefited from borrowing cheap, printed money, used it to purchase assets that are mostly dollar quoted while their liabilities are dollar denominated2. Hence, a deflation would cripple the prices of the government’s or a bank’s assets while leaving its liabilities untouched. Hence not only large banks but entire states would be obliterated by bankruptcy. Clearly the political-banker elite cannot permit this to happen. The need for constant inflation is not, therefore, something that is necessary for economic growth and the wellbeing of the general public. Rather, it is necessitated by the asset-liability mix brought about by previous inflation which would threaten the existence of large, establishment institutions if it was to reverse. They need more cheap money, more theft of your purchasing power, in order to keep their assets rising and their liabilities from doing the same. The deflation myth, therefore, is nothing more than a part of the big statist fraud, benefitting a select few and the expense of everybody else.

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1Although the failure to overcome this was not from want of trying – see Murray Rothbard, America’s Great Depression, Part III, where he argues that the deflation was the result of factors that negated the inflationary response of the government and the Federal Reserve.

2Although mortgages, which were a heavy factor in the 2008 financial crisis, are dollar denominated, the security behind the loan – the amount the lender will receive in the event that the borrower can no longer pay – is the house that the mortgage has been used to purchase. This asset is merely dollar quoted and hence during a deflation the value of the security of a bad mortgage will dissipate and with it any chance of recovery at par for the mortgagee.

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 #1 – Rising Prices = Recovering Market

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One of the positive indicators of our so-called economic recovery bandied about not only in the media but also by our monetary lords and masters at the head of central banks is the idea that rising prices (particularly in the housing market) are a sign of economic recovery. This mistaken belief is part of a wider myth that views the economy as a big number, a number which, if going up, means things are good and getting better, and if going down means the situation is bad and getting worse.

Theoretically the market price for any good is never “good” or “bad”. It simply a function of supply and demand for that good. However, if anything, relatively high prices indicate a scarcity of goods relative to the money used to buy them rather than an abundance. This situation may be a localised boon to those who are in the business of selling the scarce good, but for those of us on the other side of the transaction having to pay more hardly suggests a general increase in our prosperity. For if society is getting wealthier and producing more goods we should find that we are be able to buy more with the same amount of money rather than less – hence, prices should decline and not rise.

What is of course meant by the “recovery” of rising prices is precisely a localised recovery and improvement for a select group of people – those who borrowed cheap money heavily during the boom (mostly the politically connected big banks and investment houses) and ploughed it into assets. They can now breathe a sigh of relief as the prices of those assets once again begin to rise with the new round of monetary inflation. The rest of us, on the other hand, have to sit by and watch the purchasing power of our wages drop, unable to continue to afford to buy things because the “recovering” prices put them out of our reach.

A general recovery is not based upon rising asset prices buoyed up by paper money. It is created by a sound monetary order that allows entrepreneurs to allocate resources to where they are most urgently desired by consumers. The result should be a gradual secular price deflation, so that the money in the hand of the lowest earners gradually increases in value, enabling everyone and not just the super rich to grow wealthier and more prosperous.

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“Austrian” Business Cycle Theory – An Easy Explanation

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Against the simple and straightforward siren song of “underconsumptionist” and “underspending” theories of boom and bust, “Austrian” business cycle theory (ABCT) can seem contrastingly complex and lacking in communicability. The former types of theory, associated with “mainstream” schools of economics, in spite of their falsehood, are at least advantaged by the veneer of plausibility. A huge glut of business confidence and spending will, it seems, naturally lead to an economic boom, a boom that can only come crashing down if these aspects were to disappear. For what could be worse for economic progress if people just don’t have the nerve do anything? Add in all the usual traits of “greed” and “selfishness” with which people take pride in adorning the characters of bankers and businessmen (again, with demonstrable plausibility) and you have a pretty convincing cover story for why we routinely suffer from the business cycle. ABCT, on the other hand, with its long chains of deductive logic, can seem more impenetrable and confusing. Is there a way in which Austro-Libertarians can overcome this problem?

“Austrian” economics is unique in that all its laws are deduced from a handful of self-evident truths, the most important being the action axiom, often peppered with a few additional assumptions or empirical truths (such as the desire for leisure time). The entire corpus of economic law – right from the isolated individual choosing between simple ends all the way up to complex structures of production, trade and finance – therefore forms a unified and logically consistent whole. This is not true, however, of “mainstream” schools of thought which tend, nowadays, to be splintered and scattered into separate, specialised areas of study that are based upon their own, individual foundations. The fissure between so-called “microeconomics” and “macroeconomics” is a prime case in point; while “Austrians” will read much that is agreeable in “microeconomics” (although it still contains many faults and general misunderstandings resulting from the lack of coherence and soundness that is furnished by deduction from the action axiom), “macroeconomics”, on the other hand, seems to be a completely different ball game, considering only “the economy as a whole” without reference to its individual components1. It is this fact that “Austrians” can use to give them the upper hand when explaining the business cycle. For in ABCT, the explanations of “macro” phenomena are little more than an extension of what is found in “micro” price theory.

The market price for a good is the price at which the quantity demanded equals the quantity supplied. Prices therefore serve to ration goods as a response to their scarcity, the goods available being traded from the hands of the most eager sellers to the most eager buyers. Those buyers who are not willing to pay the market price will go away empty handed and those sellers who are unwilling to sell at the market price will not be able to get rid of their goods. What happens, then, if this relationship is disturbed by a forced fixing of prices by the government? First, if the price is raised above the market price to create a price floor, the new price will attract more sellers into the market for that good because the price that they will receive for a sale is now the price at which they are willing to sell. However, at this heightened price there are fewer people wishing to buy the good. Some, who were not previously prepared to pay the lower, market price, are certainly not going to pay the higher price now. And those who would have paid the market price before may now decide that the new price is too high so they also do not buy. What results, therefore, is an increase in sellers and a decrease in buyers which can lead to only one thing – a surplus of unsold goods. The sellers may be very eager to sell at the new price but they will have a hard time finding anyone to sell to. Secondly, the opposite case, where the price is lowered below the market price (a price ceiling) creates, as one would expect, the opposite effect. This new price will attract more buyers into the market for that good because the price that they will pay for a purchase is now the lower price at which they are willing to buy. However, at this lowered price there are fewer people wishing to sell the good. Again, some, who were not, before, prepared to sell at the market price, are certainly not going to sell at the lower price now and those who would have sold at the market price may now decide that the new price is too low so they also do not sell2. What results, therefore, is a decrease in sellers and an increase in buyers which, clearly, leads only to a shortage of goods. Buyers will swarm into the marketplace eager to purchase the articles at the new, attractive price but, to their dismay, the shelves will be empty, cleared out by all of the more hasty buyers who got there before them3.

It is this latter scenario – that of artificially lowered prices – that is relevant for ABCT. For the business cycle is, according to “Austrians”, little more than price fixing on the widest scale, the fixing and the manipulation of what is possibly the most important price in the economy – the interest rate on the loan market. Rather than being the price at which a single good is traded, the interest rate is the price at which saved funds are borrowed and lent (i.e. demanded and supplied) in the economy.

When the stock of money is fixed, if one person wants to borrow (demand) money then another must have saved it in order to lend (supply) it. The resulting rate of interest is the point at which the quantity of money saved/lent equals the quantity of money borrowed. Any borrowers who want to borrow at a cheaper rate and any sellers who want to lend at a higher rate will find themselves priced out of the market for loanable funds, the sub-marginal buyers unable to borrow any money and the sub-marginal lenders unable to lend any. This situation produces a stable amount of saving, lending, borrowing and investment because the interest rate – the price of saved funds – is in harmony with the preferences of consumers, in particular, their preferences for allocating their funds towards either capital or consumer goods. The portion of his funds that the saver retains for consumption will be spent on consumer goods (i.e., present consumption) whereas the portion that he allocates towards saving and lending for investment will be spent on capital goods that will not provide any immediate consumption but will provide a greater amount of it in the future. At the market rate of interest goods and resources in the economy will be allocated in harmony with these desires. If, for example, a borrower wishes to borrow money to build a factory (a capital good) and his calculations reveal that the prevailing rate of interest is low enough for him to make a return on this enterprise, it means that savers are willing to lend a sufficient quantity of funds in order to make it viable. If, however, the prevailing interest is too high it means that savers are not willing to lend enough funds to build the factory – the money that could be spent on building the factory they would prefer to spend on their own, immediate consumption4.

What happens, then, if the rate of interest is set below the prevailing market rate? Exactly the same as what happens when prices are forcibly lowered for any single good. At this rate borrowers who before found the rate of interest too high for their ventures suddenly find that they can afford to borrow. The quantity of funds demanded, therefore, will rise at this new, low price. Savers, however, will be less willing to lend at this price. Certainly if they weren’t prepared to lend at the previous rate of interest they will not be induced to do so by an even lower rate and some savers who were prepared to lend at the market rate will not be prepared to do so at the new, artificially fixed rate. The increase in borrowers and decrease in sellers, therefore, causes a shortage of saved funds, or at least it should do so. Why, then, does this shortage not materialise immediately at the point that the interest rate is fixed? Why aren’t the banks empty of cash and why can they keep on lending and lending and lending? Why can this situation perpetuate for years and end in a calamitous crash that causes almost unrelenting havoc?

This is where a degree of complexity enters the explanation. What is really being borrowed and lent is not money but, rather, the real goods and resources that they can buy. We said above that if someone wishes to borrow money another person has to have saved it. But what this really means is that the saver has to have worked to produce real goods and resources in order to earn that money. He then lends that money to the borrower and the borrower uses that money to buy those goods that the lender produced and diverts them towards his enterprise. If, of course, saving, lending and borrowing took place with real goods, or if the supply of money was fixed, then obviously a forced lowering of the rate at which these goods could be borrowed would result in their shortage very quickly. But the fact that the saving and lending takes place through the mechanism of an easily expanded paper money supply creates a clever smokescreen. For our entire financial system rests not on the principal of every pound borrowed requiring a pound to be saved, but rather that pounds can be “created” out of thin air by the central bank and lent out even though someone has not saved. By printing fresh money (or its digital equivalent) the volume of borrowing can expand without a corresponding expansion of the volume of saving. This easy ability to produce more money to meet the higher demand for borrowing means that the artificially low interest rate never causes a shortage of money as we would normally expect when the price of any other good is fixed below its market price. A second problem, though, is that the real goods that this new money can buy have not increased in line with the increase of the supply of money, but, rather, have remained constant and there is, therefore, still only the same quantity of goods that have to be allocated towards either consumption or investment. Surely the artificially low interest rate will mean that there will be a shortage of real goods to devote towards investment?

Unfortunately, at the beginning, this is not so. For the newly printed money transfers purchasing power over goods out of the hands of those holding existing money and into the hands of those who have the new money. The result of this is that the borrowers of the new money – those who want to devote the goods purchased to capital investment – now have an advantage over those who wish to devote them to consumption. Let’s say, for example, that I earn £1000 in a given month. This means that I have worked for and created real goods in the economy on which I can spend this £1000. Let’s say that I allocate £750 towards consumption and £250 towards saving and investment. Therefore, what I want to achieve is to consume 75% of the goods on which I can spend the money and save and invest 25%. This £250, the 25% of the goods I wish to devote to saving and lending constitutes supply in the loan market that will help to set the market rate of interest. We can illustrate this allocation accordingly:

Consumption  £750   75%

——————————

Saving          £250   25%

——————————

TOTAL           £1000  100%

If, however, a commercial bank depresses the interest rate and simply prints an extra £500 to meet the new demand at this lower rate, what has happened now? There has been no change, remember, in the quantity of goods – the new money must be still be spent on these goods. The purchasing power of the existing money that I wished to spend on consumption therefore reduces and that of the new money that is to be spent on lending and investment correspondingly increases. All that happens therefore is that the proportion of goods that can be devoted to lending and, hence, to investment has now been forcibly increased from £250 to £750 – and increase from 25% to 50% of the new total stock of money, thus:

Consumption  £750   50%

——————————

Saving          £250   17%

New Money    £500   33%

——————————

TOTAL           £1500  100%

Newly printed money that enters the loan market therefore forces the economy onto a different consumption/investment ratio from that which is desired by consumers. The poor consumer will find that the newly created money has caused the prices of goods to rise; he is forced, therefore, to curtail his consumption in real terms. The goods that he can no longer afford to buy and consume will be purchased by the new borrowers who will devote them towards their capital enterprises. It is for this reason that none of the expected effects of price fixing occur and the economy proceeds along what appears to be a sustainable boom in capital investment. The problem, though, is that capital projects usually take several years to complete and rely on a continuous supply of goods throughout this time. But consumers don’t want to save voluntarily the amount necessary to complete these projects. The interest rate must therefore be constantly kept low and the new money reeling off the printers to meet it if the projects are to continue. It is only down the line when price inflation inevitably begins to accelerate and the central bank forces an increase in the interest rate and a corresponding reduction in growth of the money supply that the problems are revealed. For now the consumption/investment ratio once again begins to reflect the preferences of consumers – they want, if we remember, more consumption and less saving which means that lending and investment has to reduce. Hence half-finished capital projects have to be left incomplete. They have been starved of the resources necessary as they can no longer afford to purchase them at the new rate of interest. This precipitates a collapse in the prices  of capital assets, a collapse that causes widespread bankruptcy and liquidation of firms and enterprises that, hitherto, had seemed sustainable and profitable. Ludwig von Mises describes the perfect analogy:

The whole entrepreneurial class is, as it were, in the position of a master-builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder’s fault was not overinvestment, but an inappropriate employment of the means at his disposal5.

Mises’ last sentence is important. As the prices of capital goods were accelerating upwards during the boom and then suddenly come crashing down, there is a temptation to analyse this as “overinvestment”. While this is true and that “too much” has been devoted to long term investment projects it should be clear from our analysis that the real problem is malinvestment – a diversion of resources from desired consumer goods to capital goods.

Observant readers might say that it is actually the return to the market rate of interest and not the fixed rate that has caused the sudden shortage of capital goods. This would not be a correct interpretation. Artificially lower prices always give the illusion of plenty, of abundance and availability for everyone. It is just that with the fixed price of a particular good the illusion becomes obvious more quickly. But with fixing the rate of interest, because it takes effect through the mechanism of money, the illusion of plenty is obscured and, for a time, looks very sound. For this new money has the very real ability to divert resources away from consumption towards capital investment. Nothing more has been created but it looks like there has. Couple that with price inflation with higher nominal wages and people, at least, think that they are better off than they were before the “miracle” of artificially low interest rates. Real abundance and plenty, however, would not merely divert resources from consumption. Rather, resources for capital investment would exist independently of and in addition to those desired for consumption, as dictated by the desires of consumers.

Conclusion

What we have seen, therefore, is that ABCT sits coherently with the examination of individual price action and is little more than an extension of it. The business cycle is simply a case of price fixing writ large, causing widespread waste, chaos and misery when its effects are finally revealed. There are no separate bases or foundations of this “macro” sphere of economic theory. There are, however, certain special features that make this form of price fixing especially insidious and long-lasting – that of the easy ability to print fresh money to meet the new, low rate of interest, permitting purchasing power to be transferred to new borrowers and, hence, the real diversion of resources. As soon as this situation ceases the smokescreens vanish to reveal the waste and futility of these diversions.

Whenever, therefore, one has difficulty in either understanding or explaining ABCT, think back to what you know about simple price fixing. In fixing the rate of interest, the most important price in the economy, “Austrian” economics, with its strict deductive logic from the action axiom, will tell you that the results will be the same.

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1Murray N Rothbard, Man, Economy, and State with Power and Market, p. 269 (n. 19).

2This isn’t just stinginess on the part of sellers; rather, the cause of their unwillingness to sell will be, in the long run, that they simply cannot – the lower price will usually not be sufficient for them to recoup the costs of production so they have to abandon the particular line altogether.

3These results were seen during the high inflation of the 1970s in the US when price controls led to long queues at gasoline station because the demanded quantity of gasoline could not be supplied at the artificially low price.

4An interesting question is whether the interest rate may strictly be considered a “price”. In the exchange of goods, the price of a good is the quantity of another good that is fetched in exchange. For example, if one apple sells for two oranges, then the “orange” price of an apple is two oranges (and the “apple” price of an orange is 0.5 apples). In the complex economy, of course, every good is exchanged for money so we always reckon prices in terms of the quantity of money received in exchange. However, whatever the other good that is received, it makes no sense to compare the two physically heterogeneous goods in terms of magnitude. For how does one calculate the “difference” between two apples and one orange, or between £2.00 and a bag of oranges? In the exchange of a present good for a future good, which is what happens in the loan market, this is not the case, however. If a borrower agrees with a lender to borrow £100 today and to pay back £110 in one year’s time, strictly the price of one unit of present money is 1.1 units of future money (or the price of 1 unit of future money is approximately 91p of present money). But because the two goods are physically homogenous we can compare the two magnitudes – 1.0 and 1.1 – in order to derive a rate or ratio between them of 10%. We would therefore state that the interest rate per annum in this scenario is 10%. This rate is therefore not strictly a price but an expression of two prices – the price of present money in terms of future money and the price of future money in terms of present money. However, it should be clear that a manipulation of the rate of interest would have the effect of fixing the actual prices of present and future money. If, for example, the interest rate is forcibly lowered to 5% then the price of one unit of present money is now 1.05 units of future money rather than 1.1 units of future money. The resulting effects of price fixing will therefore be felt in this scenario. Hence, it makes sense to speak of the rate of interest as a price just like any other and, indeed, this is how it is treated by acting humans in the loan market.

5Ludwig von Mises, Human Action, p. 557.

Money, Inflation and Business Cycles – The Pricing, Profit and Loss System Explained

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Against all of the fallacious forms of “under-consumption” theories of boom and bust Say’s law stands as a charming and simple rebuttal. Wrongly and ignorantly described as “supply creates its own demand”, a better and accurate formulation is “goods are paid for with other goods”. In short, while recognising that money is emphatically not neutral and is itself a good, goods are supplied by an individual (demand) in return for money, the latter of which is then used to buy other goods (supply).

This essay will use Say’s Law to illustrate that what is meant by “under-consumption” is, in fact, not a dissatisfaction with consumption (or rather purchasing) per se, but rather that the precise structure of production is not in harmony with the valuations of consumers; the distortion of this structure at the height of the boom proceeding to a bust is only the most extreme of this type of instance.

Say’s Law

While emphasising again that money is not neutral and its status as a good in its own right does have an effect on the structure of production, money does not in and of itself constitute demand. Rather, your demand is the goods that you have to offer for sale in the first place as it is these real goods that sustain the supplier in producing what you buy from him in turn. How productive you are determines the effectiveness of your demand as revealed in the precise exchange ratio – if the goods with which you demand are highly valued they will be able to buy more; if they are valued lower they will buy less. In reality this exchange ratio takes place not directly but through the money mechanism. For example:

1 apple          sells for         20p

20p              buys             1 orange

The mere possession of money in this scenario does not constitute demand. For in order to gain money to demand oranges a person must first have supplied apples and the amount of money he receives will be determined by his productivity in producing apples – the more productive he is the more money he gets which in turn allows him to demand more oranges. His demand is linked firmly to his original ability to produce and supply apples. It is not therefore that 20p, the money, is the demand for either one apple or one orange. It is, rather, that one apple will demand a supply of one orange1. In other words, the price of a single apple is one orange and the price of a single orange is one apple.

It follows, then, that if changes in the relative valuation occur between goods then this will be reflected in the exchange ratio between these goods. If, for example, oranges decline in value relative to money yet apples maintain their value relative to money a future exchange rate might be as follows:

1 apples        sells for         20p

20p              buys             2 oranges

In other words, whereas before one apple could buy only one orange, the value of oranges has declined so that now one apple can buy two oranges. Any change in valuation of a commodity therefore necessarily takes effect as a change in the exchange ratio between goods.

Supply, Demand and Prices

In the first place we must be somewhat suspicious of any theory that tells us that there is any under-consumption, i.e. that there is a general glut of everything. For it is suggesting that we suddenly find ourselves in the position of having too much stuff. But this is nonsensical even without any analysis for it implies that humans have suddenly stopped desiring; but human wants are insatiable and we are always striving for more. So engrained in our own experience is this fact that it seems pointless to try and prove it – an abundance of goods, all else being equal, is a cause for celebration rather than for alarm.

If we dig deeper what is really meant when there is a “general glut” is that the costs of producing goods cannot be recouped by their selling revenue, in other words that all goods are experiencing losses. But this is nonsensical because the very existence of a cost means that there is an alternative use for the capital goods that produced the final good – if a loss is experienced then it means that some other good was more highly valued than the good that was in fact produced. It is therefore impossible for there to be a general glut of all goods as the very reason for the glut – the existence of costs – presupposes that there is a demand for some other good. But if capital was misdirected and should have been used to produce another good then it follows that there is not a glut of this latter good at all but a relative shortage.

Let us take a hypothetical economy where all the only goods are fruit. Let’s say that there are twenty apples, twenty oranges, twenty bananas and twenty pears. Let us also say that it takes the use of one unit of a piece of fruit to produce a single unit of another piece of fruit and so that, in equilibrium, the exchange ratio of the different fruits will be as follows:

20 apples:20 oranges:20 bananas:20 pears

I.e., that there is a final exchange ratio of 1:1:1:1. When one fruit trades for a single fruit, there are no profits and no losses. If the apple producer, for example, trades ten of his apples for ten oranges, he can use them in production for ten more apples – in short, the cost of ten apples has yielded a revenue of ten apples. The same is true of the orange producer – he has bought ten apples with oranges which he used to produce ten more oranges, a cost of ten oranges netted against a revenue of ten oranges. Total profit and loss is zero and the economy is in a state of equilibrium.

What happens if the above numbers are multiplied – i.e. if there are forty, sixty, one hundred, one thousand or one million of each fruit? Does it make any difference? Not at all as one fruit will still trade for one other fruit which can be used to produce another piece of fruit. No fruit will be able to sell at a loss (or at a profit) and nothing will remain unsold. More of each fruit in the same ratio simply indicates a more prosperous economy than one where there are fewer pieces of each fruit.

What about, however, where the ratio of fruits is altered? Let’s say that, instead of there being twenty of each fruit there are, in fact, 10 apples, 10 oranges, 30 bananas and 30 pears. It still takes one of each fruit to produce one other fruit (i.e. the demand curve has not shifted). So what has happened to our exchange rate? It will be as follows:

10 apples:10 oranges:30 bananas:30 pears

In other words, 1:1:3:3. So now, one apple will still trade for one orange, but for three bananas or three pears. But as the production of one piece of fruit still requires only one piece of another fruit there will now be relative profits and relative losses. The apple producer, for example, can now use one apple to buy three bananas with which he will make three apples – a cost of one apple versus a revenue of three apples. The same is true of the orange producer. The poor banana producer, however, suffers. He has to spend three bananas to purchase one apple with which he can only produce one banana – a cost of three bananas versus a revenue of one banana. The same is true of the pear producer. We therefore have an instance of there being two fruits – bananas and pears – that are unable to sell for enough in order to cover their costs. But this is not a general glut, for we also have two fruits whose revenue more than covers their costs. Resources will flow out of banana and pear production and into apple and orange production, increasing the number of apples and oranges while decreasing the number of bananas and pears. The result of this is that the purchasing power of apples and oranges will fall again and that of bananas and pears will rise again, reducing the profitability of the first two industries and the losses of the latter two. This will continue until an equilibrium is restored with an exchange ratio of 1:1:1:1 and no industry is either profitable or loss making.

The result then is that there can never be a general glut of all goods, but rather specific gluts of particular goods that were not preferred mirrored by specific shortages of other goods. And as we know from our analysis of Say’s Law above these costs are ultimately expressed in terms of other goods relative to each other, i.e. the exchange ratio will widen as their values diverge.

How does this happen on the real market? Obviously gluts and shortages don’t just appear as they did in our example above; but rather, they result from the ever-shifting demand curves of consumers which have to be foreseen by entrepreneurs. For example, if entrepreneurs invest heavily in apples when in fact the public wants oranges, the capital that would have produced oranges is diverted to apples. The resulting glut of apples and relative shortage of oranges may mean that it takes five, ten or twenty apples in order to demand a single orange. If this low selling price for apples is insufficient to pay the costs of production while the high selling price for oranges results in a bumper profit for the foresighted entrepreneurs who stuck to producing oranges, then it follows that resources will flow out of apple production and into orange production until an equilibrium is restored where both apples and oranges will exchange at a ratio where they are both able to cover their costs of production.

However, as the valuations of consumers are always changing the hypothetical state of equilibrium will never be reached and there will always be relative gluts of some goods that have been overproduced and relative shortages of goods that have been under-produced.

Nothing about any of this is a cause for alarm – it is the task of entrepreneurs to adjust the structure of production to the tastes of consumers and in the normal run of the mill, so to speak, nothing about this will cause any great or dire need for concern. What we shall see, however, is when there is monetary intervention in the forms of inflation and credit expansion, very wide dislocations between the goods that are demanded and those are supplied occur, leading to extreme gluts and shortages. The analysis of these instances is no different from simple dislocations, but what will be revealed is that any attempt to “boost demand” merely ends up perpetuating the production structure that is failing to meet the ends of consumers in the favour of those producers who are selling loss-making goods.

Simple Inflation

At any one snapshot of time there is a fixed stock goods in the economy. Let us return to our hypothetical fruit economy with the same stock of goods and the same exchange ratios so that

20 apples will buy 20 oranges, or 20 bananas, or 20 pears.

In other words there is once again exchange ratio of 1:1:1:1. In the economy where money has to be earned, no one can spend without first producing real goods. So if a melon producer now produces sixteen melons and (once again, assume that one melon exchanges for one piece of any other fruit) and decides to purchase with them sixteen apples, the stock of goods in the economy will now be four apples, sixteen melons, twenty oranges, twenty pears and twenty bananas. The exchange ratios will be thus:

4 apples:16 melons:20 oranges:20 bananas:20 pears

While apples have now become more expensive relative to any other fruit (a whole five oranges, for example, is now needed to purchase one apple whereas before only one was needed), melons have become cheaper relative to any other good. Overall, therefore, what has been lost in apples has been gained in melons.

The additional purchasing power of apples caused by the demand of the melon producer spurs the apple producer into producing more. What can he do? As he has sixteen real melons he can use these in the production of sixteen more apples, thus restoring the total stock of goods to twenty apples, twenty oranges, twenty bananas and twenty pears. There has therefore been a productive exchange on the market. What was demanded by the melon producer in apples was supplied by him in melons, permitting the apple producer to fund his subsequent production of more apples. Crucially, however, as the purchasing power of other fruits was not diminished the profitability of these industries did not decline and they could carry on as before.

The fact that all of the exchanges take place in the real economy through the medium of money is of no consequence to this analysis. For in reality, the melon producer would have sold his melons to a third party, X, for money and then used the money to purchase the apples. X might have used the melons to produce pomegranates and then the apple producer uses his money received from the melon producer to buy pomegranates, the latter being used by him to produce more apples. The important point is that goods are trading for other goods and that the production of new goods must be funded by other goods.

What happens, then, when new money is printed? Is it possible for economic prosperity to be delivered by the printing and spending of new money? Let us return to our original array of goods – twenty apples, twenty oranges, twenty bananas and twenty pears. If the Government prints more money it has to spend it on these existing goods. Let’s say that, with the new money, it decides to buy sixteen apples. Does this new money in the pockets of apple producers entice it to spend more, which in turn causes their suppliers to spend more and so on until we reach ever dizzying heights of prosperity? No. For the problem is that no new real good has been supplied by the Government in return for its purchase and consumption of apples. Whereas the melon producer compensated for his consumption of apples by producing melons, all that has happened when the Government has printed more money to spend on apples is that the total of stock of all goods has declined by sixteen apples. As the stock of apples has declined relative to other goods the purchasing power of apples has risen accordingly. Instead of twenty fruits now trading for twenty others we now have:

4 apples:20 oranges:20 bananas:20 pears

What is the result of this? As the purchasing power of apples has now risen it means that this industry has become extremely profitable – with a single apple can be purchased five of any other fruit which can be used in production of five more apples, i.e. a cost of one fruit producing a revenue of five. All of the other industries, however, have now suffered relatively rising costs and lower revenues as they will each have to spend five fruits to gain one apple which will in turn produce only one of their particular fruit. What happens, once again, therefore is that resources will shift out of the orange, banana and pear industries and into the apple industry, reducing the relative surplus of the first three fruits and relieving the relative scarcity of apples. This process will stop when none of the industries can make either a profit or a loss, i.e. when one fruit again exchanges for one fruit. The shortest way for this to occur is for the apple producer to purchase four oranges, four bananas and four pears and to use them in the production of a total of twelve apples. The resulting array of goods will now be as follows:

16 apples:16 oranges:16 bananas:16 pears

What therefore is the result of the inflation? It is simply a reduction of the total number of goods available in the economy. Whereas before there were twenty pieces of each fruit now there are only sixteen. The Government, in failing to compensate for its consumption of apples with a supply of real goods in return, has simply reduced the total stock of goods by sixteen fruits. The earliest receivers of the new money, therefore, have received a benefit – the Government by being able to buy apples it hasn’t paid for in other goods and the apple producer by being the favoured receiver of the Government’s new money is ensured continuous profitability as its selling prices rise before its buying prices do. For everyone else, however, who receives the new money later, buying prices have risen faster than selling prices. They experience losses and a relative degree of impoverishment. Finally when the effects of inflation have worked themselves through the economy the result is a net loss for the economy as a whole.

This would be the effect of a one-shot inflation – the structure of production being left relatively intact but at a lower level. Things are much worse, however, when the inflation is continuous. For now, the Government keeps on buying apples with its newly printed money and not refunding this consumption with any real goods. What will happen, therefore, is that apples will be in continuous short supply relative to other goods and resources will continuously shift out of the production of other fruits and into apple production. The fruits furthest away in the supply chain from apples will suffer the most and eventually go out of business as their fruits remain permanently in high supply relative to the artificially created shortage of apples. There will be a permanent change in the structure of production in favour of the Government and its preferred suppliers at the expense of everybody else, resulting in an overall loss and reduction of total goods.

The Business Cycle

Whereas in our example of simple inflation the dislocation to the structure of production took place between different consumer goods, when it comes to the business cycle the disharmony caused is that between the demand of two classes of goods – consumer goods and capital (producer) goods. The artificial credit expansion fuelled by monetary inflation deludes entrepreneurs into thinking that more resources should be channelled into producing capital goods and fewer resources should be devoted to producing consumer goods, against the real wishes of consumers. Resources flow out of consumer goods and into capital goods. The end of the monetary inflation reveals the illusion – consumers did not have a rate of time preference and consequent rate of saving that makes the investment in capital goods profitable. The resources devoted to the production of capital goods should have been directed towards the production of consumer goods. There is, therefore, a specific glut of capital goods and a specific shortage of consumer goods. From Say’s law what this means is that consumer goods will command a high selling price in terms of capital goods and capital goods will command a low selling price in terms of consumer goods. Resources need to flow out of capital good production and into consumer good production until an equilibrium is restored where both are meeting their costs.

Indeed, economic crises are always crises of capital and not of consumer goods. This fact is often masked by the nominal price inflation of the boom accompanied and the subsequent deflation of the bust as the supply expands and contracts respectively. During the boom it is true that all prices, those of capital and consumer goods, rise and so there is a tendency to think that there is an all round prosperity. But what is really happening is that the prices of capital goods rise faster than those of consumer goods, so that there is a shift in the real price relationship (expressed in terms of goods) between consumer goods and capital goods. Once the bust happens, there is a corresponding deflation of all prices leading to the apparent view that the entire economy is suffering. But the reality is that the prices of capital goods decline faster than those of consumer goods so that, in real terms, the prices of consumer goods rise and those of capital goods fall as resources move out of the latter and into the former.

Indeed it is ironic that under-consumptionists view the alleged “problem” of the bust as a lack of consumption causing economic stagnation. For the reality is that there is no problem with consumption at all and it is in fact the desire for consumption that has been frustrated during the boom. If anything there needs to be less consumption and more saving so that the relative shift of goods out of the capital goods industry is less severe and at least some of the projects that were embarked upon in the boom may have a chance of achieving profitability (hence Government deficit spending – rampant consumption – only makes the bust even more painful). But unless that is desired by consumers it is futile to go on inflating and pumping in more credit as the structure of production that is so out of kilter with the desires of consumers is simply perpetuated as a lifeless zombie.

The Demand for Money

Up until now we have been considering cases where the relative gluts and shortages in the economy are between real goods with money serving only as an intermediary between goods. However money, or more accurately, the desire to hold money is itself a good that serves an end in its own right. Money is the most marketable of all goods and holding it provides a degree of reassurance that holding other goods does not. The desire to hold a larger cash balance, all else being equal, therefore reveals a degree of uncertainty on the part of its owner, an uncertainty that is hedged by the ability to quickly use cash to exchange for whatever goods and services are needed in the period of uncertainty. Holding money therefore in and of itself providers a satisfaction in much the same way as a real good does. So what happens, then, when the relative gluts and shortages involve not surpluses of goods against shortages of other goods, but surpluses of goods against shortages of money? In other words, when the demand to hold cash rises? Surely now our under-consumptionists can hold validly that everything will remain unsold as everyone scrambles to soak up more cash and the whole economy will collapse into a depressing slump?

The simple, and orthodox, “Austrian” answer to this apparent problem is that if the demand for cash suddenly rises then everyone must sell goods. The sudden influx of goods onto the market increases their supply resulting in a reduced price of each good in terms of money. But in terms of the ratio of goods to goods there needn’t be any change at all. For example, if the following exchange ratios existed before the demand for cash rises:

1 apple          sells for         20p

20p              buys             1 orange

The ratio of the apple to the orange is 1:1. But if the demand for cash suddenly rises such that the money prices of all goods declines then the following exchange ratio may result:

1 apple          sells for         10p

10p              buys             1 orange

Whereas the exchange ratio between goods and money is now lower, the exchange ratio between goods is the same. Exactly the same real trade in terms will therefore take place, just at lower money prices.

Indeed it is for this reason that deflation is not a problem for the running of business. For what matters for businesses is neither rising nor falling prices but the differential between their revenues and their costs. If both their revenues and their costs are falling then it is still possible to make a profit and to expand business. Indeed, the period between the dawn of the Industrial Revolution and the eve of the New Deal era was generally one of a long, secular deflation and this was the most productive period in the whole of human history.

However the story is not so straightforward for it is in fact true that a greater demand to hold cash changes the structure of production but not its level. As we noted earlier, cash is it self a good and the demand to hold cash is itself an act of consumption. An increase in the demand for it is, therefore, an increase in consumption and results in a higher societal time preference and a rise in interest rates. Indeed this makes intuitive sense. If the holding of a cash balance is a hedge against uncertainty, a higher degree of security will be accompanied by a willingness to engage in more roundabout methods of production and to exchange present money for assets that promise to pay a greater amount of money in what is, relatively, a certain future. If that certainty disappears, however, people begin to prefer liquidity today rather than liquidity tomorrow, curtailing their investment in future goods and selling them for cash now. Societal time preference and, therefore, the rate of interest rises. The selling price of the monetary commodity – e.g. gold or silver – will rise while its costs of production will fall, so that resources will shift into the gold or silver mining industry in order meet the new demand for money. There is therefore no reduction in production, merely a shifting of production out of lengthier, roundabout production processes and into the production of a) the monetary commodity, and b) lower order producer goods and consumer goods that can quickly be bought with the hoarded money when adverse conditions arise2.

Societal Profits and Societal Losses

The foregoing analysis gives the impression that a profit that appears somewhere in the economy (i.e. a relative scarcity) must be offset by a loss somewhere else in the economy (i.e. a relative glut). Is it true, therefore, that societal profits are always mirrored by societal losses?

Accounting profits are an excess of revenue over cost – that a firm has paid out less money that what it has received. Losses are the opposite, a firm paying out more money than what it receives in revenue. If all cash income was added to a firm’s profits and all cash expenditure added to its losses then it would be true that societal profits would equal societal losses as no firm could receive more in revenue than it paid out in expenditure without somebody, somewhere, paying out more in expenditure than they received in revenue in order to fund this difference. Indeed, the social function of all entrepreneurs is to arrange the structure of production in a way so that it best meets the needs of consumers. The decisions they make have to be made in advance, resulting in an appraisal of what it is that consumers will value tomorrow. They subsequently set about incurring costs by purchasing factors of production that they arrange into a production structure that they think will best meet the needs of consumers. If all of the entrepreneurs managed to arrange, on day one, the production structure exactly as consumers wanted it on day two, come that latter day revenue would exactly equal cost. The entrepreneurs would have utilised just the correct quantity of factors and have produced just the right quantity of specific goods that consumers were willing to pay for. No one entrepreneur would have bought too many producer goods and deprived an alternative end of their use, nor would any entrepreneur have bought too few producer goods and permitted too much of their use to alternative ends3. In reality, however, this state of apparent perfection is never reached and the resulting structure of production is never completely in tune with the valuations of consumers. Every structure of production is begat by a forecast, a prediction, or empathetic understanding of the businessman for his clients. It therefore never quite hits the mark and some goods will be relatively over-produced while others will be relatively under-produced. If a firm overproduces then the revenue it received was insufficient to pay for the factors of production, in other words that there were competing ends that were bidding up the prices of these factors and that the firm starved these ends of their means of production. A loss cannot materialise therefore without a corresponding underproduction elsewhere, meaning that revenue for these latter goods was more than sufficient to pay for the factors of production, in other words that these entrepreneurs did not bid up the factors enough to starve the loss-making ends of superfluous production.

So is it true, then, that every successful, profitable businessman is riding high on the losses of someone else? That for every entrepreneur arriving to work in a chauffeur-driven limousine another has been relegated to taking the bus?

Not at all, for it is entirely possible for societal-wide profits (and societal-wide losses) to emerge. This is owing to the capitalisation of durable producer goods. As a durable good is expected to produce revenue-generating consumer goods not immediately but also into the future, the capitalisation of a producer good is the market value of that asset’s future revenue, discounted to allow for the fact that these revenues are future revenues and not present revenues. At the point of purchase, therefore, the good is not recognised as an expense of the purchaser but as an asset (and correspondingly the cash that paid for it will show up on the asset side of the balance sheet of the vendor). No cost at all is shown in the accounts of anybody. Rather, the cost of the good is recognised incrementally over its lifetime as it depreciates, i.e. its use in furnishing consumer goods renders lower its ability to produce goods in the future. Entrepreneurs therefore face a choice – to increase present production and increase present sales revenue but at the same time incur the cost of heavier depreciation charges; or to reduce production and preserve the capital value of the asset but reducing sales revenue. Once again, the entrepreneur has to appraise how many goods to produce today and how many to leave for production tomorrow. If the revenue received from expanding production is exactly equal to the depreciation charge of the capital good (plus other costs) it means that he has exactly produced the favoured amount of present goods at the expense of future goods. The market was willing to pay in present goods precisely what it lost in future goods. What, though, if there is a profit? This means that the revenue received is greater than the cost of depreciation, in other words, the entrepreneur withheld from production more present goods than the market was willing to pay for. Future production will therefore be higher but at the expense of present production. And correspondingly, if there is a loss it means that revenue was insufficient to pay for the cost of depreciation – the entrepreneur produced too many goods in the present when they were more valuable in the future.

Societal-wide profits and losses therefore emerge when collectively entrepreneurs under and overproduce, respectively, present goods. Profits represent entrepreneurial saving – the deferment of present production for future production – whereas losses represent entrepreneurial dis-saving – the ravaging of future production for the sake of present production. And as we know it is saving that is the hallmark of capital accumulation, the increase in production and ultimately a higher standard of living. Dis-saving, however, results in capital consumption, a decrease in future production and ultimately a lower standard of living4.

Does this mean, then, that “vicious” entrepreneurs can simply withhold from present production increasing numbers of goods, driving the profit rate higher and higher and spreading widespread misery? No, for in the first place this ignores the non-capitalised factors of production. If an entrepreneur reduces production in order to drive up profits then he also has to reduce his demand for these latter factors – including non-durable producer goods but especially labour. The cost of these factors will therefore decrease, leading to competitors to employ them, restore full production and reduce the market share of the abstaining entrepreneur. The same would also be true of a cartel. If entrepreneurs in concert decided to restrict production, swathes of non-capitalised factors would become available and eventually the cartel would break when one of the entrepreneurs takes advantage of the opportunity this affords. But the main effect of societal profits is that they afford the ability to expand production. For if depreciation charges are lower than revenue then it means that comparatively less has to be spent on maintaining the existing stock of capital. Entrepreneurs can therefore do one of two things – either expand the existing capital stock, in which case production of the same consumer goods will be increased, thus lowering their price and capturing market share from competitors; or they can invest in more roundabout production processes that will afford the ability to provide more newly introduced consumer goods that have never appeared before. A variant on the second option is that, as entrepreneurial saving represents a fall in societal time preference rates, the interest rate will also fall and new entrepreneurs whose projects were too costly before will now offer to borrow the saved funds and invest them in their more roundabout processes of production. Hence you get the famous “Hayekian triangle” – a production structure that becomes longer and thinner as resources are directed out of producing and maintaining the existing capital stock into producing new capital.

Indeed entrepreneurial profit is simply the corollary of private saving. In both cases an excess of revenue over cost means that consumption is denied to the present in favour of the future, these funds being diverted to new, higher stages of production that result in a greater outlay of consumer goods. The greater the profit margin in the lower stages then the greater this effect will be.

Obviously the opposite happens when profits are reduced – more has to be devoted to maintaining the existing capital structure with comparatively less being used on expansion. If losses are experienced then capital is actively being consumed as there are no funds at all left over to replace the existing stock once it is fully depreciated. Production therefore declines along with the standard of living.

Conclusion

It is clear then that under-consumptionist theories are nothing but a tissue of falsehoods. In summary:

  • Goods ultimately trade for other goods and the production of one good requires the use of other, real goods;
  • General gluts cannot arise on the market; only specific gluts and specific shortages which will become apparent through the price system and ultimately through the exchange ratio between goods;
  • It is the task of entrepreneurs to ensure that these gluts and shortages do not arise, the pricing, profit and loss system regimenting them in the fulfilment of this important function;
  • The business cycle is a specific glut of capital goods and a specific shortage of consumer goods on a wide scale; that the pricing, profit and loss system has been distorted by credit expansion leading entrepreneurs to believe that the economy can support a larger capital structure than it really can;
  • Increased demand for money does not have any effect on the level of production and is no cause for alarm; it may affect the specific structure of production but this is wholly in line with the valuations of consumers.
  • Profits and losses do not offset each other – societal profits and societal losses are possible. Societal profits indicate a lowering of the societal rate of time preference, leading to capital accumulation and the expansion of production; losses indicate a raising of the societal time preference rate, leading to capital consumption and a decrease in production.

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1We are, of course, ignoring for the purpose of this illustration the issue of constancy. For more on this see Ludwig von Mises, Human Action, pp. 102-4.

2Whether an economy is operating with a fiat money or a commodity money is what makes the difference between whether an increased demand for cash will leave the time-structure of production unchanged (as in our first scenario laid out above where the exchange rate of goods remains equal) or whether the time-structure will be changed. See Jörg Guido Hülsmann, The Demand for Money and the Time-Structure of Production, Ch. 31 in Jörg Guido Hülsmann and Stephan Kinsella (eds.), Property, Freedom and Society, Essays in Honor of Hans-Hermann Hoppe. See p. 322 for an explanation of how the shift in the time-structure of the economy that occurs under commodity money (but does not under fiat money) better serves the needs of consumers than a production structure that is left as it was before. All we need to note here is that with either fiat or a commodity money the level of production does not change and that there is consequently no depression of business brought about by under-spending or under-consumption.

3This is the hypothetical “equilibrium” state that seems to be the shibboleth of mainstream economists.

4It is, therefore, supremely ironic, let alone wildly inaccurate, that opponents of the free-market charge profit-seeking with the depletion and destruction of the Earth and its natural resources. This fallacy stems from always focusing on the fact that entrepreneurs want to maximise revenue while completely ignoring the fact that they also have to minimise costs. Profit indicates a saving of resources, not their depletion – the entrepreneur has advanced fewer goods than the market was willing to pay for. By incurring costs lower than revenue he has saved resources, not decimated them. It is precisely those assets over which full private property rights (and hence, their capitalised value) are available to the capitalist-entrepreneur that are not in short supply or at any risk of being depleted. For the ever present urge to reduce costs means that they cannot be depreciated more quickly than the market is willing to pay for, otherwise losses will be incurred. Those resources over which there are no private property rights, however – in particular forests, fish stocks, “endangered” animals – are precisely the ones where we experience a depletion. With no one able to enjoy the capital value of these assets and to incur the cost of their depletion against their revenue there is no reason to avoid their decimation.

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